A currency dealer has good credit and can borrow either $1,000,000 or 800,000 pounds for one year. The one-year interest rate in the U.S. is i_$= 5% and in the euro zone the one-year interest rate is i_pound= 4%. The spot exchange rate is $1.25/pound an the one-year forward exchange rate is $1.40/pound.

a. Show how to realize a certain profit via covered interest arbitrage.

b. How do interest rates, the spot currency market, and the forward currency market adjust to produce an equilibrium?