Problem 2: ( 15 Points)

Suppose the following information on U.S. dollar and euro rates prevails in the international money market.

Spot rate

1.072 $/

One-month forward rate

1.089 $/

Interest rate ()

3.25% per year

Interest rate ($)

1.75% per year

a.Illustrate the covered-interest-parity grid and plot the information in a diagram.

b.Suppose transaction costs are approximately 1 percent. Incorporate this information into the parity grid.

c.Based on the diagram you constructed, would you move funds to the euro instrument, move them to the U.S. dollar instrument, or maintain your current portfolio?