Suppose that you’re a FX trader for a bank in New York. You are faced with the following market rates:
Spot exchange rate: $1.4000/£.
1 year dollar interest rate = 2.5%
1 year pound interest rate = 3.5%
1 year forward exchange rate: = $1.3725/£.
a) Is there a Covered Interest Arbitrage opportunity (CIA)? Explain why or why not.
b) Given the data on the previous page, spell out the actions you would take to profit from this situation: Which currency would you borrow and which currency would you lend (invest)? What is the forward transaction you would engage in? Calculate your arbitrage profits. Assume that you can borrow up to $10,000,000 in dollars or its equivalent in pounds to engage in this arbitrage.