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# CH 6 Columns Answers - 1 a 2 as An arbitrage is best...

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1. An arbitrage is best defined as: a) The act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making guaranteed profits. 2. Interest Rate Parity (IRP) is best defined as: a) An arbitrage condition that must hold when international financial markets are in equilibrium 3. When Interest Rate Parity (IRP) does not hold a) there are opportunities for covered interest arbitrage 4. A formal statement of IRP is a) 5. Suppose that the one-year interest rate is 5.0 percent in the United States, the spot exchange rate is \$1.20/€, and the one-year forward exchange rate is \$1.16/€. What must one-year interest rate be in the euro zone? a) 8.62% 6. Suppose that the one-year interest rate is 3.0 percent in the Italy, the spot exchange rate is \$1.20/€, and the one-year forward exchange rate is \$1.18/€. What must one-year interest rate be in the United States? a) 1.2833% 7. A currency dealer has good credit and can borrow either \$1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i \$ = 2% and in the euro zone the one-year interest rate is i = 6%. The spot exchange rate is \$1.25 = €1.00 and the one-year forward exchange rate is \$1.20 = €1.00. Show how to realize a certain profit via covered interest arbitrage. a) Borrow €800,000 at i = 6%; translate to dollars at the spot, invest in the U.S. at i \$ = 2% for one year; translate €848,000 back into euro at the forward rate of \$1.20 = €1.00. Net profit \$2,400. b) Borrow €800,000 at i = 6%; translate to dollars at the spot, invest in the U.S. at i \$ = 2% for one year; translate €850,000 back into euro at the forward rate of \$1.20 = €1.00. Net profit €2,000. c) Answers c) and b) are both correct 8. Suppose that you are the treasurer of IBM with an extra US\$1,000,000 to invest for six months. You are considering the purchase of U.S. T-bills that yield 1.810% (that’s a six month rate, not an annual rate by the way) and have a maturity of 26 weeks. The spot exchange rate is \$1.00 = ¥100, and the six month forward rate is \$1.00 = ¥110. The interest rate in Japan (on an investment of comparable risk) is 13 percent. What is your strategy? a) take \$1m, translate into yen at the spot, invest in Japan, hedge with a short position in the forward contract 9. A U.S.-based currency dealer has good credit and can borrow \$1,000,000 for one year. The one- year interest rate in the U.S. is i \$ = 2% and in the euro zone the one-year interest rate is i = 6%. The spot exchange rate is \$1.25 = €1.00 and the one-year forward exchange rate is \$1.20 = €1.00. Show how to realize a certain dollar profit via covered interest arbitrage. a) Borrow €800,000 at i = 6%; translate to dollars at the spot, invest in the U.S. at i \$ = 2% for one year; translate €848,000 back into euro at the forward rate of \$1.20 = €1.00. Net profit \$2,400.

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CH 6 Columns Answers - 1 a 2 as An arbitrage is best...

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