John Jones, a foreign exchange trader, wants to invest $500m or its Norwegian Krone (Nok) equivalent in an interest arbitrage. 

The following information is available to him:
Nok/$ spot exchange rate is Nok5.9547/$
Nok/$ 180-day forward rate is Nok6.0158/$
Nok/$ expected spot rate in 180 days is Nok6.1042/$
$180-day interest rate is 1.5% p.a.
Nok180-day interest rate is 4% p.a.

Required:
a) Discuss the possibility that John can make a covered arbitrage profit assuming he will use formal markets to cover this operation. What is the rate of return on this operation in annual terms? Support your answer with appropriate calculations and diagrams where possible.

b) If the $180-day interest rate changes to 2.5% p.a., and all other rates and information are maintained, do you think that he is able to make arbitrage profits? Explain why.

c) If the Nok180-day interest rate changes to 6% p.a., and all other rates and information are maintained as in part do you think that he is able to make arbitrage profits? Explain why.

d) John believes that exchange rates will not move against the way he predicts and he decides to not cover this operation. Assess his decision supporting your answer with appropriate calculations and diagrams where possible.

Answer rating: 100% (QA)

a To determine if John can make a covered arbitrage profit we need to compare the potential return from investing in Nok and converting it back to USD ... View the full answer