Impact of Arbitrage on the Forward Rate
Solve the following problem:
Assume that the annual U.S. interest rate is currently 6 percent and Germany's annual interest rate is currently 8 percent. The spot rate of the euro is $1.10 and the 1-year forward rate of the euro is $1.10. Assume that as covered interest arbitrage occurs, the interest rates are not affected, and the spot rate is not affected. Explain how the 1-year forward rate of the euro will change in order to restore interest rate parity, and why it will change. Your explanation should specify which type of investor (German or U.S.) would be engaging in covered interest arbitrage, whether they are buying or selling euros forward, and how that affects the forward rate of the euro.