150P1

Provide a solution to the following problem (you can refer to Example 6.1 down below):

Currently, the spot exchange rate is CHF 0.89/$ and the three-month forward exchange rate is CHF 0.86/$. The three-month interest rate is 5.6% per annum in the U.S. and 4.0% per annum in Switzerland. Assume that you can borrow as much as $1,120,000 or CHF 1,000,000.

1. Determine whether the interest rate parity is currently holding. 2. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit. 3. Explain how the IRP will be restored as a result of covered arbitrage activities. Please answer this well (and don't include random stuff from the internet), so after the teacher grades it I will return here and give you an upvote if the work was correct. Thank you very much!

IMPRESSO POR: 557850@csinow.edu. A impresso apenas para uso pessoal e privado. Nenhuma parte deste livro pode ser reproduzida ou transmitida sem prvia autorizao do editor. Os violadores sero processados. page 154 Covered Interest Arbitrage To understand the covered interest arbitrage (CIA) process, it is best to work with a numerical example. EXAMPLE 6.1: Suppose that the annual interest rate is 5 percent in the United States and 8 percent in the U.K., and that the spot exchange rate is si.80/ and the forward exchange rate, with one-year maturity, is $1.78/. In terms of our notation, is = 5%, 1 = 896, S = $1.80 and F = $1.78. Assume that the arbitrager can borrow up to $1,000,000 or 555,556, which is equivalent to $1,000,000 at the current spot exchange rate. Let us first check if IRP is holding under current market conditions. Substituting the given data, we find, [ES]1 +1) = [1.78] 11.80) (1. which is not exactly equal to (1 + i$) = 1.05. Specifically, we find that the curre characterized by (1 +49)