Describe the sequence of transactions required to do a covered interes

Describe the sequence of transactions required to do a covered interest arbitrage out of British pound and into U.S. dollars.

What will be an ideal response?

ANSWER

Answer: To do a covered interest arbitrage out of ₤ and into U.S. dollars, one would borrow ₤ from the bank at the bank’s ask interest rate. You would owe interest and would have to return the ₤ principal at the end of the investment horizon. You would then convert the ₤ principal into dollars at the ask spot exchange rate of ₤ per dollar. You would pay the ask rate because you are buying dollars from the bank with ₤. You would then invest the dollar principal at the bank’s bid dollar interest rate. Because you would know how much the dollar interest plus principal would be at the end of the investment horizon, you would contract to sell that amount of dollars forward for ₤. This forward contract would be made at the bank’s forward bid rate of ₤ per dollar. If the amount of ₤ that you get from the forward contract exceeds the amount of ₤ that you owe the bank from the initial borrowing, you have successfully done a covered interest arbitrage.