Question

The risk-free rate in the eurozone is 1.5% and the UK risk-free rate is 2.5%. The spot quote is 1.310/E while the one year forward quote is 1.25/E. You can borrow either €1,000,000 or £763,359. According to interest rate parity, is the forward quote correct? If not, what should it be? If the forward quote is not correct, how much money would you profit if you implemented the proper arbitrage? Hint: If forward quote is incorrect then what is over/under valued? That will tell you what to buy/sell forward.

Answer 1

1)	According to the IRPT, forward rate = 1.310*1.015/1.025 =	1.2972
	As the forward quote is different, the IRPT does not hold.
2)	As per the forward quote, GBP is undervalued and Euro
	is overvalued.
	Hence, buy GBP.
3)	Borrow GBP763359 at 2.5%. The loan will have a MV of 763359*102.5% =	£           7,82,443
	Convert the GBP763359 into Euro to get 763359*1.31 =	€        10,00,000
	Invest the euros to have a MV of 1000000*101.5% =	€        10,15,000
	Sell forward the euros to get 1015000/1.25 =	£           8,12,000
	CIA profit = 812000-782443 =	£              29,557