Question

Suppose the pound/$ spot rate is (pound symbol) .7996, the 3-month forward rate is (pound symbol) .7923, short-term interest rates in the US and Britain are .025% and .0637% respectively, use the theory of (un)covered interest rate parity to show why investors may or may not decide to invest $2m in the US or UK. Is the pound in a forward premium or discount? Why?

Answer 1

We can calculate the CIP predicted forward rate as follows:

Rate (forward) = Rate (spot) x Home interest factor / Foreign interest factor

Assuming that the rates given in the question are for a 3-month period for both the markets:

Pounds / Dollar (forward) = 0.7996 x (1 + 0.0637%) / (1+0.025%) = 0.7999

Since the 3-month forward rate in the market is 0.7923, the Pound is trading at a premium (you need to pay fewer Pounds for each Dollar than predicted by the CIP theory).

This situation can be used to make money by arbitrage. What needs to be done is:

Borrow $2M for 3 months @ 0.025%. You will need to repay 2000500 3 months later

Use $2M to buy Pounds, and you will get 2m * 0.7996 Pounds = 1599200 Pounds

Invest these at 0.637% for 3 months, and you will get 1600219 after 3 months

Sell these 1600219 Pounds today itself (since you know you will get them 3 months later) in forward market and get 1600219 / 0.7923 = 2019713 Dollars. So you make 2019713 - 2000500 = $19213 as clean profit