Question

What will be the yield for an investor who has $1,000,000 available to conduct triangular arbitrage? (3 points) Assume the following information: You have $1,000,000 to invest Current spot rate of pound = $1.30 90?day forward rate of pound = $1.28 3?month deposit rate in U.S. = 3% 3?month deposit rate in Great Britain = 4% Given this information, does the interest rate parity hold? Why? (1 point) If you use covered interest arbitrage for a 90?day investment, what will be the amount of U.S. dollars you will have after 90 days? (2 points)

Answer 1

In order to conduct triangular arbitrage or 3- point arbitrage, the investor should have an opportunity to exploit the arbitrage opportunity. This would result from a difference in the currency prices in three different nations or markets.

The yield for the investor is as below:

He would convert the dollars to pounds at the present rate ( $1000000/ 1.3 = 769230.8) This would then be invested in a 3 month deposit in Great Britain at 4% giving him a return of $1024000 after conversion to dollars using 90 day forward i.e. (769230.8+30769.23)*1.28

Therefore, his yield is 24000/ 1000000 i.e. 2.4%

For Interest rate parity to hold true, the difference in the interest rates between two nations is equal to the difference between the currency of the two nations in the forward exchange and the spot market. However, in this case, since there was an arbitrage opportunity due to differential rates in currencies, the interest rate parity does not hold.

After 90 days, the investor will have $1024000 if he uses the arbitrage opportunity.