You are a currency arbitrager for a Japanese bank. The spot rate this morning is JPY/USD 111.22, and early indications are that short-term interest rates in the United States (ninety-day rates) are about to rise from their current level of 3.125 percent. The Federal Reserve is worried about rising inflation and has announced that it is considering increasing short-term interest rates by twenty-five basis points (0.25 percent). The ninety-day forward rate quoted this morning to you by local banks are all about the same, JPY/USD 111.14. The current ninety-day yen deposit rate of interest is 2.156 percent. You have ¥250 million to invest.
a. How can you make a profit through an interest arbitrage transaction as described in Appendix 14.2? How much profit in yen can you hope to make in ninety days, given the above data?
b. If future spot exchange rates are determined by interest-rate differentials (that is, if the forward rate provided a good forecast of future spot rates), what would you expect the spot rate to be in ninety days if the Federal Reserve were to increase interest rates by twenty-five basis points?