Suppose that the current spot exchange rate is 1.50/ and the one-year forward exchange rate is 1.60/.

Question:

Suppose that the current spot is €1.50/£ and the one-year forward is €1.60/£. The one-year interest rate is 5.4 percent in euros and 5.2 percent in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, that is, £666,667, at the current spot Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit.
b. Discuss how the interest rate parity may be restored as a result of the above transactions.
c. Suppose you are a pound-based investor. Show the covered arbitrage process and determine the pound profit amount.

Exchange Rate
The value of one currency for the purpose of conversion to another. Exchange Rate means on any day, for purposes of determining the Dollar Equivalent of any currency other than Dollars, the rate at which such currency may be exchanged into Dollars...