Question

Let's suppose you have $1.5 million to invest. You are considering to invest in UK first,...

Let's suppose you have $1.5 million to invest. You are considering to invest in UK first, then convert the British Pound back to US$ in the future.

You know the following information:

Annual Interest rate on investment in US: 0.2%

Annual Interest rate on investment in UK: 1.5%

Investment period: 1 year

Current exchange rate: 1.65 $/BP

The forward exchange rate which you can apply when converting BP to US$: 1.63 $/BP In this case, what would be profit through the covered-interest arbitrage?

(The answer is $2053, can you please show me the work to get this answer.)

Homework Answers

Answer #1

Investment amount (USD) = 1,500,000

Spot rate (USD/GBP) = 1.65

Investment amount (GBP) = Investment amount (USD)/1.65USD/GBP = 909,090.91 GBP

This is invested at 1.5% p.a., so interest earned in 1 year is 1.5%*909,090.91 = 13,636.36 GBP

Total amount after one year (GBP) = 909,090.91 + 13,636.36 = 922,727.27 GBP

Hedge the exchange rate risk by by selling the total amount earned at the forward rate of 1.63USD/GBP, so the total amount earned (USD) = 922.727.27GBP*1.63USD/GBP = 1,504,045.45 USD

You had invested USD 1.5 million, so your profit is 1,504.045.45 - 1,500,000 = 4,045.45 USD (Answer)

Note: If it is assumed that USD 1.5 million is borrowed then the interest amount will have to be deducted from the profit.

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