Restored as result of covered arbitrage activities

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Reference no: EM132057280

The table below shows the information for exchange rates, interest rates and inflation rates in the US and Germany. Answer the following questions

Current spot rate: $1.60/€

One-year forward rate: $1.58/€

Interest rate in the US: 2%

Interest rate in Germany: 4%

Inflation rate in the US: 2%

Inflation rate in Germany: 3%

(a) If you borrowed $1,000 for 1 year, how much money would you owe at maturity?

(b) Find the 1-year forward exchange rate in $ per € that satisfies IRP from the perspective of a customer that borrowed $1000 traded for € at the spot and invested in Germany.

(c) There is one profitable arbitrage at these prices. How to conduct the covered interest arbitrage if you can either borrow $1000 in the US or €1000 in Germany? What would be the profit?

(d) Explain how the IRP will be restored as a result of covered arbitrage activities.

(e) A fund manager uses the concepts of purchasing power parity (PPP) to forecast spot exchange rates using the financial information. Calculate the future euro spot rate in dollar after one year that would be forecast by relative PPP.

Reference no: EM132057280

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