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?

  • CreatedMarch 26, 2015
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