help with covered interest arbitrage

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yellayella

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Current spot rate is 2$ per BU. The BU-riskfree rate is 3% and the one year forward rate is $2.10 per BU. us riskfree is 5%.
Covered interest rate arbitrage in the USD/BU market:
solution is
1.05 - (1.03*2.1)/2.0 = 1.05 - 1.0815 = -0.0315 = -3.15%
I do not understand this procedure!! what is the formula?????
 
I do not know what kind of formula they used but this is what I did:
F = S0*(1+r/1+y)
F= 2*(1.05/1.03) = 2.0388
(2.0388 - 2.10 / 2.0388) = -.03, which is more or less in the same ballpark.
 
So in this situation we would…
@ t=0
1) Enter into the one-year forward agreement
2) Borrow $1 US
3) Convert the $1 US into BU .5 (at spot rate of 2 $US/BU)
4) Deposit the BU .5 into a savings account earning the risk free rate of 3%
@ t=1
1)Withdraw BU .515 (.5*1.03 = .515)
2) Convert to US$ by at the forward rate agreed upon at t=0 (2.1 $US/BU) which equals $1.0815 (BU .515*2.1 $US/BU)
3) Pay back the borrowed $1 plus interest accrued at 5% rate which amounts to $1.05
This leaves us with $.0315 arbitrage profit.
Is this correct? Let me know… I have trouble determining the arbitrage strategies sometimes.
 
CF_AHHHHHHHHH Wrote:
——————————————————-
> So in this situation we would…
>
> @ t=0
> 1) Enter into the one-year forward agreement
> 2) Borrow $1 US
> 3) Convert the $1 US into BU .5 (at spot rate of 2
> $US/BU)
> 4) Deposit the BU .5 into a savings account
> earning the risk free rate of 3%
>
> @ t=1
> 1)Withdraw BU .515 (.5*1.03 = .515)
> 2) Convert to US$ by at the forward rate agreed
> upon at t=0 (2.1 $US/BU) which equals $1.0815 (BU
> .515*2.1 $US/BU)
> 3) Pay back the borrowed $1 plus interest accrued
> at 5% rate which amounts to $1.05
>
> This leaves us with $.0315 arbitrage profit.
>
> Is this correct? Let me know… I have trouble
> determining the arbitrage strategies sometimes.
Looks right to me.
 
I set it up like:
(1+rd) - ((1+rf)*F)/S=?
if ? = 0, then there is no arb possible
if its >0, then the rd is higher, so you would lend it
if its <0, then rd is lower, so you borrow it.
then you just walk thru the steps.
 
Just to make sure i’m following your logic…
If the difference you computed = zero | Then no arbitrage
If the difference you computed > zero | Then borrow the foreign currency and lend it in the domestic market
If the difference you computed < zero | Then borrow the domestic currency and lend it in the foreign market
 
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