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4. Assume the following information is available for the U.S. and Europe: U.S Europe One-year nominal...

4. Assume the following information is available for the U.S. and Europe:

U.S Europe

One-year nominal interest rate (annual interest rate) 4% 6%

Spot rate ----- -----   $1.13

One-year forward rate ----- ----- $1.10

a. Does IRP (interest rate parity) hold?

b. Which investors have the advantage of conducting the covered interest arbitrage?

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Answer #1

As per interest rate parity, forward rate = Spot Rate*(1+Interest Rate US)/(1+Interest Rate Europe)

=1.13(1.04)/(1.06)

= $1.1087/Euro

since actual forward rate is different, IRP does not hold

b.US Investors have the advantage, They Should borrow in USD and invest in Europe

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