Arbitrage in Montreal

1. 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.

1. 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.

1. How would you build up an arbitrage position? Describe your strategy and its mechanics.

Solution

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

Profit

1. 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

=19452.17