Question

Interest rates in Sri Lanka are 6.25% p.a and in Singapore, they are currently at 1.25% p.a. The SGD/LKR spot rate is 13.48.
(a) Calculate the theoretical two-year forward rate of the SGD implied by Interest Rate Parity.
(b) Now assume the actual two-year forward rate is SGD/LKR 11.50. What, if any, is the percentage return from engaging in Covered Interest Arbitrage? (Calculate as a percentage of your initial borrowing, accurate to 4 decimal places, making sure to include any opportunity cost in your calculations)

Kindly show all workings.

Answer 1

r1: interest rate in Singapore = 1.25%

r2: interest rate in Srilanka = 6.25%

F(2)*: 2-year theoretical forward rate

S: Spot rate

F(2)* = S*((1+r1)/(1+r2))^2 = 13.48*((1+1.25%)/(1+6.25%))^2 = 12.24

F(2): 2-year actual forward rate

Since F(2) is less than F(2)*, we will go long on the forward contract

i.e. Borrow 100,000 in LKR and conver to SGD at spot rate

SGD received = 100000*13.48 = 1348000

Invest SGD received at 1.25%

Amount received after 2-years = 1348000*(1+1.25%)^2 = SGD 1381910.6250

Amount converted back to LKR (based on 2-year forward rate) = 1381910.6250/11.50 = LKR 120166.1413

Amount in LKR to pe paid back = 100000*(1+6.25%)^2 = 112890.6250

Gains = 120166.1413-112890.6250 = LKR 7275.52

Gains % =  7275.52/100000 = 7.2755%