Assume that interest rate parity holds so that future or forward exchange rates adjust to eliminate investor arbitrage profits. If interest rates in Britain are higher than corresponding interest rates in Japan, would you expect an appreciating pound or a depreciating pound in the futures (forward) market relative to the current spot market rate? In terms of the supply and demand for pounds in the spot and forward currency markets, what is implicitly occurring in each as a result of interest rate parity? Is the pound selling forward at a premium or at a discount relative to the yen? (The presentation Ac€A?Lesson 3: On Exchange RatesAc€?? from this weekAc€?cs materials can help shed light on this subject. The portion on interest rate parity later in the presentation, so stick with it. ItAc€?cs also discussed in Chapter 16.)

5. The spot market rate for the euro is 1.4059 Canadian dollars per euro. The 3-month futures (forward) rate on the euro is 1.4147 Canadian dollars per euro. The yield on a 3-month Canadian government security is 1.16 percent (0.0116 decimal), annual percentage rate (APR). The yield on a 3-month euro area security is 0.24 percent (0.0024 decimal), annual percentage rate (APR). Show that interest rate parity (IRP) does not hold by solving for the forward rate that ensures IRP. How would you take advantage of the arbitrage opportunity arising from the actual data (i.e., borrow 1,000,000 euros, convert to Canadian dollars, invest in Canada, sell the proceeds forward and then repay your loan or borrow 1,000,000 Canadian dollars, convert to euros, invest in Europe, sell the proceeds forward and then repay your loan)?