In: Finance
Interest Rate Parity
One year rates are:
US: 2%
EUR: 1.5%
GBP: 3%
The EURUSD rate is 1.10.
The GBPUSD rate is 1.18.
1. What should the 1 year EURUSD forward rate be?
2. What should the 1 year GBPUSD forward rate be?
3. What should the 1 year EURGBP forward rate be?
4. If the 1 year EURUSD forward rate is 1.15, describe the steps needed to earn a riskless profit.
5. If the 1 year GBPUSD forward rate is 1.15, describe the steps needed to earn a riskless profit.
The EURUSD rate is 1.10
The GBPUSD rate is 1.18
EURGBP = EURUSD / GBPUSD
= 1.10 / 1.18
EURGBP = 0.9322
The formula for Forward rate = Spot * (1+Intrest of Price Currency / 1+Intrest of Price Base Currency)T
1. What should the 1 year EURUSD forward rate be?
Ans. = 1.10 *( 1 +1.5% / 1+2%)1
= 1.0946
2. What should the 1 year GBPUSD forward rate be?
Ans. =1.18 *( 1 +3% / 1+2%)1
= 1.1916
3. What should the 1 year EURGBP forward rate be?
Ans. = 0.9322 *( 1 +1.5% / 1+3%)1
= 0.9186
4. If the 1 year EURUSD forward rate is 1.15, describe the steps needed to earn a riskless profit.
Ans. As the given forward price is greater than forward price by interest rate parity, we should use Cash And Carry Arbitrage
STEP1- Long on Spot EURUSD rate @ 1.10
STEP2- Short on EURUSD forward rate @ 1.15
After 1yr Spot price =1.0946
and you have the right to sell @ 1.15
Your Arbitrage Profit is = 1.15 - 1.0946
= 0.0554