A Currency Dealer Has Good Credit and Can Borrow Either

question 23

Multiple Choice

A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year.The one-year interest rate in the U.S.is i_$ = 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 profit via covered interest arbitrage.

• A)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 = $1,017,600.
• B)Borrow €800,000 at i_€ = 6%; translate to dollars at the spot,invest in the U.S.at i_$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00.Net profit $2,400.
• C)Borrow €800,000 at i_€ = 6%; translate to dollars at the spot,invest in the U.S.at i_$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00.Net profit €2,000.
• D)Borrow €800,000 at i_€ = 6%; translate to dollars at the spot,invest in the U.S.at i_$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00.Net profit is $2,400.Additionally,one may borrow €800,000 at i_€ = 6%; translate to dollars at the spot,invest in the U.S.at i_$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00.Net profit is €2,000.

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Definitions:

Virginia Company

An English joint-stock company chartered by King James I in 1606 to establish settlements in North America, notably founding Jamestown.

Jamestown

The first permanent English settlement in the Americas, founded in 1607 in present-day Virginia.

Settlement Strategy

A planned approach to establish and develop communities or territories, often involving policies, infrastructural development, and allocation of resources.

John Rolfe

An English settler in Jamestown, Virginia, known for introducing tobacco cultivation to the colony, which became a major economic commodity.