You, a foreign exchange trader for Black Valley Capital, are exploring covered interest arbitrage opportunities between Euros () and US Dollar ($) for the next three months. Suppose that the current spot exchange rate is 0.90/$ and the three-month forward exchange rate is 0.88/$. The three-month interest rate is 6.6 percent per annum in the United States and 6.40 percent per annum in France. Assume that you can borrow up to $1,000,000 or 900,000.

i) Determine whether the interest rate parity is currently holding. (3 marks)

ii) Show how to realize a certain profit via covered interest arbitrage, if you want to realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit. (5 marks)

iii) What is the three-month forward exchange rate for the covered interest arbitrage to be infeasible? (4 marks)

b. The United States and England produce just one good wheat. Suppose the price of wheat in the United States is $5.25 and in England it is 2.35.

i) If absolute purchasing power parity holds, what should the spot exchange rate pound in dollars be? (1 marks)

ii) Suppose the price of wheat over the next year is expected rise to 8% in the United States and to 2% in England. What should the one-year forward rate pound in dollars be? (2 marks)

iii) If the United States government imposes a tariff of $.50 per bushel on wheat imported from England, what is the maximum possible change in the spot exchange rate that could occur? (assume that the pound and dollar prices of wheat remain the same as before the tariff) (5 marks)