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Covered interest arbitrage, foreign exchange

1.Use interst rate parity to answer this question. A U.S. investor has a choice between a risk-free one-year U.S. security with an annual return of 4%, and a comparable British security with a return of 5%. If the spot rate is $1.43/E, the forward rate is $1.44/E, and there are no transaction costs, the investor should invest in the U.S. security.

a.True
b. False

2.(Ma) Assume the following information:

You have $1,000,000 to invest
Current spot rate of pound = $1.60
90foward rate of pound = $1.57
3 deposit rate in U.S = 12% nominal rate
3deposit rate in U.K. = 16% nominal rate
If you use covered interest arbitrage foe a 90 day investment, what will be the amount of U.S. dollars you will have after 90 days?

3. A U.S. firm sells merchandise to a british company for E100,000 at a current exchange rate of $1.43/E. If the exchange rate changes to $1.45/E the U.S. firm will realize a _____ of ______.

Solution Preview

1.Use interst rate parity to answer this question. A U.S. investor has a choice between a risk-free one-year U.S. security with an annual return of 4%, and a comparable british security with a return of 5%. If the spot rate is $1.43/E, the forward rate is $1.44/E, and there are no transaction costs, the investor should invest in the U.S. security.

Student Response:
a.True

Correct Response:
b. False

For interest rate parity condition to hold
Forward rate / Spot rate = (1+ US interest rate ) / (1+ British interest rate)

Spot rate= $1.43 /E
US interest rate= 4%
British interest rate= 5%

Therefore , forward rate= $1.4164 /E =1.43*(1 + 4%) / ( 1 + 5%)
Actual forward rate= $1.44 /E

Therefore E is overvalued in the forward ...

Solution Summary

Answers questions on covered interest arbitrage, investment in different currencies

$2.19