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