Arbitrage in Montreal
- What principle links the four prices? What is the relevant mathematical formulation?
The relevant mathematical formulation for linking the four prices is the IRP (Interest Rate Parity) theorem:
In the theorem S stand for spot rate, F stand for forward rate, IF stand for the interest rate of foreign currency and ID stand for interest rate of domestic currency.
- Identify any arbitrage opportunities and explain how they might have come about.
Spot rate CAD 1.1520/USD
6M forward rate CAD 1.1635/USD
6M CAD money market rate 10%
6M USD money market rate 7.50%
Now putting the values in theorem
It can be seen that the theorem did not proved true which indicates that the arbitrage opportunity does exist.
- How would you build up an arbitrage position? Describe your strategy and its mechanics.
Amount 10000000 will be converted into dollars
Therefore borrow $8680555.55
Repayment of interest
Now $8680555.55 will be converted in CAD on spot rate that is equivalent to 10000000
Now 10500000 will be sold on Forward Rate
- Calculate your profit resulting from the preceding arbitrage strategy.
As the main currency is Canadian Dollar the profit is evaluated in CAD
16718.67 * 1.1635