Econ Arbirtrage Question

CFA Level II
#1

USD/EUR Spot Rate is 1.2000.

Euro Interest rate = 2%

US Interest Rate = 4%

One Year forward rate = 1.2300

What is the arbitrage on a 1EUR investment?

A) $0.007

B) $0.123

C) $0.135

Is this a carry trade question? I was going to answer it as follows:

1 EUR today convert to USD1.2000

Grow $1.2000 at 1.04% to $1.248

Convert back to Euro at new rate of 1.2300 so $1.248/1.2300 = EUR1.0146

At this stage we also grow the initial 1EUR at 1.02% = 1.02.

How do we calculate the arb profit? Isnt it 1.0146 - 1.02 = -0.0054?

Thanks

#2

I would do it as follow:

1.2 * ((1.04)/(1.02)) = 1.2235

so arb is 1.23 - 1.2235 = 0.006471

meaning I would make it being a.

where is the question located?

#3

Sorry, I just realised this is a UIRP question. I was thinking it was a carry trade (!!) You are right, it is A.

Out of interest, can the carry trade solution reconcile with UIRP?

#4

Carry trade is risky.

Arbitrage is risk-free.