An Italian currency dealer has good credit and can borrow either $1,000,000 or 800,000 for one year. The one-year interest rate in the U.S. is i_$ = 2% and in the euro zone the one-year interest rate is i = 6%. The spot exchange rate is $1.25 = 1.00 and the one-year forward exchange rate is $1.20 = 1.00. Show how you can realize a certain euro profit via covered interest arbitrage.

1. Borrow $1,000,000 at 2%; trade $1,000,000 for 800,000 at the spot rate; invest euros at i = 6%; translate euro proceeds back to dollars at the forward rate of $1.20 = 1.00. Gross proceeds will be $1,017,600.

2.Borrow $1,000,000 at 2%; trade $1,000,000 for 800,000 at the spot rate; invest euros at i = 6%; translate euro proceeds back to dollars at the forward rate of $1.20 = 1.00. Net profit will be $17,600.

3.Borrow 800,000 at i = 6%; translate euros to dollars at the spot rate, invest dollars in the U.S. at i_$ = 2% for one year; translate dollars back to 848,000 at the forward rate of $1.20 = 1.00. Net profit will be $2,400.

4. Borrow 800,000 at i = 6%; translate euros to dollars at the spot rate, invest dollars in the U.S. at i_$ = 2% for one year; translate dollars back to 850,000 at the forward rate of $1.20 = 1.00. Net profit will be 2,000.