A UK company is going to receive 1 million Euros from a Spain supplier in six months. To cover the currency risk, the importer enters into a Forward

Exchange Contract with a bank. The current quoted rates are:

Spot rate: 1.1308 EUR/GBP

An OTC option is available to sell euros at 1.1232 EUR/GBP for a premium of 0.005p per euro.

The UK company can choose 1) no hedging 2) use options

a) In each case, compare the results if in six months time the exchange rate has moved to

i) 1.0500 EUR/GBP

ii) 1.2500 EUR/GBP

iii ) Please illustrate your results.

b) Another transaction is between the UK company and a US company.

Currently, the spot rate is $1.5/ and the 12-month forward exchange rate is $1.5461. The 12 month interest rate is 2% in the U.S. and 4% in the UK.

Assume that you can borrow 1,000,000 in the UK and $1,500,000 in the U.S.

i.

Determine whether interest rate parity (IRP) is currently holding.

ii.

If IRP is not holding, how would you carry out covered interest

arbitrage? Show all of the steps and determine the arbitrage profit.

iii.

Explain how IRP will be restored as a result of covered interest arbitrage activities