Assume the one-year interest rate is 8% on GBP and 1% on EUR. At the same...

Assume the one-year interest rate is 8% on GBP and 1% on EUR. At the same time, inflation is running at an annual rate of 3% in Germany and 1.5% in UK. The current spot rate is EUR/GBP 1.17.

a) If the one-year forward premium of the euro against the pound is 8%, is there an arbitrage opportunity? Explain.

b) If there is an arbitrage opportunity, will the British or the German investor be able to make a profit? How much will an investor's profit be if he can invest GBP100,000 or EUR180,000 for 1 year? Assume that he owns this money and does not borrow. Please show your work.

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Expert Solution

ANSWER IN THE IMAGE ((YELLOW HIGHLIGHTED). FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

a. PRICE CURRENCY:
Foreign exchange rate premium discount.

Price Currency % change= [(S-F)/F]×(n/12)×100%

Where
F = Forward rate.
S= Spot rate.
n = no.of months.

8%= [(1.17-F)/F]×(12/12)×100%
F= 1.0833

Yes, there is an arbitrage opportunity.

Stratedy: Shown in B.

jeff jeffy answered 1 year ago

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