You, a foreign exchange trader in New York, can borrow and invest $3 million or the foreign currency equivalent.

Assumptions Value

Spot exchange rate (kr/$) 6.1800

3-month forward rate (kr/$) 6.1980

US dollar interest rate 3.0%, p.a.

Danish kroner interest rate 5.0%, p.a.

a. Show steps necessary to take to earn an arbitrage profit along with amount of arbitrage profit in terms of US dollar. In addition, describe why a potential profit you identify can be treated as an arbitrage profit, using definition of an arbitrage opportunity.

b. Suppose that US dollar interest rate is now 4.0% (p.a.), instead of 3.0% (p.a.). Show steps necessary to take to earn an arbitrage profit along with amount of arbitrage profit in terms of Danish kroner.

c. Suppose that US dollar interest rate on borrowing is 3.5% p.a. and US dollar interest on investing (lending) is 2.5% p.a. Similarly, Danish kroner interest rate on borrowing is 5.5% p.a. and Danish kroner interest on investing (lending) is 5% p.a.

Show whether there is any arbitrage opportunity and if there is, show steps you should take to exploit the arbitrage profits