Suppose that the CFO of the Vatican on Jan 1. 2017 had 10 million Euros to invest with a time horizon of 1 year until major renovations to St. Peter's Basilica and the papal residence were planned to begin. Suppose further that the interest rate at the time on 1 yea $ Libor deposits in the London interbank was 1.7% while the rate on 1 year Euro Libor deposits in the London market was (-.09). FInally, assume at that time 1 Euro was worth $1.04 in the FX market.
Question A) Based on the interest rate parity condition, what must the FX market have expected about the ($/euro) exchange rate by Jan 1, 2018? (an exact answer is required for full credit. Partial credit can be earned by identifying the direction of change in the $ cost of a Euro.)
Question b) Currently despite three 25 basis point increases in the US Fed Funds target rate range during 2017 and no increases in the ECB's overnight interbank rate the $ is now trading at 1.16 dollars per Euro. Assuming that this exchange rate does not change over the next 6 weeks what rate of return would the CFO of a US based company earn if she invested 10 million $ in 12 month Euro Libor deposits at the rate in part A?
C) how can you explain the difference between the breakeven rate in the $ to Euro FX rate based on the IRP condition and the actual change in that exchange rate over this year?