10. Yen carry trade at the Conan Doyle Galaxy Fund (intermediate). Dr. Watson is the chief trader at the currency arbitrage desk of the U.S.-based Conan Doyle Galaxy Fund. He is considering arbitrage opportunities between the Japanese yen

(borrow at 60 basis points/lend at 40 basis points) and the Eurodollar (borrow at 2.15 percent/lend at 2.06 percent).

a. Under what exchange rate scenario does interest rate arbitrage make sense?
The current spot exchange rate stands at ¥100 = $1.

b. The market forward rate quotes at ¥98 = $1. Show how covered arbitrage could be profitably exploited.

c. Revisit questions a and b with the corporate income tax rate in the United States at 30 percent and the capital gains rate at 15 percent.

d. The carry trade refers to uncovered interest rate arbitrage; is it consistent with efficient foreign exchange markets?

e. Dollar-denominated one-year U.S. Treasury Inflation-Protected Securities (TIPS) pay 1 percent plus consumer price index (CPI) inflation. Under what exchange rate/inflation scenario does uncovered interest rate arbitrage between yen-denominated loans/deposits and dollar-denominated TIPS make sense? TIPS are not available in yen.