Problem: Assume the interest rate is 16% on pounds sterling and 7% on the Euro. At the same time, inflation is running at an annual rate of 3% in Germany and 9% in England.
1) If the Euro is selling at a one-year forward premium of 10% against the pound, is there an arbitrage opportunity? Explain.
2) What is the real interest rate in Germany? in England?
3) Suppose that during the year the exchange rate changes from Euro2.7/£1 to Euro2.65/£1. What are the real costs to a German company of borrowing pounds? Contrast this cost to its real cost of borrowing Euro.
4) What are the real costs to a British firm of borrowing Euro? Contrast this cost to its real cost of borrowing pounds.