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covered interest arbitrage/purchasing power parity


a)180-day interest rate is 1% & 3% respectively in the US and Japan
spot rate & 180-day forward rate are equivalent=
120 yen per one US dollar
As a trader of a commercial bank how would I invest $1 million and earn risk free return by engaging in covered interest arbitage.

b)inflation rate in US and Japan & Japan respectively
Spot rate =$.0083333 per one Japanese Yen or
How much does US dollar have to depreciate to maintain purchasing power parity?

Solution Preview

Question One:
Day 0: Do the following transactions
1. Borrow $1 million at the rate of 1% for 180 days
2. Sell $1 million in spot market to buy 120 million Yen
2. Invest 120 million Yen in Japanese market ...

Solution Summary

Covered interest arbitrage is discussed.