Question

2) explain covered interest arbitrage with an example.

Answer 1

Answer:

The practice of investing in a currency that offers the higher return on a covered  basis is known as covered interest arbitrage.

For example, suppose that the

Eurodollar rate is 8% per annum, and that the Euroyen rate is 4% per annum.

Suppose further that the spot rate is Y 106/$ and the 180 days forward rate is Y  103.5/$, then a covered interest arbitrage is performed as follows:

Explanation:

Step 1. Borrow for 180 days the amount of $1,000,000 @ 8% per annum and convert

them @ the spot rate of Y 106/$ to Y 106,000,000.

Step 2. Invest the proceeds, Y 106,000,000, in a Euroyen account for six months,

earning 4% per annum, or 2% per 180 days.

Step 3. Simultaneously sell the future yen proceeds (Y 108,120,000) forward for

dollars at the 180-days forward rate of Y 103.5/$, to obtain gross revenues of

$1,044,638.

Step 4. Calculate the cost of funds (interest paid for borrowing US$) at the

Eurodollar rate of 8% per annum, or 4% per 180 days, with the principal and interest

then totaling $1,040,000. The profit from CIA is $1,044,638 - $1,040,000= $4,638.