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Assume the one-year interest rate is 8% on GBP and 1% on EUR. At the same time, inflation is running at an annual rate of 3% in Germany and 1.5% in UK. The current spot rate is EUR/GBP 1.17.
a) If the one-year forward premium of the euro against the pound is 8%, is there an arbitrage opportunity? Explain.
b) If there is an arbitrage opportunity, will the British or the German investor be able to make a profit? How much will an investor's profit be if he can invest GBP100,000 or EUR180,000 for 1 year? Assume that he owns this money and does not borrow. Please show your work.
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