1. CIAAssume the following interest rate and exchange rate quotes. You can borrow $1,000,000 or its yen equivalent ¥101,000,000:
Spot exchange rate: ¥101/$ 1-year forward rate: ¥100/$ 1-year $ interest rate: 1.50% 1-year ¥ interest rate: 0.70% . Use the rule of thumb to identify whether coved interest arbitrage is worthwhile. If yes, what is your strategy and how much is your profit (show the steps)? What market forces would occur to eliminate any further possibilities of covered interest arbitrage?
2. Carry trade (UIA) If you decide to seek the higher interest rate in available in USD but not covering the forward dollar receipts, how should you redesign your strategy? Assess the riskiness of this decision. There is a high expectation that the Fed might increase the interest rate later this year, how would the interest rate change affect the exchange rate and your profit from UIA?
3. Relative PPP Today's spot rate of the euro is USD1.0556/EUR. Assume the relative PPP holds, the U.S. inflation over one year is expected to 2 percent, while the EU inflation is expected to be 1 percent. If you plan to go on vacation in Paris, France and will need 5000 euros in one year. What is the expected exchange rate of euro? What is the expected amount of dollars you need to pay for your trip in one year?