Question

IRP arbitrage

a.

If the interest rate in the United Kingdom is 4 percent, the interest rate in the United States is 6 percent, the spot exchange rate is $1.4528/£1, and interest rate parity holds, what must be the one-year forward exchange rate? (Do not round intermediate calculations. Round your answer to 4 decimal places. (e.g., 32.1616))

One-year forward exchange rate

$  per £

b.

If the forward rate is actually $1.4822/£1, would you borrow in dollars or pounds to make an arbitrage profit?

	Dollars
	Pounds

c.

If you can borrow either $1 million or £1 million (borrow in currency identified in previous part) to capitalize on the arbitrage profit using the actual forward rate of $1.4822/£1, what is your arbitrage profit at the end of the year expressed in $dollars? (Do not round intermediate calculations. Round your answer to 4 decimal places. (e.g., 32.1616))

Arbitrage profit in $

$

Answer 1

As per Interest rate parity, forward rate = Spot Rate(1+Interest Rate US)/(1+Interest rate UK)

= 1.4528(1.06)/(1.04)

= $1.4807/Pound

b.Actual Rate 1 Pound = $1.4822 (More dollars per pound than it should be)

Borrow in Dollars

c.Borrow $1,000,000

Convert into Pound at Spot rate = 1,000,000/1.4528 = Pound 688,325.99

Invest and get 688,325.99(1.04) = Pound715,859.03

Convert Back into USD at forward rate 715,859.03*1.4822 = $1,061,046.2555

Repay Loan 1,000,000*1.06 = $1,060,000

Arbitrage Profit = $1,046.2555