Answer:
Under the covered interest rate parity theoram, the following formula must hold true, otherise there would be an arbitrage oppurtunity (1+id) = (S/F) * (1+if)
where id - interest rate in the domestic currency
if - interest rate in the foreign currency
S - Current spot foreign exchange rate
F - Forward foreign exchange rate
so (1+.06) = (1.25/1.20)*(1+.02)
1.06 = 1.0625
that measn there is present an arbitrage position.
so a currency that offers lower interest rates tends to trade at a forward foeign exchange rate premium in relation to another currency offering higher rates.
in short which has higher int. rate borrow in that currency.
now as given
Particulars Amt.
Amt. Borrow in Euro 800000
Int. earned in Euro (800000*6/100) 48000
Total amt. repaid after one year in Euro (800000+48000) 848000
convert in $ at spot rate (800000*1.25) 1000000
Int earned in $ (1000000*2/100) 20000
after one year total $ (1000000 + 20000) 1020000
convert in Euro at forward rate (1020000/1.20) 850000
Arbitrage Gain in $ (850000 - 848000) 2000
