Question

Currently, the spot exchange rate is $1.50/£ and the
three-month

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

£1,000,000.

• 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

arbitrage profit.

Answer #1

Forward rate as per Interest Rate Parity = Spot Rate*(1+Interest rate US)/(1+Interest Rate UK)

= 1.50*(1+8%*3/12)/(1+5.8%*3/12)

= $1.5081/Pound

Since forward rate is different, IRP is not holding currently

Following Steps will be undertaken:

Borrow $1,500,000

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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Page 3 of 13
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