Problem
Use the information below to answer the questions that follow. Show all calculations. Suppose you see the following quotes:
US interest rate= 8% per year
Euro interest rate= 6% per year
Today's spot rate S($/€) = $1.35/€, and the 3 month forward rate is given by F($/€) = $1.30/€
Assume that you can borrow up to €1,000,000 or $1,350,000. Assume you are a U.S. based investor, so your profits should be in USD ($)
1. Based on the information above, show whether IRP holds, and if not, what is the profit-making arbitrage strategy. Show the steps of the covered interest arbitrage process clearly.
2. Based on your answer to part (1), state all the steps by which covered interest arbitrage will restore Interest Rate Parity.
3. Using your answer to part (1), suppose that now instead of covering your transaction with a forward contract, you were to go uncovered, which is known as a carry trade. Suppose the actual spot rate 3 months from now is S90($/€) = $1.36/€. Calculate the profits/loss in USD ($) from this carry trade, keeping the other steps of the CIA problem the same.