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IAI Actuarial Core Principles · Business Economics · Balance of payments and exchange rates

An Indian insurer observes that the one-year forward rate is Rs 79 per dollar when covered interest parity implies Rs 77.88, with spot Rs 75, Indian rate 8% and US rate 4%. Ignoring transaction costs, which action yields a risk-free arbitrage profit?

Borrow rupees, buy dollars at spot, invest in the US, and sell the dollar proceeds forward at Rs 79. This gives Rs 82.16 against a repayment of Rs 81.00, a risk-free gain of Rs 1.16 per dollar, because the forward dollar is overpriced.

  1. ABorrow dollars, convert to rupees at spot, invest in India, and sell rupees forward for dollars at Rs 79
  2. BBorrow rupees, convert to dollars at spot, invest in the US, and sell dollars forward at Rs 79Correct
  3. CBorrow rupees and invest in India, leaving the position uncovered
  4. DInvest in the US and leave the dollar proceeds unhedged
  5. No arbitrage exists because interest rates differ

Explanation

Dollars are overpriced forward (79 > 77.88). Borrow Rs 75 at 8% (owe 81.00), convert to $1, invest at 4% to get $1.04, sell forward at 79 to receive Rs 82.16, a profit of Rs 1.16. Option A reverses the trade and would lose money. Unhedged positions are not arbitrage.

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