Question

Question 1
(a) Assume the following information:

Spot rate of £ = $1.60
180-day forward rate of £ = $1.59
180-day British interest rate = 4%
180-day U.S. interest rate = 3%
Based on this information, is covered interest arbitrage by U.S. investors feasible (assuming that U.S. investors use their own funds ($1 million))? Explain.

(b) Covered Interest Arbitrage in Both Directions. The one-year interest rate in New Zealand is 6 percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is $0.50. The forward rate of the New Zealand dollar is $0.54. Is covered interest arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is or is not feasible.

(c) Assume that annual interest rates in the United States are 4 percent, while interest rates in France are 6 percent.
(i) According to IRP, what should the forward rate premium or discount of the euro be?
(ii). If the euro’s spot rate is $1.10, what should the one-year forward rate of the euro be?

(d) The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14.
Based on the international Fisher effect, what is the expected change in the spot rate over the next year?
Question 2
(a) The one-year risk-free interest rate in Mexico is 10 percent. The one-year risk-free rate in the United States is 2 percent. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14.
(i). What is the forward rate premium?
(ii). What is the one-year forward rate of the peso?

Answer 1

a) As per Interest rate parity

Theoretical Forward rate = Spot rate * (1+ US interest rate ) /(1+ British interest rate )

= 1.6* (1+0.03)/(1+0.04)

= 1.5846154

As this is different from the 180-day forward rate , Arbitrage is possible

Arbitrage steps :

1 . Convert $1 million to UK pounds today at spot rate to get 1/1.6 million pounds = 625000 pounds

2. Invest these pounds today in Britain for 180 days. Maturity amount = 625000* (1+0.04) =650000 pounds

3. Sell 650000 pounds in forward at a rate of $1.59/pound to get 1.0335 million US Dollars

Thus, US investors can effectively get an interest rate of 3.35% by using Covered Interest Arbitrage as against 3% stated.