Suppose you are working for a large, international investment bank, and you observe the annual interest rate on the German corporate bonds and the British corporate bonds are 1.25% and 2.4% respectively. In addition, the current (spot) / exchange rate is 1.1900, and the euro is traded at a forward premium of 1.15% against the British pound. Note: Assume your bank does not have any funds denominated in both currencies.

a) Is there is an arbitrage opportunity? Yes/No, explain.

b) Now, suppose the interest rate on the German corporate bonds increases by 35 basis points. What would you do? Explain.

c) (Continued from part b) Suppose your firm can move the markets (i.e., change the spot exchange rate, the forward exchange rate, and the corporate bond yields in both countries), what happens to these four variables after the transactions you carried in part (a)? Explain in words.

d) (Continued from part b) Fine the annualized forward premium/discount on the British pound such that your bank will be indifferent between holding the German corporate bonds and the British corporate bonds.

Note: 1) Quote the exchange rates as E/ and F/. 2) Interest rates are expressed in decimal points (i.e., if R = 0.1, then R = 10%). 3) Use the approximate form of covered interest rate parity. 4) Instead of the assumption made in class (individuals are small players and cannot affect the exchange rates and interest rates), the investment bank in this question is a LARGE player that has the ability to change the exchange rates and the corporate bond interest rates when it carries transactions in the spot exchange market, the forward exchange market, and corporate bonds markets in Germany and Britain. 5) Use the subscripts G and B to represent all the variables and terms used for Germany and Britain respectively in your written explanation.