Question

. Suppose that the forward rate of £ in $ is given: F1$/£=$1.20/£, but all other values are the same (see Slide #21).

First show that the “covered interest arbitrage” is possible. Then, discuss the arbitrage strategies and its profit in $. Review lecture notes Slide #19, 20, 21, and 22.

4.3 Interest Rate Parity and Covered Interest Arbitrage Interest rate parity: Which way do you go? 4.3 Interest Rate Parity and Covered Interest Arbitrage Interest rate parity: Which way do you go? If F, dif/5, df > [(1+iº)/(1+i)] If Fdf/S, d'f <[(1+i^)/(1+i")]} then so... then SO... Fédit must fall Se dit must rise id must rise if must fall Sell fat Fdf Buy fat Salt Borrow at id Lend at it F.dif must rise s, d'f must fall id must fall it must rise Buy f at F_df Sell f at S, dif Lend atid Borrow at it Butler / Mulóretired Finance Be Chapter 4 The Writerstiera Parity Cardiore Butler / Mulcretiore Firence de Chapter 4 The International Parity Carditore 4-20 19 20 4.3 Interest Rate Parity and Covered Interest Arbitrage Interest rate parity is enforced through "covered interest arbitrage" An Example: Given: i$ = 7% S$/£ = $1.20/£ if = 3% F $/£ = $1.25/£ F481€ / S, $1€ > (1+i%) / (1+if) 1.041667 > 1.038835 The currency and Eurocurrency markets are not in equilibrium. 4.3 Interest Rate Parity and Covered Interest Arbitrage Covered interest arbitrage 1. Borrow $1,000,000 +$1,000,000 at i* = 7% $1,070,000 2. Convert $s to £s £833,333 at S$£ = $1.201£ $1,000,000 3. Invest £s +£858,333 at if = 3% -£833,333 4. Convert £s to $s +$1,072,920 at F $£ = $1.25/£ -£858,333 5. Arbitrage profit = $2,920 Bules / Multinational Finance Be Chapter 4 The International Parity Conditions Butler / Mulbiratiara Firence &e Checker 4 The International Parity Candice 421 4-22 21 22

Answer 1

Covered Suterest Arbitrage is possible because t F > $16 So 1+ Civen = i it 7/ 3% $12 So. = $1.201ť E $1.25% € $12 1.25 120 1.07 1.03 1.041667 > 1.038835 Hence covered possible interest Arbitrage is

Arbitrage strategy Borrow & today 72 we get 1,000,000$ today we get 8,33,3 33 £ today 2 Convert & into t $1.29% 3 Invest £ @ 3% 833,333 X 1.03 858, 332.99 L after 1 year sell & forward 858,332991X 1.25$1€ 1.25 $/ € 1072,916 $ after 1 year Repay & loan 1,000,000 x 1.07 $1,070,000 after a year. 4 and 5 From Step Arbitrage profit $(1072,916 $ 2916 - 10 70,000) - Shot on OnePlus
Interest rate parity is possible because