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2) The spot USD /GBP rate is 1.1505. The1 year t-bill rate in the US is .9335%. The 1 year rate in the UK is 0.7969%. a) Calc

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Answer #1

Sol.2 (a) 1 Year forward rate based on interest rate parity

1 * (1+0.007969) GBP = 1.1505 * (1+0.009335) USD

1.007969 GBP = 1.17049 USD

GBP = 1.1612 USD

(b) Yes, arbitrage opportunity is available there as the one year forward rate should be 1 GBP = 1.1612 USD as per the principle of interest rate parity, but the rate is 1 GBP = 1.35 USD

Step1 - Borrow USD 1,000,000 @ 0.9335%, total payable after one year = USD 1,009,335

Step2- Convert USD 1,000,000 into GBP = 1,000,000 / 1.1505 = GBP 869,187

Step3- Invest GBP 869,187 @ 0.7969% simultaneously enter into a forward contract that converts the full maturity amount of the deposit (which works out to 876,114 GBP) into GBP at the one-year forward rate of GBP = 1.35 USD

Step4- After one year, settle the forward contract at the contracted rate of GBP = 1.35 USD, which would give the investor USD 1,182,754

Step5- Repay USD 1,009,335, and the profit for the investor = USD 173,419

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