zephyranalyst

Well i agree that your above trade is not risk free, but the difference between buying a stock and buying a forward contract is the price you get in the future is fixed, unless the counterparty defaults and then your screwed so its not entirely risk free, but lets face it would could spend the day arguing that alot of the stuff the cfa teachs is you is not entirely applicable to the real world, thats because alot of it is just financial theory, and may not hold in practice, but its the CFAI's exam and we just have to accept that for the exam

needhelp1700

ok try not to get hung up on the infinite return. Reading your other posts, you understand this. Its just you are getting hung up on my infinite return comment and you are mixing before borrowing cost returns and after borrowing cost returns. I will try another attempt:

Dreary said:
It's not correct to view it like that. Here an investment of 1000 yen turned into 1004.9629 yen, a return of 0.496%. Whether those 1000 yen were yours or your sister's is immaterial. No such thing as infinite return.


Ok the book in its calculation is asking the first question: If you invest 1000 yen (invest in US then convert back to YEN) then you turned it into 1009.8155. Whats your return? its = 3.88% 1009.8155/1000 -1 = .0098 *360/90 = 3.93% That is what the book did.

Now the book says if you can earn 3.93% and you can borrow at 2% do you make money. Yes.

Now in the method i first demonstrated calculating the arbitrage profit. We subtract he principle and interest from 1009.8155.

Regarding infinite return, maybe its best for you to forget it but I will attempt another explanation. It does matter whose money it is. Did you invest 1000? No. You didn't have to put any money at risk. The bank/sister did. When it blows up. They lose, not you. They are only getting back the 2% interest rate you borrowed at. You get all profits.

how much money did you start with. ZERO. whats your initial investment= Zero. Did you invest in 1000 Yen YES but your net investment is 1000 less 1000 loan so zero. You turned 0 in $4.

Your IBM example is not arbitrage:
We can make it arbitrage by the following:
You borrow 100k at 9%. You long IBM stock 100k. You enter a forward to sell IBM at the end of the year at 110k. It doesn't matter what happens (IBM could drop, could go up, it doesn't affect your profit). You make 1k. Its an arbitrage profit because you lock in your return (profits) and you lock in your loan rate (borrowing costs). Arbitrage means that you returns and cost are fixed and known. If its not, then its not arbitrage.

I hope this is helpful. I think you really understand this but the books example is getting you confused and my infinite return really sent you the wrong direction.

Rasec

stingreye Wrote:
-------------------------------------------------------
> Now the book says if you can earn 3.93% and you
> can borrow at 2% do you make money. Yes.

ok, I re-read it again and I think you're right...you are earning about 1.93% above the risk-free rate, which then becomes risk-free return.

> how much money did you start with. ZERO. whats
> your initial investment= Zero. Did you invest in
> 1000 Yen YES but your net investment is 1000 less
> 1000 loan so zero. You turned 0 in $4.

This is debatable, as you are making some questionable assumptions, e.g., that you can borrow without any kind og collateral, and you're ignoring opportunity costs.
>
> Your IBM example is not arbitrage:
> We can make it arbitrage by the following:
> You borrow 100k at 9%. You long IBM stock 100k.
> You enter a forward to sell IBM at the end of the
> year at 110k. It doesn't matter what happens (IBM
> could drop, could go up, it doesn't affect your
> profit). You make 1k. Its an arbitrage profit
> because you lock in your return (profits) and you
> lock in your loan rate (borrowing costs).
> Arbitrage means that you returns and cost are
> fixed and known. If its not, then its not
> arbitrage.

I agree with that. I brought up the IBM example to talk about the infinite return thing.