You are working in the arbitrage division of a large international bank.Thismorningyou noticed in your Bloomberg currency page that USD/JPY is trading at 112.00 and the 3- month forward rate on USD/JPY is at 111.65. You also discovered that the dollar interest rate for 3-month maturity is at 2.50% per annum, while the yen interest rate for the same 3-month term is at 0.50% per annum. According to the Covered Interest Arbitrage (CIA) theory, do you see an arbitrage opportunity? What does the Covered Interest Arbitrage Theory say?

If you do see an opportunity, how should you act? You can either borrow $1,000,000 from a US bank or ¥100,000,000 from a Japanese bank to start the execution of your trades. If you do act and borrow, you need to return both the principal and the interest at the end of 3-months.

Please list all the transactions you need to execute and indicate how much profit you would make in JPY (or in USD) form and in percentage terms at the end of 3 months.

If you think the USD/JPY forward rate and the interest rates in the US and Japan are out of balance, Explain the mechanism how the markets would move back to equilibrium.