# Interest rate parity

2. As the money manager of Boston Bank you have $1,000,000 available for six months. You have the opportunity to lend the fund in U.S. or lend the fund to prospective customers in Montreal or Landon.

Use the following information to answer this problem: (45Points)

- Present spot rate: $1.7120/£

$0.8861/C$

- Six month forward rate: $1.6726/£

$0.8742/C$

- Interest rate in U.S. is 8.00% annual

- Interest rate in U.K. is 10.5%

- Interest rate in Canada is 9.5%

a. Are interest rates and forward rates in equilibrium? Why or why not? Show your work.

b. Where should you invest for maximum yield?

c. What forward rate would create an equilibrium situation associated with investing in U.S. or Canada?

d. Would your decision about where to invest change if the U.K. interest rate was 15%?

e. If there is an arbitrage opportunity, for a transaction size of U.S. $1,000,000, (or £1,000,000) that you can borrow, how can you take advantage of the situation without taking undue risks? Show your work and profit or losses.

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# xxxxxx

xxxxxxxxxxxxxxxxxxxxxxxxxxxxx xxxx xxxxxx | ||

xxxxx | ||

Amount available for x months | $1,000,000 | |

xxxxxxx xxxx rate: | xxxxx | /£ |

$0.89 | /C$ | |

- Six xxxxx xxxxxxx xxxxx | xxxxx | /£ |

xxxxx | xxx | |

% | ||

x xxxxxx xxxxxxxx xxxx xx xxxx is | 8.00% | |

- Annual xxxxxxxx xxxx in U.K. is | xxxxxx | |

- xxxxxx xxxxxxxx rate xx Canada is | 9.50% | |

Solution: | ||

a) | xxx interest xxxxx xxx xxxxxxx xxxxx xx equilibrium? Why xx xxx not? xxxx xxxx work. | |

The following equation xxxxxxxxxx xxxxxxxx rate xxxxxx | ||

xxxxx | ||

is xxx expected xxxxxx spot xxxxxxxx xxxx at time t + x | ||

k xx the number of xxxxxxx xxxx xxx xxxxxx xxxx time x | ||

St xx xxx xxxxxxx xxxx xxxxxxxx rate xx xxxx x | ||

xx xx xxx xxxxxxxx rate in the US | ||

xx xx the interest rate in a foreign country or xxxxxxxx xxxx | ||

For US x and £ | ||

* xxxx | x | * 1.03 |

The xxxxxxxx xxxx xx xxxx is too low xx xxxxxxxx rate xx xx x xx xxx high. xx xxxxx to bring equillibrium, xxx xxxxxxxx rate xx xx should be xxxxxxxxx xx 12.65% xx xxxxxxxx xxxx xx xx reduced xx xxxxx | ||

xxx US $ and C x | ||

* xxxx | = | * |

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