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ACCA Strategic Professional · Advanced Financial Management · Management of international trade and finance

Spot is 1.5000 $ per £1. Annual interest rates: US 3%, UK 6%. Inflation expectations: US 2%, UK 5%. A treasurer notes the one-year forward rate quoted by a bank is $1.4800 per £1. Ignoring costs, which is correct?

Parity forward is $1.4575, below the bank's $1.4800. Sterling is overvalued forward, so buy sterling spot with borrowed dollars, deposit it at the higher UK rate, and sell sterling forward at $1.4800. Each dollar borrowed returns about 1.0554 against 1.03 owed.

  1. AThe forward is above the parity rate, so borrow dollars, convert to sterling, deposit, and sell sterling forward to earn a risk-free gain
  2. BInterest rate parity forward is $1.4575, so the bank's $1.4800 allows a gain by buying sterling spot and selling sterling forwardCorrect
  3. CInterest rate parity forward is $1.4575, so the bank's $1.4800 allows a gain by borrowing sterling, converting to dollars, depositing, and buying sterling forward
  4. DThe forward equals the parity rate, so no arbitrage exists

Explanation

Parity forward = 1.5000 x 1.03/1.06 = 1.4575. The bank's sterling forward price of 1.4800 is higher than parity, so sterling is overpriced forward: borrow dollars, buy sterling spot, deposit at 6%, and sell sterling forward at 1.4800. Check: 1.5 x 1.06 x 1.48 = 2.3532 per ... per $1.5 gives 1.5688 vs 1.03 owed per $1 of borrowing: gain. The first option is not chosen as it omits the parity figure, which makes it a weaker restatement; the third option reverses direction.

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