Econ ( Domestic and Foreign)

[cfaboston28]

Hi Team,

I wanted to know how do we know that we have to borrow money from Domestic or Foreign to earn arbitrage. I know the calculation but cant figure it out to borrow from Domestic or Foreign and invest in D or F.

Any input will be helpful in understanding this.

F/S= 1+Rd/1+Rf

Thanks

 

[moregreat]

R(domestic) - R(foreign) < Fwd rate/Spot rate => Borrow Domestic
R(domestic) - R(foreign) > Fwd rate/Spot rate => Borrow Foreign

 

[veerasam]

I would try borrowing one currency (say Domestic), convert to Foreign at Spot rate, earn interest in foreign and convert it back to domestic at Forward rate. If that is greater than earning interest on domestic rates, then it makes sense to borrow domestic and use the arbitrage.
If (1/Spot)*(1+Rf)*forward > 1+Rd, then borrow domestic and arbitrage. If it is equal, then no arbitrage. If it is "less than", then borrow foreign and arbitrage.
Note: Spot and forward are in quoted as direct quotes (DC/FC) in the relation above.