--%>
Assignment Help - homework help

Determining interest rate parity

Presently, spot exchange rate is $1.50/£ and three-month forward exchange rate is $1.52/£. Three-month interest rate is 8.0% per annum within the U.S. and 5.8% per annum within the U.K. Suppose that you can borrow as much as $1,500,000 or £1,000,000. 

a) Determine if the interest rate parity is presently holding.

b) In case IRP is not holding, how could you carry out the covered interest arbitrage? Display all steps and also compute the arbitrage profit.

c) Describe how IRP will be restored due to covered arbitrage activities.

E

Expert

Verified

Firstly, let summarize the given data:

   S = $1.5/£; F = $1.52/£;  I$ = 2.0%;  I£ = 1.45%

   Credit = $1,500,000 or £1,000,000.

a. (1+I$) = 1.02

    (1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280

Hence, IRP is not holding exactly.

b. a) Borrow $1,500,000; repayment will be $1,530,000. 

    c) Buy £1,000,000 spot using $1,500,000.

    d) Invest £1,000,000 at pound interest rate of 1.45%;

         Maturity value will be £1,014,500.  

    e) Sell £1,014,500 forward for $1,542,040

    Arbitrage profit will be $12,040 

c. As per the, arbitrage transactions described above,

   Dollar interest rate will rise;

a) The spot exchange rate will rise;

b) The pound interest rate will fall;

c) These adjustments will continue until IRP holds.

d) The forward exchange rate will fall.

   Related Questions in Financial Accounting

  • Q : Case study of an economic and labour

    The woman in the dark suit (serious women always wear black suits) leafed through the papers on her desk. She was a fund manager and she was nearing the deadline for an investment decision by one of her leading clients, who wanted to invest in sovereign bonds in a dev

    		•
  • Q : Human race in our modern world Here are

    Here are two papers addressed to the in-class essay from the previous class. Study them in the context of the exact wording of the assignment and take some notes that will enable you to refer to specific features of the two papers when talking about their relative qua

    		•
  • Q : Desribe cash budget Give a short

    Give a short introduction of the term ‘cash budget’? And also write down the dissimilar techniques to make it?

    		•
  • Q : Liability and Assets What are Liability

    What are Liability and Assets in Accounting equation. Also describe it with the help of formula.

    		•
  • Q : Deviations from purchasing power parity

    Explain about deviations from purchasing power parity for countries competitive positions within the world market.

    		•
  • Q : Measures to avoid financial crisis In

    In integrated world financial market, financial crisis in country is rapidly transmitted to the other countries, resulting in the global crisis. State some of the measures would you propose in order to avoid the recurrence of the Asia-type crisis.

    		•
  • Q : Relative and absolute purchasing power

    Explain about the purchasing power parity, both the relative and absolute versions. List the things which results in the deviations from purchasing power parity?

    		•
  • Q : Explain Return on Assets or ROA Return

    Return on Assets (ROA): It is an indicator of how gainful a company is associative to its net assets. ROA provides an idea as to how proficient management is at employing its assets to produce earnings. Computed by dividing a company's annual earnings

    		•
  • Q : Multinational corporations Explain

    Explain Multinational corporations (MNCs) and what the economic roles do they play?

    		•
  • Q : Proceeds on disposal The following

    The following information is taken from the financial statements of an entity: 20x4 20x3 Property, plant and equipment $4,600,000 $4,200,000 Accumulated depreciation (1,800,000) (1,350,000) Depreciation expense 560,000 Gain on disposal of PPE 65,000 The asset disposed of had a cost

    		•