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Covered Interest Arbitrage & Purchasing Power Parity

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Congratulations, you just won the Irish Lottery! You bought a ticket while you were on vacation in Ireland, and your winnings amount to 1 million (euros) after all taxes were deducted.

1. If the current exchange rate is US$1 equals .70, how much did you win in US dollars?

2. Suppose that the interest rate in Irish banks is 2% for a one year CD. In the USA, the rate is 4% for a one year CD. If you left your winnings in Ireland, how many euros would you have in a year? If you had taken your winnings back to the USA, how many dollars would you have?

3. Suppose when you cashed in your CD in Ireland a year from now, the exchange rate had changed from US$1 to ? .70 to US$1 to ? .65. How much would your Irish bank account be worth in US dollars at that point? Would you have been better off leaving your winnings in Ireland or bringing them home to the USA?

4. Explain how banks and individuals can use "covered interest arbitrage" to protect themselves when they make international financial investments.

5. Using the theory of purchasing power parity, explain how inflation impacts exchange rates. Based on the theory of purchasing power parity, what can we infer about the difference in inflation between Ireland and the USA during the year your lottery winnings were invested?

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Solution Summary

The solution provides 393 words of detailed calculations and explanations for these problems to aid the understanding of covered interest arbitrage and purchasing power parity.

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1. 1,000,000/0.7 = $1,428,571

2. 1,000,000x1.02 = 1,020,000 Euros

$1,428,571*1.04=$1,485,714

3. 1,020,000/0.65=$1,569,231

In this case it's better to leave the money in Ireland.

4. There's a good short example in the link below, see "Example" on this page:

http://en.wikipedia.org/wiki/Covered_interest_arbitrage

Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his ...

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