Answer the following THREE questions. You are evaluating a covered interest rate arbitrage strategy (CIA) versus an uncovered interest rate arbitrage strategy (UIA) based on the following information:
Spot Rate 1.2500 $/€; 3-month forward rate 1.2900 $/€; 3-month interest rate on U.S. dollars: 8.00% per annum; 3-month interest rate on Euro (€): 4.00% per annum.
1. CIA: What should you do if you carry out a covered interest arbitrage?
a) Buy $ spot.
b) Lend € 3 month later.
c) Borrow $ now.
d) Buy € forward.
e) The arbitrage profit is $1.0423 per $ transacted.
2. CIA: What will be the impact on the currency and interest rate markets?
a) $ appreciates in the spot market.
b) Interest rate on € decreases.
c) Spot rate (S expressed as $/€) decreases.
d) Interest rate on $ decreases.
e) Forward rate (F expressed as $/€) increases.
3. UIA: What should you do if you carry out an uncovered interest arbitrage?
a) Borrow $ now.
b) Lend € 3 month later.
c) Buy € forward.
d) Buy $ spot.
e) The arbitrage profit is $1.0525 per $ transacted.