Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate

$1.49 Excluding Tax

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QUESTION:

Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate is €1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot exchange rate.

a. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also, determine the size of the arbitrage profit.

b. Discuss how the interest rate parity may be restored as a result of the above transactions.

c. Suppose you are a pound-based investor. Show the covered arbitrage process and determine the pound profit amount.


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