Question: Interest Rate Parities Explain the difference between the covered and uncovered interest rate parities. Then answer questions below. A foreign exchange trader at J.P. Morgan

Interest Rate Parities

Explain the difference between the covered and uncovered interest rate parities. Then answer questions below.

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. Using the following quotes can Heidi make covered interest arbitrage (CIA) profit? Show all the steps involved in the arbitrage.

Assumptions

Value

Arbitrage funds available

$5,000,000

Spot exchange rate (kr/$)

6.1720

3-month forward rate (kr/$)

6.1980

US dollar 3-month interest rate

3.000%

Danish kroner 3-month interest rate

5.000%

The same trader observes that the kr/$ spot rate has been holding steady, and both the US dollar and Danish krone interest rates have remained relatively fixed over the past week. He wonders if he should try an uncovered interest arbitrage (UIA) and thereby save the cost of forward cover. Many of his research associates -- and their computer models -- are predicting the spot rate to remain close to kr 6.18/$ for the coming 3 months. Using the same data as in (a), find the UIA profit in USD and KRONE. Show all the steps involved in the arbitrage.

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