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Looking for interest arbitrage opportunities

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Martin Lee has $10,000 to invest and is looking for interest arbitrage opportunities. Consider the following information:

  • Spot rate for POUND/USD is 1.45£/1$.
  • 1 year ahead forward rate for POUND/USD is 1.35£/1$
  • Nominal Interest rate in the US is 10% per annum.
  • Nominal Interest rate in Eurozone is 7.5% per annum.

a) Assume that Martin's home currency is denominated in US dollars. Calculate and explain if a covered interest arbitrage opportunity exists.

b) Martin has a strong feeling that the spot price for POUND/USD will remain unchanged for the whole year and is considering engaging in an Uncovered Interest Arbitrage to save on the cost of forward cover. Calculate and explain through your working how much profit would he make if his prediction is correct.

Explain when would a speculator choose each of the above approach as mentioned in part (a) and (b)?

Reference no: EM132546407

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