A US-Based Currency Dealer Has Good Credit and Can Borrow $1,000,000

question 18

Multiple Choice

A U.S.-based currency dealer has good credit and can borrow $1,000,000 for one year. The one-year interest rate in the U.S. is i_$ = 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 dollar 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)Both c and b