Interest rate parity Consider Figure 3.29, which indicates (approximately) the difference between interest rates in the United States and the UK, Rus Ruk on a one-year T-bill (i.e. a two-year bill with one year left to maturity) on the horizontal axis, and the forward premium on the pound for delivery in one year, (F – S)/S, on the vertical axis. If you wish, assume you already hold a portfolio of both T-bills. Note:

a. At point Z, in what direction will short-term arbitrage capital flow and what will be the arbitrage profits? 

b. What steps will arbitrageurs take from point Z in order to make their profits and what will be the consequences on the forward discount on the pound and the interest rate differential?

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F is the US dollar price of the British pound for delivery in one year (the bid). $ is the US dollar price of the British pound for spot delivery (the ask). Ris the interest rate on a hypothetical US one-year T-bill (the ask). R is the interest rate on a hypothetical UK one-year T-bill (the bid). (F-S)/S 1(+) Z Interest 2% -1 rate parity 0 1% Rus-Ruk Figure 3.29 Interest rate parity and arbitrage