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%.