Explain how U.S. investors could use covered interest
Subject: Business / Finance
Question
Assume the following information: • British pound spot rate = $1.71 • British pound one-year forward rate = $1.69 • British one-year interest rate = 8% • U.S. one-year interest rate = 5%
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a. Explain how U.S. investors could use covered interest arbitrage to lock in a higher yield than 5%. What would be their net gain (per Dollar) from doing so?
b. If a large number of investors undertook this transaction, explain how the spot and forward rates of the pound would change as covered interest arbitrage occurs.
