a) The Forward Exchange Rate at 3 months quoted at the Chicago Board of Trade today between Euro and USD is $1.35. The spot exchange rate is $1.4. Assume that the Covered Interest Rate Parity holds. Is the risk free interest rate going to be higher in the Euro Area or in the United States? Why?
b) What is the exact interest rate differential between the 2 areas?
c) Now you are told that the risk free interest rate in the Euro Area for a sovereign bond with maturity 3 months is 5%; in the US the risk free interest rate on an equivalent bond is 6%. Is this situation possible in equilibrium? Is there any arbitrage opportunity here? If so, make an example of an arbitrage for this world.