Question

The spot rate between the U.K. and the U.S. is £.7544/$, while the one-year forward rate...

The spot rate between the U.K. and the U.S. is £.7544/$, while the one-year forward rate is £.7526/$. The risk-free rate in the U.K. is 4.31 percent and risk-free rate in the United States is 2.60 percent. How much in profit can you earn on $6,500 utilizing covered interest arbitrage?

Multiple Choice

  • $106.84

  • $127.37

  • $94.97

  • $111.45

  • $101.89

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Homework Answers

Answer #1

IRPT Fwd Rate = Spot rate * (1 +Hi ) / ( 1+Fi )

Hi = Int rate in UK

Fi = Int rate in US

= 0.7544 ( 1 + 0.0431) / ( 1 + 0.0260 )

= 0.7544 ( 1.0431 / 1.0260)

= 0.7670

As IRPT fwd rate and actual Fwd rate are not same, there is arbitrage gain.

Covered Int Arbitrage :

Take Loan of USD 6500

Convert into Pound using spot Rate

amount in Pound = 6500 * 0.7544

= Pound 4903.6

Deposit in UK for 1 Year and realize the maturity value.

= Pound 4903.6 ( 1.0431 )

= Pound 5114.95

Reconvert into USD using Fwd rate

= 5114.95 / 0.7526

= USD 6796.37

Loan along with Int after 1 Year = 6500 * 1.026

= USD 6669

Profit = USD 6796.37 - USD 6669

= USD127.37

OPtion B is correct.

Pls do rate, if the answer is correct and comment, if any further assistance is required

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