Somebody needs to post the entire correct answer with calcs or I’m going to jam this pencil into my neck
agree with fsa-suckas calcs, that’s how i did it. 1) Borrow ADF, convert to USD spot, invest dollar After 1 year the payout is = .1432 * 1.072 = .15351 2) To cover ADF exposure on the forward date, you enter into a forward contract to buy 1.066 ADF(you borrowed 1 ADF, so you owe 1.066 ADF on the forward date) and sell 1.066 \* .1430 = .152438
I’m taking the covered interest rate parity equation, and taking everything over to one side in dollar terms: So F/S=(1+rd)/(1+rf) becomes (1+rd)- (1+rf)*F/S = 0 So the arbitrage profit in domestic currency is 1+rd (so the rate you can invest at) less (1+rf) * F/S (the rate you can borrow at). Does that make sense?
Ok this thread was pissing me off so I looked it up at Q-bank: Let us first check if an arbitrage opportunity exists. Applying the interest rate parity theorem, we have: Forward rate = 0.1432 x 1.072/1.066 = 0.1440 /ADF \> 0.1430 /ADF (quoted forward rate) This implies that an arbitrage opportunity exists. The inequality implies that ADF is mispriced (weak) in the forward market or is underpriced relative to the dollar. We should buy ADF in the forward market and sell the dollar in the spot market. This requires that we borrow in Andorra and convert the francs into dollars at the spot rate. Invest the proceeds in U.S. securities @ 7.2%, and simultaneously enter into a forward transaction where we sell the dollars for ADF @ 0.1430 $/ADF. Assuming that we borrow 1 ADF today and convert it into dollars, we will have 0.1432 dollars to invest at 7.2% for one year. After one year we will have 0.1432 x 1.072 = 0.1535 dollars. At that point, we will owe an Andorran bank 1 x 1.066 or 1.066 ADF, including interest. We will need to convert enough dollars at the forward rate to pay off this loan. At the forward contract rate, we will need to convert 1.066 x 0.1430 = 0.1524 dollars into ADF to pay off our obligation. This will leave us with an arbitrage profit of 0.1535 – 0.1524 = 0.0011 dollars. I’m just too tired now to read it.
Man, I feel dumb. I mean, I know all that stuff. This was a strength of mine in level I. The wheels are defintely falling off the bus. mcpass, thanks for posting that.
I still don’t quite agree because I think you need to discount your arbitrage profit in year 1 back to today. That’s your real arbitrage profit today.
thx chrismaths i did the same thing u did. didnt catch that last part
1.072*0.1432-(1*0.143)*1.066=0.001072 -> A
SR = 0.1432 USD/ADF FC = 0.1430 USD/ADF USD = DC -> IR(DC) = 1.072 ADF = FC -> IR(FC) = 1.066 Borrow Foreign i.e. Borrow ADF Borrow 1ADF (notional) Need to payback -> 1*1.066 = 1.066ADF Covert borrowed a ADF to USD at Spot Rate. 1ADF * 0.1432 USD/ADF = 0.1432USD 0.1432USD lend in USA getback -> 0.1432*1.072 = 0.1535104 USD Convert back USD to AFR using the Forward contract rate 0.1535104/0.1430 = 1.0734993 ADF GAIN = (1.0734993 - 1.066) ADF = 0.0074993ADF convert 0.0074993ADF to USD at the then Spot Rate (i.e. the Forward Rate) 0.0074993*0.1430 = 0.0010723999 = A … Have I done anything wrong here???
Hi Dinesh…this is exactly what I did… int rate is high in US and is appreciating ( invest in and borrow in ADF). Also, I did think about discouting this profit to find the PV but i went with the assupmtion of finding profit at the end of year ( may not be the most accurate assumption).
MCPass …isnt the formula supposed the SR = FR*(1+DCr/1+FCr) ?? Please clarify…
sparty419 Wrote: ------------------------------------------------------- > MCPass …isnt the formula supposed the SR = > FR*(1+DCr/1+FCr) ?? > > Please clarify… no, the formula is F = S (1+rD / 1+rF)
awesome, Dinesh
- IF (domestic rate - foreign rate) < (forward - spot / spot) then borrow domestic and lend foreign. IF (domestic rate - foreign rate) > (forward - spot / spot) then borrow foreign and lend domestic. 2. .072 - .066 = .006. 3. .143 - .1432 / .1432 = -.0013 4. In this example we borrow foreign and lend domestic 5. .1432 Andorran x 1.066 = .15265 (to be returned to Andorran bank after 1 year) 6. lend $1 to U.S., and after 1 year receive $1.072 7. Convert 1.072 back to Andorran at forward rate 0.1430 /ADF = .15329 Andorran 8. Subtract: (.15329 - .15265) = .0006 Andorran (rounded = .001), which is close to answer A: .0011
Holy thread bump!
Ouch that hurts. Bumping old threads is the worse thing that happens to AFThreads. It, time and again reminds you of your dark and scary past.