The spot USD / GBP rate is 1.5711. The1 year t-bill rate in the US is. 19%. The 1 year rate in the UK is 0.39%.

a) Calculate the 1 year USD/GBP 1 year forward rate.

b) If the observed 1 year forward rate is 1.60 USD/GBP, is there an arbitrage opportunity? How would you take advantage of this? Show all your transactions and steps.

Spot USD/GBP rate = 1.5711

(a) 1 year USD/GBP forward rate:

= [Spot rate * (1 + Domestic currency interest rate) ] : (1 + foreign currency interest rate)

= [1.5711 * (1+0.19%) ] : (1 + 0.39%)

= 1.56797, which means the USD will be at a forward premium

b) The observed 1 year forward rate is 1.60 which differs from the ideal forward rate.

This means an arbitrage opportunity exists here.

c) I would sell GBP forward for 1 year @ 1.60.

This means that I will receive USD 1.60 for every 1 GBP I sell instead of 1.56797 that is the ideal deal.

This is how I would take advantage of the arbitrage opportunity.