# Econ

Assume an investor living in Italy can borrow in the domestic lira (ITL) or in the foreign French franc (FRF). Given the following information, determine whether an arbitrage opportunity exists. If so, how much would the investor profit by borrowing ITL 44,280,000 or the equivalent in FRF? (Assume a period of one year & state the profit in domestic currency terms). Spot rate (ITL/FRF) 295.20000 Forward rate (ITL/FRF) 299.10000 Domestic (Italian) interest rate (%) 5.00000 Foreign (French) interest rate (%) 3.50000 A) An arbitrage opportunity results in a profit of ITL 58,725. B) An arbitrage opportunity results in a profit of ITL 1,424,774. C) No arbitrage opportunity.

A

44,280,000 ITL * 1.05 = 46,494,000 ITL 44,280,000 / 295.2 = 150,000 FRF 150FRF * 1.035 = 155,250 FRF 155,250FRF * 299.1 = 46,435,275 ITL 46,494,000 - 46,435,275 = 58,725… A

Forward price = 295.2 * 1.05/1.035 = 299.47 > 299.1 so borrow FRF 44280000 ITL = 150000 FRF borrow 150000 FRF -> need to return 150000*1.035 = 155250 FRF convert to ITL 44280000 forward-> 46494000 convert at forward of 299.1 155466.33 profit = 196.339017 FRF = * 299.1 = 58275 ITL Choice A.

A is correct

299.10000/295.20000 *1.035 = 1.0486737804878 < 1.05 Borrow FRF Borrow 150000 FRF Payback 155250 FRF Lend 44280000 GetBack 44280000*1.05 = 46494000 ITL Convert at FR = 46494000/299.10000 = 155446.3390 FRF Settle: 155446.3390 - 155250 FRF Win: 196.339 FRF Or Win: 196.339*299.10000 = 58724.9949 ITL Ans A

I’m also going w/ A Profit I got in FF is 196.34

me too, phew!

Typically, I’ve seen that the if the profit would be quoted in terms of the currency you borrowed, in this case FRF, but it makes sense to be able to convert at the forward rate at that time. Good q