Suppose that the current spot exchange rate is €0.80/$ and the three-month forward exchange rate

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QUESTION:

Suppose that the current spot exchange rate is €0.80/$ and the three-month forward exchange rate is €0.7813/$. The three-month interest rate is 5.60 percent per annum in the United States and 5.40 percent per annum in France. Assume that you can borrow up to $1,000,000 or €800,000.

a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize a profit in terms of U.S. dollars. Also, determine the size of your arbitrage profit.

b. Assume that you want to realize a profit in terms of euros. Show the covered arbitrage process and determine the arbitrage profit in euros.


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