# Covered interest arbitrage

How does banks use "Covered interest arbitrage to protect themselves

when we use the theory of purchase power parity, how dose inflation impacts exchange rates and what is the difference in inflation between Ireland and the USA?

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How does banks use "Covered interest arbitrage to protect themselves

Answer: Covered interest arbitrage is the transfer of liquid funds from one monetary center (and currency) to another to take advantage of higher rates of return or interest, while covering the transaction with a forward currency hedge. Since the foreign currency is likely to be at a forward discount, the investor loses on the foreign transfers currency transaction per se. But if the positive interest differential in favor of the foreign money center exceeds the forward discount on the foreign currency (when both are expressed in percentage per year), it pays to make the foreign investment.

Covered Interest Arbitrage when Foreign Interest Rates are Higher than U.S. Interest Rates:

For example, When interest rates in Germany are greater than in the United States (or elsewhere), a U.S. investor can exchange dollars for dms today and use these dollars to buy a 3-month T-bill in Frankfurt at 12%. He earns 4% more per year (or 1% more per 3 months) than if he had used his dollars to buy a 3-month T-bill in the New York at 8%. If the spot rate today is $.333 and the spot rate in three months is $.330, he will lose $.003 or 1% on the foreign exchange conversion. The annualized 4% gain from the German ...

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How do banks use Covered interest arbitrage to protect themselves, how dose inflation impact exchange rates, what is the difference in inflation between Ireland and the USA.

Covered interest arbitrage problems

2. Exchange rate pass through. Assume that the export price of a Nissan Maxima from Osaka Japan is ¥3,000,000. The exchange rate is ¥122/$. The forecast rate of inflation in the United States is 2% per year and tis 0% per year in Japan.

a. What is the export price of the Nissan at the beginning of the year expressed in US dollars?

b. Assuming purchasing power parity holds, what should the exchange rate be at the end of the year?

c. Assuming 100% pass through of exchange rate changes, what should be the dollar price of a Nissan at the end of the Year?

d. Assuming 70% pass through of exchange rate changes what should be the price of a Nissan at the end of the Year?

4. International fisher effect, Assume that one year interest rates ate 3% in the United States and 5% in the Euro Zone. The spot rate between the euro and the dollar is â?¬1.02/$. Assuming the international fisher effect holds, what should the â?¬/$ rate be one year in the future?

5. Covered interest arbitrage- Denmark A. James Change a foreign exchange trader at JP Morgan Chase, can invest $5 million or the foreign currency equivalent of the bank's short term funds in a covered interest arbitrage with Denmark. He has the following quotes:

sport exchange rate DKr7.5000/$

three month forward rate DKr7.5372/$

three month dollar interest 3% per year(.0.75% for 90 days)

three month krone interest 5% per year (1.25% for 90 days)

can James Cang make a covered interest arbitrage profit?

7. Covered interest arbitrage- Japan I, Yukiko Miyaki a foreign exchange trader at Credit Swiss first boston want to invest $800,000 or its yen equivalent in a covered interest arbitrage between US dollars and Japanese yen she has the following quotes:

Spot Exchange rate ¥124/$

Six month forward exchange rate ¥123/$

Six month dollar interest rate 3.00% per year 1.50% for 180 days)

Six month yen interest rate 1.00% per year .0.50% for 180 days)

The bank does not calculate transaction costs on any individual transaction because these costs are part of the overall operating budjet of the arbitrage department . Explain and diagram the specific steps Yukiko must take to make a covered interest arbitrage profit.

10. Mary Smith- Mary smith is a foreign exchange dealer for a bank in New York she has $1,000,000 or its swiss franc equivalent for a short term money market investment and wonders if she should invest in US dollars for three months or make a covered interest arbitrage investment in Swiss franc she faces the following rates:

Spot exchange rate SF.6000/$

Three month forward rate SF1.5800/$

Three month US interest rate 8.00% p.a. (2.00% per quarter)

Thee month swiss franc interest rate 6.00%p.a. (1.50% per quarter0

Where do you recommend Ms Smyth invest? Why?

14. Covered interest arbitrage against the Norwegian Krone A Foreign exchange trader sees the following prices on his computer screen

Spot rate NKr8.8181/$

3 month forward rate NKr8.9169/$

US 3 month treasury bill rate 2.60% p.a

Norweigan 3 month treasury bill rate 4.00% p.a.

Could a trader profit by placing $500,000 of principle in a covered interest arbitrage operation in Norway?

15. Frankfurt and New York Money and foreign exchange markets in Frankfurt and new york are very efficient the following information is available:

Frankfort New York

Spot exchange rates $0.90000/â?¬ $0.9000/â?¬

One year T-bill rate 6.50% 3.20%

Expected inflation rate unkown 2.00%

a. what do the financial markets suggest for inflation in Europe next year

b. Estimate today's one year forward exchange rate between the dollar and the euro