# Help with Covered Interest Abritrage

I am having a heck of a time with this topic. Any hints or ticks would be appreciated. I have no trouble identifying whether a arbitrage opportunity exists. But once I identify the opportunity I can never tell what currency I should borrow and lend in. Does anyone have any tricks for working through this?

aghhh. Just tried another problem and still can not figure out how to decide what currency to borrow in. Any help?

please post a problem or direct us somewhere- much more useful

I have USD:JPY spot at 116.35 and US Int rate of 4% and JPY Int rate of 1.5% Forward rate is USD:JPY 112.99 I have determined that the correct forward rate is 113.55 so it looks to me like the JPY is overvalued in the forward market and the USD is undervalued This is where I get fouled up. Now I have to decide if I should lend in JPY or lend in USD I think that that I should sell forward the JPY which means that I need to buy USD at the spot rate…but I am not sure

Here’s how I would do this: First, identify what is overvalued/undervalued: In this case, as you said, the Yen appears to be overvalued. Equivalently, the Dollar is undervalued. An arb opportunity exists on either side actually, long dollar or short yen. From a technical standpoint it doesn’t really matter. From a practical standpoint, lets take the perspective of our domestic currency, the Dollar (for me anyways). So we’ve identified the problem as being: The futures price is undervaluing the dollar. How can I take advantage of this? In this case, because the future is undervaluing the dollar, we want to buy the future. We have to keep in mind what this means: This means that I will be buying the dollar at the Futures price at maturity of the contract. In otherwords, I will have to have YEN to exchange for those dollars that I will be purchasing. Lets assume \$1M notional principal. What I will do then is borrow 1M at 4%, convert it at spot of 116.35 to receive Y116,350,000, and invest it at 1.5%. (NOTE: I have 0 risk here because I am long the forward which guarantees me that I can convert the YEN that I now have into 's at a pre-set rate) Now here’s how this goes down: - At maturity, my YEN investment pays off Y118,095,250. - Next, I will convert my Y118,095,250 into \$ at the contract rate of 112.99 for \$1,045,183.20 - I will now pay off my obligation to the bank that lent me the original \$1M which is \$1,040,000. And I’ve pocketed the difference of \$5,183.20 Points to keep in mind: 1. Identify overpriced/underpriced 2. Sell overpriced/Buy underpriced 3. Remember that in an arb situation, there should be no money out of pocket (why i borrowed 1m from the bank instread of fronting it) 4. Work backwards. We knew I wanted to buy the forward, which meant I needed YEN. This further meant that I needed 's to convert into Yen at the current rate. Since I needed \$, I borrowed them. We’re given the interest rates in the problem. It makes complete sense that I would borrow at my rate, and since I now posess YEN, I would invest them at the Japanese rate. 5. Work out what happens at maturity. My YEN’s pay off (principal X (1+r)). My YEN is exchanged at the contract rate, and then my obligation (principal X (1+r)) gets settled. Hope this helps! Donnie