The document discusses covered interest arbitrage opportunities given exchange rates and interest rates between the US dollar and British pound. It asks the reader to: 1) Calculate the 3-month covered interest differential and determine if gains can be made; 2) Consider whether gains are possible after accounting for 700 basis point transaction costs; 3) Determine if gains are possible if interest income is taxed at 40% but capital gains abroad are taxed at 20%; 4) Illustrate where returns lie relative to the covered interest parity line and how arbitrage returns rates to this line.

1. 1. Suppose that the U.S. dollar-pound exchange rate equals to $1.30/pound, while the 3-month
forward rate is $1.40/pound. The yield on 1-year U.S. and U.K. Treasury bills are 8% and 12%,
respectively:
a.
Calculate the 3-month covered interest differential using the exact formula (f = (i-i*)/(1+
i*)). Are there net gains to be made?
b.
Suppose that a U.S. firm faces transactions costs that further reduce gains from investing
abroad by 700 basis points. Would there now be net gains from engaging in covered interest
arbitrage?
c.
Referring to part a. above, suppose the interest income is taxed at 40% in each country, but
any capital gains from investing abroad are taxed at 20%. Are there net gains to be made?
(Do not include the transactions costs from part b above.)
d.
With reference to part a., show where the return lies relative to the CIP line using the
approx. Explain how arbitrage in money markets and foreign markets will return back to the
CIP line.