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