Question

As an employee in the treasury department for a large U.S. corporation, you have gathered the following information: Quoted Spot rate of British pound (£) = $1.59600 Quoted Spot rate of Australian dollar (A$) = $.70 Quoted Cross exchange rate: £1 = A$2.28 One – year forward rate of A$ = $.71 One – year forward rate of £ = $1.58005 One – year British interest rate = 9.09% One – year Australian interest rate = 7.00% You have been asked by your boss to assess whether triangular arbitrage is feasible and, if so, how it should be conducted to make a “profit” on behalf of the shareholders. other possibilities for generating arbitrage profit. Since you took an international finance course at St. John's University, you know covered interest arbitrage may present an opportunity. Determine whether covered interest arbitrage is feasible and, if so, show the steps involved to make a “profit” on behalf of the shareholders.

Answer 1

For checking the possibility of triangular arbitrage, we find out the implied cross rate between the British Pound and the Australian Dollar. The implied cross rate will be equal to the Spot rate of pound divided by the spot rate of Australian Dollar i.e. =1.596/0.7 = 2.28. Since the implied rate is equal to the actual rate, there is no possibility of a triangular arbitrage.

With covered interest parity-

We start by borrowing 100 USD. Convert it to pound and obtain =100/1.596= 62.66 Pound by the spot rate. We put it on interest and obtain = 62.66*(1+0.0909)=68.355 pounds. The 100 USD borrowed obliges us to pay =108 USD after 1 year. Now since we have to convert the pounds to USD, we use the forward rate and convert the 68.355 pounds into = 68.355*1.58005 = 108.0043 USD. So, now we pay back the 108 USD we have to pay and keep 0.0043 USD per 100 USD borrowed, which is a 0.0043% arbitrage profit.