In: Finance
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??
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.