Suppose that the current spot exchange rate is 1.50/ and the one-year forward ex

Question

Suppose that the current spot exchange rate is 1.50/ and the one-year forward exchange rate is 1.45/ . The one-year interest rate is 5.6% in euros and 4.9% in pounds. You can borrow at most 1,500,000 or the equivalent pound amount, i.e., 1,000,000 at the current spot exchange rate. a. Show how you can realize a guaranteed profit from covered interest arbitrage. Also determine the size of the arbitrage profit. Assume that you are a euro-based investor, i.e., you can borrow whichever currency you like, but your final profit must be in euros. b. Discuss how the interest rate parity may be restored as a result of the above transactions. c. Suppose you are a pound-based investor now (i.e., you can borrow whichever currency you like, but your final profit must be in pounds). Show the covered interest arbitrage process and determine the pound profit amount.

Explanation / Answer

a. If you are an euro based investor and there was no forward contract you would have borrowerd 1,500,000 and apid an interest of 0.056*1,500,000 = 84,000 and hence your total outflow after an year would be 1,584,000 euros

Now due to forward swap you can covert 1,500,000 Euros to 1,000,000 pounds and pay 49,000 pounds as intrerest and convert the remaining 1,000,000 -49.000 =951,000 pounds into euros after one year as is 951,000*1.45 =1,378,950 euros

Hence you total profit is 1,584,000 - 1,378,950 = 205,050 euros

b. Interest rate parity will be restored as more and more investors perform the same exchange as described above. As more people do the same thing, the interest rate of pound will slowly start increasing and the interest rate of euro will start decreasing until there can be no profit.

c. If you had no swap agreemet, you would pay 49,000 pounds as interest on 1,000,000 pound loan and the the total outflow would be 1,049,000

However, since the interest rate in euros is higher pound is depreciating after an year there is no possibility of a covered interest rate arbitrage

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