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The current exchange rate is $0.7000 per € and the six-month domestic and foreign risk-free interest...

The current exchange rate is $0.7000 per € and the six-month domestic and foreign risk-free interest rates are 5% and 7% per annum (both expressed with continuous compounding). If the six-month forward rate is quoted currently at $0.6000 per €, compute the domestic yield (DY) and the covered foreign yield (CFY) for the six-month period.

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Answer #1

Forward Rate = Spot Rate * e^(Domestic Rate - Foreign Rate) * Domestic Rate

Forward Rate = 0.7 * e^((0.05 - 0.07) * 0.05)

Forward Rate = 0.7 * 0.99

Forward Rate = 0.693

in our case covered interest rate parity holds as calculated forward rate is not equal to actual forward rate. There exists an arbitrage opportunity.

since the forward price of euro is lower than that implied by the covered interest parity relation. These actions will tend to increase spot rate and lower the forward rate, thereby bringing the forward premium back in line with the interest differential.

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