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:

Call

An option contract that gives the holder the right, but not the obligation, to buy a specified amount of an underlying asset at a specified price within a specified time.

Put Option

An agreement that grants the holder the option, without the requirement, to sell a predetermined quantity of a fundamental asset at an agreed-upon price during a defined period.

Forward Contracts

Customized contracts between two parties to buy or sell an asset at a specified price on a future date, used for hedging or speculation.

Futures Contracts

Agreements for the future delivery of assets like commodities or securities at a price fixed upon the contract's signing.