I was hoping someone could give me a few pointers on arbitrage.
I just don’t get how you figure out which currency to borrow or lend.
In this question:
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1 year U.S. Interest Rates = 8%
1 year U.K. Interest Rates = 10%
1 year $/₤ forward rate = 1.70
Current $/₤ spot rate = 1.85
This is the calculation:
Given the above relationship, interest rate parity does not hold.
(If interest parity held, 1.70 = 1.85 × (1.08 / 1.10), but 1.85 × (1.08 / 1.10) = 1.82).
Therefore, an arbitrage opportunity exists.
To determine whether to borrow dollars or pounds, express the foreign rate in hedged US$ terms (by manipulating the equation for IRP). We get:
(1.70 / 1.85) × 1.10 = 1.0108, which is less than 1.08 (U.S. rate), so we should start by borrowing British pounds and lending U.S. dollars.
——-
Based on the above I see how you determine that an arbitrage opportunity exists, but I don’t get why we should borrow pounds and lend dollars. I guess I’m just having trouble putting the numbers into words.
Any insights appreciated.
I just don’t get how you figure out which currency to borrow or lend.
In this question:
——-
1 year U.S. Interest Rates = 8%
1 year U.K. Interest Rates = 10%
1 year $/₤ forward rate = 1.70
Current $/₤ spot rate = 1.85
This is the calculation:
Given the above relationship, interest rate parity does not hold.
(If interest parity held, 1.70 = 1.85 × (1.08 / 1.10), but 1.85 × (1.08 / 1.10) = 1.82).
Therefore, an arbitrage opportunity exists.
To determine whether to borrow dollars or pounds, express the foreign rate in hedged US$ terms (by manipulating the equation for IRP). We get:
(1.70 / 1.85) × 1.10 = 1.0108, which is less than 1.08 (U.S. rate), so we should start by borrowing British pounds and lending U.S. dollars.
——-
Based on the above I see how you determine that an arbitrage opportunity exists, but I don’t get why we should borrow pounds and lend dollars. I guess I’m just having trouble putting the numbers into words.
Any insights appreciated.