The spot exchange rate is 114 ¥/$, the one-year forward price is 112.58 ¥/$ and prevailing one year continuously compounded risk-free interest rate in the USA is 2.85%.
a) What is the prevailing one-year interest rate in Japan if there is no arbitrage opportunity in the market?
b) Describe the arbitrage operations if the spot exchange rate changes to 113.5 ¥/$ but the forward is traded at the same price of 112.58 ¥/$. Clearly state your position in the replicative portfolio. How much should you borrow and lend in the two currencies per one unit of the base currency? Should you issue BUY or SELL orders in the FOREX and FRW markets?