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

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.

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