After depositing these funds for 6 months, and earning a return of 4%, your deposit grows to <u>416,000pounds</u>.
When you convert your <u>416,000pounds</u> back to dollars, you end up with approximately <u>$520,000</u>, for a profit of about <u>$20,000 </u>over your original $500,000.
However, had you simply deposited your $500,000 in an account and accrued 2% interest, you would have <u>$510,000</u> ($500,000 x 1.02), for a profit of <u>$10,000</u>.
This example illustrates that covered interest arbitrage <u>does</u> offer a significantly larger return than simply depositing the funds in a domestic account under internet rate parity.
<h3>What is the covered interest rate arbitrage?</h3>
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.
<h3>Data and Calculations:</h3>
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 <u>does</u> offer a significantly larger return than simply depositing the funds in a domestic account under internet rate parity.
Learn more about covered interest arbitrage at brainly.com/question/14699039
