Covered Interest Arbitrage: Suppose that youre a FX trader for a bank in New York. You are faced with the following market rates:

Spot exchange rate: 110.55/$.

1 year dollar interest rate = 1.50%

1 year yen interest rate = 0.25%

1 year forward exchange rate: = 108.15/$.

Assume that you may borrow up to $1,000,000 (or its equivalent in yen) to engage in this arbitrage. Show all calculations as you respond to the questions below.

a) Is there an arbitrage opportunity? Explain with calculations why or why not. (10 points)

b) Spell out the actions you would take to profit from this situation. (30 points)

Which currency would you borrow and what amount?

Which currency would you lend (invest) and what amount?

What is the forward transaction you would engage in? State clearly the currency you would sell forward, the currency you would buy forward, and the respective amounts.

Calculate your arbitrage profits, either in US dollars or in Japanese yen.

Note: Please respond to the questions above. It is not enough to merely draw a graph or show some calculations without verbal explanations.