If you have a Japanese bond with a return of 2%, and an American bond paying 5%, but both current and forward exchange rates are 100 yen to 1 usd, how would one take advantage of this opportunity to make riskless returns?

As far as I see, you could short the American bond, but how would you pay it back? What would one do in practice?


1 Answer 1


You can have a look at the wikipedia article about covered interest rate parity.

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Any deviation is an arbirtage opportunity. In your case, $${{S_{t}}}\frac {(1+i_{\ ¥})}{(1+i_{\\\$})} = F_{t+k}$$

If you think of USDJPY now (how many JPY per USD), if JPY interest rate is 2% and USD 5% you get (for a year), the value of

$${100}*\frac {(1+0.02)}{(1+0.05)} = 97.1428571428571$$ which is the fair forward value. The higher interest rate country is depreciating (US). Here is your arbitrage.

In reality though, the two bonds will not have the same expiry date, coupon payments will fall on different dates and you only have one forward contract. So there is no real riskless arbitrage here.


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