Question

How much is your arbitrage profit in Euros at expiration, if you know that the current exchange rate is Euro 1.2 / GBP, the 60-day forward rate is Euro 1.12 /GBP, the risk free rate in Europe is 2% and the risk free rate in the UK is 4%? Make your calculation so that the spot transaction is for GBP 500,000.

Please provide your arbitrage profit in Euros rounded to two decimals.

Answer 1

	Forward rate= EURO per GBP * (1+Interest rate in EURO)/(1+Interest rate in GBP)
	Forward rate=	=1.20*(1+0.02)/(1+0.04)
	Per GBP	1.1769
	Since given forward rate is 1.12, we can see that some arbitrage opportunity is available
	If fund invested in GBP so amount=	=500000*(1+4%)
		£   520,000.00
	If amount invested in EURO
	Equivelent Euro=	500000*1.20
	Equivelent Euro=	600,000
	The amount payable in EURO	=600000*(1+2%)
		612,000
	The amount converted back to GBP=	612000/1.12
	The amount converted back to GBP=	£   546,428.57
	So this way there will be gain	£     26,428.57