Question

1) What is international currency arbitrage all about? Consider the following data: UK 90-day interest rate = .07 Europe 90 day interest rate = .048 £1.00 = €1.200, Foo =€ 1.1765 You work for PNB Paribas in France. From a French point of view, is covered interest arbitrage available? If not, why not? If so, employ €10,000,000 and show how you would exploit the opportunity? Explain how the act of exploiting the arbitrage opportunity eliminates it. (in answering this question, ignore differences)

Answer 1

Answer:

- International currency arbitrage is about simultaneous buy and sales of currency in the market to make risk-free profit from the differential in exchange rate and difference between market interest rate each currency brings about.

- In the question, from the French point of view, there are not opportunities for arbitrage.

To illustrate, for example, we have €10,000,000 for investment:

First, exchange €10,000,000 for £8,333,333.33 at spot ( 10 million /1.2)

Enter into Forward contract to fixed exchange rate after 90 days at £1.00 = €1.1765

Invest £8,333,333.33 at 90-day, 7% per annum to receive £8,479,166.66 at maturity ( Principal + interest = 8,333,333.33 x [1 + (7.0% x 90/360)] )

Convert £8,479,166.66 to €9,921,816.66 ( 8,433,333.33 x 1.1765).

While if we keep the amount in € and invest, we will get €10,120,000

=> Return on € of the investment is €9,921,816.66/€10,120,000 -1 = 1.96%

In other words, the higher return on £ denominated asset over the € is not large enough to cover the depreciation of £ in comparison to €.

- As investment in € denominated asset yields higher returns, investor will exchange have higher demand of £ in forward transaction which will increase the value of £ in forward transaction. Besides, higher demand for € denominated asset will cause the price to increase, that is, interest rate decrease. Gradually, the arbitrage transactions will exploit the arbitrage opportunity.

Explanation: