The three-month dollar interest rate in New York is 4% per annum. Alternatively, the three-month euro interest rate in Frankfort is 7% p.a. The current $/ spot exchange rate is $1.1230/. The euro three-month forward rate is quoted at $1.1246/.

1. Show how a U.S. arbitrageur would exploit a possible covered interest arbitrage opportunity with a nominal $46,000,000. Dont start with the formula. Explain in your own words the transactions the arbitrageur would execute and calculate the profit/loss the arbitrager would make or face.

2. Use the Interest Rate Parity formula (IRP) to show whether the interest rate parity condition is violated. If violated, at what 3-month forward rate would it hold?

3. Use the International Fisher Effect (IFE) to find what should be the expected three-month spot exchange rate of dollars against the euro (If not performing chain calculations, use interest rates up to four decimal places).

4. Assume that the real rate of interest in both the euro zone and the U.S. is 1.4% per annum; use the Fisher Effect (FE) to calculate the expected annualized three-month rates of inflation in the euro zone and the U.S. (Expressed as a % p.a. up to four decimal places).

5. Use the results in question 4 above and the Relative Purchasing Power Parity (RPPP) formula to estimate the expected three-month spot exchange rate of the dollars against the euro.

6. What do you notice about the answers to questions 2,3, and 5? Are they what you expect?