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.

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.

B.

jeff jeffy answered 1 year ago

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