9) You are free to invest in any currency. You can trade at the following prices

Question

9) You are free to invest in any currency. You can trade at the following prices: Spot rate, Russian ruble per dollar 20 RUB/S 6 month forward rate for rubles 22 RUB/S 6-month Russian interest rate 6-month U.S. interest rate 18% 6% a) Is covered interest arbitrage worthwhile? If so, explain the steps and compute the profit. Suppose that there is no forward market for the Russian ruble. Explain how an investor can engage in "uncovered" interest arbitrage and whether this is a true arbitrage or not. b)

Explanation / Answer

a)

Borrow 1000 RUB at 18%, after 6 months pay 1000*(1+18%/2) = 1090

Convert to USD: 1000/20 = 50 $

Invest at 6%, after 6 months get 50*(1+6%/2) = 51.5

Convert into RUB: 51.5*22 = 1133 RUB

profit = 1133 - 1090 = 43 RUB

b) uncovered arbitrage is investor will have no profit of investing in higher interest rate currency

Borrow 100$ at 6%

Convert into =100*20 = 2000 RUB

Invested at 18%

RUB after 6 months = 2000*(1+18%/2) = 2180

convert back to $, should get 100*(1+6%/2) = 103

USD = 2180/103 = 21.17

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