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Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and that the spot exchange rate is $1.12/€ and the one-year forward exchange rate, is $1.16/€. Assume that an arbitrageur can borrow up to $1,000,000.
a) This is an example where interest rate parity holds.
b) This is an example of an arbitrage opportunity; interest rate parity does NOT hold.
c) This is an example of a Purchasing Power Parity violation and an arbitrage opportunity.
d) None of the above.
How do we know that this is an example of arbitrage opportunity?
Why does interest rate parity NOT hold?
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