IBF301 | Que Anh Nguyen
Chapter 6_Tutorial Questions
A. Eun Chap 6
1. Discuss the implications of the interest rate parity for the exchange rate determination.
2. Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000… (pg. 291)
3. While you were visiting London, you purchased a Jaguar …. (pg. 291)
4. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is ….
(pg. 291)
5. Omni Advisors case study pg. 292-293
6. Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange
rate is €1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds. …. (pg. 293)
7. James Clark pg. 295
B. Additional MCQs
1. When Interest Rate Parity (IRP) does not hold
A) there are opportunities for covered interest arbitrage.
B) is usually a high degree of inflation in at least one country.
C) financial markets are in equilibrium.
D) the financial markets are in equilibrium and there are opportunities for covered interest
arbitrage.
2. Suppose you observe a spot exchange rate of $2.00/£. If interest rates are 5 percent APR in the
U.S. and 2 percent APR in the U.K., what is the no-arbitrage 1-year forward rate?
A) $2.0588/£ B) £1.9429/$ C) £2.0588/$ D) $1.9429/£
3. Suppose that you are the treasurer of IBM with an extra U.S. $1,000,000 to invest for six
months. You are considering the purchase of U.S. T-bills that yield 1.810 percent (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.
B) Take $1m, translate into yen at the spot, invest in Japan, and repatriate your yen earnings back
into dollars at the spot rate prevailing in six months.
C) Take $1m, translate into yen at the forward rate, invest in Japan, hedge with a short position in
the spot contract.
D) Take $1m, invest in U.S. T-bills.
4. Suppose that the annual interest rate is 5.0 percent in the United States and 3.5 percent in
Germany, and that the spot exchange rate is $1.12/€ and the forward exchange rate, with one-year
maturity, is $1.16/€. Assume that an arbitrager can borrow up to $1,000,000. If an astute trader
finds an arbitrage, what is the net cash flow in one year?
IBF301 | Que Anh Nguyen
A) $15,000 B) $10,690 C) $46,207 D) $21,964.29
5. An Italian currency dealer has good credit and can borrow €800,000 for one year. The one-year
interest rate in the U.S. is i$ = 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 euro-denominated profit via covered interest arbitrage.
A) Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate proceeds
back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B) Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one
year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit is €2,000.
C) Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one
year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit is €2,000.
Alternatively, one could borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the
U.S. at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 =
€1.00. Net profit is $2,400.
D) Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one
year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit is $2,400.
6. If the interest rate in the U.S. is i$ = 5 percent for the next year and interest rate in the U.K. is i£
= 8 percent for the next year, uncovered IRP suggests that
A) the pound is expected to depreciate against the dollar by about 3 percent.
B) the pound is expected to depreciate against the dollar by about 3 percent and the dollar is
expected to appreciate against the pound by about 3 percent.
C) the dollar is expected to appreciate against the pound by about 3 percent.
D) the pound is expected to appreciate against the dollar by about 3 percent.
7. Will an arbitrageur facing the following prices be able to make money?
Borrowing Lending Bid Ask
$ 5% 4.5% Spot $1.00 = €1.00 $1.01 = €1.00
€ 6% 5.5% Forward $0.99 = €1.00 $1.00 = €1.00
A) No; the transactions costs are too high.
B) Yes, borrow €1,000 at 6 percent; trade for $ at the bid spot rate $1.00 = €1.00; invest $1,000 at
4.5 percent; hedge this with a forward contract on €1,045 at $1.00 = €1.00.
C) Yes, borrow $1,000 at 5 percent; trade for € at the ask spot rate $1.01 = €1.00; Invest €990.10
at 5.5 percent; hedge this with a forward contract on €1,044.55 at $0.99 = €1.00; receive
$1.034.11.
D) none of the options
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8. As of today, the spot exchange rate is €1.00 = $1.60 and the rates of inflation expected to
prevail for the next year in the U.S. is 2 percent and 3 percent in the euro zone. What is the one-
year forward rate that should prevail?
A) €1.00 = $1.6157 B) €1.6157 = $1.00
C) $1.00 × 1.03 = €1.60 × 1.02 D) €1.00 = $1.5845
9. Forward parity states that
A) the nominal interest rate differential reflects the expected change in the exchange rate.
B) an increase (decrease) in the expected inflation rate in a country will cause a proportionate
increase (decrease) in the interest rate in the country.
C) any forward premium or discount is equal to the actual change in the exchange rate.
D) any forward premium or discount is equal to the expected change in the exchange rate.
10. The Efficient Markets Hypothesis states
A) current asset prices (e.g., exchange rates) fully reflect all the available and relevant information.
B) markets tend to evolve to low transactions costs and speedy execution of orders.
C) current exchange rates cannot be explained by such fundamental forces as money supplies,
inflation rates and so forth.
D) none of the options
11. If the exchange rate follows a random walk
A) the best predictor of future exchange rates is the forward rate Ft = E(St + 1/It).
B) the future exchange rate is expected to be the same as the current exchange rate, St = E(St +
1), and the best predictor of future exchange rates is the forward rate Ft = E(St + 1/It).
C) the future exchange rate is unpredictable.
D) the future exchange rate is expected to be the same as the current exchange rate, St = E(St +
1).
12. One implication of the random walk hypothesis is
A) given the relative inefficiency of foreign exchange markets, it is difficult to outperform the
technical forecasts unless the forecaster has access to private information that is not yet reflected
in the current futures exchange rate.
B) given the efficiency of foreign exchange markets, it is difficult to outperform the market-based
forecasts unless the forecaster has access to private information that is not yet reflected in the
current exchange rate.
C) given the efficiency of foreign exchange markets, it is difficult to outperform the market-based
forecasts unless the forecaster has access to private information that is already reflected in the
current exchange rate.
IBF301 | Que Anh Nguyen
D) none of the options
13. Which of the following issues are difficulties for the fundamental approach to exchange rate
forecasting?
A) The model itself can be wrong.
B) One has to forecast a set of independent variables to forecast the exchange rates. Forecasting
the former will certainly be subject to errors and may not be necessarily easier than forecasting the
latter.
C) The parameter values, that is the a's and β's, that are estimated using historical data may
change over time because of changes in government policies and/or the underlying structure of the
economy. Either difficulty can diminish the accuracy of forecasts even if the model is correct.
D) none of the options
14. According to the research in the accuracy of paid exchange rate forecasters,
A) the forecasters do a better job of predicting the future exchange rates than the market does.
B) you can make more money selling forecasts than you can following forecasts.
C) the average forecaster is better than average at forecasting.
D) none of the above.
