Currently, the spot exchange rate is $1.50/£ and the
forward exchange rate is $1.52/£. The three-month interest rate is
8.0% per annum in the U.S. and 5.8% per annum in the U.K.
Assume that you can borrow as much as $1,500,000 or
• Determine whether the interest rate parity is currently holding.
• If the IRP is not holding, how would you carry out covered
interest arbitrage? Show all the steps and determine the
Forward rate as per Interest Rate Parity = Spot Rate*(1+Interest rate US)/(1+Interest Rate UK)
Since forward rate is different, IRP is not holding currently
Following Steps will be undertaken:
Convert into Pound at Spot rate and get 1,500,000/1.50 = Pound 1,000,000
Invest for 3 months and get 1,000,000*(1+5.8%*3/12) = Pounds 1,014,500
Convert into USD at forward rate and get 1,014,500*1.52 = $1,542,040
Repay Loan 1,500,000*(1+8%*3/12) = $1,530,000
Arbitrage Profit = $12,040
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