Question

World Nation Bank offers the following information (ignore bid/ask spreads):

Spot rate on Pound = $1.28 (US$1.28 / 1GBP)

            180 day forward rate on Pound = $1.30 (US$1.30 / 1 GBP)

Customers can borrow or deposit US dollars for 180 days at 4% per year (2.0% per 180 days)

Customers can borrow or deposit Pounds for 180 days at 3.2% per year (1.6% per 180 days)

Suppose a US customer has $100,000, if he deposits the $100,000 in World National bank he will have $102,000 at the end of 180 days. If he uses covered interest arbitrage, how many US dollars will he have at the end of 180 days?

US dollars from covered interest arbitrage = ___________________

Suppose a British customer has 100,000 Pounds, if she deposits the 100,000 Pounds in World National bank she will have 101,600 Pounds at the end of 180 days. If she uses covered interest arbitrage, how many Pounds will she have at the end of 180 days?

Pounds from covered interest arbitrage = _______________________

Answer 1

1. If US Customer uses covered interest arbitrage, then he will convert $ 100,000 into pounds on spot rate, i.e., 78,125 GBP ($ 100,000/ $ 1.28 ), if he deposit 78,125 GBP in World National bank for 180 days @ 3.2% per year , then he will get 79,375 GBP.

Converting into dollars, 79,375 GBP x $ 1.30 = $ 103,187.5

US dollars from covered interest arbitrage = $ 103,187.5

2. 1. If British customer uses covered interest arbitrage, then he will convert 100,000 GBP into US dollars on spot rate, i.e., $ 128,000 (100,000 GBP x $ 1.28 ), if he deposit $ 128,000 in World National bank for 180 days @ 4% per year , then he will get $ 130,560.

Converting into pounds, $ 130,560/ $ 1.30 = 100,430.77 GBP

Pounds from covered interest arbitrage = 100,430.77 GBP