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3) The spot USD /GBP rate is 1.5711. The1 year t-bill rate in the US is...

3) The spot USD /GBP rate is 1.5711. The1 year t-bill rate in the US is .19%. The 1 year rate in the UK is 0.39%. a) Calculate the 1 year USD/GBP 1 year forward rate. b) If the observed 1 year forward rate is 1.60 USD/GBP, is there an arbitrage opportunity? How would you take advantage of this? Show all your transactions and steps.

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Answer #1

Spot USD/GBP rate = 1.5711

a) 1 year USD/GBP forward rate = Spot rate * (1+Domestic currency interest rate)/(1+foreign currency interest rate)

= 1.5711 * (1+0.19%)/(1+0.39%)

= 1.56797, which means the USD will be at a forward premium

b) The observed 1 year forward rate is 1.60 which differs from the ideal forward rate. This means an arbitrage opportunity exists here.

c) I would sell GBP forward for 1 year @ 1.60. This means for every 1 GBP I sell I would get USD 1.60 instead of the ideal 1.56797. This is how I would take advantage of the arbitrage opportunity.

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