Covered and Uncovered Interest Rate Arbitrage A. In June 2007, a Japanese foreign exchange trader wants to invest 99,200,000 Yen in a covered interest arbitrage between US$ and Japanese Yen. She has the following quotes: Spot exchange rate: 124 Yen/$ Six-months forward rate: 123 Yen/$ Six-month dollar interest rate: 3.00% per year Six-month yen interest rate: 1.00% per year 1. What is the dollar equivalent on spot market of 99,200,000 Yen? 2. Suppose first that the bank does not calculate transaction costs which are part of the overall budget of the arbitrage department. Explain the steps the trader must take to make a profit. Calculate this profit. 3. Suppose now that the bank wants to take into account transaction costs. Assume that transaction costs on forex markets are 0.2% per transaction (no transaction costs on borrowing and lending). Is the strategy still profitable? B. Using a model to forecast exchange rates, the research department expects the spot rate to remain at 124 Yen/$ at the end of the six-months. 1. Using the same data as in the previous exercise, what is the strategy the foreign exchange trader should follow given her expectations on the future spot rate (assuming no transaction costs)? 2. Calculate the profit she could make if her expectations hold true. What is the maximum depreciation of the dollar (relative to the yen) that can be realized without losses for the trader? 3. Compare this strategy with a covered interest arbitrage. 4. Six-months later, the yen trades at 114 Yen/$, compute the profit or losses made in this uncovered interest rate arbitrage. Comment.
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The dollar equivalent on the spot market of 99,200,000 Yen is calculated by dividing the amount in Yen by the spot exchange rate. So, 99,200,000 Yen / 124 Yen/$ = $800,000. Show moreā¦
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