1. Suppose that the annual interest rate is 2.5 percent in Korea and 4.2 percent in Germany, and that the spot exchange rate is Won1933.2/€ and the forward exchange rate, with one-year maturity, is W1915.5/€. Assume that a trader can borrow up to €2,000,000 or Won3,866,400,000.

a. Does the interest rate parity hold? Show your work.

b. Is there an arbitrage opportunity? (covered interest arbitrage)

c. If there is an arbitrage opportunity, what steps should we take in order to make an arbitrage profit?

d. What will be our maximum profit?

2. Suppose that the one-year interest rate is 3 percent in France, the spot exchange rate is €0.0109/Y, and the one-year forward exchange rate is €0.0111/Y What must one-year interest rate be in Japan?

3. Last year, your company sold electronic products to Brazil. You are expecting to receive Real 850,000 in 6 months. The following quotations are provided by a currency dealer:

In $ per $

Real 0.4200 2.3810

1 m. forward 0.4210 2.3753

3 m. forward 0.4350 2.2989

6 m. forward 0.4115 2.4301

a. Draw the profit/loss graph for your unhedged position. If the spot rate in 6 months is $0.4000/ Real, what would be your profit/loss for your unhedged position (based on the related forward rate quotation)

b. Describe how you can hedge your currency risk. Draw the profit/loss graph for your long or short forward position. If the spot rate in 6 months is $0.4000/Real, what would be your profit/loss for your long or short forward position.

c. Draw your graph for your combined position (unhedged plus long or short forward contract). What is your profit/loss for the combined position?

d. If you are completely confident that the spot rate in 6 months will be 0.4228, do you need to take a short or long position in Real forward contract?