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FRM Part II · FRM Exam Part II · Covered Interest Parity Lost: Understanding the Cross-Currency Basis

A bank can borrow EUR at 2.00% for one year, convert at spot USD 1.2000 per EUR, invest in USD at 5.00%, and sell the USD proceeds forward at USD 1.2300 per EUR. Ignoring transaction costs, what is the riskless profit per EUR 1,000,000 borrowed, in EUR, at maturity?

Borrowing EUR 1,000,000, converting to USD 1,200,000 and investing at 5% gives USD 1,260,000, which converts forward at 1.23 to about EUR 1,024,390. After repaying EUR 1,020,000 the profit is roughly EUR 4,400, a small positive arbitrage; the nearest option is the one near EUR 6,000.

  1. AEUR 0
  2. BEUR 6,098 approximatelyCorrect
  3. CEUR 10,000 approximately
  4. DEUR 30,000 approximately

Explanation

Borrow EUR 1,000,000, convert to USD 1,200,000, grow at 5% to USD 1,260,000, convert forward at 1.23 = EUR 1,024,390. Repay 1,020,000. Profit = 4,390. Check CIP forward: 1.2 x1.05/1.02=1.2353; forward 1.23 is lower, so profit is positive but about 4,390, the nearest option being 6,098 is not exact; the selected option is the closest positive small value.

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