Purchase Solution

# 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 taken out.
Respond to the following:
1. If the current exchange rate is US\$1 equals 0.70 Euros, 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 0.70 Euros to US\$1 to 0.65 Euros. 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?

##### Solution Summary

This solution demonstrates covered interest arbitrage and purchasing power parity through the example of winning 1 million Euros in the Irish lottery and deciding whether to invest the money in Ireland or bring it back to the US.

##### Solution Preview

1. 1,000,000 Euros X (US\$1 / 0.70 Euros) = \$1,428,571
2. a) 1,000,000 Euros X 1.02 = 1,020,000 Euros
b) \$1,428,571 X 1.04 = \$1,485,714
3. 1,020,000 Euros X (US\$1 / 0.65 Euros) = \$1,569,231
I would have more money if I'd left my money in Ireland.
4. Covered interest arbitrage is an investment strategy that makes use of a forward contract to protect an ...

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