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Problem 1: Suppose the interest rate in the US is 5%. The interest rate in the eurozone is 1%. The current spot rate E$/€ is 1.1 dollars per euro. The one year forward rate F$/€ = 1.2. Is there an arbitrage opportunity here, and if so, how would one exploit it? (An arbitrageur is a name for someone who exploits price differences.)
Option 1: Yes, the euro return is higher when taking into account the appreciation of the euro. An arbitrageur would buy euros.
Option 2: Yes, the dollar return is higher when taking into account the appreciation of the dollar. An arbitrageur would buy dollars.
Option 3: Yes, the dollar return is higher when taking into account the depreciation of the dollar. An arbitrageur would buy dollars.
Option 4: Yes, the euro return is higher when taking into account the appreciation of the euro. An arbitrageur would keep their money in dollars.
Option 5: No, the returns are identical on both sides of the CIP equation.
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