The table below shows the interest rate structure that exists between the UK and the US. The current spot exchange rate between the dollar and the pound is $1.55/.

US interest Rates. UK interest Rstes

3 months 1.5% 2.35%

6 months 1.75% 2.5%

9 months 2.25% 2.95%

12 months. 2.75% 3.25%

working for a government department that has frequent dealings in the foreign exchange markets, particularly arranging forward cover,our first job is always to check the forward quote against the interest rate structure. If there is an anomaly, work out if we could make a risk-free profit from the trade. The three-month forward quote that is on your screen is $1.5415/pound

Required:

1. (a) Is the quote correct? If not, what should it be? Explain how could we make an

   arbitrage profit if the price is incorrect.

2. (b) Explain what the following tells us about exchange rate determination: covered

   interest arbitrage, and the International Fisher Effect.

3. (c) The one-year spot rate for the UK is 3.25% from the above table. Say the one-year forward in one years time at 3.6504%; the one-year forward for year two at 4.0512%; and the one-year forward for year three at 5.2593%. .Say the computer screen has frozen at this page and we need to know the two-, three- and four-year spot rates. From these figures, calculate the spot rates.

4. (d) Explain the difference between the three traditional theories of the term structure of interest rates.