Covered Interest Arbitrage Problems

1) Taking advantage of the â€œcarry tradeâ€

Example:

Spot rate = 95 pesos/$

You have $1,000,000

Interest Rates:

One year Govt debt Rate Mexico

USA 7%

1% Forward Rate = 10 pesos/$ Can you make money off of this ????

What are the effects of covered interest arbitrage?

Calculation of % premium or discount Premium or discount size should be equal to but opposite in sign to interest rate difference

[(Fwd â€“ Spot)/Spot] X 12/n X 100 = % premium or discount

Use this formula with direct rates (units of local currency per one unit of foreign)

Indirect rates are units of foreign currency per one unit of local currency (be Careful this is a common mistake on exams) 2) You have $1,000,000 to start with Here are the facts:

Yen Spot Rate = 106 Yen/$

Yen Fwd Rate = 1035 Yen/$

(6 months)

Interest Rates in Japan are 4% per annum (2% for 6 months)

Interest Rates in the USA are 8% per annum (4% for 6 months) for securities

of similar risk and maturity

What should you do?

## Solution:

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