Question 6 20 marks Suppose oneyear interest rate is 6 in eu

Question 6 (20 marks) Suppose one-year interest rate is 6% in euros and 4% in British Pound. The current spot exchange rate is GBP/EUR 1.50 and the one-year forward exchange rate is GBP/EUR 1.65. You can borrow at most EUR1,000,000 or the equivalent of Pound amount (i.e., GBP666,666.67) at the current spot exchange rate. (10 marks) Assume that you are realize a guaranteed profit from Covered Interest Arbitrage. Also determine the size of your arbitrage profit. (a) a euro-based investor, explain how you can Discuss how the Interest Rate Parity may be restored as a result of (b) (5 marks) the above arbitrage transactions. (c) If you are a British investor instead, analyze the covered (5 marks) arbitrage process and determine the profit amount in Pound.

Solution

The formula above can be altered to determine the forward exchange rate,

F = S * ((1 + i_f) / (1 + i_d)).

Where:

i_d is the interest rate in the domestic currency or the base currency.

i_f is the interest rate in the foreign currency or the quoted currency.

S is the current spot foreign exchange rate.

F is the forward foreign exchange rate.

F = 1.5* ((1 + .04) / (1 + .06)) = 1.47

Given one year forward exchange 1.65

but by covered interest rate parity F = 1.47. All other things being equal, it would make good sense to borrow in the British pounds, convert it in the spot market to Euros and invest the proceeds in Euros.

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Market participants will rush in to exploit an arbitrage opportunity if one exists, and the resultant demand will quickly wipes out the imbalance

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