Jack is a foreign exchange trader for a bank in New York. He has $1 million (or Swiss franc equivalent) available to borrow and will then invest it in a short term money market investment. He is wondering whether he can make a CIA or UIA profit by borrowing in either the U.S. dollar or Swiss franc, and then investing in the other. He has the following data:
arbitrage funds available $1,000,000
spot exchange rate (SFr/$) 1.2810
3-month forward rate (SFr/$) 1.2740
expected spot rate in 90 days 1.2700
U.S. dollar 3-month interest rate 4.800% per annum
Swiss franc 3-month interest rate 3.200% per annum
1. Assess whether CIA profit is possible. Is there a CIA profit potential; if yes, what is it? Show your work. Which currency should Jack borrow in and which should he invest in? Why?
2. Given your conclusions for question 1, show how Jack can make profit (i.e. show how and what numbers you get for how much he would owe on borrowing in the one currency and how much he would make in investing in the other currency).
3. What is the exchange rate risk that Jack is taking by engaging in CIA?