Question

The spot rate between the U.K. and the U.S. is £.7559/$, while the one-year forward rate is £.7529/$. The risk-free rate in the U.K. is 4.37 percent and risk-free rate in the United States is 2.63 percent. How much in profit can you earn on $5,500 utilizing covered interest arbitrage?

Answer 1

Fair forward rate as per Interest rate parity theory = Spot rate*(1+Interest rate UK)/(1+Interest rate US)

= 0.7559*(1+4.37%)/(1+2.63%)

= Pounds 0.7687/$

Since actual rate is different, arbitrage is possible

Following steps will be taken:

Convert Dollar into Pounds at Spot rate and get 5500*0.7559 = Pounds 4,157.45

Invest for one year and get 4157.45*(1+4.37%) = Pounds 4,339.13

Convert into Dollars at forward rate = 4,339.13/0.7529 = $5,763.22

Amount if invested in Dollars = 5500*(1+2.63%) = $5644.65

Hence, arbitrage profit = $118.57