Term Papers on International Monetary Relations

Term Paper Title	International Monetary Relations
# of Words	831
# of Pages (250 words per page double spaced)	3.32

International Monetary Relations

Unit 4 - International Monetary Relations, part 1

Assignment Type: Individual Project

Due Date: 8/7/2004

Name

Part 1:

Assume that the 180-day interest rate is 1% and 3%, respectively in the U.S. and Japan. Also, the spot rate and 180-day forward rate are equivalent at 120 yen per one U.S. dollar ($.008333 per one Japanese yen). Discuss how you, as a trader for a commercial bank with $1,000,000 to invest, could earn a risk-free return by engaging in covered interest arbitrage? Be sure to show your calculations.

As a trader for a commercial bank there are several ways to invest in foreign currency to make a profit for the bank. One way that investors know to invest in a foreign investment is comparing the rates of return of foreign investments with those of domestic investment. If rates of return from a foreign investment are larger, the smart investor will shift funds abroad. Interest arbitrage refers to the process of moving funds into foreign currencies to take advantage of higher investment yields abroad. (Carbaugh) There is a risk associated with this process due to the fluctuation of the exchange rate. The risk can be eliminated by using the covered interest arbitrage. This is done in two separate processes. Initially exchange is made with domestic currency for a foreign currency that has a higher current spot and interest rate than the domestic currency at the time. This currency is then used to finance a foreign investment. As you’re doing this you also will contract in the forward market to sell the foreign currency that is expected from the investment. (Carbaugh) You want this to coincide with the maturity of the investments.

Assume that you had 1 million dollars that you wanted to invest and the interest rate is 1% in the U.S. and 3% in Japan for 180 days. Assume that the spot rate and the 180 day forward rate are equivalent at 120 yen per one U.S. dollar. (.00833 yen) With the interest rates being better in Japan the wise investment would be in the Japanese market. By investing using the covered arbitrage it will earn a risk-free investment return profit of 2% or 240,000 yens which would equal 2000 US dollars.

Extra return = (Japan interest rate- U.S. interest rate)

3% - 1% = 2%

Exchange Rate = Yen/dollar

120 yen = one dollar

240,000/120 = 2000

240,000 x .008333 = 1999.92

The covered interest arbitrage reduces the normal risk o...

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