A foreign exchange trader at Goldman Sachs can invest $1.2 million, or the forei

Question

A foreign exchange trader at Goldman Sachs can invest $1.2 million, or the foreign currency equivalent of the bank's short term funds, in a covered interest arbitrage with British pound. Using the following quotes (interests are per year), can the trader make covered interest arbitrage (CIA) profit? What actions would he or she take to make the profit? Calculate the expected profit.

Arbitrage Funds Available

$1,200,000

Spot Exchange Rate ($/

Arbitrage Funds Available

$1,200,000

Spot Exchange Rate ($/

Explanation / Answer

if Interest Rate Parity hold goods than

(1+U.S. dollar 6-month interest rate)^(1/2) should be = Spot Rate/Forward Rate * (1+ interest rate of British)^(1/2)

(1+U.S. dollar 6-month interest rate)^(1/2) should be = 1.54/1.545 *(1+4.60%)^(1/2)

U.S. dollar 6-month interest rate should be = (1.54/1.545 *(1+4.60%)^(1/2))^2 - 1

U.S. dollar 6-month interest rate should be = 3.92%

As US Dollar 6-month interest rate = 2.60%

Yes trader can make covered interest arbitrage by borrowing in US Dollar and investing in British Pound

Borrow Amount in dollar = 1200000

Amount to be paid in 6 month in dollar = 1200000*(1+2.6%)^(1/2) = $ 1215499.90

Amount Invested in Pound = 1,200,000 *1.54 = 1848000

Amount Receivable in pound in 6 Month = 1848000*(1+4.6%)^(1/2) = 1890026.13

Trader should go now to hedge the amount recievable in pound to Sell 1890026.13 pound in 6 month forward

Amount recievable in Dollar in 6 month = 1890026.13/1.545

Amount recievable in Dollar in 6 month = $ 1223317.88

Expected profit from covered interest arbitrage = 1223317.88-1215499.90

Expected profit from covered interest arbitrage = $ 7817.98

Expected profit from covered interest arbitrage = $ 7818 approx

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