Question

Interest Rate Parity and Covered Interest Arbitrage

Suppose you are a currency trader and you have the following information:

Spot rate:                                                                    $1.30/£

One year interest rate for the U.S. dollar:                   3%

One year interest rate for the pound:                         2%

1. Please calculate the one-year forward rate based on the Interest Rate Parity.

2. If the actual one-year forward is quoted at $1.28/£, do you find a covered interest arbitrage opportunity? Please explain.

3. If there exists a covered interest arbitrage opportunity, then show all the necessary procedures to capitalize on this opportunity and calculate your net profit (suppose you can borrow up to $1,300,000 or £1,000,000).

Answer 1

as per interest rate parity theory Frward rate = spot rate *(1+id) / (1+if) = 1.30 * 1.03/1.02 = $ 1.31

The Actual one yaer Forward rate is quoted at $ 1.28

There is an arbitrage oppertunity because forward rate is underpriced in forward market

the arbitrager can make a profi by Borrow in USD And Invest in EUR

2) Calculating arbitrage profit

Borrow USD For one year	1,300,000.00
Convert using spot rate
And Take a forward cover at $ 1.28 /EUR
Converting USD to EUR:
EUR	1300000*1.3
	1,690,000.00
Invest EUR for one year
Maturity value after one year :	EUR 1690000*1.02
	1,723,800.00
Convert EUR to USD   using Forward rate :	1723800/1.28
	1,346,718.75
Boroowing liability	1300000*1.03
	1,339,000.00
Profit 1346718.75 - 1339000	$ 7,718.75