Problem 4.

5 Danish CIA (A)

Steve Shi, a foreign exchange trader at J.P. Morgan Chase, can invest $5 million, or the foreign currency equivalent of the bank's short term funds, in a covered interest arbitrage with Denmark. He has the following quotes: Assumptions Arbitrage funds available Spot exchange rate (kr/$) 3-month forward rate (kr/$) US dollar 3-month interest rate Danish kroner 3-month interest rate Value $5,000,000 6.1720 6.1980 3.000% 5.000%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency. Difference in interest rates (ikr - i$) Forward discount on the krone CIA profit potential 2.000% -1.678% 0.322%

This tells Steve Shi that he should borrow dollars and invest in the higher yielding currency the Danish kroner, for CIA profit.

START $ 5,000,000.00 Spot (kr/$) 6.1720 kr 30,860,000.00

U.S. dollar interest rate (3-month) 3.000% 1.0075 $

END 5,037,500.00 5,041,263.31 $ 3,763.31 Forward-90 (kr/$) 6.1980 kr 31,245,750.00

---------------> 90 days ---------------->

1.0125

5.000% Danish kroner interest (3-month)

Steve Shi generates a covered interest arbitrage (CIA) profit because he is able to generate an even higher interest return in Danish kroner than he "gives up" by selling the proceeds forward at the forward rate.

Problem 4.14 Statoil of Norway's arbitrage

Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it considers the U.S. dollar as its functional currency, not the Norwegian krone. Ari Karlsen is a currency trader for Statoil, and has immediate use of either $4 million or the Norwegian krone equivalent). He is faced with the following market rates, and wonders whether he can make some arbitrage profits in the coming 90 days. Assumptions Arbitrage funds available Spot exchange rate (Nkr/$) 3-month forward rate (Nkr/$) U.S. dollar 3-month interest rate Norwegian krone 3-month interest rate Value $4,000,000 6.5520 6.5264 5.625% 4.250% Krone Equivalent 26,208,000

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency. Difference in interest rates ( i Nkr - i $) Forward premium on the krone CIA profit -1.375% 1.569% 0.194%

This tells Ari Karlsen he should borrow U.S. dollars and invest in the lower yielding currency, the Norwegian krone, selling the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.

Norwegian krone interest rate (3-month) 4.250% 26,208,000.00 Spot (Nkr/$) 6.5520 $ 4,000,000.00 Borrow US$ 1.0106250 26,486,460.00 Forward-90 (Nkr/$) 6.5264 $ 4,058,356.83 $ 4,056,250.00 $ 2,106.83

---------------> 90 days ---------------->

1.01406250

START

5.625% U.S. dollar interest rate (3-month)

END

Ari Karlsen can make $2,106.83 for Statoil on each $4 million he invests in this covered interest arbitrage (CIA) transaction. Note that this is a very slim rate of return on an investment of such a large amount. Annualized rate of return: 0.2107%