All interest rates are given as p.a. You must ajust to the period. Take money an

Question

All interest rates are given as p.a. You must ajust to the period. Take money and interest rates to four decimals before rounding.

Wolfang (Bubba) Smidt is a foreign exchange trader with Wells Fargo Bank in California. He notifies the following quotes.

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Spot exchange rate   £.80/$

Six-month foward rate £.82/$

Six month $ interest rate 2.0% per year

Six-month £ interest rate 2.8% per year

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A) Ignoring trancastion costa, is interest parity holding or is covered interest arbitrage possible? Use numbers to justify this answer.

B) Test the arbitrage possibility by assuming Wolfgang is authorized to work with either $1,000,000 or its current equivalent of £ 800,000. Show any profit in $.

Explanation / Answer

A) Ignoring trancastion costa, is interest parity holding or is covered interest arbitrage possible? Use numbers to justify this answer. Ans) Forward Rate (FR) = Spot Rate * (1+Home Currency Rate i.e United King dom for the the Forward Period)/(1+Foreign Currency Rate i.e United States for the forward Period) = £                                       0.80 * 1+1.43%/1+1% = £                                       0.80 *1.0143/1.01 = £                                       0.80 *1.0043 = £                                   0.8034 Six months forward Rate £                                   0.8200 Arbitage £                                   0.0166 Six month $ interest rate = 2%*6 Months/12 Months 1% Six-month £ interest rate = 2.8%*6 Months/12 Months 1.43% B) Test the arbitrage possibility by assuming Wolfgang is authorized to work with either $1,000,000 or its current equivalent of £ 800,000. Show any profit in $. Ans) If he is holding Pounds then he will get loss of amout of the $24390.24 if he is holding Dollars then he will get the profit of amount of $16400 Or A) Ignoring trancastion costa, is interest parity holding or is covered interest arbitrage possible? Use numbers to justify this answer. Ans) Forward Rate (FR) = Spot Rate * (1+Home Currency Rate i.e United States for the the Forward Period)/(1+Foreign Currency Rate i.e Unit King dom for the forward Period) = $                                       1.25 * 1+1%/1+1.43% = $                                       1.25 * 1+1%/1+1.43% = $                                       1.25 *0.9957 = $                                   1.2489 Six months forward Rate $                                   1.2500 Arbitage $                                   0.0011 Six month $ interest rate = 2%*6 Months/12 Months 1% Six-month £ interest rate = 2.8%*6 Months/12 Months 1.43% B) Test the arbitrage possibility by assuming Wolfgang is authorized to work with either $1,000,000 or its current equivalent of £ 800,000. Show any profit in $. Ans) if he is holding Dollars then he will get the profit of amount of $1100

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