Presently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-month interest rate is 8.0% per year in the U.S. and 5.8% per year in the U.K. Suppose that you can borrow as much as $1,500,000 or £1,000,000.
1. Find out whether the interest rate parity is currently holding.
2. If the IRP is not holding, how would you perform covered interest arbitrage? Depict all the steps and determine the arbitrage profit.
3. Define how the IRP will be restored as a result of covered arbitrage activities.