CH 7 - 98 Chapter 7 C 3) Interest rate parity (forward...

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Unformatted text preview: 98 Chapter 7 C 3) Interest rate parity (forward premium und r conditions of interest rate parity) : (1+rh) _1zihflif (1+if) Definitional Problems 1. Capitalizing on discrepancies in quoted prices involving no risk and no investment of funds is referred to as p 2. Three common forms of international arbitrage are arbitrage, arbitrage, and arbitrage. 3. arbitrage is possible if there are differential exchange rates between locations. 4. Locational arbitrage is possible if one bank’s rate is higher than another bank’s rate. 5. Realignment in the exchange rates of banks will eliminate locational arbitrage. More specifically, market forces will the ask rate of the bank from which the currency was bought to conduct locational arbitrage and will the bid rate of the bank to which the currency was sold to conduct locational arbitrage. 6. arbitrage involves capitalizing on a discrepancy in the cross exchange rate between two currencies. '7. The exchange rate between two nondollar currencies is referred to as the exchange rate. 8. If the dollar value of two foreign currencies implies a lower value for one of these currencies than that quoted by a bank, triangular arbitrage could be initiated by that currency. 9. Triangular arbitrage opportunities will be eliminated quickly, as market forces will force the cross exchange rate to equal to cross exchange rate implied by the two dollar spot exchange rates. 10. arbitrage involves investing in a foreign country and covering against exchange rate risk by engaging in forward contracts. 11. Covered interest arbitrage tends to force a relationship between the of two countries and their forward exchange rate premium or discount. 12. To capitalize on high foreign interest rates using covered interest arbitrage, a US. investor would convert dollars to the foreign currency, invest in the foreign country, and simultaneously the foreign currency forward. lntemationai Arbitrage and Interest Rate Parity 99 13. Covered interest arbitrage will probably be eliminated by market forces. The factors that will be affected by this realignment are the spot rate, the foreign interest rate, the US. g, and the forward rate of the foreign currency. 14. The equilibrium state obtained once market forces cause the interest rates and exchange rates to be such that covered interest arbitrage is no longer feasible is called 15. If interest rate parity exists, then the rate of return achieved from covered interest arbitrage should be equal to the rate available in the country. 16. According to interest rate parity (IRP), if a foreign country’s interest rate is higher than the US. interest rate, the foreign currency should with respect to the US. dollar. 17. If interest rate parity (IRP) exists, then .zrwsnm-zi mi rate it}. arbitrage will not be possible. 18. An approximation to the interest rate parity (IRP) relationship is the expectation that the foreign currency will change by an amount equal to the interest rate between the two countries involved. 19. The interest rate parity (IRP) line is the diagonal line cutting the intersection of axes on a graph relating the interest rate differential and the 20. Points lying to the of the interest rate parity (IRP) line represent a situation in which US. investors would achieve a lower return on a foreign investment than they would on a domestic one. 21. Assume IRP does not hold. Covered interest arbitrage should then only be attempted if abnormal returns remain after considering , potential , and 1. arbitrage 12. sell 2. locational; triangular; covered interest 13. interest rate 3. locational 14. interest rate parity (IRP) 4. bid; ask 15. home 5. increase; decrease 16. depreciate 6. triangular 17. covered interest 7. cross 18. differential 8. buying 19. forward premium 9. quoted 20. left 10. covered interest 21. transaction costs; currency restrictions; 11. interest rates taxes i True/False Problems 1. Arbitrage can be defined as capitalizing on a discrepancy in quoted prices that does not involve risk but involves an investment of funds. 100 10. 11. 12. I3. 14. 15. 16. 17. 18. Chapter 7 If the demand and supply conditions for a particular currency vary among banks, that currency may be priced at different rates among banks, enabling locational arbitrage. If the cross exchange rate of two nondollar currencies implied by their individual spot rates with respect to the dollar is less than the cross exchange rate quoted by a bank, locational arbitrage is possible. For locational arbitrage to be possible, one bank’s ask rate must be higher than another bank’s bid rate for a currency. Technology enables more consistent prices among banks and reduces the likelihood of significant discrepancies in foreign exchange quotations among locations. Assume locational arbitrage is possible and involves two different banks. The realignment that would occur due to market forces would increase one bank's ask rate and would decrease the other bank’s bid rate. Locational arbitrage explains why prices among banks at different locations will not normally differ by a significant amount. Cross exchange rates are used to determine the relationship between the dollar and two nondollar currencies. To obtain the value of Currency Y in units of Currency Z, you would divide the value of Currency Y in dollars by the value of Currency Z in dollars. Triangular arbitrage tends to force a relationship between the interest rates of two countries and their forward exchange rate premium or discount. Triangular arbitrage is risk free in that there is no uncertainty about the prices at which currencies are bought and sold. Generally, discrepancies that enable triangular arbitrage will occur within a single bank. Because of triangular arbitrage, exchange rates are usually aligned correctly. Covered interest arbitrage involves capitalizing on exchange rates between locations. Covered interest arbitrage is feasible until the forward rate of the foreign currency is sufficiently below the spot rate to offset the foreign interest rate advantage. The euro’s forward rate exhibits a percentage discount that is equal in sign and size to the difference between the foreign interest rate and the US interest rate. From a US. investor viewpoint, covered interest arbitrage is not possible in this case. Several factors are affected when market forces cause a realignment resulting from covered interest arbitrage. For example, the forward rate of the foreign currency would increase. The equilibrium state in which covered interest arbitrage is no longer possible is called interest rate parity (IRP). International Arbitrage and Interest Rate Parity 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 10] If interest rate parity exists, then the rate of return achieved from covered interest arbitrage should be equal to the interest rate available in the foreign country. Interest rate parity (IRP) states that the foreign currency’s forward rate premium or discount is roughly equal to the interest rate differential between the US and the foreign country. The interest rate in South Africa is 8%. The interest rate in the U.S. is 5%. The South African forward rate should exhibit a premium of about 3%. The interest rate in Pakistan is 10%; the interest rate in India is 5%. The Pakistani rupee exhibits a forward discount of 4%. From a Indian investor’s viewpoint, covered interest arbitrage is pessible. The larger the degree by which the foreign interest rate exceeds the home interest rate, the larger will be the forward discount of the foreign currency specified by the IRP formula. If the foreign interest rate is less than the home interest rate, the interest rate parity relationship suggests that the forward rate should exhibit a discount. For points lying to the left of the interest rate parity (IRP) line, covered interest arbitrage is not possible from a U.S. investor’s perspective, but is possible from a foreign investor’s perspective. If interest rate parity (IRP) exists, then foreign investors will earn the same returns as US. investors. The actual relationship between the forward rate premium and interest rate differentials generally supports interest rate parity (IRP). if interest rate parity (IRP) does not hold, there is still the possibility that covered interest arbitrage is not worthwhile because of such factors as transaction costs, currency restrictions, and differential tax laws. Even if covered interest arbitrage appears feasible after accounting for transaction costs, the act of investing funds overseas is subject to political risk. Because of interest rate parity, a foreign currency’s forward rate will normally not move in tandem with the spot rate. Locational arbitrage is normally conducted by banks whose computers can continuously monitor the quotes provided by other banks. Answers to T rue/F alse Problems auswwr F 7. T T 8. F F 9. T F 10. F T 11. T T 12. F 102 Chapter 7 13. T 23. T 14. F 24. F 15. T 25. T 16. T 26. F 17. F 27. T 18. T 28. T 19. F 29. T 20. T 30. F 21. F 31. T 22. T Multiple Choice Problems Arbitrage involves Capitalizing on a discrepancy in quoted prices. An investment of funds tied up for a length of time. Risk. - All of the above 9????” Which of the following is not mentioned in the text as a form of international arbitrage? Locational arbitrage Triangular arbitrage Transactional arbitrage Covered interest arbitrage All of the above are mentioned in the text as forms of international arbitrage. apogee» Bamy Bank quotes a single rate for the Saudi Arabian riyal of $0.25. Nanny Bank quotes a single rate for the Saudi Arabian riyal of $0.27. Conducting locational arbitrage, you would riyals at Barny Bank, riyals at Nanny Bank, and make a profit of per unit. Sell; buy; $.02 Buy; sell; $.02 Sell; sell; $0 Buy; buy; $0 None of the above 3‘" 9999‘?” :5 Bank A quotes a bid rate of $0.300 and an ask rate of $0.305 for the Malaysian ringgit (MYR). Bank B quotes a bid rate of $0.306 and an ask rate of $0.310 for the ringgit. What will be the profit for an investor that has $500,000 available to conduct locational arbitrage? $2,041,667 $9,804 $500 $1,639 999‘!“ International Arbitrage and Interest Rate Parity 999‘?“ 9° 9.0 .cri» PP sap-99's 103 American Bank quotes a bid rate of $0.026 and an ask rate of $0.028 for the Indian rupee (INR); National Bank quotes a bid rate of $0.024 and an ask rate for $0.025. Locational arbitrage would involve Buying rupees from American Bank at the bid rate and selling them to National Bank at the ask rate. Buying rupees from National Bank at the ask rate and selling them to American Bank at the bid rate. Buying rupees from American Bank at the ask rate and selling to National Bank at the bid rate. Buying rupees from National Bank at the bid rate and selling them to American Bank at the ask rate. Locational arbitrage is not possible in this case. American Bank quotes a bid rate of $0.026 and an ask rate of $0028 for the Indian rupee; National Bank quotes a bid rate of $0.024 and an ask rate for $0025. An American investor has $700,000 to conduct locational arbitrage. What is the total amount he will end up with after all necessary transactions have been conducted? $728,000 728,000 Indian rupees $701,400 $701,700 Bank X quotes a bid rate of $0.025 and an ask rate of $0.028 for the Thai baht (THB). Bank Y quotes a bid rate of $0.029 and an ask rate of $0.030 for the baht. As a result of realignment of exchange rates due to locational arbitrage, Bank Y’s bid rate will adjust to exactly $0.028. $0.025. $0.030. $0.029. ‘ None of the above Assume you discovered an opportunity for locational arbitrage involving two banks and have taken advantage of it. Because of your and other arbitrageurs’ actions, the following adjustments must take place. 0 One bank’s ask price will rise and the other bank’s bid price will fall. One bank’s ask price will fall and the other bank’s bid price will rise. One bank’s bid/ask spread wiil widen and the other bank’s bid/ask spread will fall. a and c Which of the following is an example of triangular arbitrage initiation? Buying a currency at one bank’s ask and selling at another bank’s bid, which is higher than the former bank’s ask. Buying Singapore dollars from a bank (quoted at $0.55) that has quoted the South African rand (ZAR)/Singapore dollar (S$) exchange rate at ZAR2.50 when the spot rate for the South African rand is $0.20. Buying Singapore dollars from a bank (quoted at $0.55) that has quoted the South African rand/Singapore dollar exchange rate at ZAR3.00 when the spot rate for the South African rand is $0.20. . Converting funds to a foreign currency and investing the funds overseas. l04 Chapter 7 10. Your just received a gift from a friend consisting of 1,000 Thai baht, which you would like to exchange for Australian dollars (AS). You observe that exchange rate quotes for the baht are currently $0.023, while quotes for the Australian dollar are $0.576. How many Australian dollars should you expect to receive for your baht? a. A$39.93 b. A$25,043.48 c. A$553.00 (1. None of the above 11. Hewitt Bank quotes a value for the Japanese yen (¥) of $0.007, and a value for the Canadian Dollar (CS) of $0.821. The cross exchange rate quoted by the bank for the Canadian dollar is ¥l 18.00. You have $5,000 to conduct triangular arbitrage. How much will you end up with if you conduct triangular arbitrage? a. $6,053.27 b. $5,030.45 c. $6,090.13 d. Triangular arbitrage is not possible in this case. 12. National Bank quotes the following for the British pound and the New Zealand dollar: Quoted Bid Price Quoted Ask Price Value of a British pound (:3) in $ $1.61 $1.62 Value of a New Zealand dollar (NZ$) in 3% I $0.55 $0.56 Value of a British pound in New Zealand dollars NZ$2.95 NZ$2.96 Assume you have $10,000 to conduct triangular arbitrage. What is your profit from implementing this strategy? a. $77.64 1). $197.53 c. $15.43 (1. $111.80 13. Hewitt Bank quotes a value for the Japanese yen of $0.007, and a value for the Canadian dollar of $0.821. The cross exchange rate quoted by the bank for the Canadian dollar is ¥118.00. Which of the following is unlikely to occur as a result of realignment due to triangular arbitrage? Hewitt Bank increases its price of Canadian dollars with respect to the U.S. dollar. Hewitt Bank increases its price of Japanese yen with respect to the dollar. c. Hewitt Bank reduces the number of Japanese yen to be exchanged per Canadian dollar received. d. Hewitt Bank reduces its price of Japanese yen with respect to the dollar. 53‘?“ International Arbitrage and interest Rate Parity 105 14. Which of the following is not true regarding covered interest arbitrage? a. Covered interest arbitrage tends to force a relationship between the interest rates of two countries and their forward exchange rate premium or discount. b. Covered interest arbitrage involves investing in a foreign country and covering against exchange rate risk. c. Covered interest arbitrage opportunities only exist when the foreign interest rate is higher than the interest rate in the home country. (1. If covered interest arbitrage is possible, you can guarantee a return on your funds that exceeds the returns you couid achieve domestically. e. All of the above are true regarding covered interest arbitrage. 15. Assume the following information: 1) You have $900,000 to invest 2) Current spot rate of Australian dollar (A$) is $0.62 3) ISO—day forward rate of the Australian dollar is $0.64 4) ISO—day interest rate in the U.S. is 3.5% 5) 180-day interest rate in Australia is 3.0% If you conduct covered interest arbitrage, what is the dollar profit you will have realized after 180 days? a. $56,903.23 b. $61,548.39 0. $27,000 d. $31,500 16. Assume the following information: 1) You have $400,000 to invest 2) Current spot rate of Sudanese dinar (SDD) is $000570 3) 90-day forward rate of the dinar is $000569 4) 90-day interest rate in the U.S. is 4.0% 5) 90—day interest rate in Sudan is 4.2% If you conduct covered interest arbitrage, what amount will you have after 90 days? a. $416,000.00 b. $416,800.00 c. $424,242.86 d. $416,068.77 e. None of the above 17. Assume the following information: 1) You have $300,000 to invest 2) Current spot rate of Chilean peso (CLP) is $000350 3) Expected spot rate of pesos in 90 days is $000354 4) 90-day forward rate of the pesos is $0.003 S6 5) 90-day interest rate in the U.S. is 3.7% 6) 90-day interest rate in Chile is 4.0% 106 Chapter 7 If you conduct covered interest arbitrage, the return you will realize after 90 days is %. a. 5.19 b. 4.00 c. 5.78 d. 3.70 e. None of the above 18. The cross exchange rate quoted by Bank X bank for the Brazilian real (BRR) is 98 Japanese yen (¥). Bank X also quotes a value for the yen of $0.009, and a value for the real of $0.88. You have $150,000 to conduct triangular arbitrage. What is your return from conducting triangular arbitrage? a 0.23% b. 7.26% c. 1 1 . 10% d 7.42% e None of the above 19. Which of the following is not true regarding covered interest arbitrage? 3. Covered interest arbitrage is a reason for observing interest rate parity (IRP). b. If the forward rate is equal to the spot rate, conducting covered interest arbitrage will yield a return that is exactly equal to the interest rate in the foreign country. When interest rate parity holds, covered interest arbitrage is not possible. When interest rate disparity exists, covered interest arbitrage may not be profitable. 6. All of the above are true 9.0 The following information refers to questions 20 and 21. 1) You have $100,000 to invest 2) The current ask quote for Australian dollars (A$) in the Spot market is $0.71 3) The current bid quote for Australian dollars (All) in the spot market is $0.70 4) The one-year forward rate (ask) for A$ is $0.71 5) The one year forward rate (bid) for AS is $0.70 6) The one-year US. interest rate is 7% 7) The one-year Australian interest rate is 9%. 20. If you conduct covered interest arbitrage, what US dollar amount will you have after one year? a $153,521.10 b. $107,464.80 c. $105,493.00 (1 $110,557.10 e None of the above 21. If you conduct covered interest arbitrage, the return you will realize after one year is %. a 7.46 b. 5.35 c. 5.49 d 10.56 e None of the above International Arbitrage and Interest Rate Parity 22. 99.0.3.9: 26. 9"!” 107 Which of the following factors is not affected when market forces resulting from covered interest arbitrage cause a market realignment? The current spot rate The future spot rate The forward rate Home interest rates Foreign interest rates According to interest rate parity (IRP) The forward rate differs from the spot rate by a sufficient amount to offset the inflation differential between two currencies. The future spot rate differs from the current spot rate by a sufficient amount to offset the interest rate differential between two currencies. The future spot rate differs from the current spot rate by a sufficient amount to offset the inflation differential between two currencies. The forward rate differs from the Spot rate by a sufficient amount to offset the interest rate differential between two currencies. Assume that interest rate parity holds. The Mexican interest rate is 50%, and the US. interest rate is 8%. Subsequently, the US. interest rate decreases to 7%. According to interest rate parity, the peso’s forward will Premium; increase Discount; decrease Discount; increase Premium; decrease Which of the following formulas is not an exact or approximate representation of interest rate parity (IRP)? (1 + if ) p = —m:- - 1 (1 + 2,.) (1 + ih) [9 3 “‘1‘— F (1 + If) h _ if a and c Which of the following is not true regarding interest rate parity (IRP)? When interest rate parity holds, c0vered interest arbitrage is not possible. When the interest rate in the foreign country is higher than that in the home country, the forward rate of that country’s currency should exhibit a discount. When the interest rate in the foreign country is lower than that in the home country, the forward rate of that country’s currency should exhibit a premium. When covered interest arbitrage is not feasible, interest rate parity must hold. All of the above are true 108 Chapter 7 27. The following is a graphical representation of the interest rate parity (IRP) iine: i, — 54%) Forward discount (%) Forward premium (%) The dashed line is the IRP line. Which of the following is not true (assume that there are no market imperfections)? a. Any point lying on the IRP line represent interest rate parity. b. Any point lying to the left of the IRP line represent covered interest arbitrage opportunities for foreign investors. c. Any point lying to the right of the IRP line represent covered interest arbitrage opportunities for home country investors. d. Any point lying to the left of the IRP line represent covered interest arbitrage opportunities for home country investors. 28. if interest rate parity does not hold, covered interest arbitrage may be possible. Before deciding whether to conduct covered interest arbitrage, which of the following factors does not need to be investigated? Transaction costs Currency restrictions Taxes Political risk All of the above should be considered rap-99‘s» 29. Bank Y quotes a bid rate for the Indian rupee (INR) of $00254 and an ask rate of $0.0257. Bank Z quotes a bid rate for the Indian rupee of $0.0258 and an ask rate of $0.0259. You have just completed an international finance course and detect an opportunity for arbitrage in these quotes. Your rich uncle is willing to lend you $1,000 for one day if you repay him $1,005 tomorrow. If you accept your uncle’s offer, the return from conducting arbitrage, after accounting for the cost of borrowing, is a. —0. 1 1%. b. 0.11%. c. 1.07%. d. 0.28%. International Arbitrage and Interest Rate Parity 109 Answers to Multiple Choice Problems 1. a $900 000 ———’—- = A$1,451,612.9O >< 1.03 3- E $0.62 ( ) ' :21 14 5161.29 0.64 $0.27 —$0.25 = $0.02 $ ’ 9 = X $ = $956,903.23 4. :1 Thus, the rofit is $56,903.23 w = MYR1,639,344.26 x $0.306 16 d p $0305 ' $400 000 = $501,639.34 —’— : SDD?O,175,438.60 x (1.042) $00057 Thus, the profit is approximately $1,639 = SDD73,122,807.02 x $000569 : $416,068.77 5. b 6. a W : [NR28,000,000 x $0.026 1&0?) 000 ‘ -—-’— : CLP85,714,285.71 1.04 = $728,000 $00035 X( ) x: CLP89,142,857.14 x $000356 3' 3 = $317,348.57 9. e 10. 3 Thus, the realized return is $317,348.57 $00237 THE X THBLOOO _—1 4 5.78% $0.576 7 A$ $300,000 = A$39.93 18. a 1$15' 3300 wow = 3111117045455 x 98 ’ : C$6,090.13 x 118 0'88 $0821 4 ¥16,704,545.45 >< $0.009 = ¥718,635.81 x $0.007 = $150,340.91 = $5,030.45 Thus, the realized return is 12. 0 $10 000 $150,340.91 _1 2 023% ’ = £6,172.84 x 2.95 $150900 $1.62 4 NZ$18,209.88 >< $0.55 :3- g = $10,015.43 ' w = A$l40,845.10x (1.09) Thus, the profit is $15.43 $031 = A$153,521.10x $0.70 13. b = $107,464.80 14. c 15. a 110 21. 22. 23. 24. 25. 26. 27. 28. GQQNOO—U‘ $107,464.80 $100,000 —1 = 7.46% Chapter 7 29. a $1900 = 1NR38,910.51 x 150.0253 = $190389 $0.025? Thus, your loss from conducting arbitrage, after accounting for the cost of borrowing the $1,000 is $1,003.89 - $1,005.00 = - $1.11, which gives a return of-$1.11/$I,000 = -0.] 1% ...
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This note was uploaded on 02/26/2012 for the course FIN 308 taught by Professor Ratner during the Fall '11 term at Rider.

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CH 7 - 98 Chapter 7 C 3) Interest rate parity (forward...

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