Question

An investor can borrow $904,900 or equivalent pound. The current spot exchange rate is $2.0841/Pound, and the one-year forward rate is $1.9864/Pound. If a one-year interest rate in the US is 9.29%, the UK rate is 17.33%, what is the covered interest arbitrage profit?

Group of answer choices

2.5397%

1.4730%

2.6159%

3.0731%

2.0064%

Answer 1

Answer to the question:

Given: Current Spot Exchange rate - $2.0841 per pound

            One year forward exchange rate - @1.9864 per pound

Forward premium on £ = [Forward rate – Spot rate / spot rate] *100

                                                = 1.9864 – 2.0841 / 2.0841 * 100

                                                = - 4.69%

Interest rate in $ = 9.29 %

Interest rate in £ = 17.33%

Interest rate differential = 8.04 %

Since negative interest rate differential is lower than the forward premium there is a possibility of arbitrage inflows into pound, i.e. by investing in pounds

Therefore covered interest arbitrage profit is calculated by following the below mentioned steps

Step 1: Borrow $ 904,900

            Amount payable after 1 year in $ terms =$ 988,965.21 ($ 904,900 * 1.0929)

Step 2: Convert borrowed amount in £ and invest therein @ 17.33% per year

            i.e. invest £ 434,192.22 ($904,900/spot rate 2.0841) for one year

            and get £ 509,437.73 (£ 434192.22 * 1.1733) after one year

Step 3: Convert proceeds from investment in $ at one year forward rate

            i.e. convert £ 509,437.73 in $ at one year forward rate of $1.9864/£ to get

$ 1,011,947.11

After following above steps we get that arbitrage profit = $22981.90 ($1,011,947.11 - $ 988,965.21)

Therefore arbitrage profit in % terms = Profit / basic amount *100

                                                                        = $ 22,981.90 / $ 904,900 * 100

                                                                        = 2.5397%

Therefore the correct answer is option A i.e. 2.5397%