A currency dealer has good credit and can borrow either €
1,000,000 or £ 750,000 for two years. The 2-year euro interest rate
is 5%, and the 2-year pound interest rate is 6%. The
spot exchange rate is
£0.75/€, and the 2-year forward exchange rate is £0.80/€.
Show how to realize a certain profit via covered interest
arbitrage.
How do interest rates, the spot currency market, and the
forward currency market adjust to produce an
equilibrium? Provide some explanation of the adjustment...