Question

Suppose that the six-month interest rate in the United Kingdom is 0.5% per annum the sixmonth interest rate in Germany is 1.2% per annum. If the spot exchange rate is GBP/EUR 1.1286 and the six-month forward exchange rate is GBP/EUR 1.1312. Assume that the arbitrager can borrow up to EUR 1,000,000 or the equivalent GBP amount, at the spot rate.

a. Can the arbitrager make a covered interest arbitrage (CIA) profit, justify your answer?

b. If yes, determine how much profit can be realised. Show all your calculations.

Answer 1

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convert Maturity "EUR" to GBP to repay Borrowed Amount. By following this strategy. arbitrage ay can make a covered interest arbitrage CCIA) profit b) By following Strategy giveo below Can Cayn profit. arbitrageux o Borrow EUR 1,000,000 equivalent GBP Tc GiBp: 1,000,000 X 1:12862 1128600 Therefore Borrowed Amount of GBP 1128600 Convert to EUR 1,000,000. ii) And Invest EUR 1,000,000 at Six month Interest rate 1.2.1. p.a. Matured amount = EUR 1,000,000 (1+0.006] = EUR 1,006,000__ i) convert this EUR 1,006,000 to GBP to Xepay Borrowed Amount, at Forward rate. GBP/EUR 1.1312 Converted GBP - 1,006,000 X 1.1312 1137, 987.20