Consider a US investor with $1000 to place in a bank deposit either in US and Gr

Question

Consider a US investor with $1000 to place in a bank deposit either in US and Great Britain. The one-year interest rate on bank deposits is 5% in GB and 1% in US. The one-year forward dollar-pound exchange rate is 1.2575 dollars per pound and the spot rate is 1.25 dollars per pound.

(a) What is dollar denominated return on US deposits?

(b) What is the riskless dollar-denominated return on British deposit using forward cover?

(c) Is there an arbitrage opportunity?

(d) According to CIP, what should be the equilibrium forward exchange rate?

Explanation / Answer

Answer:(a) The dollar denominated return on US deposits is

=$1000*(1+0.01)

=$1010

Answer:(b) The riskless dollar-denominated return on British deposit using forward cover is equal to $1056.3.

=$1000*(1.2575/1.25)*(1+0.05)

=$1056.3

Answer:(c) Yes, there is an arbitrage opportunity. The dollar denominated return on british deposits is higher than that on Deposits.The net return on each dollar deposits in a bank is equal to 1% versus 5.63% (=(1.2575/1.25)*(1.05)).

Answer:(d) Equilibrium =1.25*(1.01/1.05)

=$1.202 per pound

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