A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$ = 3.5% and in the euro zone the one-year interest rate is i€ = 6.5%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how to realize a certain profit via covered interest arbitrage.
Borrow $1,000,000 at 3.5%. Trade $1,000,000 for €800,000; invest at i€ = 6.5%; translate proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,022,400.
Borrow €800,000 at i€ = 6.5%; translate to dollars at the spot, invest in the U.S. at i$ = 3.5% for one year; translate €852,000 back into dollars at the forward rate of $1.20 = €1.00. Net profit $12,600.
Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 3.5% for one year; translate $1,035,000 back into euro at the forward rate of $1.20 = €1.00. Net profit €10,500.
Both B) and C)