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Covered Interest Arbitrage. Assume the following information: • British pound spot rate = $1.65. • British...

Covered Interest Arbitrage. Assume the following information: • British pound spot rate = $1.65. • British pound one-year forward rate = $1.65 • British one-year interest rate = 12 %. • U.S. one-year interest rate = 10 %. Explain how U.S. investors could use covered interest arbitrage to lock in a higher yield than 9 percent. What would be their yield? Explain how the spot and forward rates of the pound would change as covered interest arbitrage occurs.

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Answer #1

As per Interest rate parity:

As per Interest rate parity the difference in spot fate and forward rate exits due to differences in interest rate between two countries.

F/S = (1+ra)/(1+rb)

F= forward rate

S = spot rate.

ra = interest rate of price currency.

rb= interest rate of base currency.

If the above equation does not hold good then there is a chance of Arbitrage.

Spot Pound rate Rises,

Forward Pound rate declines.

ANSWER IN THE IMAGE. FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

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