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Consider the following information in the international money markets:
Spot rate : $0.95:€
Forward rate (one year) : $0.97:€
Interest rate (DM) : 7% per annum
Interest rate ($) : 9% per annum
a. Assume no transaction costs or taxes exist, do covered interest arbitrage profits exist in this situation? Describe flows.
b. Suppose now that transaction costs in the foreign exchange market equal to 0.25% per transaction. Do unexploited covered arbitrage profits still exist?
c. Suppose no transaction costs exist. Let the capital gain tax on currency profits equal to 25% and the ordinary income tax on interest income equal 50%. In this case, do covered arbitrage profits exist? How large are they? Describe the transactions required to exploit these profits.
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