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 back at forward rate of $1.20 = 1.00,, invest in the U.S. at i_$ = 2% for one year; translate $979, 200 back into euro at the forward rate of $1.20 = 1.00. Net profit $17.500

d.

Borrow 800,000 at i = 6%; translate to dollars back at forward rate of $1.20 = 1.00,, invest in the U.S. at i_$ = 2% for one year; translate $979, 200 back into euro at the forward rate of $1.20 = 1.00. Net loss $-16,000