Question:International Parity Relationships and Forecasting Foreign Exchange Rates

2.

Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in Germany, and that the spot exchange rate is $1.60/ and the forward exchange rate, with one-year maturity, is $1.58/. Assume that an arbitrager can borrow up to $1,000,000 or 625,000.

• a. Determine whether the interest rate parity 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.
• c. Explain how the IRP will be restored as a result of covered arbitrage activities.

A.

$238.65

B.

$14,000

C.

$46,207

D.

$7,000

Circle the correct answer above and provide the workings to the answer above here: