Suppose that the current spot exchange rate of the EUR is USD 1.25 / EUR and the 3-month forward exchange rate is USD $1.10 / EUR. The 3-month interest rate is 4% per annum in the US and 3% per annum in Germany. Assume that you can borrow EUR 1,000,000 or USD 1,000,000.
Determine whether interest rate parity is currently holding.
If IRP is no holding, how would you carry out covered interest arbitrage (CIA)? Show all the steps and determine the arbitrage profit. Assume you choose to keep your profits in US dollars.
Do the problem again, assuming that you choose to keep your profits in euros.