Currency Forward Contracts currency, understand, interest, mkt

segalm

I am having a hard time with these types of FRA. I understand the convered interest arbitrage and which currency should be sold or bought but the steps are hard to follow. I don't follow step 2, can someone please help explain?

1) If fwd price is higher and you sell at mkt price
2) buy 1/(1+rf)^T units of foreign ccy
3) hold position and earn interest
4) at maturity deliver the ccy and get paid the fwd price

tikfed

steps 2 and 3 combined means you are ending up with 1 Unit of the foreign currency.

do you see that?

buy 1/(1+rf)^T units of foreign currency.
It earns (1+rf)^t of Interest

you end up with 1 unit of foreign currency.

when you deliver that - in Step 4 - you end up with Forward currency contract amount for the 1 unit of FC.

CP

redskins44

Thanks CP...i got the unit of foreign ccy. So to calculate the rate of return from this arbitrage, you take the (fwd price/spot price)-1? And is spot price what we got from step 2?
Can you please walk me through this question?
For example p.54 from text book. Euro trades at $1.0231, USD risk free is 4% and Euro risk free is 5%. 6 months forward contracts are quoted at $1.0225.
Indicate how you can earn a risk free profite and outline the steps.

eoin

CP- i actually used 1eur and got the same answer as you but the book's answer of return is not factoring in the cost of borrow. So they have (1.0225-.9988)=.0237 as arbitrage profit.