Question

IRP arbitrage2

a.

If the interest rate in the United Kingdom is 5 percent, the interest rate in the United States is 4 percent, the spot exchange rate is $1.6789/£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 $1.6617/£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 $1.6617/£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)

= 1.6789(1.04)/(1.05)

= $1.6629/Pound

b.Actual Rate 1 Pound = $1.6617 (Less dollars per pound than it should be)

Borrow in Pounds

c.Borrow Pound1,000,000

Convert into Pound at Spot rate = 1,000,000*1.6789= $1,678,900

Invest and get 1,678,900(1.04) = $1,746,056

Convert Back into USD at forward rate 1,746,056/1.6617 = Pound 1,050,764.8793

Repay Loan 1,000,000*1.05 = Pound 1,050,000

Arbitrage Profit = Pound 764.8793 or 764.8793*1.6617 = $1,271