Let\'s suppose you have $1 million to invest. You are considering to invest in U
ID: 2597335 • Letter: L
Question
Let's suppose you have $1 million to invest. You are considering to invest in UK first, then convert the British Pound back to US$ in the future. You know following information: Annual Interest rate on investment in US: 2% Annual Interest rate on investment in UK: 4% Investment period: 1 year Current exchange rate: 1.52 $/BP Forward exchange rate which you can apply when converting BP to US$: 1.50 $/BP What will be profit or loss if you apply the covered-interest arbitrage? Profit, about $36,838 Profit, about $28,424 Profit, about $16,645 Profit, about $26,315
Explanation / Answer
The Answer is "D"
Covered rate parity : (1 + id) = (F/S) * (1 + if).
(1+id) = 1+0.02 = 1.02
(1+if) = 1+0.04 =1.04
F = S*(1+id / (1+if) = 1.52 *1.02/1.04= 1.612
Factual < Ftheoretical
Thus there is an Arbitrage Opportunity
1) Convert $ 1million Spot into BP = $1,000,000*1.52 = BP 657,894.74
2) Buy Future contract to Sell BP @ 1.5$/BP
3) Invest in UK
After 1 year UK invetsment is worth 657,894.74*(1+0.04) = 684,210.53
4) Convert to $ using futures = 684,210.53 * 1.50 = 1,026,315.79
Profit =1,026,315.79- 1.000,000 = $26,315
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