1.You are working on the trading desk at a large, highly-rated investment bank. You have the following prices available to you:

Spot dollar/pound Exchange Rate: 1.5943 $/(1=1.5943$)

3-month Forward dollar/pound Rate 1.5857 $/

The 3-month US (dollar) risk-free rate is 1.25%.

(Interest rates are quoted in annualized, continuously-compounded form.)

a.If there are no transaction costs, and you can either buy or sell at these exchange rates and borrow or lend at these interest rates, what must the 3-month British (pound) interest rate (annualized, c.c.) be for there to be no arbitrage? (5 points)

b.Under the same assumptions, suppose that the annualized, continuously-compounded 3-month sterling interest rate is 3.5%. Describe exactly what transactions you would undertake at these prices/rates to lock in an arbitrage profit. (5 points)

c.Now suppose the British rate is the one you calculated in (a) and that there is a 10 basis point (0.1%) bid/ask spread around both that rate and the U.S. rate (e.g.You can borrow at 1.30% and lend at 1.20%). The spot exchange rate is 1.5940-1.5947. Compute the lower and upper no-arbitrage bounds for the 3-month forward. (Bonus question, no credit)