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Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent...

Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and that the spot exchange rate is $1.12/€ and the one-year forward exchange rate, is $1.16/€. Assume that an arbitrageur can borrow up to $1,000,000.

This is an example where interest rate parity holds.

This is an example of an arbitrage opportunity; interest rate parity does not hold.

This is an example of a Purchasing Power Parity violation and an arbitrage opportunity.

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Answer #1

(C) This is an example of an arbitrage opportunity; interest rate parity does not hold as there is an arbitrage opportunity due to variation of exchange rates but interest rates are showing huge gap in comparison to FX rate so interest rate theory isn't holding up.

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