Covered interest arbitrage is a strategy where an investor uses a forward contract to hedge against exchange rate risk. The strategy involves two currencies and four transactions. Given the information, here's how a U.S. investor could use covered interest arbitrage:

1. Convert U.S. dollars to Canadian dollars: The investor starts with $1 million and converts it to Canadian dollars at the spot rate of $0.80/Canadian dollar. This gives the investor $1,000,000/$0.80 = CAD 1,250,000.

2. Invest in Canadian interest-bearing account: The investor then invests this amount in a Canadian account that earns 4% interest for 90 days. After 90 days, the investor has CAD 1,250,000 * (1 + 4%/4) = CAD 1,262,500.

3. Enter into a forward contract: Simultaneously, the investor enters into a 90-day forward contract to convert the future Canadian dollar balance back to U.S. dollars at the forward rate of $0.79/Canadian dollar.

4. Convert Canadian dollars back to U.S. dollars: At the end of the 90 days, the investor converts the Canadian dollars back to U.S. dollars using the forward contract, resulting in $1,262,500 * $0.79 = $997,175.

The yield or return on the investment is then (Final amount - Initial amount) / Initial amount * 100% = ($997,175 - $1,000,000) / $1,000,000 * 100% = -0.2825%.

This negative yield suggests that covered interest arbitrage is not profitable given these market conditions.

However, if it were profitable, market forces would act to eliminate the opportunity. As investors rush to take advantage of the arbitrage opportunity, the demand for Canadian dollars would increase, causing the spot rate to increase. Simultaneously, the supply of U.S. dollars would increase, causing the U.S. interest rate to decrease. These changes would continue until the covered interest arbitrage opportunity no longer exists.

Question

Covered interest arbitrage is a strategy where an investor uses a forward contract to hedge against exchange rate risk. The strategy involves two currencies and four transactions. Given the information, here's how a U.S. investor could use covered interest arbitrage:

1. Convert U.S. dollars to Canadian dollars: The investor starts with $1 million and converts it to Canadian dollars at the spot rate of $0.80/Canadian dollar. This gives the investor $1,000,000/$0.80 = CAD 1,250,000.

2. Invest in Canadian interest-bearing account: The investor then invests this amount in a Canadian account that earns 4% interest for 90 days. After 90 days, the investor has CAD 1,250,000 * (1 + 4%/4) = CAD 1,262,500.

3. Enter into a forward contract: Simultaneously, the investor enters into a 90-day forward contract to convert the future Canadian dollar balance back to U.S. dollars at the forward rate of $0.79/Canadian dollar.

4. Convert Canadian dollars back to U.S. dollars: At the end of the 90 days, the investor converts the Canadian dollars back to U.S. dollars using the forward contract, resulting in $1,262,500 * $0.79 = $997,175.

The yield or return on the investment is then (Final amount - Initial amount) / Initial amount * 100% = ($997,175 - $1,000,000) / $1,000,000 * 100% = -0.2825%.

This negative yield suggests that covered interest arbitrage is not profitable given these market conditions.

However, if it were profitable, market forces would act to eliminate the opportunity. As investors rush to take advantage of the arbitrage opportunity, the demand for Canadian dollars would increase, causing the spot rate to increase. Simultaneously, the supply of U.S. dollars would increase, causing the U.S. interest rate to decrease. These changes would continue until the covered interest arbitrage opportunity no longer exists.

Knowee AI · Accepted Answer