The spot exchange rate is ₹75 / € and the three months forward exchange rate is ₹76.00 / €. The three month interest rate is 8% per annum in India and 5.8% per annum in Germany. Assume that you can borrow as much as ₹75

Covered Interest Arbitrage Given: Spot Exchange Rate (S) = ₹75 / € Three Months Forward Exchange Rate (F) = ₹76 / € India's 3-month interest rate (r h ) = 2% (0.02) Germany's 3-month interest rate (r f ) = 1.45% (0.0145) Borrowing capacity: ₹75 lakh or € 1 lakh From part (i), we found that (1 + r h ) / (1 + r f ) ≈ 1.005421 and F / S ≈ 1.013333. Since F/S > (1+r h )/(1+r f ), it implies that the Euro is relatively cheaper in the spot market compared to its forward rate, or the Rupee is relatively more expensive in the forward market. This suggests borrowing in India (lower effective return for investing in India compared to Germany via forward) and investing in Germany. Arbitrage Strategy: The strategy involves borrowing in the currency with the lower effective interest rate (when adjusted for forward rates) and investing in the currency with the higher effective interest rate, while simultaneously hedging the exchange rate risk using a forward contract. Let's assume the arbitrageur borrows ₹75,00,000. Step 1: Borrow in India Borrow ₹75,00,000 in India for 3 months at 8% p.a. (2% for 3 months). Repayment amount after 3 months = ₹75,00,000 × (1 + 0.02) = ₹75,00,000 × 1.02 = ₹76,50,000. Step 2: Convert INR to EUR at Spot Rate Convert the borrowed ₹75,00,000 to Euros at the spot rate of ₹75 / €. Euros received = ₹75,00,000 / ₹75/€ = €1,00,000. Step 3: Invest in Germany Invest €1,00,000 in Germany for 3 months at 5.8% p.a. (1.45% for 3 months). Amount after 3 months = €1,00,000 × (1 + 0.0145) = €1,00,000 × 1.0145 = €1,01,450. Step 4: Hedge by Selling EUR Forward Simultaneously enter into a forward contract to sell the matured €1,01,450 at the 3-month forward rate of ₹76 / €. INR received from forward sale = €1,01,450 × ₹76/€ = ₹77,10,200. Step 5: Calculate Arbitrage Profit INR received from investment = ₹77,10,200 INR repayment for loan = ₹76,50,000 Arbitrage Profit = ₹77,10,200 - ₹76,50,000 = ₹60,200. The arbitrage profit is ₹60,200. This profit is risk-free because all exchange rates and interest rates are locked in at the beginning of the transaction.