Assume that U.S.-based potential arbitragers do not hold cash, but dollar-denominated securities. Covered investment in sterling-denominated securities then requires the execution of four transactions:

(a) sale of domestic securities with transaction costs of "d %,

(b) spot purchase of pounds sterling with costs of", %,

(c) purchase of sterling-denominated securities with transaction costs of "[, and

(d) forward sale of pounds sterling with transaction costs of "F.

a) Reformulate the Interest Rate Parity theorem taking into account the above transaction costs.

b) What are the upper and lower limits on the implicit interest rate?

c) What do your conclusions in

(a) and

(b) imply in terms of the interest parity line as drawn in figure 2.3?