Final answer:
John would need to compare exchange rates and interest rates, convert his funds to yen, invest in a higher-rate instrument, and use a forward contract to lock in the exchange rate for a future date. The risks include exchange rate fluctuations, credit risk, and transaction costs.
Step-by-step explanation:
When exploring covered interest arbitrage opportunities between the U.S. dollar and Japanese yen using $3,500,000, John would need to follow several steps:
Determine the current exchange rate between the two currencies.
Investigate the interest rates available for financial instruments in the U.S. and Japan.
Convert the $3,500,000 into Japanese yen at the current exchange rate.
Invest that amount into the financial instrument that provides the higher interest rate.
Use a forward contract to lock in the exchange rate for converting these funds back to U.S. dollars at the maturity of the investment based on the expected interest gain.
The potential risks associated with this arbitrage strategy include exchange rate fluctuations that could nullify the profit from interest differentials, the credit risk of the financial instrument in Japan, and transaction costs that could reduce the net gain from the arbitrage.