Which currency to borrow/sell. currency, problems, question, always, borrow

segalm

This has always given me problems and I am a retaker.


When you are doing a question where there is an arbitrage oppurtunity, currency forwards etc. Can some one please explain how do you know which currency to borrow or sell.

I can calculate the arbitrage profit from there but I am always clueless on when to borrow/sell.

An answer will be greatly appreciated as this will also clear up some covered arbitrage issues in econ as well.

liquidity

please provide an example problem and we can walk through the solution...

that is more helpful, than talking in the air.

CP

5566

Most of the time its borrow domestic, cash to foreign, invest at foreign rate, cash to domestic and subtract out the domestic borrowed plus interest. If its a negative number, go the other way...

giorgio10

buy low sell high!!!! just think of everything that way.

llxx

I use the interest rates to guide me rather than the currencies. Currencies are too confusing.

Borrow in currency where interest rates are too low.
Lend in currency where interest rates are too high.

BelalM

After all of this I am more clear but still not 100% sure. I think soddy 1979 generic answer has helped me most but my general sticking point is determining which currency is over/under valued

CP in the second example, the no arbitrage forward price is greater than the ($0.00817) is greater than the 3 month forward contract ($0.00813)

I just want you to let me know if my thinking below is correct. I am using the simplest currency quotation so it is clear.

JPY:US = 10.00817 NO ARBITRAGE PRICE
JPY :US = 10.00813 forward contract

Therefore JPY is undervalued in the forward market since it is below the no arbitrage price.

Therefore I should enter into a forward contract to buy JPY in three months time @$0.00813.

At the same time i should sell JPY now. In order to sell JPY I would need to be holding JPY.

Therefore the steps i thought were

1. Borrow 1000 JPY, this is worth 1000 x(1.02)^0.25 in three months = 1004.96 JPY

2. Sell 1000 JPY now and buy $US = $8.12

3. Invest $us at US rfr =$8.12 x (1.045)^0.25= $8.21US

4. Buy forward contract with $8.21US = 8.21/0.00813 =1009.84jpy

5. Profir = 1009.84-1004.96 = 4.88 JPY


The yield on the transaction would be the solution to 1000 X (1+I)^0.25 = 1009.84

This is equalt to 3.93% > 2%.