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.