Suppose that the current spot exchange rate is 1.50/ and the one-year forward exchange rate is 1.60/. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most 1,000,000 or the equivalent pound amount, i.e., 666,667, at the current spot exchange rate.

a. Determine if IRP holds here.

b. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit.

c. Discuss how the interest rate parity may be restored as a result of the above transactions.

d. Suppose you are a pound-based investor. Show the covered arbitrage process and determine the pound profit amount.