On the Forex market, you observe the following hypothetical quotes:

Spot rate: :$ = 1.15

One-year interest rate in the UK = 0.5%

One-year interest rate in the US = 0.25%.

Suppose the one-year forward :$ exchange rate quoted by JP Morgan is 1.13. Is there an arbitrage opportunity? If there was an arbitrage opportunity, what steps would you have taken to make an arbitrage profit, and how much would you have profited with $1 million invested for this purpose?

There is an arbitrage opportunity since the intrinsic forward exchange rate is determined to be higher than the market forward rate. An arbitrage return can be earned by the following steps:

1. Convert $1 million to Pounds at the stated forward, i.e sell dollars to buy pounds at the rate of 1.13

2. After a year, sell the Pounds and buy equivalent dollars at the intrinsic spot rate which would be 1.15%

3. The amount converted into dollars would be $ 1.015 million while the amount invested was $1 million, hence earning an arbitrage return of almost 1.5%