Assume the following information: Current spot rate of Euro = $1.4175/1 Euro 1-y

Question

Assume the following information: Current spot rate of Euro = $1.4175/1 Euro 1-year forward rate of pound = $1.4246/1 Euro 1-Year deposit rate in U.S. = 2.6% per year 1-Year deposit rate in Europe = 1.4% per year I) From a graphical analysis viewpoint of the Interest Rate Parity Condition, does this situation a. Lie above the IRP Line b. Lie on the IRP Line c. Lie below the IRP Line Pick either A, B or C: __________ II) If the above situation who (if anyone) would benefit from covered interest arbitrage for a 1-year investment, a. European Investors can earn a higher return from covered interest arbitrage compared to investing locally (Investing locally is a European Investor depositing money in European Bank) b. Neither European nor US Investors c. US Investors can earn a higher return from covered interest arbitrage compared to investing locally (US Investor depositing money in US Bank) Pick either A, B or C: __________

Explanation / Answer

Question 1

Answer is C - Lie below IRP

Interest rate parity formula says

Forward rate/Spot rate = (1+Foreign country interest rate)/(1+Domestic interest rate)

As per this equation Forward rate should have been

Spot rate* (1+RF)/(1+RD) = $1.4175*(1+.026)/(1+.014) = $1.4343

Actual forward rate as of today is $1.4246

Hence this particular situation lie below the IRP line

Question 2

Answer is C- In a covered interest arbitrage condition, US investor who is investing in USD will benefit.

E.g

a) Borrow 1 Euro in europe today

b) Convert it to USD $1.4175

c) Invest at 2.60% in USD

d) Buy forward contract to convert USD to Euro in 1 year @ 1.4246

One year later

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