Six month Forward rate Ft,t+6 = $1.5280 1.5292/ Interest rate in US = 4.6 4.8% Interest rate in UK = 3 3.3% Do it both ways : (a) borrow in US and invest overseas and (b) borrow overseas and invest in US. Solution: (A) Borrow in US; invest in UK. Profit = $ 3,439 Step 1: Borrow $ 1mm in US at 4.8% / 2 = 2.4% for 6 months. Repay $1.024 million at t+6 Step 2: a) Convert $1mm to buy at ask spot quote (dealer sells at ask) Receive ( $1,000,000) divided by ($1.5095 / ) = 662,471 b) Invest at 3% / 2 = 1.5 % for 6 months. At t+6, receive 662,471 (1.015) = 672,408 c) Simultaneously, sell 672,408 in the forward market at bid (dealer buys at bid). At t+6 months, receive ( 672,408) ($ 1.5280 per ) = $ 1,027,439 After paying back the $ loan, you have a gain of $3,439 ---------------------------------------------------------------------------------------------------(B) If you Borrow in UK, invest in US. Profit = negative; loss & no arbitrage Step 1: Borrow 1mm in UK at 3.3% / 2 = 1.65% for 6 months. Repay 1.0165 million at t+6 Step 2: a) Convert (sell) 1mm to buy $ at bid spot quote (dealer buys at bid) Receive ( 1,000,000) ($1.5080 / ) = $ 1,508,000. b) Invest $ at 4.6% / 2 = 2.3% for 6 months. At t+6, receive $ 1,508,000 (1.023) = $1,542,684. c) Simultaneously, sell $ 1,542,684 (you buy ) in forward market at ask (dealer sells at ask). At t+6 months, receive ($1,542,684) ( 1 / $1.5292) = 1,008,817.7 Repay 1,016,500. After paying back the loan, you have a loss of 7,682