Covered interest risk-free arbitrage

CFA Level I
#1

An investor examines the following rate quotes for the Brazilian real (BRL) and the Australian dollar (AUD) and shorts BRL500,000.

  • Spot rate BRL/AUD: 2.1128
  • BRL 1-year interest rate: 4.1%
  • Forward rate BRL/AUD: 2.1388
  • AUD 1-year interest rate: 3.1%

The risk-free arbitrage profit that is available is closest to:

  1. A.–BRL6,327.
  2. B.BRL1,344.
  3. C.BRL6,405.

Why don’t we use the covered interest formula? I don’t really understand the method here.

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Correct B
From practice questions

#2

The forward rate should be 2.1128 x 1.041 / 1.031 = BRL 2.1333, but some valued counterparty :clown_face: is willing to pay you BRL2.1388. Therefore, you want to have AUD a year from now, which means you need AUD today; you exchange BRL today for AUD.

#3

Okay, that makes sense what you are saying. I think I have to reread the book here because I got a pretty low score on this chapter. Thank you for your input!