Impact of Arbitrage on the Forward Rate Assume that the annual U.S. interest rate is currently 8 percent and Japan’s annual interest rate is currently 7 percent. The spot rate of the Japanese yen is $.01. The 1-year forward rate of the Japanese yen is $.01. Assume that as covered interest arbitrage occurs the interest rates are not affected and the spot rate is not affected. Explain how the 1-year forward rate of the yen will change in order to restore interest rate parity, and why it will change. [Your explanation should specify which type of investor (Japanese or U.S.) would be engaging in covered interest arbitrage and whether these investors are buying or selling yen forward, and how that affects the forward rate of the yen.]
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