Today, Feb 14th, 2021, I have collected the following from Bloomberg:

The spot rate: USD 1.21/EUR

2-year USD YTM=0.11%

2-year EUR YTM=-0.72%.

Note: YTM is always quoted per year. if we want to make this even more realistic we can include the bid-ask spreads on the bonds, and on the exchange rates. we will put this aside for now but come back to it when we work on swaps.

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QUESTION 1

Solve for the no-arbitrage 2-year forward rate. please round to 2 decimal places.

QUESTION 2

Assume that the 2-year forward rate is USD 1.21/EUR. Is there an arbitrage opportunity? compute the profit if you can borrow up to USD 1,000,000 (or the equivalent in EUR). please round to the nearest US cent.

QUESTION 3

Suppose that you invest in the strategy known as the "carry trade". What will be your profit/loss if the spot rate in 2 years is USD 1.00/EUR.

QUESTION 4

Suppose that unexpectedly the FED increases the fed funds rate by 50bp. The new YTM on the 2-year U.S. bonds jumps to +0.70%. The European Central Bank keeps the target interest rate stable. What will happen to the spot and forward exchange rates?

Answer rating: 100% (QA)

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