Determine whether the interest rate parity is currently holding
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Determine whether the interest rate parity is currently holding

3. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.

a. Determine whether the interest rate parity is currently holding.

b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.

c. Explain how the IRP will be restored as a result of covered arbitrage activities.

Hint
Accounts & Financec) According to the interest rate parity (IRP) hypothesis, the difference in interest rates between two nations is equal to the difference between the forward and spot exchange rates. By linking interest rates, spot exchange rates, and foreign exchange rates, interest rate parity (IRP) plays a crucial role in the foreign currency markets. IRP is the key formula that controls ...

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