Question

Use the following information to answer the next three questions.

1. As of today, the spot exchange rate is £1.25/$. The U.S. interest rate is 7% and the interest rate in the euro zone is 10%. What is the one-year forward rate (in terms of a direct quote from the US view) that should prevail according to IRP? Round intermediate steps and your final answer to four decimals.

Suppose that the one year forward rate is $.75/£ . Find the profit (in terms of percentage returns) you could earn via covered interest arbitrage. Assume the US is the home country. Round intermediate steps to four decimals.

.1033 |
||

.0387 |
||

.0669 |
||

.0433 |

3.

Which of the following could occur to eliminate the arbitrage opportunity?

An increase in the spot rate for pounds in terms of dollars. |
||

A decrease in the forward rate for pounds in terms of dollars. |
||

A decrease in the spot rate for pounds in terms of dollars. |

Answer #1

1.

As per Interest Rate parity, forward rate = Spot Rate (1+Interest Rate Pound)/(1+Interest Rate Dollar)

= 1.25(1+10%)/(1+7%)

= Pound 1.2850/Dollar

One year forward rate = $0.75/Pound or 1.333 Pound/Dollar

Borrow 1.25 pound

Convert into USD and invest for one year and get 1(1.07) = $1.07

Convert back into pound = 1.07*1.3333 = Pound 1.4266

Cost of pound after interest = 1.25(1.1) = Pound 1.375

% return = (1.4266-1.375)/1.375 = 0.0387 (approx.)

3.

A decrease in the forward rate for pounds in terms of dollars.

Since pound is overvalues in forward market

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