I still seem to be struggling with this. Can anyone tell me an easy way to figure that if an arbitrage opportunity exists based on the Interest Rates and FX rate, then where should one borrow and where should one invest - domestic vs. foreign? Simple logic - invest where interest rate is higher doesn’t seem to apply in all cases. Schweser did a poor job explaining this. Any help is appreciated.
http://www.analystforum.com/phorums/read.php?11,628414,628439#msg-628439 read this thread and try and use the method I laid out on top. I do not try and work out which one to borrow. Use an arbitrary borrowing and work thro – if at the end I end up losing the other should have been what I should’ve borrowed. CP
I just put $100 in each, hedge em, and whichever works out worse I short. Same as cpk’s approach essentially.
I committed this formula to memory for these types of problems: For direct quotes (DC/FC) if r(domestic) - r(foreign) < (Forward-Spot)/Spot ------------- borrow domestic for r(domestic) - r(foreign) > (Forward-Spot)/Spot ------------- borrow foreign
Thanks for the help guys. moto376: this may sound dumb but - How to figure if forward and spot should be direct quotes or indirect quotes? moto376 Wrote: ------------------------------------------------------- > I committed this formula to memory for these types > of problems: > > For direct quotes (DC/FC) > if > r(domestic) - r(foreign) < (Forward-Spot)/Spot > ------------- borrow domestic > for > r(domestic) - r(foreign) > (Forward-Spot)/Spot > ------------- borrow foreign
You use the direct quote to figure out the domestic currency. For example /GBP, the would be domestic, for GPB/$, GPB would be domestic in that equation. Try this problem and see if the formula helps you answer it: Given the following information: The U.S. interest rate is 6%. The GBP/USD spot rate is 2.2. The GBP forward rate is 2 GBP/USD The domestic Great Britain interest rate is 8%. Which of the following statements is FALSE? A) Capital will flow into Great Britain. B) If you start by borrowing $1,000, your arbitrage profits will be $128. C) If you start by borrowing 1,000 GBP, your arbitrage profits will be 116 GBP. D) To arbitrage borrow Dollars at 6%, convert them to GBPs and lend the GBPs out at 8%.
Based on the formula above A,B and D can be false…but for C im getting an arbitrage profit of GBP 86. So not sure which is the correct choice. I think B?