# Question

Assume that the following information is known about the current spot exchange rate between the U.S. dollar and the British pound (£), inflation rates in Britain and the United States, and the real rate of interest—which is assumed to be the same in both countries:

Current spot rate, S = $1.4500/£ (£0.6897/$)

U.S. inflation rate, iUS = 1.5% per year (0.015)

British inflation rate, iUK = 2.0% per year (0.020)

Real rate of interest, R = 2.5% per year (0.025)

Based on this data, use the parity conditions of international finance to compute the following:

a. Expected spot rate next year

b. U.S. risk-free rate (on a 1-year bond)

c. British risk-free rate (on a 1-year bond)

d. One-year forward rate

Finally, show how you can make an arbitrage profit if you are offered the chance to sell or buy pounds forward (for delivery one year from now) at the current spot rate of $1.4500/£ (£0.6897/$). Assuming that you can borrow $1 million or £689,700 at the risk-free interest rate, what would your profit be on this arbitrage transaction?

Current spot rate, S = $1.4500/£ (£0.6897/$)

U.S. inflation rate, iUS = 1.5% per year (0.015)

British inflation rate, iUK = 2.0% per year (0.020)

Real rate of interest, R = 2.5% per year (0.025)

Based on this data, use the parity conditions of international finance to compute the following:

a. Expected spot rate next year

b. U.S. risk-free rate (on a 1-year bond)

c. British risk-free rate (on a 1-year bond)

d. One-year forward rate

Finally, show how you can make an arbitrage profit if you are offered the chance to sell or buy pounds forward (for delivery one year from now) at the current spot rate of $1.4500/£ (£0.6897/$). Assuming that you can borrow $1 million or £689,700 at the risk-free interest rate, what would your profit be on this arbitrage transaction?

## Answer to relevant Questions

Classic City Exporters (CCE) recently sold a large shipment of sporting equipment to a Swiss company—the goods will be sold in Zurich. The sale was denominated in Swiss francs (SF) and was worth SF500,000. Delivery of the ...What is the difference between an option’s price and its payoff? Draw payoff diagrams for each of the portfolios below (X = strike price). a. Buy a share of stock and short a call with X = $35 b. Buy a risk-free zero-coupon bond with a face value of $35 and sell a put with X = $35. c. ...Explain the following paradox. A put option is a highly volatile security. If the underlying stock has a positive beta, then a put option on that stock will have a negative beta (because the put and the stock move in ...What is meant by early-stage and later-stage venture capital investment? What proportions of venture capital have been allocated between the two in recent years? Which stage requires a higher expected return? Why?Post your question

0