International Financial Management 6th Edition by Sanjiv Eun, Cheol Resnick, Bruce Sabherwal

Exercise 20

Suppose that the current spot exchange rate is €1.50/ and the one-year forward exchange rate is €1.60/. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e., 666,667, at the current spot exchange rate.
a. 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.