An arbitrager at Deutsche Bank notices that the yield on Brazilian Real 6-month risk-free bills is 5.5% per annum and the yield on U.S. 6-month T-bills is 7% per annum. The arbitrager also observes that the spot exchange rate is $0.6507/BRL and 6-month forward exchange rate is $0.6617/BRL. Assume that the spread in the borrowing and lending rates in either currency is zero.
a) Given the above quotes, compare the covered yield in BRL with the nominal yield in dollar and infer whether a covered interest arbitrage opportunity exists and what does it imply for funds flow due to arbitrage.
b) What transactions will the arbitrageur undertake to realize arbitrage profits in dollars net of transaction cost? Write all the steps clearly and show your calculations in each step. Assume that the bank has allowed a transaction size of $10 million or its BRL equivalent at the current spot rate. Also assume that the transaction cost is 0.2% of the transaction size to be deducted from the gross arbitrage profits at the end of 6-month period.
c) Suppose the nominal interest rates stay at the levels quoted above, what should be the no-arbitrage annualized forward premium/discount on BRL against $?