First step is to identify which currency is overvalued in the forward market eg $/£ (GBP is base currency) let’s say this rate should be 1.4995 using interest rate parity but the quoted forward is 1.5110. Here GBP is overvalued therefore we should sell GBP forward (this is the same as buying USD forward). Step 2 is to recognise we need to deliver GBP so we need to buy GBP now to hedge this obligation i.e. buy at spot. Step 3, we finance this spot purchase by borrowing in USD.
So our overall trade is: borrow USD and buy GBP spot. Hold GBP until delivery and then sell at the overvalued forward rate to get USD. Use these USD to pay of the borrowing and to leave us with a profit.
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