Question 1(25 marks) (a) Assume the following information: Spot rate of = $1.60 180-day forward rate of = $1.59 180-day British interest rate = 4% 180-day U.S. interest rate = 3% Based on this information, is covered interest arbitrage by U.S. investors feasible (assuming that U.S. investors use their own funds ($1 million))? Explain. (5 marks) (b) Covered Interest Arbitrage in Both Directions. The one-year interest rate in New Zealand is 6 percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is $0.50. The forward rate of the New Zealand dollar is $0.54. Is covered interest arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is or is not feasible. (10 marks) (c) Assume that annual interest rates in the United States are 4 percent, while interest rates in France are 6 percent. (i) According to IRP, what should the forward rate premium or discount of the euro be? (ii). If the euros spot rate is $1.10, what should the one-year forward rate of the euro be? (6 marks) (d) The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. Based on the international Fisher effect, what is the expected change in the spot rate over the next year? (4 marks)

Question 2 (25 marks) (a) The one-year risk-free interest rate in Mexico is 10 percent. The one-year risk-free rate in the United States is 2 percent. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. (i). What is the forward rate premium? (3 marks) (ii). What is the one-year forward rate of the peso? (3 marks) 2 (iii). Based on the international Fisher effect, what is the expected change in the spot rate over the next year? (3 marks) (iv). If the spot rate changes as expected according to the IFE, what will be the spot rate in one year? (3 marks) (v). Compare your answers to (b) and (d) and explain the relationship. (3 marks) (b) Assume that the spot exchange rate of the British pound is $1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent? (5 marks) (c) Assume that locational arbitrage ensures that spot exchange rates are properly aligned. Also assume that you believe in purchasing power parity. The spot rate of the British pound is $1.80. The spot rate of the Swiss franc is 0.3 pounds. You expect that the one-year inflation rate is 7 percent in the United Kingdom, 5 percent in Switzerland, and 1 percent in the United States. The one-year interest rate is 6 percent in the United Kingdom, 2 percent in Switzerland, and 4 percent in the United States. What is your expected spot rate of the Swiss franc in one year with respect to the U.S. dollar? Show your work. (5 marks)