1.Assume that a small economy has a domestic interest rate of 5 percent.The foreign rate of interest is 3 percent.The small country has no restrictions on capital mobility.What are the possible explanations for the interest rate differential?What further implications may this have on both countries in the short and long term?

2.Calculation:(30 marks).Currently, the spot rate exchange rate is $1.50/ and the three-month forward exchange rate is $1.52/.The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K.Assume that you can borrow as much as $1,500,000 or 1,000,000.

1. Determine whether the interest rate parity (IRP) is currently holding.
2. If the IRP is not holding, how would you carry out covered interest arbitrage?Show all the steps (calculations) and determine the arbitrage profit.
3. Explain how the IRP will be restored as a result of covered arbitrage activities.