--%>
Assignment Help - homework help

Determining interest rate parity

Presently, spot exchange rate is $1.50/£ and three-month forward exchange rate is $1.52/£. Three-month interest rate is 8.0% per annum within the U.S. and 5.8% per annum within the U.K. Suppose that you can borrow as much as $1,500,000 or £1,000,000. 

a) Determine if the interest rate parity is presently holding.

b) In case IRP is not holding, how could you carry out the covered interest arbitrage? Display all steps and also compute the arbitrage profit.

c) Describe how IRP will be restored due to covered arbitrage activities.

E

Expert

Verified

Firstly, let summarize the given data:

   S = $1.5/£; F = $1.52/£;  I$ = 2.0%;  I£ = 1.45%

   Credit = $1,500,000 or £1,000,000.

a. (1+I$) = 1.02

    (1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280

Hence, IRP is not holding exactly.

b. a) Borrow $1,500,000; repayment will be $1,530,000. 

    c) Buy £1,000,000 spot using $1,500,000.

    d) Invest £1,000,000 at pound interest rate of 1.45%;

         Maturity value will be £1,014,500.  

    e) Sell £1,014,500 forward for $1,542,040

    Arbitrage profit will be $12,040 

c. As per the, arbitrage transactions described above,

   Dollar interest rate will rise;

a) The spot exchange rate will rise;

b) The pound interest rate will fall;

c) These adjustments will continue until IRP holds.

d) The forward exchange rate will fall.

   Related Questions in Financial Accounting

  • Q : Define deviance Define deviance ; give

    Define deviance; give three illustrations of deviant behavior and use them to explain why deviance is socially constructed.

    		•
  • Q : Acc company A began operation on

    company A began operation on january 1,2012. The annual reporting period ends December 31.The trial balance on January 1,2013 was as follows

    		•
  • Q : Explain Return on Assets or ROA Return

    Return on Assets (ROA): It is an indicator of how gainful a company is associative to its net assets. ROA provides an idea as to how proficient management is at employing its assets to produce earnings. Computed by dividing a company's annual earnings

    		•
  • Q : Liability and Assets What are Liability

    What are Liability and Assets in Accounting equation. Also describe it with the help of formula.

    		•
  • Q : Creatives and Suites What happens when

    What happens when creativity based on individual exceptionalism has evolved as part of the orthodoxy of Western managerial practice is applied within a creative business organisation in the business of “symbolic production&rdquo

    		•
  • Q : Define Money fund Money fund: Money

    Money fund: Money fund is as well main instrument of the money market. This fund that can be employed for fulfilling the requirements of banks to repay the customers.

    		•
  • Q : Highlights of Lobbying Define the term

    Define the term Lobbying in the the act of attempting to persuade affiliates of a legislative body to cast their vote in favor of the lobbyist.

    		•
  • Q : NPV capital budgeting framework Specify

    Specify intuition behind NPV capital budgeting framework?

    		•
  • Q : Asian firms building the production

    Since NAFTA was developed, several Asian firms particularly those from the Korea and Japan has made the extensive investments in the Mexico. Why do you think these Asian firms decided to build the production facilities in the Mexico?

    		•
  • Q : Depriciation techniques What are the

    What are the merits and demerits of the techniques shown below of depreciation? • Straight line process • Reducing balance process• Revaluation process • Usage process &b

    		•