Attempt covered interest arbitrage

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Reference no: EM133638021

Suppose that the six-month interest rate in the United States is 3%, while the six-month interest rate in Canada is 7%. Further, assume the spot rate of the Canadian dollar is $0.50.

Suppose that you have $500,000 with which to attempt covered interest arbitrage. Assume the forward rate is $0.48131, as you just calculated, and the interest rates are the same as have been used throughout this problem.

To start, you exchange your $500,000 (at the spot rate of $0.50) for 1,000,000 Canadian dollar. After depositing these funds for 6 months, and earning a return of 7%, your deposit grows to 1,070,000 Canadian dollar.

When you convert your 1,070,000 Canadian dollar back to dollars, you end up with approximately $ , for a profit of about $ over your original $500,000.

However, had you simply deposited your $500,000 in an account and accrued 3% interest, you would have $ , for a profit of $.

This example illustrates that covered interest arbitrage offer a significantly larger return than simply depositing the funds in a domestic account under interest rate parity.

Reference no: EM133638021

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