Financial Market: Assume that one euro (EUR) currently costs NOK 8.00 in the spo

Question

Financial Market:

Assume that one euro (EUR) currently costs NOK 8.00 in the spot-market and NOK 7.6500 in the 6- months forward market. The current, one-year interest rate on NOK-denominated, governmentissued money-market securities is 3.25 percent, while the one-year rate on similar, risk-free Eurocertificates is 4.00 percent. One-year borrowing rates are 3.40 percent and 4.15 percent, respectively, in NOK and EUR.

(a) Calculate the NOK-return on a one-year NOK 1,000,000 investment in Euro-certificates!

(b) Do the quotes above facilitate currency arbitrage? Briefly explain!

(c) May differential taxation of investment returns in NOK and EUR affect your conclusion regarding currency arbitrage opportunities? Briefly explain!

Explanation / Answer

1 euro is 8 NOK

6m forward rate is 1 euro is 7.65 NOK.

1 year forward rate is 1 euro = 8 × (1 + 0.0325)/(1 + 0.04) = 7.9423 NOK, we use interest rates and not borrowing rates to arrive at forward rate.

The currency whose interest rate is high euro in this case is expected to depretiate going forward.

A.Current value of 1 million nok in euro is 1,000,000 /8 =125,000 euro.

After 1 year 125,000 euro will become 125,000 ×1.04 =130,000 euro.Converting to NOK we get 130,000 × 7.9423 =1,032,499 NOK.

B.In the above example if 1,000,000 NOK is kept in nok government money market fund at 3.25% itwill become 1,000,000 × 1.0325 = 1,032,500 NOK.

so there is moneymarket hedging benifit of 1$

Also the 1 year rates are 7.9423 higher than 6m forward so we can long on 6M forward of 7.65 and short on 1 year forward.gain 0.2923 nok

Also we can short on spot at 8nokand long on 6M forward market at 7.65 NOK.gain is 0.35 nok

C.Yes if taxes on NOK returns are very high compared to taxes on euro returns then it may eliminate the arbitrage gain on the currency strategy So for the currency arbitrage strategy to be profitable the taxes on both returns should be either same or nok taxes must be lesser.If should not be very higer compared to nok return taxes.

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