Task 1 of 2 - Report (ACs 1.1, 1.2, 4.1, 4.2, 4.3, 5.1, 5.2, 5.3)
Tim & Co is building a new factory in Yorkshire, England. They must pay a final
construction payment of £ 9,000,000 in six months’ time.
Foreign exchange and interest rate quotations
are as follows: You can trade at the following
prices:
Spot rate, euro € per €1.4876/£
British pound sterling
£
One-year forward €1.4906/£
exchange rate
One-year euro interest 4.10 %
rate
One-year pounds’ 3.55%
sterling interest rate
Prepare a portfolio of evidence that addresses the following questions.
1. Is covered interest arbitrage worthwhile? If so, explain the steps and compute
the profit based on an initial transaction of £9,000,000. Briefly discuss your
findings.
2. Identify laws and regulations controlling the financial services industry.
3. Assess the principles of direct and indirect taxation and review the
implications on a range of business stakeholders.
4. Evaluate the key characteristics of different types of securities and assess the
strengths and weaknesses of the securities.
Delivery and submission:
• 1x Report - 3000 words
, Referencing:
• Each section must reflect any supporting Harvard style citations.
• A comprehensive Harvard style reference list must be included at the end of
the work.
COMPUTING THE PROFIT
COVERED INTEREST ARBITRAGE: By employing a forward contract to cover (remove exposure to)
exchange rate risk, an investor can profit from the difference in interest rates between two nations
using the covered interest arbitrage trading technique. Individual investors or banks can utilize forward
contracts to take advantage of the forward premium (or discount) and generate a risk-free profit from
differences in the interest rates of two nations. The fact that the interest rate parity criterion does not
always apply presents a chance to make risk-free income.
A covered interest arbitrageur uses the current spot exchange rate to convert domestic money into
foreign currency, then invests the foreign currency at the foreign interest rate. In addition, the
arbitrageur bargains a forward contract to sell the amount of the foreign investment's future value at a
delivery date that coincides with the foreign investment's maturity date in order to exchange the
foreign-currency funds for domestic currency.
SOLUTION: as per the table Tim & Co, investor with £9,000,000 is considering to build a factory in
England, using a covered interest arbitrage strategy to invest domestically. The Sterling pound interest
rate is 3.55% in the while the euro interest rate is 4.1% in the euro area. The current spot exchange rate
is € 1.4876 /£ and the one year forward exchange rate is €1.4906 /£. For simplicity, lets ignores
compounding interest. Investing £ 9,000,000 domestically at 3.55 % for six months ignoring
compounding, will result in a future value of £ 9,159,750. However, exchanging £ 9,000,000 for euros
today, investing those euros at 4.1% for six months ignoring compounding, and exchanging the future
value of euros for pound at the forward exchange rate (on the delivery date negotiated in the forward
contract), will result in £9,166,015.161, implying that investing in other currency using covered interest
arbitrage is the superior alternative.
A visual representation of a simplified covered interest arbitrage scenario, ignoring compounding
interest. In this numerical the arbitrageur is guaranteed to do better than would be achieved by
investing domestically.
One-year scenario
i d = 3.55% £9,319,500 ≈
£9,000,000
Insert @ dollar deposit rate £9,350,144 ≈
Exchange for euros
Exchange for dollars
Tim & Co is building a new factory in Yorkshire, England. They must pay a final
construction payment of £ 9,000,000 in six months’ time.
Foreign exchange and interest rate quotations
are as follows: You can trade at the following
prices:
Spot rate, euro € per €1.4876/£
British pound sterling
£
One-year forward €1.4906/£
exchange rate
One-year euro interest 4.10 %
rate
One-year pounds’ 3.55%
sterling interest rate
Prepare a portfolio of evidence that addresses the following questions.
1. Is covered interest arbitrage worthwhile? If so, explain the steps and compute
the profit based on an initial transaction of £9,000,000. Briefly discuss your
findings.
2. Identify laws and regulations controlling the financial services industry.
3. Assess the principles of direct and indirect taxation and review the
implications on a range of business stakeholders.
4. Evaluate the key characteristics of different types of securities and assess the
strengths and weaknesses of the securities.
Delivery and submission:
• 1x Report - 3000 words
, Referencing:
• Each section must reflect any supporting Harvard style citations.
• A comprehensive Harvard style reference list must be included at the end of
the work.
COMPUTING THE PROFIT
COVERED INTEREST ARBITRAGE: By employing a forward contract to cover (remove exposure to)
exchange rate risk, an investor can profit from the difference in interest rates between two nations
using the covered interest arbitrage trading technique. Individual investors or banks can utilize forward
contracts to take advantage of the forward premium (or discount) and generate a risk-free profit from
differences in the interest rates of two nations. The fact that the interest rate parity criterion does not
always apply presents a chance to make risk-free income.
A covered interest arbitrageur uses the current spot exchange rate to convert domestic money into
foreign currency, then invests the foreign currency at the foreign interest rate. In addition, the
arbitrageur bargains a forward contract to sell the amount of the foreign investment's future value at a
delivery date that coincides with the foreign investment's maturity date in order to exchange the
foreign-currency funds for domestic currency.
SOLUTION: as per the table Tim & Co, investor with £9,000,000 is considering to build a factory in
England, using a covered interest arbitrage strategy to invest domestically. The Sterling pound interest
rate is 3.55% in the while the euro interest rate is 4.1% in the euro area. The current spot exchange rate
is € 1.4876 /£ and the one year forward exchange rate is €1.4906 /£. For simplicity, lets ignores
compounding interest. Investing £ 9,000,000 domestically at 3.55 % for six months ignoring
compounding, will result in a future value of £ 9,159,750. However, exchanging £ 9,000,000 for euros
today, investing those euros at 4.1% for six months ignoring compounding, and exchanging the future
value of euros for pound at the forward exchange rate (on the delivery date negotiated in the forward
contract), will result in £9,166,015.161, implying that investing in other currency using covered interest
arbitrage is the superior alternative.
A visual representation of a simplified covered interest arbitrage scenario, ignoring compounding
interest. In this numerical the arbitrageur is guaranteed to do better than would be achieved by
investing domestically.
One-year scenario
i d = 3.55% £9,319,500 ≈
£9,000,000
Insert @ dollar deposit rate £9,350,144 ≈
Exchange for euros
Exchange for dollars
