Textbook Problem

Impact of Arbitrage on the Forward Rate Assume that the annual U.S. interest rate is currently 8 percent, whereas Japan’s annual interest rate is currently 7 percent. The spot rate of the Japanese yen is $0.01. The one-year forward rate of the Japanese yen is $0.01 . Assume that as covered interest arbitrage occurs, neither the interest rates nor the spot rate is affected. Explain how the one-year forward rate of the yen will change so as to restore interest rate parity, and why it will change. [Your explanation should specify which type of investor (Japanese or U.S.) would engage in covered interest arbitrage, whether these investors would buy or sell yen forward, and how that affects the forward rate of the yen.]