Question

Use the following information to questions 4-5

The year interest rate in the US is 5% and the 1 year risk free interest rate in the U.K. is 8.5%. to The current spot rate is $1.50/Pound and the current forward rate is $1.44/Pound

4. Which statement is correct?

a. Covered interest rate arbitrage involves borrowing in USD and investing in pounds.

b. covered interest rate arbitrage involves borrowing in pounds and investing in USD

c. IRP holds so covered interest rate arbitrage profit is not possible

d. covered interest rate arbitrage involves borrowing in USD and investing in USD

5. Which is the covered interest rate arbitrage profit in USD that you will realize in one year if you can borrow today 1 million of whichever currency you decide to borrow in?

a. USD 13,750

B. USD 19800

C. USD 12600

D. IRP holds so covered interest rate arbitrage is not possible

Answer 1

Forward rate as per IRP = Spot rate*(1+Interest rate US)/(1+Interest rate UK)

= 1.50(1+5%)/(1+8.5%)

= $1.4516/Pound

4.Since Pound is cheaper in forward rate than fair rate,

b. covered interest rate arbitrage involves borrowing in pounds and investing in USD

as more pounds can be available while converting back at forward rate

5.Borrow 1,000,000 Pounds

Convert to Dollars = 1,000,000*1.5 = 1,500,000

Invest and get 1,500,000*(1+5%) = 1,575,000

Convert back to pounds 1,575,000/1.44 = Pounds 1,093,750

Repay Loan 1,000,000*(1.085) = Pounds 1,085,000

Arbitrage profit = Pounds 8,750

i.e. USD 8750*1.44 = $12,600

i.e. C