Differentiate fully speculation and arbitraging, Corporate Finance

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Question:

(a) With the help of illustrative and numerical examples differentiate fully speculation and arbitraging in the context of foreign exchange.

(b) Shirley, a trader in the foreign exchange department of Sanwa Bank, Singapore Office, specialises in arbitraging US$ against EURO. She observes the following rates at 9:10 am Singapore time:

Spot rate EURO 1.8200 = $1.000.

Three months forward rate - EURO 1.8000 = $1.000

Yamada can borrow or invest US$ for three months at 9.1% p.a or EURO for 3 months at 5% per annum.

Transaction costs to the above are $ 8000.

She is allowed to borrow $5 million or an equivalent amount in EURO

(i) How can Shirley make a risk free profit? Assuming she prefers to make her profit in dollars.

(ii) If the dollar 3-month interest rate should increase to 10.1% p.a, other conditions remaining the same, would she still make profit using the same strategy as she uses in your answer to part (a) above?


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