Question

1. You have $1,000,000 to invest:

Current spot rate of pound: $1.30

90-days forward rate of pound $1.28

3 month deposit rate in U.S 3%

3 month deposit rate in U.K 4%

If you covered interest rate arbitrage for a 90 days investment, what will be the amount of U.S dollar you will have after 90 days?                                      

Answer 1

Since it is a case of covered interest rate arbitrage, we would start by converting the $1 million to = 1/1.3 = 0.7692 million Pounds and going long on the forward rate as well. Then, we will put our pounds to use by lending them at the 4% rate. After 3 months, we will get back = 0.7692 x 1.04^(3/12) = 0.77677 million pounds. Now, we make use of the forward and convert it to USD and we will have = 0.77677 x 1.28 = $0.9942 million. So, we see that this trade will actually give us a loss. Hence, it is not advisable to go with this. We can instead put our USD to interest and get = 1 x 1.03^(3/12) = $1.0074 million after 3 months.