Question

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.
(Numbers should be rounded to at least 3 decimal places. Please include currency symbols $, € in
your answer)

Answer 1