Question: A currency dealer has good credit and can borrow either 1,000,000 euros or 750,000 pounds for two years. The 2-year euro interest rate is 5% and the 2-year pound interest rate is 6%. The spot exchange rate is 0.75 pounds/euro and the 2-year forward exchange rate is 0.80 pounds/euro.
a. Show how to realize a certain profit via covered interest arbitrage.
b. How do interest rates, the spot currency market, and the forward currency market adjust to produce equilibrium? Provide some explanation of the adjustment process.