Question

You are considering to invest in UK first, then convert the British Pound back to US$ in the future. You know following information: Annual Interest rate on investment in US: 2% Annual Interest rate on investment in UK: 1% Investment period: 1 year Current exchange rate: 1.52 $/BP Forward exchange rate which you can apply when converting BP to US$: 1.53 $/BP What will be profit or loss if you apply the covered-interest arbitrage? Group of answer choices Profit, about $36,838 Profit, about $16645 Profit, about $28,424

Answer 1

Answer: please refer to the explanation section

Explanation:

The investors always want to invest in countries with high interest rate , the problem is exchange rate fluctuation have serious impact on investment returns they can decrease or increase the returns. Investors eliminate the impact of exchange rate fluctuations by using forward contracts this strategy is known as Covered Interest rate Arbitrage.

The question did not provide us with the investment amount, Let us  assume we want to invest 10000 British Pound in the UK

Current exchange rate = 1.52$ per BP

Forward Exchange Rate = 1.53$ per BP

Interest Rate on Investments (US) = 2%

Interest Rate on Investments (UK) = 1%

10000 BP = 10000 x 1.52 = $15200

We use $15200 to buy 10000 British pounds

Interest on the UK Investment (in British Pounds) = 10000 x 1% = 100 BP

Investment plus interest = 10000 + 100 = 10100 BP

Investment plus Interest (converted to dollars) = 10100 x 1.53 = $15435

Profit = $15435 - $15200 = $235  

Interest when investing ($15200) in the United States

interest = $15200 x 2/100 = $304

We Make a profit of $235 when we invest in the UK, The Profit made on foreign investments is less than the profit Made when investing domestically (investing in the US). We get a Profit of $304 when we invest in the united States