a. The euro-denominated return on Dutch deposits for this investor is 4.04%. This is simply the interest rate offered by the Dutch bank.

b. To calculate the euro-denominated return on British deposits, we first convert the initial investment to pounds using the spot rate (1000 euros / 1.5 euros per pound = 666.67 pounds). This amount is then invested in a British bank, yielding an interest of 2% (666.67 pounds * 0.02 = 13.33 pounds). At the end of the year, the total amount in pounds (666.67 pounds + 13.33 pounds = 680 pounds) is converted back to euros using the forward rate (680 pounds * 1.575 euros per pound = 1071 euros). The return is then (1071 euros - 1000 euros) / 1000 euros = 7.1%.

c. There is an arbitrage opportunity here because the return on British deposits (7.1%) is higher than the return on Dutch deposits (4.04%). An investor could take advantage of this by borrowing money in the Netherlands, converting it to pounds, investing in Britain, and then converting the proceeds back to euros. This would not be an equilibrium in the forward exchange rate market because the forward rate does not equal the expected future spot rate (which would be determined by the interest rate differential between the two countries).

d. According to covered interest parity (CIP), the forward rate should be such that there is no arbitrage opportunity. This means that the forward rate should be equal to the spot rate times the ratio of the interest rates in the two countries. In this case, the equilibrium forward rate should be 1.5 euros per pound * (1 + 0.04) / (1 + 0.02) = 1.53 euros per pound.

Question

a. The euro-denominated return on Dutch deposits for this investor is 4.04%. This is simply the interest rate offered by the Dutch bank.

b. To calculate the euro-denominated return on British deposits, we first convert the initial investment to pounds using the spot rate (1000 euros / 1.5 euros per pound = 666.67 pounds). This amount is then invested in a British bank, yielding an interest of 2% (666.67 pounds * 0.02 = 13.33 pounds). At the end of the year, the total amount in pounds (666.67 pounds + 13.33 pounds = 680 pounds) is converted back to euros using the forward rate (680 pounds * 1.575 euros per pound = 1071 euros). The return is then (1071 euros - 1000 euros) / 1000 euros = 7.1%.

c. There is an arbitrage opportunity here because the return on British deposits (7.1%) is higher than the return on Dutch deposits (4.04%). An investor could take advantage of this by borrowing money in the Netherlands, converting it to pounds, investing in Britain, and then converting the proceeds back to euros. This would not be an equilibrium in the forward exchange rate market because the forward rate does not equal the expected future spot rate (which would be determined by the interest rate differential between the two countries).

d. According to covered interest parity (CIP), the forward rate should be such that there is no arbitrage opportunity. This means that the forward rate should be equal to the spot rate times the ratio of the interest rates in the two countries. In this case, the equilibrium forward rate should be 1.5 euros per pound * (1 + 0.04) / (1 + 0.02) = 1.53 euros per pound.

Knowee AI · Accepted Answer

a. The euro-denominated return on Dutch deposits for this investor is 4.04%. This is simply the interest rate offered by the Dutch bank.

b. To calculate the euro-denominated return on British deposits, we first convert the initial investment to pounds using the spot rate (1000 euros / 1.5 euros per pound = 666.67 pounds). This amount is then invested in a British bank, yielding an interest of 2% (666.67 pounds * 0.02 = 13.33 pounds). At the end of the year, the total amount in pounds (666.67 pounds + 13.33 pounds = 680 pounds) is converted back to euros using the forward rate (680 pounds * 1.575 euros per pound = 1071 euros). The return is then (1071 euros - 1000 euros) / 1000 euros = 7.1%.

c. There is an arbitrage opportunity here because the return on British deposits (7.1%) is higher than the return on Dutch deposits (4.04%). An investor could take advantage of this by borrowing money in the Netherlands, converting it to pounds, investing in Britain, and then converting the proceeds back to euros. This would not be an equilibrium in the forward exchange rate market because the forward rate does not equal the expected future spot rate (which would be determined by the interest rate differential between the two countries).

d. According to covered interest parity (CIP), the forward rate should be such that there is no arbitrage opportunity. This means that the forward rate should be equal to the spot rate times the ratio of the interest rates in the two countries. In this case, the equilibrium forward rate should be 1.5 euros per pound * (1 + 0.04) / (1 + 0.02) = 1.53 euros per pound.

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