Consider an investor has 10000 USD and plans to invest his money for one year. He has the following data: The spot and 12-month forward exchange rates between EUR and USD are St=$1.2187/€ and Ft=$1.2369/€ respectively. The bond rates of USD and ERU are i$,12-month=2% p.a. and i€,12-month=3% p.a..

(1) Calculate whether the covered interest rate parity (CIP) holds.

(2) If CIP does not hold, please construct an arbitrage strategy with detailed procedures and calculate the profit from the strategy. What are the marginal effects on St, i$,12-month, i€,12-month and Ft respectively?

(3) If we consider tax and the rates of capital gains and ordinary income are τ_k=20%,τ_y=30%, please calculate whether CIP holds or not. Draw the CIP line in a figure and mark the areas of capital inflow and capital outflow.

Answer rating: 100% (QA)

1 To calculate whether the covered interest rate parity CIP holds we need to compare the expected rate of return on the investment in each currency Th... View the full answer