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Suppose the annual US interest rate is 3% and the annual Mexican interest rate is 8%: Suppose that the current spot exchange rate is 12 Mexican pesos per US dollar. Ac- cording to the covered interest parity condition (CIP), what should the 1 year forward Peso per US dollar exchange rate be?

(Uncovered interest parity) What is the relationship among the forward exchange rate, the spot exchange rate, and the interest rate? Suppose the (1-year) interest rate on bank deposits is 2% in Canada and 1.5% in United States. If the (1-year) forward US$–C$ exchange rate is C$1.5 per US$ and the spot rate is C$1.2 per US$, what is the expected US$–C$ exchange rate one year ahead?

Suppose you are working for an international investment firm, and you observe that the annualized return for 3-year Australian corporate bonds is 2.83% while and the annualized 3-year French corporate bonds is 3.58%.

1. You get the following quotes:

EA$/€ = 1.3653

3-year forward rate: FA$/€, 3-year = 1.3894

Is there any arbitrage opportunity?  If yes, what would you do?  If not, why?  Explain.  (8 points)

Note:  Assume your firm does not have any funds denominated in A$ and € and remember to do the interest rate conversion into appropriate time period (use the simple compounding method to covert annualized interest rate to the appropriate time period).

1. Suppose your firm can move the markets (i.e., change the spot exchange rate, the forward exchange rate, and the corporate bond yields in both countries), what happens to these four variables after the transactions you carried in part (a)? Explain in words.  (8 points)
2. Find the A$/€ spot rate such that your firm will be indifferent between holding the Australian corporate bonds and the French corporate bonds. (4 points)

Note:

• Keep your answers to 4 decimal points if needed.
• This question requires you to use the precise form of covered interest rate parity.
• Instead of the assumption made in class (individuals are small players and cannot affect the exchange rates and interest rates), the firm in this question is a LARGE player that has the ability to change the exchange rates and the corporate interest rates when it carries transactions in the spot exchange market, the forward exchange market, and corporate bonds markets in Australia and France.
• Use the subscripts “A” and “F” to represent all the variables and terms used for Australia and France respectively in your written explanation. You must use these notations; otherwise, you will receive a grade of ZERO for the whole question. 

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