Interest Rate Parity dollars, convert, interest, forward

sabaruch

(from SChweser QBank)
If the $/₤ forward rate is lower than what interest rate parity indicates, the appropriate strategy would be to borrow:

A) pounds, convert to dollars at the spot rate, and lend the dollars.

B) pounds, convert to dollars at the forward rate, and lend the dollars.

C) dollars, convert to pounds at the spot rate, and lend the pounds.

Correct answer is A. But why is that? Thanks.

flyinggirl

your getting pounds cheaper, convert them immediately so the arbitrage isent lost and lend the $ at a higher rate

xilige

Fwd is cheaper so buy it.
So you'll get delivery of the GBP at expiry .

Now think how you can make money.

If you borrow GBP at spot convert into USD and invest USD , you'll have MORE USD to pay for the delivered GBP than you need. keep this extra USD as your profit

thecfawannabe

This says that your $ interest rates are going to cheaper in the future. Get pounds, convert them to dollars on the spot rates and lend the dollars at current higher rates.

Swanand

My thought process was:

Forward is undervalued, so we should purchase the pound forward and sell the pound short. In order to sell the pound short, we need pounds, so we borrow pounds, convert it to USD and invest it in a risk free asset. At expiration we take our USD proceeds, convert to pounds at the forward rate and pay off our loan and keep the excess.

NO EXCUSES