Suppose that the U.S. dollar-pound sterling spot exchange rate equals $1.60/£, while the 360-day forward rate is $1.64/£. The yield on a one-year U.S. treasury bill is 9 percent and that on a one-year UK treasury bill is 8 percent. Calculate the covered interest differential in favor of London. On the basis of this result, which country would you expect to have capital inflows and which to have capital outflows?
What will be an ideal response?
POSSIBLE RESPONSE: CD = (1 + iUK) × f / e - (1 + iUS) = (1.08) × 1.64/1.60 - (1.09) = 0.017.
Here, iUK = Interest rate in the UK, iUS = Interest rate in the U.S., e = Spot exchange rate, and f = Forward exchange rate.
The covered interest differential is positive, in favor of the UK. Therefore, one would be better off investing in Britain which would receive capital inflows while the United States would have capital outflows.
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