b
Subject:FinancePrice: Bought3
b. Suppose that the current spot exchange rate is €1.50/? and the one-year forward exchange rate is €1.58/?. The one-year interest rate is 6.0% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e.,
?666,667, at the current spot exchange rate.
i. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit.
(10 arks)
ii. Discuss how the interest rate parity may be restored as a result of the above transactions.
(5 marks)
iii. Suppose you are a pound-based investor. Show the covered arbitrage process and determine the pound profit amount.
