An Italian currency dealer has good credit and can borrow €800,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how to realize a certain euro-denominated profit via covered interest arbitrage.
Group of answer choices
Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate all dollar back into euro at the forward rate of $1.20 = €1.00. Net profit €2,000.
Both c) and b)
Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate part of dollar back into euro at the forward rate of $1.20 = €1.00. Net profit $2,400.