Question

Currently, interest rate is 2 percent per annum in the U.S. and 6 percent per annum...

Currently, interest rate is 2 percent per annum in the U.S. and 6 percent per annum in the euro zone, respectively. The spot exchange rate is $1.25 = €1.00, and the one-year forward exchange rate is $1.20 = €1.00. As informed traders recognize the deviation from IRP and start carrying out covered interest arbitrage transactions to earn a certain profit, how will IRP be restored as a result?

A. Interest rate in the euro zone will rise; interest rate in the U.S. will fall; euro will appreciate in the spot market; euro will appreciate in the forward market

B. Interest rate in the euro zone will fall; interest rate in the U.S. will rise; euro will depreciate in the spot market; euro will depreciate in the forward market

C. Interest rate in the euro zone will rise; interest rate in the U.S. will fall; euro will depreciate in the spot market; euro will appreciate in the forward market

D. Interest rate in the euro zone will fall; interest rate in the U.S. will rise; euro will appreciate in the spot market; euro will depreciate in the forward market

Homework Answers

Answer #1

Fair forward rate as per IRP = Spot rate*(1+Interest rate US)/(1+Interest rate Eurozone)

= 1.25*(1+2%)/(1+6%)

= $1.2028/Euro

Hence, restoration of IRP will occur as follows:

C. Interest rate in the euro zone will rise; interest rate in the U.S. will fall; euro will depreciate in the spot market; euro will appreciate in the forward market

All of these will lead to restoration of IRP as increase in Interest rate in eurozone, falling of US interets rate, depreciation of euro in spot market will decrease forward rate as per IRP.

Appreciation of Euro in forward market to reach $1.2028 will restore IRP as well.

Know the answer?
Your Answer:

Post as a guest

Your Name:

What's your source?

Earn Coins

Coins can be redeemed for fabulous gifts.

Not the answer you're looking for?
Ask your own homework help question
Similar Questions
The spot exchange rate is currently $1.31/£ and the six-month forward exchange rate is $1.25/£. The...
The spot exchange rate is currently $1.31/£ and the six-month forward exchange rate is $1.25/£. The six-month interest rate is 5.7% per annum in the U.S. and 4.7% per annum in the U.K. Assume that you can borrow as much as $1,310,000 (in the US) or £1,000,000 (in the U.K.). a. Determine whether the interest rate parity (IRP) is currently holding. b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps...
Suppose that the annual interest rate is 2.47 percent in the United States and 4.25 percent...
Suppose that the annual interest rate is 2.47 percent in the United States and 4.25 percent in Germany, and that the spot exchange rate is $1.60/€ and the forward exchange rate, with one-year maturity, is $1.58/€. Assume that an arbitrager can borrow up to $2,750,000 or €1,718,750. If an astute trader finds an arbitrage, what is the net profit in one year? -------------------------------------------------------------------- An Italian currency dealer has good credit and can borrow €937,500 for one year. The one-year interest...
Currently, the spot exchange rate is $1.50/£ and the six-month forward exchange rate is $1.52/£. The...
Currently, the spot exchange rate is $1.50/£ and the six-month forward exchange rate is $1.52/£. The six-month interest rate is 8.0% per annum in the U.S. and 3% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000. Answer The Following: a. Determine whether the interest rate parity is currently holding? b. If the IRP is not holding, how would you carry out covered interest arbitrage? (Show all the steps and determine the arbitrage...
Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The...
Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000. • Determine whether the interest rate parity is currently holding. • If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.
Currently the spot exchange rate is $1.33/£ and the one year forward exchange rate is $1.32/£....
Currently the spot exchange rate is $1.33/£ and the one year forward exchange rate is $1.32/£. The yearly interest rate is 1% in US and 3% in U.K. Assume you can borrow as much as $1,330,000. a.      Is interest rate parity currently (IRP) holding? b.      If IRP is not holding, how would you execute a covered interest arbitrage? Show all the steps what you are going to do today and in one year. Also determine the arbitrage profit. c.      Explain how IRP will...
A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year....
A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$= 5% and in the euro zone the one-year interest rate is i€= 4%.  The spot exchange rate is $1.25/€ and the one-year forward exchange rate is $1.40/€. Show how to realize a certain profit via covered interest arbitrage. How do interest rates, the spot currency market, and the forward currency market adjust to produce an equilibrium?
Suppose that the one-year interest rate is 2.45 percent in the United States; the spot exchange...
Suppose that the one-year interest rate is 2.45 percent in the United States; the spot exchange rate is $1.1527/€; and the one-year forward exchange rate is $1.1231/€. What must one-year interest rate be in the euro zone to avoid arbitrage?
A Euro based currency dealer has good credit and can borrow $2,250,000 for one year or...
A Euro based currency dealer has good credit and can borrow $2,250,000 for one year or its equivalent in Euro. The one-year interest rate in the U.S. is i$ = 2.15% and in the euro zone the one-year interest rate is i€ = 5.58%. The spot exchange rate is $1.35 = €1.00 and the one-year forward exchange rate is $1.29 = €1.00. Show how to realize a certain Euro profit via covered interest arbitrage. Convert it into dollars as well.
Suppose you observe that 90–day interest rate across the eurozone is 5%, while the interest rate...
Suppose you observe that 90–day interest rate across the eurozone is 5%, while the interest rate in the U.S. over the same time period is 3%. Further, the spot rate and the 90–day forward rate on the euro are both $1.25. You have $500,000 that you wish to use in order to engage in covered interest arbitrage. To start, you exchange your $500,000 for __________. euros, and deposit the funds in a bank in the eurozone. To lock in the...
The three-month interest rate on yen is i¥=1% per annum; the three-month interest rate on euros...
The three-month interest rate on yen is i¥=1% per annum; the three-month interest rate on euros is i€=5.5% per annum. Which one of the following statements is correct? Select one: a. Based on the Uncovered Interest Rate Parity, the euro is expected to appreciate by 4.5% against yen next three months. b. In a carry trade between euro and yen for three months, the profit will be ¥0.0315(for each yen borrowed) if the euro has appreciated 2% against yen in...