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You are running the trading desk at a large, high‐grade investment bank. You have the following rates available to you:
Spot Dollar/Yen Exchange Rate 113.68 U/$ 3-month Forward Dollar/Yen Rate 113.11 U/$ 3-month US (dollar) Risk-free Interest Rate 3.50%
Assume that there are no transaction costs, and that you can either buy or sell at these exchange rates. Also, the interest rates above are quoted in annualized, continuously‐compounded form, and are the same for borrowing or lending.
a. What must the 3‐month Japanese (yen) interest rate (annualized, continuously compounded) be for there to be no arbitrage?
b. Suppose that the annualized, continuously‐compounded 3‐month Yen interest rate is 1.0%. Describe exactly what transactions you would undertake at these prices/rates to lock in an arbitrage profit.
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