Question

BL lives in the US and has $800,000 surplus funds that he wants to invest for one year in any currency. He receives the following quotes from a commercial bank:

Spot rate= 1 British Pound: $50-55

One-year forward rate= 1 British Pound: $58-64

One-year US interest rate= 6%

One year UK interest rate= 1%

(i) With supporting calculations, advise BL whether covered interest arbitrage is worthwhile.

(ii) Would your advice differ, if transaction costs in respect of the covered interest arbitrage amount to $5,000?

(iii) Using the interest rate parity model, calculate the interest differential between the two countries.

Answer 1