Question

Suppose that the U.S. dollar-pound exchange rate equals to $1.30/pound, while the 3-month forward rate is $1.40/pound. The yield on 1-year U.S. and U.K. Treasury bills are 8% and 12%, respectively:

a. Calculate the 3-month covered interest differential using the exact formula (f = (i-i*)/(1+
i*)). Are there net gains to be made?

Answer 1

The 3-month covered interest differential can be calculated using the formula f = (i-i*)/(1+ i*). In this case, the covered interest differential is negative, indicating net gains can be made. This means an investor can borrow in the domestic currency, convert it to the foreign currency at the spot rate, invest it in the foreign country at the foreign interest rate, and then sell the foreign currency at the forward rate to pay back the loan, earning a profit.

Step-by-step explanation:

The 3-month covered interest differential formula is given by f = (i-i*)/(1+ i*), where f represents the forward rate, i represents the domestic interest rate, and i* represents the foreign interest rate. In this case, the domestic interest rate is 8% and the foreign interest rate is 12%. Plugging in these values, we get f = (0.08-0.12)/(1+0.12) = -0.04/1.12 = -0.0357.

Since the covered interest differential is negative, there are net gains to be made. This means an investor can borrow in the domestic currency, convert it to the foreign currency at the spot rate, invest it in the foreign country at the foreign interest rate, and then sell the foreign currency at the forward rate to pay back the loan, thereby earning a profit.