Question

Consider the following information available in the Diamond Bank:
        Spot Rate for the British Pound Sterling                                                        $1.60
        90 – day forward rate of the pound                                                                $1.59
        90 – day UK interest rate                                                                                       4%
        90 – day U.S. interest rate                                                                                     3%
(a)Given this information, would it be a prudent strategy to engage in covered interest arbitrage? Explain
(b)If covered interest arbitrage is profitable how much profit would an investor earn if he/she uses $1,000,000?
(c)Briefly discuss the realignment process that will yield interest rate parity.

Answer 1

Fair forward rate = Spot rate*(1+Interest rate Dollar)/(1+ Interest Rate Pound)

= 1.60(1+0.03)/(1+0.04)

= $1.5846/Pound

Since actual forward rate is different, Covered interest arbitrage is possible and should be undertaken

b.Convert into pound at spot rate = 1,000,000/1.60 = Pound 625,000

Invest and get 625,000(1+0.04) = Pound 650,000

Convert back into USD at forward rate = 650,000*1.59 = $1,033,500

Dollar cost = 1,000,000(1+0.03) = 1,030,000

Arbitrage Profit = $3,500

c.Realignment Process:

This arbitrage process by market participants will increase the supply of pound and the value of pound would reduce to $1.5846 and will eliminate Covered interest arbitrage