Question:

Toshi Numata, FX analyst at Credit Suisse (Tokyo), observes that the /$ spot rate has been holding steady, and both U.S. dollar and yen interest rates have remained relatively fixed over the past few weeks. Toshi wonders if he should try an interest arbitrage strategy. Toshi's research associates and their prediction models are predicting the spot rate to move to 100.00/$ 90 days from today. Assume each year has 360 days and the interest rate for short loans is priced using the simple interest rate method.

Table 2. - Use for Questions a) to c)

Assumptions

Value

Arbitrage funds available ()

YEN 80,000,000

Equivalent arbitrage funds available ($)

USD 1,000,000

Spot rate (/$)

80.00

90-day forward rate (/$)

90.00

180-day forward rate (/$)

95.00

U.S. dollar LIBOR rate p.a. for the next 180 days

2.000%

Japanese yen LIBOR rate p.a. for the next 180 days

0.000%

a)Calculate the expected gain in $ from an Uncovered Interest Arbitrage (UIA) strategy using the expected spot rate in 90 days predicted by Toshi's research associates.(3 marks)

b)The actual spot rate 90 days from today turned out to be72.00 (/$) instead of 100 (/$) as predicted. Discuss how Toshi's interest arbitrage strategy in question a) is affected. (3 marks)

c)Discuss how a Covered Interest Arbitrage strategy is different from an Uncovered Interest Arbitrage strategy