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Chapter 7

Q. 7.ST.2

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.

Step-by-Step

Verified Solution

.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.