The British Pound Sterling (GBP) is the fourth most popularly traded currency and the third most commonly held reserve currency. The British Pound Sterling represents the economy of The United Kingdom, which consists of England, Scotland, Wales, and Northern Ireland; the Pound Sterling is the sixth largest currency in terms of Gross Domestic Product, and the 8th largest in terms of Purchasing Power Parity in the world.
However, in 2022, the GBP seems to be volatile and keep on decreasing since March. The GBP reach its lowest point on 27th September 2022 at USD1.06852/GBP since 1985. Among the reasons for is fall, in GBP value is local and international traders appearing increasingly anxious about the UK’s economic outlook, with runaway inflation caused by Russia’s war in Ukraine, which poses a threat to economies around the world including the UK.
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The soaring inflation- nearly 9.9% (the highest since the 1980s and predicted to continue to soar at 11% in November 2022) and a cost-of-living crisis pose an immediate challenge to the government, especially after the newly appointed UK prime minister, Liz Truss resigned on 20th October 2022 who holds the position only for 45 days.
The GBP continues to drop against USD and EUR a day after the Bank of England hiked interest rates to 50 basis points. As it raised rates, the bank announced that the UK may already be in recession, defined as two successive quarters of economic contraction. There are fears that higher interest rates could stifle investment as the cost of borrowing rises.
Lindsay Pakenham is working as Chief Finance Officer with Whidbey Holding in London. Whidbey is the producer of gas turbine and currently rely on its financier, Deutsche Bank in Frankfurt. Whidbey will send sufficient monthly payments (in US dollars) to the Bremen Bank. If the EUR appreciates against the GBP over time, it may affect the company’s wealth. Lindsay believes that she can overcome this issue by taking advantage of the current situation. She knows that any currency mispricing can be overcome by doing arbitrage. She also believes that the arbitrage profit can offset any negative impact on her company.
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Lindsay requests a quotation of GBP/EUR from Bank A and Bank B. Assume that she has GBP 8 million as authorized by Whidbey. (a) Determine whether the quotations given are appropriate. Prove your answer. (b) If the quotations are not appropriate, can Lindsay make any profit from the locational arbitrage and WHY? Assume there is no commission/fees involved.
Lindsay also trying to take an opportunity of making a triangular arbitrage profit. She requested the quotation from Bank X, Y, and Z. Using the authorized fund of GBP 8 million, is she able to make a profit? If yes, how much?
One of the Whidbey major suppliers, Hapag is located in Kuwait. Hapag is entering a contract to sell which will be paid in 6 months by Whidbey AG worth in Kuwaiti Dinar (KWD). Because of the huge pressure on GBP, Lindsay is looking at the covered interest arbitrage opportunity to cover the loss due to the transaction. Linsay has information as follows.
a) Based on an authorized fund of GBP 8 million or equivalent, which country should Whidbey borrow and invest in if the company intends to get profit from covered interest arbitrage? (b) Should Lindsay enter a long position or a short position on a 180-day forward contract on KWD? (c) Determine the amount of profit from this covered interest arbitrage in GBP.
The government of the UK has reduced the tax rate in order to protect the value of GBP. What other action should the Bank of England implement to stop further changes in its currency value?
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