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a) Suppose that one year interest rates in the US are 0.04 (4%) and .02 (2%) in Europe. The current spot rate is $1.20/€, calculate the forward rate consistent with covered interest rate parity. Explain your answer.
b) Suppose that one year interest rates in the US are 2% and that one year interest rates in Europe are 5%. The current $/€ exchange rate is 1.1. Suppose that you have $1000 to invest. Use the uncovered interest rate parity (UIP) condition (the approximation) and solve for the expected exchange rate, one year hence, that is consistent with UIP. Show that with this particular exchange rate, the returns in 'like' currencies are approximately the same.
c) Explain the intuition underlying your results from part b.
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