What would happen to interest rates and bond prices

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Reference no: EM13974570

One-year zero coupon treasury bonds are selling for £975.61 in the U.K. and for $963.86 in the U.S. Assume $1,000 face value in dollars for the U.S. bond and £1,000 face value for the U.K bond, and round interest rates to two decimal places, e.g. 2.50%. The current spot ex-rate is $1.5350/£. Use THIS IRP formula: ius ≈ iuk +/- %CHG in £. Use this formula (F – S) / S to calculate the forward discount/premium (or the %CHG function on your calculator). a. Using a time value of money calculation, calculate the one-year yields (YTM) in the U.S. and in the U.K. for T-bills (round to 2 decimal place, e.g. 3.45%). b. If interest rate parity (IRP) is holding, should the British pound be selling at a forward discount or premium? How much and why? Explain in an essay with full sentences. (Use the IRP formula above.) c. Based on your answer in part b, and using the current spot ex-rate, calculate and report the expected one year forward ex-rate if interest rate parity holds. (Note: You don’t need the IRP equation to answer this question.) d. If interest rate parity does not hold and the actual one-year forward rate is $1.5657/£, calculate and report the actual forward discount or premium for the pound (to 2 decimal places). Using that forward discount or premium and the one-year yields from part a, compare an American investor’s rate of return in the U.S. versus the effective dollar return in the U.K. For the U.K. investment, assume the US investor would use a forward contract to cover ex-rate risk, and use the formula: Effective Dollar Return in UK = Interest Rate in UK +/- Forward Discount (%) or Premium (%) for the £. e. Starting with either $1M or £1M, calculate and report the covered interest arbitrage profit you could make (express the arbitrage profit in both pounds and dollars in one year, using the one-year forward ex-rate). Explain each transaction in words. f. Based on your answers to part d and e, explain what would happen to interest rates and bond prices in the U.K. and explain why that would happen in an essay. What would happen to interest rates and bond prices in the U.S. and why would that happen?

Reference no: EM13974570

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