Question

2. Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in Germany, and that the spot exchange rate is $1.60/€ and the forward exchange rate, with one-year maturity, is $1.58/€. Assume that an arbitrager can borrow up to $1,000,000 or €625,000

a. Determine whether the interest rate parity is currently holding.

b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.

A. $238.65 B. $14,000 C. $46,207 D. $7,000

Circle the correct answer above and provide the workings to the answer above here:

c. Explain how the IRP will be restored as a result of covered arbitrage activities.

Answer 1

If IRP is holding ......... one year farward rate should be .....spot rate * [ ( 1+USr ) / (1+Gr) ]

= 1.60 * [ (1.02) / (1.06) ] = 1.54

(a) As the given forward exchange rate = 1.58 is not matching with expected spot rate after one year = 1.54. Hence IRP is not holding currently

(b) ........ Select - Option - D .... $ 7000

Step - 1 .......... Use 1000,0000 dollars to aquire 625,000 pounds

Step - 2 .......... Invest 625000 pounds @ of 4% ....... it's Future value = 625000 * (1.04) = 650,000

Step - 3 ......... Convert Pounds into dollars at forward exchange rate = 1.58.

= 650000 * 1.58 = $ 1,027,000

Step - 4 ......... Repay the 1000.000 dollar with 2% interest rate. = 1,020,000.

Hence the arbitrage Profit = 1027,000 - 1020,000 = $ 7000

Question - c

Due to covered arbitrage activities...... (1) Demand for dollar loan increases and as a result we see increase in US interest rate. At the same time supply increases in german pounds as a result interest rates falls from 4%. This process will continue till expected spot rate increases from 1.54 to 1.58.