QUESTION TWO

Suppose that the current spot exchange rate is 1.50/ and the one-year forward exchange rate is 1.60/. The one-year interest rate is 5.4% in Euros and 5.2% in pounds. You can borrow at most 1,000,000 or the equivalent pound amount, i.e., 666,667, at the current spot exchange rate.

Required

a). Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit.

b). Discuss how the interest rate parity may be restored as a result of the above transactions.

c). Suppose you are a pound-based investor. Show the covered arbitrage process and determine the pound profit amount.