At the beginning of the year of 1996, the yearly interest rate was 6 percent in the United States and 2.8 percent in Japan. At the time the exchange rate was 95 yen per dollar. Mr. Jorus, the manager of a Bermuda-based hedge fund, thought that the substantial interest advantage related with investing in the United States relative to investing in Japan was not probable to be offset through the decline of the dollar against the yen. Thus he concluded that it might be a good idea to borrow in Japan and invest in the United States. At beginning of 1996, actually, he borrowed ¥1,000 million for one year and invested in the U.S. At the ending of the year 1996, the exchange rate became 105 yen per dollar. How much profit did Mr. Jorus earn in dollar terms?
Let us compute primary the maturity value of U.S. investment:
(¥1,000,000,000/95)(1.06) = $11,157,895.
The dollar amount obligatory to pay off yen loan is:
(¥1,000,000,000)(1.028)/105 = $9,790,476.
The dollar profit = $11,157,895 - $9,790,476 = $1,367,419.
Mr. Jorus was capable to realize a large dollar profit because the interest rate was higher in the U.S. than in Japan and the dollar in fact appreciated against yen. It is an illustration of uncovered interest arbitrage.