The International Banking Fund, the IBF, has forecasted that the global economy is likely to experience a contraction of 3% in 2020, due to the ravages of the COVID-19 pandemic on both developing and advanced economies. Investors believe that The Deutsche Bundesbank, the central bank of the Federal Republic of Germany, will employ direct foreign intervention strategies in the future, to minimize the economic fallout and increase the volume of exports.

Assume the following information:

1 - year U.S. interest rate = 3%

1- year German interest rate = 6%

Spot rate of euro = $1.09

1. What is the central bank likely to undertake and how will this affect the value of the euro
2. Without using an exchange rate model, what is your prediction for the one year forward rate given the likely action of Germany's central bank, all things being equal?
3. Using the interest rate parity equation, was your prediction correct? What should the forward rate be?                                                      
4. Based on the one year forward rate you predicted, which investor is likely to benefit from covered interest arbitrage?                                       
5. Compute the profit and yield to the investor who stands to benefit from covered interest arbitrage.                                                    
6. Draw a diagram to illustrate your understanding of the relationship between interest rate parity and covered interest rate arbitrage and the interplay of market forces that will occur to eliminate arbitrage opportunities.    

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1 To increase imports Central bank will want to devalue its currency to make its export... View the full answer