Presently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The interest rate of three month is equal to 8.0% per annum in the U.S. & 5.8% per annum in the U.K. One can borrow as much as $1,500,000 or £1,000,000.
a. If the IRP is not holding, how would he/she perform covered interest arbitrage? Estimate all the steps and find out the arbitrage profit.
b. Estimate how the IRP will be restored consequently of covered arbitrage activities.
Let’s summarize the given data primary:
S = $1.5/£; F = $1.52/£; I$ = 2.0%; I£ = 1.45%
Credit = $1,500,000 or £1,000,000.
a. (1) Borrow $1,500,000; repayment will be $1,530,000.
(2) Buy £1,000,000 spot via $1,500,000.
(3) Investing £1,000,000 at the pound interest rate of 1.45%;
maturity value will be £1,014,500.
(4) Sell £1,014,500 forward for $1,542,040
Arbitrage profit will be $12,040
b. Following the arbitrage transactions defined above,
- The dollar interest rate will go up;
- The pound interest rate will drop off;
- The spot exchange rate will go up;
- The forward exchange rate will drop off.
- These adjustments will continue till IRP holds.