You are newly recruited as a financial analyst of Baba Bank. You have collected the following information of Spain and Britain.

Interest rate of Euro () per annum	8.5%
Interest rate of Pound (GBP) per annum	14.5%
Annual Inflation rate of Spain	4.5%
Annual Inflation rate of Britain	9.0%

1. Suppose that the euro is selling at a one year forward premium of 13% against pound. Explain how to explore the arbitrage opportunity.

2. What are the real interest rates in Britain and Spain respectively?

3. You also collect the information about the change of exchange rates as follows:-

current exchange rate	1.25/
exchange rate in year one	1.22/

Determine the real costs to a Spain firm of borrowing pounds for one year.

Compare this cost to its real costs of borrowing euros for one year.

4. Given the information of change of exchange rates in part (iii),

Determine the real costs to a British firm of borrowing euros for one year.

Compare this cost to its real costs of borrowing pounds for one year.