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Interest Rate Parity One year rates are: US: 2% EUR: 1.5% GBP: 3% The EURUSD rate...

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.

Solutions

Expert Solution

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

jeff jeffy answered 1 year ago

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