Question

Currently the spot exchange rate is $1.33/£ and the one year forward exchange rate is $1.32/£. The yearly interest rate is 1% in US and 3% in U.K. Assume you can borrow as much as $1,330,000.

a.      Is interest rate parity currently (IRP) holding?

b.      If IRP is not holding, how would you execute a covered interest arbitrage? Show all the steps what you are going to do today and in one year. Also determine the arbitrage profit.

c.      Explain how IRP will be restored as a result of the above arbitrage strategy?

Answer 1

a.As per IRPT, Forward rate = spot rate*(1+interest rate dollar)/(1+interest rate Pound)

= 1.33*(1+0.01)/(.1+0.03)

=$1.304/pound

Since actual forward rate is different, Interest rate parity is not holding

B. borrow. $1,330,000

Convert into pound at spot rate = 1,330,000/1.33

= Pound1,000,000

Invest and get 1,000,000*(1.03) = pound 1,030,000

Convert back into dollar at forward rate = 1,030,000*1.32 = $1,359,600

Pay back loan = 1,330,000*(1.01) = $1,343,300

Arbitrage profit = $16,300

C.because of arbitrageurs, the demand for pound will increase and the value of pound will decrease to $1.304/pound

Hence, IRP will be restored