In keeping with operational progress, Clover Machines has made progress in setting up operational structures in Brazil and India. Looking into the future and anticipating financial transactions in these countries, Brian Bent, Clover's CFO, has cultivated relationships with leading banks. Mr. Bent also notes that the economic situation in these countries is quite different from that in the United States. Currency markets appear more volatile, and the banking sector not as efficient. Currency forward markets in particular do not have the depth and efficiency of markets for major currencies. Also credit markets-for both borrowing and lending-appear highly volatile.

Mr. Bent is aware of the potential of currency arbitrage. Volatile markets sometimes provide arbitrage opportunities to investors because of mispricing. Low-liquidity and high-volatility markets offer more arbitrage opportunities than do stable and high-liquidity markets such as in the United States. As he sets up financial shop in these emerging markets, Mr. Bent is wondering whether Clover can exploit market conditions. He requests a junior analyst, Adao Ronaldinho, to obtain currency and interest rate quotations from a few banks. This information is as follows:

BRLUSD Spot Quotes

Bank

Bid

Ask

Banco do Brasil

0.6152

0.6171

Itau

0.6149

0.6166

Bradesco

0.6172

0.6185

Unibanco

0.6167

0.6178

Note that BRLUSD indicates USD per BRL

BRLUSD Six-Month Forward Quotes

Bank

Bid

Ask

HSBC

0.5943

0.5972

Itau

0.5889

0.5911

Note that BRLUSD indicates USD per BRL

Interest Rates (simple interest basis)

Bank: Currency

Bank Borrows

Bank Lends

BNP Paribas USD

2.4%

3.0%

Unibanco: BRL

12.2%

13.1%

Mr. Bent requests answers to the following questions:

1.There appears to be a wide disparity between the spot quotes. If Clover wishes to simply use these markets to short BRLunload BRL revenues, for instanceit would choose to transact with Bradesco. But is there opportunity for currency arbitrage contained in these spot rates? Assume that USD 1 million is directed toward this activity. Note that BRLUSD indicates USD per BRL

2.How would bank commissions for currency transactions affect arbitrage? Assume a roundtrip (for buying and selling) transaction fee of USD 175 (same fee in all banks; half of this amount for a single trip). Is the transaction identified in (1) profitable after commissions? Next, assume round-trip commissions are a percentage fee of transaction size: What is the break-even percent commission?

3.Mr. Bent notes high interest rates in Brazil. How can Clover deploy USD 1 million to exploit these rates? A possible strategy is to invest in a foreign currency and lock-in USD returns by using forward rates. Calculate the annualized return of such an investment. Note that quoted rates apply to six-month transactions but have been annualized. Ignore bank commission and fees. Compare your strategy with covered interest arbitrage. What are the similarities and differences?

4.Employ an investment strategy opposite to that discussed in (3). That is, evaluate opportunities for deploying BRL 1 million in a USD-denominated interest-bearing deposit. Apply the method used in answering (3).

5.Discuss the prevalence of currency arbitrage. Which entities are best positioned to exploit them? What should be the optimal strategy of firms such as Clover?