Question

The spot exchange rate is currently $1.31/£ and the six-month forward exchange rate is $1.25/£. The six-month interest rate is 5.7% per annum in the U.S. and 4.7% per annum in the U.K. Assume that you can borrow as much as $1,310,000 (in the US) or £1,000,000 (in the U.K.).
a. Determine whether the interest rate parity (IRP) is currently holding.
b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit. [Hint: You need to determine whether the US investor or UK investor can borrow and capitalize]
c. Explain how the IRP will be restored as a result of covered arbitrage activities.

Answer 1