Reference no: EM133070543

Sunsuke Nakata is a foreign exchange dealer for a US bank. She wishes to consider whether Purchasing Power Parity holds between the US$ and the Japanese yen. She also wonders whether she should invest in US$ or in Japanese yen to make a covered interest arbitrage (CIA) profit. She can borrow US$1,000,000 or dollar-equivalent to invest for the next 12 months. Consider US as home market and Japan as foreign market. She faces the following interest rates, exchange rates and inflation rates:

3-month nominal interest rates in Japan and the US are 7% and 9%, respectively.

Spot and 3-month forward rates, respectively, are ¥142/US$1 and ¥139/US$1.

Inflation rates in Japan and the US are 4% and 5.5%, respectively.

-Does interest parity hold? If not, where do you recommend that Natasha Nguyen borrow and invest and why?

-Assuming no transaction costs, what would Natasha's covered interest arbitrage profit (or loss) be on the borrowed amount of US$1 million or dollar-equivalent yen (use 2 decimal points)?