1 Covered Interst rate parity example 2 3 The current spot rate for USD and against Euro is $1.2255 and the interest rate in Euro is 4% and 2% in the US 4 You spotted a forward rate 1-year from now at $1.2075. How much can you make by artirage with this rate? 5 Suppose you have $10,000,000 credit line 6 N/A forward rate = 1.02980769 7 Since the N/A forward rate is lower than the offered rate $1.2075, you want to sell (short forward) Euro In 1 year. 8 What If you do it the wrong way? 9 1. Borrow Euro and exchanged into USD. You'll get $10,000,000. Owe Euro 8159934.72 10 2. Short forward and then deposit the USD in the US. You will get 10200000 USD 11 3. IN one year, buy back Euro at the offered rate at $1.2075 8447204.97 12 4. You have to repay the Europeanbank where you borrow the Euro from: 8486332.11 13 Profit/loss -39127.14 14 15 The right way is: 16 1. Borrow USD and buy Euro at the spot rate of $1.2255. 8159934.72 17 2. Deposit the Euro in Europe at 4%. You will get: 8486332.11 in one year 10247246 18 3. Buy USD (sell Euro) at the offered rate since you shorted the forward. 194: Pay back the US bank $10,200,000 and profit of 47246.022 20 Your assignment is to do arbitrage if the 6-month forward rate offered is $1.2057