One year us interest rates are 7 and european

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66. One year U.S. interest rates are 7%, and European interest rates are 5%. The spot euro direct exchange rate quote is 1.30 and the 1-year forward rate direct quote is 1.25. If you can borrow either $1 million or €1 million to start with, what would be your dollar profits from interest arbitrage based on these data? This is called covered interest arbitrage; the steps are outlined below: According to interest rate parity, the forward rate should be (1.07/1.05) × 1.30 = $1.32; since the rate is only $1.25, you should borrow euros. 1. Borrow €1 million; in 1 year you owe €1 million × 1.05 = €1,050,000. 2. Sell euros and buy dollars spot: €1,000,000 × $1.30 = $1,300,000. 3. Invest in the United States and earn 7%: $1,300,000 × 1.07 = $1,391,000.
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