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Interest Rate Parity: Lending and Borrowing

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Rus = 5%

ruk = 7%

E0 = 2.0 dollars per pound

F0 = $1.97/ £ (one-year delivery)

where the interest rates are annual yields on U.S. or U.K. bills. Given this information:

a. Where would you lend? Why?

b. Where would you borrow? Why?

c. How could you arbitrage?

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Solution Summary

Given US and UK interest rates and spot and forward rates for pound, the solution identifies the country in which to lend, the country in which to borrow and identifies arbitrage opportunity.

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rus = 5%

ruk = 7%

E0 = $2.00 / £

F0 = $1.97 / £ (one-year delivery)

where the interest rates are annual yields on U.S. or U.K. bills. Given this information:

For no arbitrage situation
Forward rate / Spot rate = (1+US interest rate ) / (1+ UK interest rate)

Or Forward rate = Spot rate x (1+US interest rate ) / (1+ UK interest ...

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