Suppose the interest rate in the U.S. is 5%, and interest rate in U.K. is 10%. The spot exchange rate is S($/£)=1.2. What if the one-year forward exchange rate was a tiny bit too high at $1.146/£? Please construct a CIA transaction
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Step 1: The forward rate is too high, so we can buy dollars forward and sell dollars spot. Show more…
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At present, the dollar is trading against the British pound at spot GBP/USD = 1.1517, and at one-year (365-day) forward at 64 forward points. One-year (360-day) eurodollar deposits for the U.S. dollar is 5.39%, while half-year (180-day) eurosterling is 4.11%. Using the covered interest parity condition, determine if: (a) there is an arbitrage opportunity (hint: be sure to pay attention to the difference between the tenor of the forward versus that of deposits); (b) explain how you may exploit this opportunity, if any?
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