Here are some prices in the international money markets:

Spot rate Forward rate (one year) Interest rate () Interest rate ($)

= $0.95/ = $0.97/ = 7% per year = 9% per year

i Assuming no transaction costs or taxes exist, do covered arbitrage profits exist in the above situation? Describe the flows. (3 marks)

ii Suppose now that transaction costs in the foreign exchange market equal 0.25% per transaction. Do unexploited covered arbitrage profit opportunities still exist? (2 marks)

iii Suppose no transaction costs exist. Let the capital gains tax on currency profits equal 25%, and the ordinary income tax on interest income equal 50%. In this situation, do covered arbitrage profits exist? How large are they? Describe the transactions required to exploit these profits. (3 marks)