Covered Interest Arbitrage
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Quotes for the US dollar (US$) and Thai Baht (Bt) are as follow:
Spot contract midpoint S0Bt/US$=Bt 24.96/US$
1-year forward midpoint F0Bt/US$=Bt25.64?US$
1-year Eurodollar interest rate I$=6.125%per year
a) Your newspaper does not quote 1-year Eurocurrency interest rates on thai baht. Make your own estimate of iBt.
b) Suppose that you can trade at the prices for S0Bt/US$ , F0Bt/US$ and I$ just given and that you can also either borrow or lend at a Eurocurrency interest rate of iBt = 10% per cent. Based on a $1 million initial amount, how much profit can you generate through covered interest arbitrage ?
c) Outline and explain how the markets are likely to respond to the transactions you propose.
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Answers questions on covered interest arbitrage etc.
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Quotes for the us dollar(US$)and Thai Baht(Bt) are as follow:
Spot contract midpoint S0Bt/US$=Bt 24.96/US$
1-year forward midpoint F0Bt/US$=Bt25.64/US$
1-year Eurodollar interest rate I$=6.125%per year
a) Your newspaper does not quote 1-year Eurocurrency interest rates on thai baht. Make your own estimate of iBt.
Using the interest rate parity condition (no covered interest arbitrage)
Forward rate / Spot rate = (1+ Thai baht eurocurrency interest rate) / (1+ Euro dollar interest rate)
or 25.64 / 24.96 = (1+ Thai baht eurocurrency interest rate) / (1+ 6.125%)
or Thai baht ...
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