A foreign exchange arbitrageur notices that the Japanese yen to U.S. dollar spot exchange rate is JPY 108/USD and the three-month forward exchange rate is JPY 107.45/USD. The three-month $ (U.S dollar) interest rate is 5.20% per annum and the three-month Y (Japanese Yen) interest rate is 1.20% per annum.
a) Is the interest parity holding? Why or why not?
b) Is there an arbitrage possibility? If yes, what steps would be needed to make an arbitrage profit? Assuming that the arbitrageur is authorized to work with $1,000,000 for this purpose, how much would the arbitrage profit be in dollars?
Provides steps necessary to determine an interest rate parity analysis.