Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in Germany, and that the spot exchange rate is exist1.60/euro and the forward exchange rate, with one-year maturity, is exist1.58/euro. Assume that an arbitrager can borrow up to exist1,000,000 or euro 625,000.
(a) Determine whether interest rate parity is currently holding.
(b) If IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.
(c) Explain how IRP will be restored as a result of covered arbitrage activities.