1. Suppose the annual interest rate is 3.5% in U.S. and 4.5% in U.K., and that the spot exchange rate is S($/£) = 1.3918 and the forward exchange rate with 12-month maturity is F12($/£) = 1.3526. Assume you are a U.S. trader and can borrow up to $1,000,000 (or £1,000,000). Answer the following questions.
a. Is there an arbitrage opportunity according to the Interest Rate Parity based on the above information? (show your work!)
b. Show the strategy to capture the arbitrage profit by setting up a transaction table. Listing the required transactions and cash flows. Your arbitrage profit should be in U.S. dollar.
IRPT FWD Rate = Spot Rate * (1+Hi )/ (1 +Fi)
where HI is int rate in US & Fi is Int rate in London
= 1.3918 * (1.035) / 1.045
Actual Fwd rate is not equal to IRPT forward rate, Hence arbitrage is possible.
Fwd Discount = Fwd rate - Spot rate / Spot rate
= 1.3526 - 1.3918 / 1.3918
= -0.0392 / 1.3918
Adjusted Fi = 4.5% -2.8%
Thus Borrow in Pounds
Borrow Pounds 1,000,000
COnvert it into USD using Spot rate
AMount in USD = 1,000,000 * 1.3918
Dposit this amount in USD
Maturity Value = 1391800 * 1.035
= USD 1,440,513
COnvert it into Pounds using Fwd rate
Amount in Pound s = 1,440,513 / 1.3526
Settle the loan along with Int
= 1,000,000 * 1.045
= Pound 1,045,000
Book Profit = 1,064,995.56 - 1,045,000
Arbitrage Profit in USD = 19,995.56 * 1.3526
= USD 27,046
Get Answers For Free
Most questions answered within 1 hours.