Question

Suppose £ represents British pound and ¥ represents Japanese yen. If E¥/£ = 150 in Tokyo while E¥/£ = 155 in London. How would you do arbitrage to make a profit?

What is the meaning of covered interest parity? How do you use it to determine the forward exchange rate?

What is the meaning of uncovered interest parity? How do you use it to determine the spot exchange rate?

Answer 1

Arbitrage is the term used for the method where in a simultaneous position is taken in two different markets,the first position is to purchase the asset at a lower price from a market and sell the same asset in a market where its value or worth is higher.For eg: tomatoes cost $1 per kg in a market and 2$ per kg in another market, so what an arbitrageur will do is purchase the tomato from the market that sells it at 1$ per kg and sell the same tomatoes for $2 per kg in the other market hence making a small profit by taking advantage of the price difference in the same asset in 2 different markets.

So in the above mentioned case to earn a profit the arbitrageur will purchase British Pound/Japanese Yen=150 from Tokyo and sell it in London because in London Britis Pound/ Japanese Yen=155.

Covered Interest parity is a conept in International financial market which states that the difference in interest rates between 2 countries equals the difference between the forward exchange rate and spot exchange rate.

The difference between covered interest rate parity and the uncovered interest parity is that,The covered interest rate parity is when there are no conditions favourable for arbitrage in the International foreign exchange market.