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.

Question

Quizplus · Accepted Answer

To determine whether interest rate parity holds, we need to compare the expected returns from investing in each currency directly versus investing in the other currency through the forward markets.

In the US, investing $1,000,000 at 5.0% for one year would yield $1,050,000 at the end of the year.

In Germany, investing €892,857 (equivalent to $1,000,000/1.12) at 3.5% for one year would yield €924,107 at the end of the year, which could be exchanged for $1,075,610 at the spot rate of $1.16/€.

Thus, investing in the US directly would give a return of $50,000, while investing in Germany through the forward market would give a return of $75,610. This represents an arbitrage opportunity for the investor to borrow $1,000,000 at 5.0% in the US, exchange it for €892,857, invest it in Germany at 3.5%, and then exchange the proceeds at the one-year forward rate to receive $1,075,610, resulting in a risk-free profit of $25,610.

Therefore, choice B is correct as this is an example of an arbitrage opportunity where interest rate parity does not hold.

Suppose That the One-Year Interest Rate Is 5