Question

Suppose that the six-month interest rate in the United States is 2%, while the six-month interest rate in Britain is 4%. Further, assume the spot rate of the pound is 1.25. Suppose that you have $500,000 with which to attempt covered interest arbitrage. Assume the forward rate is $1.22596, as you just calculated, and the interest rates are the same as have been used throughout this problem. To start, you exchange your $500,000 (at the spot rate of 1.25) for 400,000pound. After depositing these funds for 6 months, and earning a return of 4%, your deposit grows to 416,000pound. When you convert your 416,000pound back to dollars, you end up with approximately_________________ , for a profit of about over your original $500,000. However, had you simply deposited your $500,000 in an account and accrued 2% interest, you would have ____________ , for a profit of ______________. This example illustrates that covered interest arbitrage ___________offer a significantly larger return than simply depositing the funds in a domestic account under internet rate parity.

Answer 1

After depositing these funds for 6 months, and earning a return of 4%, your deposit grows to 416,000pounds.

When you convert your 416,000pounds back to dollars, you end up with approximately $520,000, for a profit of about $20,000 over your original $500,000.

However, had you simply deposited your $500,000 in an account and accrued 2% interest, you would have $510,000 ($500,000 x 1.02), for a profit of $10,000.

This example illustrates that covered interest arbitrage does offer a significantly larger return than simply depositing the funds in a domestic account under internet rate parity.

What is the covered interest rate arbitrage?

The covered interest rate arbitrage is a trading strategy that enables an investor to:

• Use favorable interest rate differentials.
• Invest in a higher-yielding currency.
• Hedge the exchange risk through a forward currency contract.

Data and Calculations:

Funds for covered interest arbitrage = $500,000

Forward rate = $1.22596

Six-month interest rate in the United States = 2%

Six-month interest rate in Britain = 4%

Spot rate = $1.25

Value of $500,000 in pounds = $400,000 ($500,000/$1.25)

Expected returns on deposit for 6 months = 4%

New value of $500,000 in pounds after 6 months = $416,000 ($400,000 x 1.04)

Dollar value of 416,000 pounds = $520,000 ($416,000 x $1.25)

The gain or profit from the original $500,000 funds = $20,000 ($520,000 - $500,000)

Thus, the example illustrates that covered interest arbitrage does offer a significantly larger return than simply depositing the funds in a domestic account under internet rate parity.

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