22 Suppose US interest rates are 58 British interest rates a

22. Suppose U.S. interest rates are 5.8%, British interest rates are 9.2%, and the current spot rate is £1=$1.60. How could one take advantage of this if the forward rate is actually £1=$1.55. What trades should you make to obtain an arbitrage profit? Select one: a. Borrow in pounds invest in US b. Borrow in US invest in pounds c. It is impossible to detemine d. No arbitrage opportunity exists

Solution

ACCORING TO INTEREST RATE PARITY THEORM,

FORWARD RATE = SPOT RATE*(1+ US RATE)/(1 + POUND RATE)

FORWARD RATE = 1.60 * (1+0.058)/(1+0.092) = 1.55

THEORTICAL FORWARD RATE AND ACTUAL FORWARD RATE ARE EQUAL.

SO ARBITRAGE IS NOT POSSIBLE .

CORRECT ANSWER : d : No arbitrage opportunity exists