First, let's check if the Interest Rate Parity (IRP) holds. The IRP condition states that the forward premium (or discount) should be equal to the interest rate differential between the two countries.

The forward premium (or discount) can be calculated as (Forward rate - Spot rate) / Spot rate. In this case, it is ($1.15/€ - $1.20/€) / $1.20/€ = -0.04167 or -4.167%.

The interest rate differential is the difference between the US interest rate and the German interest rate, which is 5% - 3% = 2%.

Since the forward discount is not equal to the interest rate differential, the IRP does not hold.

Now, let's set up a covered interest arbitrage:

1. Borrow $1,000,000 in the US at an interest rate of 5%.
2. Convert this amount into euros at the spot rate of $1.20/€. This gives you €833,333.33.
3. Invest this amount in Germany at an interest rate of 3%. After one year, you will have €833,333.33 * 1.03 = €858,333.33.
4. Enter into a forward contract to convert €858,333.33 back into dollars at the forward rate of $1.15/€ after one year. This gives you $986,583.33.
5. After one year, repay the loan in the US. You owe $1,000,000 * 1.05 = $1,050,000.

Your profit from this arbitrage opportunity is the money you have after repaying the loan minus the money you borrowed, which is $986,583.33 - $1,050,000 = -$63,416.67.

So, you would actually make a loss from this arbitrage opportunity, not a profit. This is because the forward rate is less than the spot rate, but the interest rate in the US is higher than in Germany.

Question

First, let's check if the Interest Rate Parity (IRP) holds. The IRP condition states that the forward premium (or discount) should be equal to the interest rate differential between the two countries.

The forward premium (or discount) can be calculated as (Forward rate - Spot rate) / Spot rate. In this case, it is ($1.15/€ - $1.20/€) / $1.20/€ = -0.04167 or -4.167%.

The interest rate differential is the difference between the US interest rate and the German interest rate, which is 5% - 3% = 2%.

Since the forward discount is not equal to the interest rate differential, the IRP does not hold.

Now, let's set up a covered interest arbitrage:

1. Borrow $1,000,000 in the US at an interest rate of 5%. 
2. Convert this amount into euros at the spot rate of $1.20/€. This gives you €833,333.33.
3. Invest this amount in Germany at an interest rate of 3%. After one year, you will have €833,333.33 * 1.03 = €858,333.33.
4. Enter into a forward contract to convert €858,333.33 back into dollars at the forward rate of $1.15/€ after one year. This gives you $986,583.33.
5. After one year, repay the loan in the US. You owe $1,000,000 * 1.05 = $1,050,000.

Your profit from this arbitrage opportunity is the money you have after repaying the loan minus the money you borrowed, which is $986,583.33 - $1,050,000 = -$63,416.67.

So, you would actually make a loss from this arbitrage opportunity, not a profit. This is because the forward rate is less than the spot rate, but the interest rate in the US is higher than in Germany.

Knowee AI · Accepted Answer

First, let's check if the Interest Rate Parity (IRP) holds. The IRP condition states that the forward premium (or discount) should be equal to the interest rate differential between the two countries.

The forward premium (or discount) can be calculated as (Forward rate - Spot rate) / Spot rate. In this case, it is ($1.15/€ - $1.20/€) / $1.20/€ = -0.04167 or -4.167%.

The interest rate differential is the difference between the US interest rate and the German interest rate, which is 5% - 3% = 2%.

Since the forward discount is not equal to the interest rate differential, the IRP does not hold.

Now, let's set up a covered interest arbitrage:

1. Borrow $1,000,000 in the US at an interest rate of 5%. 
2. Convert this amount into euros at the spot rate of $1.20/€. This gives you €833,333.33.
3. Invest this amount in Germany at an interest rate of 3%. After one year, you will have €833,333.33 * 1.03 = €858,333.33.
4. Enter into a forward contract to convert €858,333.33 back into dollars at the forward rate of $1.15/€ after one year. This gives you $986,583.33.
5. After one year, repay the loan in the US. You owe $1,000,000 * 1.05 = $1,050,000.

Your profit from this arbitrage opportunity is the money you have after repaying the loan minus the money you borrowed, which is $986,583.33 - $1,050,000 = -$63,416.67.

So, you would actually make a loss from this arbitrage opportunity, not a profit. This is because the forward rate is less than the spot rate, but the interest rate in the US is higher than in Germany.

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