Question $6$: Ch $6$

Suppose an investor received the following quotes:

Spot exchange rate: USD $\frac{0\mathrm{.}83}{?}$ Euro;

$6-$month forward exchange rate: USD $\frac{0\mathrm{.}87}{?}$ Euro.

The $6-$month interest rate is $4\%$ per annum in the U$.$S$.$ and $5\%$ per annum offered by a European

bank. Assume that the investor can borrow as much as US $$1,000,000.$

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

B$.$ If the IRP is not holding, how would the investor carry out a covered interest arbitrage?

Show all the steps and determine the arbitrage profit.

C$.$ Once the arbitrage is implemented, how would the interest rates and exchange rates

change to restore the IRP? They would go up or down? Briefly discuss.