A Polish currency dealer has good credit and can borrow either 1,600,000 or $2,000,000 for one year. The one-year interest rate in the U.S. is i_$ = 6.25% and in the euro zone the one-year interest rate is i = 2%. The spot exchange rate is $1.20 = 1.00 and the one-year forward exchange rate is $1.25 = 1.00. Show how you can realize a certain euro profit via covered interest arbitrage.

Multiple Choice

a. Borrow $2,000,000 at 6.25%; trade $2,000,000 for 1,666,667 at the spot rate; invest euros at i = 2%; translate euro proceeds back to dollars at the forward rate of $1.25 = 1.00 for gross proceeds of $2,125,000. Net profit will be $5,000

b. Borrow 1,600,000 at i = 2%; translate euros to dollars at the spot rate, invest dollars in the U.S. at i_$ = 6.25% for one year; translate dollars back to $2,000,000 at the forward rate of $1.20 = 1.00. Net profit will be 2,000.

c. Arbitrage opportunity does not exit

d. Borrow $2,000,000 at 6.25%; trade $2,000,000 for 800,000 at the spot rate; invest euros at i = 2%; translate euro proceeds back to dollars at the forward rate of $1.20 = 1.00. Net profit will be $17,600.