Chapter Seven Answers

1. Locational Arbitrage. Explain the concept of locational arbitrage and the scenario necessary for it
to

be plausible.

ANSWER: Locational arbitrage can occur when the spot rate of a given currency varies among

locations. Specifically, the ask rate at one location must be lower than the bid rate at another

location. The disparity in rates can occur since information is not always immediately available to all

banks. If a disparity does exist, locational arbitrage is possible; as it occurs, the spot rates among

locations should become realigned.

2. Locational Arbitrage. Assume the following information:

Beal Bank Yardley Bank

Bid price of New Zealand $.401 $.398

dollar
Ask price of New Zealand $.404 $.400
dollar

Given this information, is locational arbitrage possible? If so, explain the steps involved in locational

arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. What market
forces would occur to eliminate any further possibilities of locational arbitrage?

ANSWER: Yes! One could purchase New Zealand dollars at Yardley Bank for $.40 and sell them to

Beal Bank for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased

at Yardley Bank ( $1million/$.400)=2.5milllion. These New Zealand dollars could then be sold to Beal
Bank for $1,002,500, (2.5 million *$.401).

thereby generating a profit of $2,500.

The large demand for New Zealand dollars at Yardley Bank will force this bank's ask price on New

Zealand dollars to increase. The large sales of New Zealand dollars to Beal Bank will force its bid

price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank,

locational arbitrage will no longer be beneficial.

3. Triangular Arbitrage. Explain the concept of triangular arbitrage and the scenario necessary for it
to be plausible.

ANSWER: Triangular arbitrage is possible when the actual cross exchange rate between two

currencies differs from what it should be. The appropriate cross rate can be determined given the

values of the two currencies with respect to some other currency.

4. Triangular Arbitrage. Assume the following information:

Quoted Price

Value of Canadian dollar in $.90

U.S. dollars
Value of New Zealand $.30
dollar in U.S. dollars
Value of Canadian dollar in NZ$3.02
New Zealand dollars

Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect

triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use. What

market forces would occur to eliminate any further possibilities of triangular arbitrage?

Canadian investors would earn a return of 11 percent using covered interest arbitrage, the same as

they would earn in Canada.

12. Interest Rate Parity. Why would U.S. investors consider covered interest arbitrage in France
when the interest rate on euros in France is lower than the U.S. interest rate?

ANSWER: If the forward premium on euros more than offsets the lower interest rate, investors
could

use covered interest arbitrage by investing in euros and achieve higher returns than in the U.S.

13. Interest Rate Parity. Consider investors who invest in either U.S. or British one-year Treasury
bills.

Assume zero transaction costs and no taxes.

a. If interest rate parity exists, then the return for U.S. investors who use covered interest arbitrage

will be the same as the return for U.S. investors who invest in U.S. Treasury bills. Is this

statement true or false? If false, correct the statement.

ANSWER: True

b. If interest rate parity exists, then the return for British investors who use covered interest

arbitrage will be the same as the return for British investors who invest in British Treasury bills.

Is this statement true or false? If false, correct the statement.

ANSWER: True

14. Changes in Forward Premiums. Assume that the Japanese yen’s forward rate currently exhibits a
premium of 6 percent and that interest rate parity exists. If U.S. interest rates decrease, how must
this

premium change to maintain interest rate parity? Why might we expect the premium to change?

ANSWER: The premium will decrease in order to maintain IRP, because the difference between the

interest rates is reduced. We would expect the premium to change because as U.S. interest rates

decrease, U.S. investors could benefit from covered interest arbitrage if the forward premium stays

the same. The return earned by U.S. investors who use covered interest arbitrage would not be any

higher than before, but the return would now exceed the interest rate earned in the U.S. Thus,
there is

downward pressure on the forward premium.

15. Changes in Forward Premiums. Assume that the forward rate premium of the euro was higher
last

month than it is today. What does this imply about interest rate differentials between the United

States and Europe today compared to those last month?

ANSWER: The interest rate differential is smaller now than it was last month.

16. Interest Rate Parity. If the relationship that is specified by interest rate parity does not exist at
any

period but does exist on average, then covered interest arbitrage should not be considered by U.S.

firms. Do you agree or disagree with this statement? Explain.

ANSWER: Disagree. If at any point in time, interest rate parity does not exist, covered interest

arbitrage could earn excess returns (unless transactions costs, tax differences, etc., offset the excess

returns).

17. Covered Interest Arbitrage in Both Directions. The one-year interest rate in New Zealand is 6

percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar
(NZ$)

is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for

U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest

arbitrage is or is not feasible.

ANSWER:

To determine the yield from covered interest arbitrage by U.S. investors, start with an assumed
initial

investment, such as $1,000,000.

$1,000,000/$.50 = NZ$2,000,000 × (1.06)

= NZ$2,120,000 × $.54 = $1,144,800

Yield = ($1,144,800 – $1,000,000)/$1,000,000 = 14.48%

Thus, U.S. investors can benefit from covered interest arbitrage because this yield exceeds the U.S.

interest rate of 10 percent.

To determine the yield from covered interest arbitrage by New Zealand investors, start with an

assumed initial investment, such as NZ$1,000,000:

NZ$1,000,000 × $.50 = $500,000 × (1.10)

= $550,000/$.54 = NZ$1,018,519

Yield = (NZ$1,018,519 – NZ$1,000,000)/NZ$1,000,000 = 1.85%

Thus, New Zealand investors would not benefit from covered interest arbitrage since the yield of

1.85% is less than the 6% that they could receive from investing their funds in New Zealand.

18. Limitations of Covered Interest Arbitrage. Assume that the one-year U.S. interest rate is 11

percent, while the one-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is
willing

to purchase the currency of that country from you one year from now at a discount of 13 percent.

Would covered interest arbitrage be worth considering? Is there any reason why you should not

attempt covered interest arbitrage in this situation? (Ignore tax effects.)

ANSWER: Covered interest arbitrage would be worth considering since the return would be 21.8

percent, which is much higher than the U.S. interest rate. Assuming a $1,000,000 initial investment,

$1,000,000 × (1.40) × .87 = $1,218,000

Yield = ($1,218,000 – $1,000,000)/$1,000,000 = 21.8%

However, the funds would be invested in Malaysia, which could cause some concern about default

risk or government restrictions on convertibility of the currency back to dollars.

19. Covered Interest Arbitrage in Both Directions. Assume that the annual U.S. interest rate is

currently 8 percent and Germany’s annual interest rate is currently 9 percent. The euro’s one-year

forward rate currently exhibits a discount of 2 percent.

a. Does interest rate parity exist?

ANSWER: No, because the discount is larger than the interest rate differential.

b. Can a U.S. firm benefit from investing funds in Germany using covered interest arbitrage?

ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of

investing in Germany.
is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for

U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest

arbitrage is or is not feasible.

ANSWER:

To determine the yield from covered interest arbitrage by U.S. investors, start with an assumed
initial

investment, such as $1,000,000.

$1,000,000/$.50 = NZ$2,000,000 × (1.06)

= NZ$2,120,000 × $.54 = $1,144,800

Yield = ($1,144,800 – $1,000,000)/$1,000,000 = 14.48%

Thus, U.S. investors can benefit from covered interest arbitrage because this yield exceeds the U.S.

interest rate of 10 percent.

To determine the yield from covered interest arbitrage by New Zealand investors, start with an

assumed initial investment, such as NZ$1,000,000:

NZ$1,000,000 × $.50 = $500,000 × (1.10)

= $550,000/$.54 = NZ$1,018,519

Yield = (NZ$1,018,519 – NZ$1,000,000)/NZ$1,000,000 = 1.85%

Thus, New Zealand investors would not benefit from covered interest arbitrage since the yield of

1.85% is less than the 6% that they could receive from investing their funds in New Zealand.

18. Limitations of Covered Interest Arbitrage. Assume that the one-year U.S. interest rate is 11

percent, while the one-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is
willing

to purchase the currency of that country from you one year from now at a discount of 13 percent.

Would covered interest arbitrage be worth considering? Is there any reason why you should not

attempt covered interest arbitrage in this situation? (Ignore tax effects.)

ANSWER: Covered interest arbitrage would be worth considering since the return would be 21.8

percent, which is much higher than the U.S. interest rate. Assuming a $1,000,000 initial investment,

$1,000,000 × (1.40) × .87 = $1,218,000

Yield = ($1,218,000 – $1,000,000)/$1,000,000 = 21.8%

However, the funds would be invested in Malaysia, which could cause some concern about default

risk or government restrictions on convertibility of the currency back to dollars.

19. Covered Interest Arbitrage in Both Directions. Assume that the annual U.S. interest rate is

currently 8 percent and Germany’s annual interest rate is currently 9 percent. The euro’s one-year

forward rate currently exhibits a discount of 2 percent.

a. Does interest rate parity exist?

ANSWER: No, because the discount is larger than the interest rate differential.

b. Can a U.S. firm benefit from investing funds in Germany using covered interest arbitrage?

ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of

investing in Germany.

c. Can a German subsidiary of a U.S. firm benefit by investing funds in the United States through

covered interest arbitrage?

ANSWER: Yes, because even though it would earn 1 percent less interest over the year by investing

in U.S. dollars, it would be able to sell dollars for 2 percent more than it paid for them (it would be

buying euros forward at a discount of 2 percent).