Texts: Covered Interest Arbitrage with a 6-month horizon
US interest rate = 6%
Eurozone interest rate = 2%
The current spot rate is $1.0/€
The 6-month futures rate is $1.1/€
Please list the steps of the arbitrage strategy (at least 5 steps).
1. Borrow $20,000 at the US interest rate of 6%.
2. Convert the borrowed amount to euros at the current spot rate of $1.0/€, resulting in €20,000.
3. Invest the euros in the Eurozone at the interest rate of 2% for 6 months.
4. Simultaneously, enter into a futures contract to sell €20,000 at the 6-month futures rate of $1.1/€.
5. At the end of the 6-month period, receive the principal plus interest from the Eurozone investment, which would be €20,400 (€20,000 + 2% interest).
6. Convert the euros back to dollars at the 6-month futures rate of $1.1/€, resulting in $22,440 ($20,400 * $1.1/€).
7. Repay the borrowed amount of $20,000 plus interest at the US interest rate of 6%, which would be $21,200 ($20,000 + 6% interest).
8. Calculate the overall profit by subtracting the borrowed amount plus interest from the converted amount, which would be $1,240 ($22,440 - $21,200).
If you can start with a fund of $20,000 or €20,000, what would be your overall profit from the arbitrage in dollars? (show all your work)
Overall profit = Converted amount - Borrowed amount plus interest
Overall profit = $22,440 - $21,200
Overall profit = $1,240
Once the arbitrageurs around the globe execute their strategy, the following would happen:
Euro interest rate _______________ (increase or decrease)
The spot rate of € _______________ (increase or decrease)