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Assignment: Integrative Problem - Exchange Rate Behavior

Data: Beginning of year

Spot rate of £ = $1.596

Spot rate of Australian dollar (A$) = $.70 Cross exchange rate: £1=A$2.28 One-year forward rate of £1= A$.71 One-year U.S. interest rate = 8.00% One year British interest rate = 9.09% One-year Australian interest rate = 7.00%

Question 1

Determining whether triangular arbitrage is feasible and, if so how it should be conducted to make a profit.

Background: Triangular arbitrage is used to capitalize on a discrepancy that might exist in the exchange rates between two currencies whose transactions are conducted in the spot market. i) Developing the cross exchange rate that should exist between the British Pound (£)
*…show more content…*

To illustrate the feasibility of covered interest arbitrage we assume we have an amount of US $500,000 to invest.

Investing in a domestic bank deposit at 8% interest ($500,000 x 1.08) would yield $540,000.

Covered interest arbitrage using the British bank: i) Day 1 we convert the $500,000 to pounds using the current spot rate of the pound, i.e. $1.596

$500,000 ÷ 1.596 = £313,283.21 ii) Sell the £313,283.21 one year forward using the one year British interest rate of 9.09%: (313,283.21 x 1.0909) = £ 341,760.65 . This is the amount to be received on maturity including interest. iii) In one year when the deposit matures we fulfill the forward contract obligation by converting the £341,760.65 to US$ based on the forward contract rate of the pound - $1.58004: (341,760.65 x 1.58004) = $539,995.50

Covered interest arbitrage is not feasible in this case as investing in a domestic bank deposit is slightly more beneficial.

Covered interest arbitrage using the Australian bank: i) Day 1 we convert the$500,000 to A$ using the current spot rate of the A$ i.e. $.70

$500,000÷0.70 = A$714,285.71 ii) Sell the A$714,285.71 one year forward using the one year Australian interest rate of 7%: (A$714,285.71 x 1.07) = A$ 764,285.71. This is the maturity amount including interest. iii) In one year when deposit matures fulfill the forward contract obligation by converting A$764,285.71 to

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