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: 1.48 $/BP Forward exchange rate which you can apply when converting BP to US$: 1.47 $/BP What would be profit if you apply the covered-interest arbitrage?

Answer 1

Sell the future and buy the british pound.

Step-by-step explanation:

The non arbitrage parity explains that the future exchange rate is the cost of carrying the underlying asset. In the case of currencies is

`USD/BP * (1+US.interest)/(1+UK.interest)`

If we replace with numbers:

`1.48 * (1.02)/(1.04) = 1.4515`

That means the future exchange rate is actually cheaper than the value of the forward. So, in order to make profits, you have to sell the future and buy the british pound. In one year, you will win 1.47 - 1.4515 = 0.0185.