Arbitrage in Montr´eal. As an arbitrageur with Banque de Montr´eal in Montreal, Province Qu´ebec, Canada you see the following CAD/USD information on your customized trading system as inputs for algorithmic execution:
Spot rate CAD 1.1520/USD
6M forward rate CAD 1.1635/USD
6M CAD money market rate 10.00% p.a.
6M USD money market rate 7.50% p.a.
Having only recently started in your position fresh out of school your position limit is CAD
10m or its USD equivalent. Transaction costs for trading in these markets total around USD
1,700 and would be paid at the end of the 6 months. Being based in Canada any arbitrage profit should accrue in CAD. Assuming that you can trade, borrow and invest at the above quoted rates.
(a) What principle links the four prices? What is the relevant mathematical formulation?
(b) Identify any arbitrage opportunities and explain how they might have come about.
(c) How would you build up an arbitrage position? Describe your strategy and its mechanics.
(d) Calculate your profit resulting from the preceding arbitrage strategy.