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International Finance

14. Assume the interest rate is 16% on pounds sterling and 7% on the Euro. At the same time, inflation is running at an annual rate of 3% in Germany and 9% in England.

a. If the Euro is selling at a one-year forward premium of 10% against the pound, is there an arbitrage opportunity? Explain.

b. What is the real interest rate in Germany? in England?

c. Suppose that during the year the exchange rate changes from Euro2.7/£1 to Euro2.65/£1. What are the real costs to a German company of borrowing pounds? Contrast this cost to its real cost of borrowing Euro.

d. What are the real costs to a British firm of borrowing Euro? Contrast this cost to its real cost of borrowing pounds.

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a. If the Euro is selling at a one-year forward premium of 10% against the pound, is there an arbitrage opportunity? Explain.

ANSWER. According to interest rate parity, with a Euro rate of 7% and a 10% forward premium on the Euro against the pound, the equilibrium pound interest rate should be

1.07 x 1.10 - 1 = 17.7%

Since the pound interest rate is only 16%, there is an arbitrage opportunity. It involves borrowing pounds at 16%, converting them into Euro, investing them at 7%, and then selling the proceeds forward, locking in a pound return of ...

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