Question

Assume the following information:

            Current spot rate of Euro                  =                      $1.156/1 Euro

            1-year forward rate of Euro              =                      $1.175/1 Euro

            1-Year interest rate in U.S.                =                      3.2% per year

            1-Year interest rate in Euro              =                      2.3% 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, 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)

1. 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)
2. Neither European nor US Investors
3. 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:     __________

Answer 1

I). As per interest rate parity, the forward rate should be 1.156*(1+3.2%)/(1+2.3%) = $1.1662/Euro

The quoted forward rate is $1.175/Euro, so this will lie above the IRP line. (Option A)

II). (F/S)*(1+US rate) = (1.175/1.156)*(1+3.2%) = 1.049 > (1+Euro interest rate) which is 1+2.3% = 1.023, so borrow in Euros and invest in dollars, hence, European investors can earn a higher return via covered interest arbitrage than investing in Euros. Option A is correct.