Question

Suppose that the interest rates in the U.S. and Germany are equal to 5%, that the forward (one year) value of the € is F$/€ = 1$/€ and that the spot exchange rate is E$/€ = 0.75$/€. Please answer the following questions by explaining all steps of your analysis:

Does the covered interest parity condition hold? Why or why not?

How could you make a riskless profit without any money tied up assuming that there are no transaction costs in buying and or selling foreign exchange?

PLEASE SHOW ALL STEPS

Answer 1

Yes, given quotation covers the interest rate parity theory. It is, because, the interst rate in both the countries is same ie. 5%.

Given 1euro = $.75 (spot rate)

1 euro = $1 (forward rate)

forward rate as per the quotation

FR($/Euro)/SR($/Euro) = 1+$interest rate/ 1+euro interest rate

FR($/Euro)/ .75 = 1+ 5% / 1+5%

FR($/Euro) = .75 (because interest rate in both the countries is same)

but given FR($/Euro) = 1$/euro

here investors buy dollars at spot rate and after a year sell them in the market, thereby makes profit. That is the concluded decision because there is no buying and selling cost.