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Problem 6.7

Takeshi Kamada, a foreign exchange trader, wants to take advantage of potential profits from a covered interest arbitrage (CIA) between the US dollar and Japanese yen. Given the current spot exchange rate, 180-day forward rate, and interest rates in both currencies, the rule of thumb indicates he should borrow yen and invest in dollars since the difference in interest rates exceeds the forward premium. Doing so would allow him to lock in a CIA profit, even though the profit potential is small at -0.042%. The strategy involves investing $5 million in dollars at the higher 4.8% rate for 180 days, then selling the proceeds forward into yen at the 117.80 rate to repay the original y

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810 views

Problem 6.7

Takeshi Kamada, a foreign exchange trader, wants to take advantage of potential profits from a covered interest arbitrage (CIA) between the US dollar and Japanese yen. Given the current spot exchange rate, 180-day forward rate, and interest rates in both currencies, the rule of thumb indicates he should borrow yen and invest in dollars since the difference in interest rates exceeds the forward premium. Doing so would allow him to lock in a CIA profit, even though the profit potential is small at -0.042%. The strategy involves investing $5 million in dollars at the higher 4.8% rate for 180 days, then selling the proceeds forward into yen at the 117.80 rate to repay the original y

Uploaded by

Samer
Copyright
© © All Rights Reserved
Available Formats
Download as XLS, PDF, TXT or read online on Scribd
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Problem 6.

7 Takeshi Kamada -- CIA Japan

Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage
possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars
and Japanese yen. He faced the following exchange rate and interest rate quotes.

Assumptions Value Yen Equivalent


Arbitrage funds available $5,000,000 593,000,000
Spot rate (¥/$) 118.60
180-day forward rate (¥/$) 117.80
180-day U.S. dollar interest rate 4.800%
180-day Japanese yen interest rate 3.400%

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 ¥ - i $) -1.400%


Forward premium on the yen 1.358%
CIA profit potential -0.042%

This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to
lock-in a covered interest arbitrage (CIA) profit.

U.S. dollar interest rate (180 days)


4.800%

$ 5,000,000 → → 1.0240 → → $ 5,120,000


↑ ↓
↑ ↓
↑ ↓
↑ ↓
↑ ↓
Spot (¥/$) ---------------> 180 days ----------------> Forward-180 (¥/$)
118.60 117.80
↑ ↓
↑ ↓
↑ 603,136,000
593,000,000.00 → → 1.0170 → → 603,081,000
Japanese yen 55,000
3.400%
START Japanese yen interest rate (180 days) END

Takeshi Kamada generates a CIA profit by investing in the higher interest rate currency, the dollar, and
simultaneously selling the dollar proceeds forward into yen at a forward premium which does not completely negate
the interest differential.

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