Question

In: Finance

CAN ANYONE ASSIST ME PLEASE URGENT : Suppose that the current spot exchange rate is €/£...

CAN ANYONE ASSIST ME PLEASE URGENT :

Suppose that the current spot exchange rate is €/£ 1.50/52 and the one-year forward
exchange rate is €1.60/64₤. The one-year interest rate is 5.4% in euros and 5.2% in
pounds. You can borrow at €1,000,000 or the equivalent pound at the current spot
exchange rate. Which country’s money market you decide to invest? Why? Calculate the
amount of arbitrage profit and loss in €?
Bid-Ask Prices? How to solve??

Solutions

Expert Solution

Converting the Euros to Pounds at the current Ask rate

Notional in Pounds = Notional in Euros * 1 / (Euro / Pound spot rate)

Notional in Pounds = €1,000,000 * (1 / €1.52 / £)

Notional in Pounds =  £657,894.74

Investing th notional in Pounds amount in a 1 year money market deposit at 5.2%

Deposit amount in Pounds after 1 year = Notional in Pounds * (1 + interest rate in Pounds)

Deposit amount in Pounds after 1 year = £657,894.74 * (1 + 5.2%)

Deposit amount in Pounds after 1 year = £692,105.26

Converting this amount to Euros at the Euro / Pound 1 year forward bid rate

Amount in Euros = Deposit amount in Pounds after 1 year * one-year forward Euro / Pound exchange rate

Amount in Euros = £692,105.26 * €1.60 / ₤

Amount in Euros = €1,107,368.42

Arbitrage profit = Amount in Euros - Notional in Euros

Arbitrage profit = €1,107,368.42 - €1,000,000

Arbitrage profit = €107,368.42

Instead if I were to invest in the Euro Money market

Deposit amount in Euros after 1 year = Notional in Euros * (1 + interest rate in Euros )

Deposit amount in Euros after 1 year =  €1,000,000 * (1 + 5.4%)

Deposit amount in Euros after 1 year = €1,054,000

Arbitrage profit = Amount in Euros - Deposit amount in Euros after 1 year

Arbitrage profit = €1,107,368.42 - €1,054,000

Arbitrage profit = €53,368.42

I'll still be better €53,368.42 by investing in a Pound money market deposit than a euro money market deposit.

Which country’s money market you decide to invest?

UK Pounds since the currency is trading at a forward premium compared to Euroes

Why? Calculate the amount of arbitrage profit and loss in €?

€53,368.42 comprared to a similar deposit in Euros, €107,368.42 overall


Bid-Ask Prices? How to solve??

When I convert Euros to Pounds I will use the Ask rate since I want to buy Pounds & the excahnge rate is quoted as Euro/ Pound. Similarly converting Pounds to Euros I will use the bid rate since I will be selling pounds.


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