Question

Consider a Spanish investor with 5,000 euros to place in a bank deposit in either Spain or Great Britain. The (one-year) interest rate on bank deposits is 3% in Britain and 4.5% in Spain. The (one-year) forward euro-pound exchange rate is 1.7 euros per pound and the spot rate is 1.6 euros per pound. Answer the following questions! a) What is the euro-denominated return (i.e. the total amount of Euros) on Spanish deposits for this investor? b) What is the (riskless) euro-denominated return on British deposits for this investor using forward cover? c) Is there an arbitrage opportunity here? Explain why or why not. Is this an equilibrium in the forward exchange rate market? d) If the spot rate is 1.6 euros per pound, and interest rates are as stated previously, what is the equilibrium forward rate, according to covered interest parity (CIP)? e) Suppose the forward rate takes the value given by your answer in (d). Compute the forward premium on the British pound for the Spanish investor (where exchange rates are in euros per pound). Is it positive or negative - and what does that mean? Why do investors require this premium/discount in equilibrium?

Answer 1

Q.a Effective Income is 4.5%

Principal Amount in Euro	5000
Interest @ 4.5%	225
Prinicipal + Interest	5225
Less : Principal	-5000
Effective Income	225
Effective Income %	4.50%

Q.b Effective Income 9.44%

Principal Amount in Euro	5,000.00
Principal Amount in GBP	3,125.00	(5000*1.7)
Interest @ 3%	93.75	(3125*3%)
Prinicipal + Interest	3,218.75	Total
Prinicipal + Interest in Euro	5,471.88	(3218.75/1.7)
Effective Income	471.88	Interest Income
Effective Income %	9.44%	Effective Income

Q.c: Arbitrage Opportunity :

Yes, there is an arbitrage opportunity. The euro-denominated return on British deposits is higher than that on Spaid deposits. The net return on each euro deposit in a Spain bank is equal to 4.50% versus 9.44% on a British deposit (using forward cover). This is not an equilibrium in the forward exchange market. The actions of traders seeking to exploit the arbitrage opportunity will cause the spot and forward rates to change

Q.d Equilibrium Forward Exchange rate is 1.6233

Forward Exchange Rate	F = S * (1+id)/(1+if)
	F is the forward exchange rate
	S is the current spot exchange rate
	id is the interest rate in domestic currency (base currency)
	if is the interest rate in foreign currency (quoted currency)
Forward Exchange Rate	1.623300971
Current Forward Exchange rate	1.7

Q.e Forward premium / discount :

Forward premium is 1.46% = (1.62/1.60) - 1. The existence of a positive forward premium would imply that investors expect the euro to depreciate relative to the British pound. Therefore, when establishing forward contracts, the forward rate is higher than the current spot rate.