Question 7.ST.2: Assume the following information: Spot rate of £ = $1.60 180...
Assume the following information:
Spot rate of £ = $1.60
180-day forward rate of £ = $1.56
180-day British interest rate = 4%
180-day U.S. interest rate = 3%
Based on this information, is covered interest arbitrage by U.S. investors feasible (assuming that U.S. investors use their own funds)? Explain.
.No. Covered interest arbitrage involves the exchange of dollars for pounds. Assuming that the investors begin with $1 million (the starting amount will not affect the final conclusion), the dollars would be converted to pounds as shown here:
$1 million/$1.60 per £ = £625,000
The British investment would accumulate interest over the 180-day period, resulting in
£625,000 × 1.04 = £650,000
After 180 days, the pounds would be converted to dollars:
£650,000 × $1.56 per pound = $1,014,000
This amount reflects a return of 1.4 percent above the amount with which U.S. investors initially started. The investors could simply invest the funds in the United States at 3 percent. Thus, U.S. investors would earn less using the covered interest arbitrage strategy than investing in the United States.