Suppose that the interest rate is 3% per annum in the U.S. and 2% per annum in France, and that the one-year forward exchange rate is $1.25/€ and the current spot exchange rate is $1.20/€. Assume that you are a dollar-based investor and that you can borrow at most $1,200,000 or the equivalent in euros, €1,000,000.
a. Show if IRP holds.
b. If IRP does not hold, describe the covered interest arbitrage process and determine the arbitrage profit in dollars.
c. Explain how IRP will be restored as a result of the covered interest arbitrage transactions.