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Explain investor foreign exchange carry trade strategy

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Question - A UK investor observes the current spot exchange rate at X0 = 1.34 GBP/USD. He also forms a rational expectation on the spot exchange rate after six months at X1 = 1.33 GBP/USD. The current UK interest rate is 0.8% per annum and the US interest rate is 1% per annum. (Take 180 days for the interest rate computation. The foreign exchange quotation in this question follows quotation convention in real life).

(1) Explain each step of the investor's foreign exchange carry trade strategy. Estimate the net profit of this foreign exchange carry trade.

(2) Find the fair value of the six-month forward exchange rate of GBP/USD.

(3) What does the unbiased forward exchange rate hypothesis state? If the market value of the six-month forward exchange rate of GBP/USD equals the fair value estimated in (2) of this question, do you think the unbiased forward exchange rate hypothesis holds in this economy? Briefly explain.

Reference no: EM133179941

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