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Use the following information to answer the question
Use the following information to answer the question. The Canadian annual interest rate is 2 percent. The interest rate in the U.K. is 4 percent. The spot rate is CAD$1.60/£. The forward rate is CAD$1.58/£ and has a one-year maturity. An arbitrager can borrow a maximum of CAD$1,000,000 or £625,000. What is the net cash flow in one year?
| A. |
CAD$238.65 |
|
| B. |
CAD$14,000 |
|
| C. |
CAD$46,207 |
|
| D. |
CAD$11,300 |
|
| E. |
CAD$7,000 |
Expert Solution
Assuming Canada is home country & UK is forein country.
| Particulars | Amount |
| Spot Rate | 1.6000 |
| Hi | 2.0000% |
| Fi | 4.0000% |
| Home Country | Canada |
| Foreign Country | UK |
| Forward rate after ( in Years) | 1 |
| Actual Fwd Rate | CAD 1.5800 |
| Fwd rate after ( In Months) | 12 |
| Amount Borrowed | CAD 1,000,000.00 |
According to Int Rate parity Theorm,
Fwd rate After 1 Years = Spot rate * [ ( 1 + Hi ) ^ n ] / [ ( 1 + Fi ) ^ n ]
= $ 1.6 * [ ( 1 + 0.02) ^ 1 ] / [ ( 1 + 0.04 ) ^ 1 ]
= $ 1.6 * [ ( 1.02) ^ 1 ] / [ ( 1.04 ) ^ 1 ]
= $ 1.6 * [ 1.02 ] / [ 1.04 ]
= $ 1.6 * [ 0.9808 ]
= $ 1.5692
As Actual Fwd rate is not equal to IRPT Fwd rate, Covered Interest arbitrage exists.
Foreign Currency Premium or Discount:
= [ [ Fwd rate - Spot Rate ] / Spot Rate ] * 100
= [ [ $ 1.58 - $ 1.6 ] / $ 1.6 ] * 100
= [ [ $ -0.02 / $ 1.6 ] * 100
= [ -0.0125 ] * 100
= -1.25 %
Annualized % = Premium or Discounted / No. of Years
= -1.25 % / 1
= -1.25 %
| Effective Rate in Home Country | 2.00% |
| Effective Rate in Foreign Country | 2.75% |
Effective Rate in Foreign currency = Int rate + Fwd Premium %
= 4 % + -1.25 %
= 2.75 %
Country which is cheap to Borrow is Home Country i.e Canada
Arbitrage Strategy:
| Step | Activity |
| 1 | Borrow in Home Country |
| 2 | Convert Into Foreign currency using spot rate |
| 3 | Invest in foreign currency for specified period |
| 4 | Realize the Maturity Value in Foreign Currency |
| 5 | Convert foreign currency proceedings into Home Currency using Actual Fwd Rate |
| 6 | Maturity of Loan in Home country |
| 7 | Repay the loan along with Int and book profit |
Step 1:
Amount Borrowed CAD 10,00,000.00
Step 2:
Amount in Foreign Currency GBP 6,25,000.00
Step 3:
Invest in foreign currency for specified period 1 Years
Step 4:
Realize the Maturity Value in Foreign Currency
Maturity Value = Amount Deposited * ( 1 +r ) ^ n
r = Int Rate per anum
n - Time period in Years
= 625000 * ( 1 + 0.04 ) ^ 1
= 625000 * ( 1.04 ) ^ 1
= 625000 * ( 1.04 )
= 650000
Step 5:
Convert foreign currency proceedings into Home Currency using Actual Fwd Rate
= 650000 * 1.58
= 1027000
Step 6:
Maturity of Loan in Home country
= 1000000 * ( 1 + 0.02 ) ^ 1
= 1000000 * ( 1.02 ) ^ 1
= 1000000 * ( 1.02 )
= 1020000
Step 7
Profit = Amount realized from Inv - maturity Value of Loan
= 1027000 - 1020000
= 7000
Book Profit of 7000
Profit realized is CAD 7000.
OPtion E is correct.
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