Question

Suppose that the current spot exchange rate is GBP1= €1.50 and the one-year forward exchange rate is GBP1=€1.60.
One-year interest rate is 5.4% in euros and 5.2% in pounds.
If you conduct covered interest arbitrage using EUR 25,000,000, which of the following will happen in the market?

A. EUR will depreciate in spot market
B. GBP will appreciate in forward market
C. Interest rate in EUR will decrease
D. Interest rate in GBP will increase
E. None of the above is correct

Answer 1

As per IRPT, fair forward rate = Spot Rate*(1+Interest rate Euro)/(1+Interest Rate Pound)

= 1.50*(1+0.054)/(1+0.052)

= Euro 1.5029/Pound

Since the actual forward rate is 1 pound = Euro 1.60

It means that pound is overvalued in the forward market and Euro is undervalued

While doing covered arbitrage, we will convert Euro into pound at spot rate, invest and convert it back into Euros to earn profit

Now, the market will start reaching the equilibrium stage with any of the following changes:

Pound will depreciate in forward market(since it is overvalued)

Euro will depreciate in spot market (since it is overvalued in spot market)

Interest Rate in Euro will increase

Interest rate in Pound will decrease

Hence, A. EUR will depreciate in spot market

A is the correct answer