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Parity Relationships and Arbitrage

8. You are an expatriate working for CommerzBank in Frankfurt West Germany, and
observe the following prices. Formulate an arbitrage strategy to profit from the
situation.

? Dollar per Euro exchange rate is 1.25 spot and 1.26 for 180-day forward.
? German interest rate is 6.00% compounded daily.
? U.S. stock market index is 1500 today.
? At today's level of the index, the average annual dividend yield on the stocks in
the index is 3% (for simplicity, assume the dividends for your six-month holding
period will all be paid at the end of 180 days).
? The U.S. stock market index 180-day futures price is 1564

Solution Preview

8. An arbitrage to take advantage of this involves the following steps:

a. Borrow ? 800,000 in Frankfurt, at 6% compounded daily.

b. Convert it to $1,000,000 and invest in the stocks in the U.S. stock market index (a million
...

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