Question

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 What is the central bank likely to undertake and how will this affect the value of the euro? 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? Using the interest rate parity equation, was your prediction correct? What should the forward rate be? Based on the one year forward rate you predicted, which investor is likely to benefit from covered interest arbitrage? Compute the profit and yield to the investor who stands to benefit from covered interest arbitrage.

Answer 1

* Difference in interest rate in the two countries = difference in spot and forward rate of the currencies of the two countries

0.06(interest rate in Germany)-0.03(interest rate in USA) = 1.09(Spot rate euro = $) - x(forward rate euro=$),

x = 1.06 (theoritical ideal forward rate)

* As Germany is less affected by the Covid-19 pandemic we assume its economy to do better than USA's economy, So by this assumption we calculate the forward exchange rate to be euro = $ 1.07.

Putting the values given in question in the formula:

Spot Rate: euro 1 = $ 1.09, interest rates in Germany = 6%, in USA = 4%

Forward Rate = 1.09 * (1 + 0.03)/( 1 + 0.06)

euro 1 = $ 1.06

* So the actual forward exchange rate should be euro = $ 1.06

*Based on our assumption investors in USA will benefit by investing in Germany in the following manner

Step 1: Borrow $ 1000 @ 3% interest rate , so the amount payable at the end of year = $1030

Step 2: Convert $1000 in euro at the spot rate of euro = $ 1.09 = 917.43  euro

Step 3: Deposit 917.43 euro @ 6% and get the amount at the end of year = 972.48 euro

Step 4: Convert 972.48 euro back to $ @ one year foward rate euro = $ 1.07 = 1040.55

* So the investor will get 1040.55-1030 = $10.55 per 1000 dollar invested thus making a 1.06% risk free profit from covered interest arbitrage opportunity.