- CFA Exams
- CFA Level I Exam
- Study Session 4. Economics
- Reading 10. Currency Exchange Rates: Understanding Equilibrium Value
- Subject 2. Foreign Exchange Forward Markets

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**CFA Practice Question**

Given the following table of information, describe the covered arbitrage opportunity.

A. No arbitrage opportunity exists. $ investors will invest in $ denominated securities and £ investors in £ denominated securities.

B. Both $r investors and £ investors will invest in dollar denominated securities.

C. $ investors will invest in £ denominated securities and £ investors in $ denominated securities.

**Explanation:**Assume investments of $10K or £ 10K. Dollar investors can earn $10,000*(.11) = $1,100 or ($10,000/.4580)*.(1.08)*.4515 - $10,000 = $647. The £ investors can earn £10,000*(.08) = £ 800 or (£10,000*.4490)*(1.11)/.4620 - £10,000 = £788. Each investor can make more money investing in local markets than in foreign markets. The bid-ask spreads off set the interest arbitrage. Remember when exchanging currency or investing money, you always get the least desirable rate.

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**User Contributed Comments**
12

User |
Comment |
---|---|

ehc0791 |
The bid/ask in the interest rate confuses me. |

wink44 |
ust remember that at each turn for the bid/ask you're going to have to pay the higher one, and sell the lower one. Meaning, when you exchange your USD for GBP, you're going to pay the ask (and give up more dollars). When you go to exchange your GBP for USD, you're going to receive less (the bid). Just remember that for each turn, you have to have to pay more and sell for less. |

paolino9290 |
ehc0791: Re your question on interest rates, always bear in mind that you borrow at the higher rate and lend/invest at the lower rate |

mishis |
so, if I want to avoid thinking through the logic details, how do I apply irate spreads to IRP formula, (1+ifgrn)/(1+idom)=e(s)/S (1.11/1.08)*.449=.4615? |

ramdabom |
good q |

Warrior23 |
Paolino - Dont you mean borrow at the lower rate and lend at the higher. Why would you want to pay a higher rate to earn a lower one. You would lose the differential. |

Hishy |
ask rate = borrow bid rate = invest |

msns |
Looks to me that there is an arbitrage opportunity here. Assuming that we borrow GBP and invest in $, then applying the Interest rate parity relationship, we get the forward bid rate for GBP as .449*1.11/1.081=.4610. Similarly, assuming that we borrow $ and invest in GBP and applying the interest rate parity relationship, we get the forward ask rate for GBP as .0458* 1.112/1.08=.47157. Thus the forward bid and ask rates as given in the problem are less than what the parity relationship suggests. This presents an arbitrage opportunity. We sell GBP now, invest in $ securities and buy GBP later. This will give us an arbitrage profit. Therefore option b sounds right i.e both $ and GBP investors will invest in $ securities. Does this sound right? |

NIKKIZ |
msns: that's what I figured too. I can understand the logic of the given answer - how can one compare a return in dollars against a return in GBP? |

Greatrussian |
I was confused that the Spot and Forward rates are shown as "USD/EUR" but the question asks about USD/GBP". |

janis36 |
I was confused by the fact that dollar is more valuable than pund. o_o |

harrybay |
msns: There is indeed an arbitrage opportunity, but it's not profitable enough. It's more profitable for local investors to invest locally than to take advantage of the arbitrage. |