Describe the sequence of transactions required to do a covered interest arbitrage out of Japanese yen and into U.S. dollars
What will be an ideal response?
To do a covered interest arbitrage out of Japanese yen and into U.S. dollars, one would borrow yen from the bank at the bank's ask interest rate. You would owe interest on the yen and would have to return the yen principal at the end of the investment horizon. You would then convert the yen principal into dollars at the ask spot exchange rate of yen per dollar. You would pay the ask rate because you are buying dollars from the bank with yen. You would then invest the dollar principal at the bank's bid dollar interest rate. Because you would know how much the dollar interest plus principal would be at the end of the investment horizon, you would contract to sell that amount of dollars forward for yen. This forward contract would be made at the bank's forward bid rate of yen per dollar. If the amount of yen that you get from the forward contract exceeds the amount of yen that you owe the bank from the initial borrowing, you have successfully done a covered interest arbitrage.
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