QUESTION 3 (25 MARKS)

(a) Differentiate between Translation and Transaction Exposure

(6 marks)

(b) Currently the exchange rate is USD1.5000/GBP and the three-month forward exchange rate is USD1.5200/GBP. The three-month interest rate is 8.0% per annum in the U.S. and 5.80% in the U.K. Assume you can borrow as much as USD1,500,000 or GBP1,000,000.

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

(6 marks)

(ii) If the IRP is not holding, show the procedures you carry out covered interest arbitrage. Calculate the arbitrage profit.

(9 marks)

(iii) Explain how the IRP will be restored as a result of the covered arbitrage activities.

(4 marks