Q3. Suppose that interest rates on Eurodollars and Eurofrancs (Swiss) follow a flat yield curve and are 12% and 7% per annum respectively. You are given that inflation in Switzerland is at 4% and the current spot rate for the Swiss franc is $0.3985.

1. (a)Give an estimate of the inflation figure in the United States.

(b)Further information is obtained, showing that the price level is US$6,500 in the United States and SFr15,500 in Switzerland. Use the implied absolute-PPP exchange rate for US$/SFr to explain why one currency is undervalued relative to the other.

(c)What is the spot rate implied by these interest rates for the franc three years from now?

(d)If the 3-year forward rate for the Swiss franc is $0.4535, calculate the arbitrage profit possible on a nominal sum, and describe the transactions necessary to obtain such a profit.