Given the following information: The U.S. interest rate is 6%. The GBP/USD spot rate is 2.2. The GBP forward rate is 2 GBP/USD The domestic Great Britain interest rate is 8%. Which of the following statements is least accurate? A) If you start by borrowing 1,000 GBP, your arbitrage profits will be 116 GBP. B) Capital will flow into Great Britain. C) If you start by borrowing $1,000, your arbitrage profits will be $128. D) To arbitrage borrow Dollars at 6%, convert them to GBPs and lend the GBPs out at 8%. Your answer: C was incorrect. The correct answer was A) If you start by borrowing 1,000 GBP, your arbitrage profits will be 116 GBP. If rD − rF < (forward–spot) / spot then borrow domestic and lend foreign. If rD − rF > (forward–spot) / spot then borrow foreign and lend domestic. rD − rF = 0.08 − 0.06 = 0.02 > −0.09 = [(2 − 2.2) / 2.2] so borrow USD, lend GBP. Borrow $1,000 pay 6% (to pay $1,060); convert the 1,000 to 2,200 GBP Lend out the GBP 2,200 at 8% (to receive GBP 2,376) Forward contract to convert the GBP 2,376 to dollars at 2 GBP/ (to receive $1,188) At end receive GBP 2,376, convert $1,188, pay off loan of $1,060, your profit is $128 HUH?
A) If you start by borrowing 1,000 GBP, your arbitrage profits will be 116 GBP. If you borrow 1,000 GBP at the end of one year you will owe (1,000*1.08) = 1,080 GBP. Convert that 1,000 into USD: (1000/2.2) = $454.55 Invest $454.55 for one year: (454.55*1.06) = $481.82 Convert $481.82 back into GBP to pay back your loan: (481.82*2) = 963.64 GBP So you owe 1,080 GBP but you only have 963.64 GBP. You have less than you owe so you would have a loss (not a profit) of 116 GBP. B) Capital will flow into Great Britain. Yes, because the interest rate is higher than in the US so people will want to invest at that high rate. C) If you start by borrowing $1,000, your arbitrage profits will be $128. If you borrow $1,000 at the end of one year you will owe (1,000*1.06) = $1,060. Convert that $1,000 into GBP: (1000*2.2) = 2,200 Invest 2,200 GBP for one year: (2,200*1.08) = 2,376 Convert 2,376 GBP back into USD to pay back your loan: (2,376/2) = $1,188 So you owe $1,060 but you have $1,188 so your arbitrage profit is (1,188-1060) = $128 D) To arbitrage borrow Dollars at 6%, convert them to GBPs and lend the GBPs out at 8%. This explains exactly what you did in C. Borrowed USD, converted to GBP and invested them, then converted back to USD at the end of a year. So A is the least accurate.
ok…I didn’t even notice the “least” in the question…nevermind… Thanks anyway