IRP and Covered Interest Arbitrage If irP failed to hold, an arbitrage would exist. It's easiest to see this in the form of an example Consider the following set of foreign and domestic interest rates and spot and forward exchange rates Spot exchange rate S($/￡)|=$1.25/￡ 360-day forward rate 360 ($/E)|=$1.20/￡ U.S. discount rate is=|7.10% British discount rate 11.56% McGraw-Hilylrwoin 5-10 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-10 IRP and Covered Interest Arbitrage If IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rate S($/£) = $1.25/£ 360-day forward rate F360($/£) = $1.20/£ U.S. discount rate i$ = 7.10% British discount rate i£ = 11.56%
IRP and Covered Interest Arbitrage a trader with S1.000 to invest could invest in the U.S., in one year his investment will be worth $1,071=$1,000×(1+is)=$1,000×(1.071) Alternatively this trader could exchange $1,000 for e800 at the prevailing spot rate, (note that E800 $1,000÷$1.25/￡) Invest￡800atte=11.56%for one year to achieve i892. 48. Translate i892 48 back into dollars at F360(/f)=$1.20/f, the f892. 48 will be exactly $1,071 McGraw-Hilylrwoin 5-11 Copyright@ 2001 by The McGraw-Hill Companies, Inc. All rights
McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 5-11 IRP and Covered Interest Arbitrage A trader with $1,000 to invest could invest in the U.S., in one year his investment will be worth $1,071 = $1,000(1+ i$ ) = $1,000(1.071) Alternatively, this trader could exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at i£= 11.56% for one year to achieve £892.48. Translate £892.48 back into dollars at F360($/£) = $1.20/£, the £892.48 will be exactly $1,071