Question

The risk-free 1-year term deposit rate in the US is 2% and the equivalent deposit in the UK carries 4% interest. The US Dollar is expected to neither appreciate or depreciate against the British Pound over the following year. Confirm that Uncovered Interest Rate Parity does not hold. Then, design. a. sequence of currency trades, deposits, or loan to exploit this arbitrage opportunity. Point out which steps in your strategy involve taking on risk and explain the nature of that risk

Answer 1

Interest Rate Parity says that forward premium/discount on a currency should be equal to the interest rate differential between two countries i.e. higher interest rate currency will trade at discount, equal to the difference between the interest rates, and vice versa.

In this case, UK has a higher interest rate compared to US. Therefore, as per Interest Rate Parity, Dollar will Apreciate, by 2%(approx).

But, it is expected to Neither Appreciate or Depreciate. Therefore, Uncovered Interest Rate Parity does not hold.

Steps for Arbitrage:

US Dollar should Appreciate, but it is not. Therefore, USD Forward is Undervalued. Therefore, Buy USD in Forward and Sell in Spot.

Now,

1) Borrow USD for 1 year.

2) Buy GBP using the borrowed USD.

3) Invest GBP for 1 year

4) Enter into 1 year Forward Contract to Sell GBP.

After 1 year,

5) Realize Invested GBP

6) Buy USD under Forward Contract.

7) Repay Borrowed USD with Interest.

8) Balance Left will be Arbitrage Gain.

There is NO RISK in this strategy. There is NO OTFLOW upfront. ONLY INFLOW at the END.