CFA Practice Question

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CFA Practice Question

Given the following data, what will an arbitrageur earn after one year on a covered interest arbitrage if he begins with $1 million borrowed money?

In New York today Interest rate = 7%
In London today spot rate = $1.75/£ Interest rate = 12%
In London one year forward rate = $1.68/£
A. $7,560
B. $5,200
C. $6,800
Explanation: Begin by borrowing $1,000,000 at 7%, owing $1,070,000 at year end. Convert the $1,000,000 at $1.75/£ = £571,428.57 and invest this in London at 12% yielding £640,000 at year end. At the same time, sell the £640,000 forward at a rate of $1.68/£ for delivery in one year yielding $1,075,200 at year end. At the end of the year, collect the £640,000 and deliver to the bank's foreign exchange dept. in return for $1,075,200. Repay the $1,070,000 from the $1,075,200 leaving a profit of $5,200.

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