Question

Assume the following information: Spot rate of £ = $1.60

180-day forward rate of £ = $1.56

180-day British interest rate = 4%

180-day U.S. interest rate= 3%

(a) Based on this information, is covered interest arbitrage by U.S. investors feasible (assuming that U.S. investors use their own funds)? Explain.

(b) Does interest rate parity exist? Explain.

(Please provide detailed answers)

Answer 1

According to interest rate parity therom currency with higher interest rate will sell in discount in futures market to cancel the arbitrage

Interest in us is 3%

Interest in uk is 4%

So pound will sell in discount in forward market

Arbitrage free price is = s×(1+rf)/(1+rh)

Rf is foreign interest

rh is home interest

= 1.60×(1.03)/1.04 = 1.5846

Actual forward rate is 1.56

So arbitrage opportunity exists for us investors and feasible as theoretical rate and current futures rate is different

b) yes interest rate parity therom holds here in the given case until futures price is equal to theoretical rate investors will take the arbitrage opportunity so ultimately futures price will be equal to arbitrage free price