c. If the USD/JPY spot and 9-month forward exchange rates and the interest rates

Question

c. If the USD/JPY spot and 9-month forward exchange rates and the interest rates in the US and Japan are as indicated below, is there an arbitrage opportunity? If so, what trades must be made to take advantage of the opportunity, how profitable is it, and what is this type of arbitrage called? orrowmeloqAle·077% fer 9 months and buy Then, invest lla dollar ot 2.011%eramonths.T USD/JPY exchange rates 109.91 spot rate 9-month forward rate 10846 atter a menths yu got interest rates Japan US 0.077% 2.016% This is Covered inkrest arbitrage

Explanation / Answer

Interest rate parity postulates that the difference between the spot rate and forwarch exchange rate is can be explained by the interest rate differential by using following equation:

Forward Rate (FR) = Spot Rate (S) * (1+ io)/(1+id) where io and id are interest rate in other country and domestic country respectively. We are given the following information:

1USD = 109.91 JPY; 9 month FR = 108.46; iJPY = 0.077% and iUSD = 2.016%

As per the interest rate parity, the forward rate should be = 109.91 * (1+0.077%)/(1+2.016%) = 107.821

SInce there is difference between the actual forward rate and expected forward rate, there is an arbitrage opportunity which can be captures as below:

This is basis the covered interest rate parity .

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