2. Uncovered Interest Parity

Consider a Dutch investor with 100 euros to place in a bank deposit in either the Netherlands or Great Britain. The (one-year) interest rate on bank deposits is 2% in Britain and 4.04% in the Netherlands. The (one-year) forward euro-pound exchange rate is 1.575 euros per pound and the spot rate is 1.5 euros per pound. Answer the following questions, using the exact equations for UIP and CIP as necessary.

a. What is the euro-denominated return on Dutch deposits for this investor?

b. What is the (riskless) euro-denominated return on British deposits for this investor using forward cover?

c. Is there a riskless arbitrage opportunity here? Explain why or why not. Is this an equilibrium in the forward exchange rate market?