How to solve

FINA $371$: International Financial Management

Assignment #$3$

Submission: in a pdf file to the Assignment folder "Assignment $3"$ on D$2$L$.$

Note: You can discuss with your friends but the submission must be of your own. Note that there are similar problems from the slides and$/$or practice problems. If you have any questions, just ask!

Grade: $10$ points

$(5$ pts$)$ You observe the following information:

Spot exchange rate of the euro: $$\frac{1\mathrm{.}08}{}$lon

Six$-$month forward exchange rate: $$\frac{1\mathrm{.}13}{}$

Six$-$month interest rate for the euro: $5\%$ per annum

Six$-$month interest rate for the dollar: $7\%$ per annum

Assume that you can borrow as much as $$1,080,000$ or $1,000,000.$

a$.$ Determine whether the interest rate parity $($IRP$)$ is currently holding.

b$.$ If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit. $[$Hint: You need to first determine whether the US investor or European investor can borrow and capitalize$]$

c$.$ Explain how the IRP will be restored as a result of covered arbitrage activities $($i$.$e$.$ what's the new forward rate?$)$