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Suppose U.S. interest rates are 9%, British interest rates are 11%, and the current spot rate is 1 = $1.60. is the symbol for British
Suppose U.S. interest rates are 9%, British interest rates are 11%, and the current spot rate is 1 = $1.60. is the symbol for British pounds. You estimate that the equilibrium one-year forward rate is F=$1.5712, meaning 1 should be worth $1.5712 in theory (or alternatively, 0.6365 = $1). In practice, however, the forward rate seen in the market is $1.65 (meaning 1 = $1.65 or 0.6061 = $1). In order to profit from this, you do the following steps:
- (1) Borrow US dollars at 9% in the US (means youll owe $1.09 at end of the year for each dollar borrowed).
- (2) Sell dollars for pound in the spot market. For each dollar, youll get (1/1.6) or 0.625.
- (3) Invest your pounds in the UK at 11% (at year end youll get 0.625*1.11=0.6938).
- (4) Enter a forward rate agreement to buy $1.09 (amount youll owe in a year) by selling your pounds at the forward rate of 0.6061 = $1. Hence, in order to buy $1.09, it will cost 0.6606.
- (5) In a year, you complete the forward rate agreement and use the pounds you have invested to convert 0.6606 into $1.09. You can then repay your $1.09 loan in the US.
What is your net gain (in pounds per dollar borrowed)? Give your answer to four decimal places.
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