### CFA Practice Question

There are 227 practice questions for this study session.

### CFA Practice Question

The spot rate on the pound is \$1.5005/£, the 360-day forward is \$1.5020/£, the 360-day interest rate in the U.S. is 2.25%, and in the U.K. it is 1.9%. Is covered interest arbitrage possible and if so, what are your profits, assuming \$1,000,000 or its equivalent in the other currency?

A. Covered interest arbitrage is not possible.
B. Covered interest arbitrage is possible with a profit of \$2,481.
C. Covered interest arbitrage is possible with a profit of \$1,652.

The interest rate differential and forward premium/discount are such that you want to invest in the U.S. money market. Borrow £666,444.52, then convert it in the spot market to \$1,000,000 (666,444.52 x 1.5005). Invest in the U.S. money market at 2.25%. Enter a forward contract to deliver \$1,022,500 in 360 days for £680,758.76 (\$1,022,500/1.5020). In 360 days, exercise the forward contract and repay the loan of £679,106.96 (£666,444.52 x 1.019), leaving a profit of £1652 or \$2,481. In practice, you would only enter a forward contract for \$1,020,019, the amount necessary to repay the loan, leaving you with the \$2,481.

User Comment
rhardin How do I know that I want to invest in US market? I'm confused...
Allen88 This is what I thought. Calculating the actual forward rate, I did, (\$1.5005/1.019)*(1.0225) and got \$1.506 per pound. Since the forward contract is \$1.502 per pound that means that the dollar appreciated in value compared to the actual forward calculation (\$1.506). This means that the pound depreciated a lot more than expected so we would want to borrow pound and then repay pound.
Offboard You calculate forward rate and get 1,5056\$ per 1 pound (and that should be the rate), but you see the rate 1,5005\$ on the market. You conclude that pound is trading cheap, so you should borrow in pounds and loan in dollars.
tushi123 Is an arbitrage profit possible if I do not take a loan?
jpowers You are going long the contract and must pay dollars to receive pounds. Therefore, you need to invest in U.S Dollars to make the payment at expiration.
bbadger It doesn't really matter. You need to invest in USD, but at \$1.502/USD, profit is \$2481 or 1652GBP. B.
davcer from other perspective, the fwd rate that brings no arbitrage is (1.5005/1.019)*1.0225 that is 1.5056 usd/pounds, since the actual fwd is 1.502 usd/pounds you have a difference of .00365 usd/pounds so in the final amount of pounds you have to repay (679,107 pound*.00365 usd/pounds)=2481.33 usd
davcer dont get confused, you have to invest the money at the highest rate, in this case us mkt at 2.25%
at the beginning you have 1,000,000 usd or the equivalent in pounds 666,444.
If you invest in the us mkt you get 1,022,500
if you invest in the uk mkt you get 679,106
bring back the usd to pounds with the fwd exchange to get 680,758 pounds, so you have a difference of 1,652 pounds or 2,481 usd.
xn0315 should I pay in USD or pound?
davidt87 you borrow in £ (lower interest rate) and invest in \$ (higher interest rate) and lock in your conversion at the forward rate which should be priced to negate the potential profit but isn't