Answers to End of Chapter 7 Questions

39. Forward Rates for Different Time Horizons. Assume that interest rate parity (IRP) exists.
Assume this information provided by today’s Wall Street Journal.
Spot rate of British pound = $1.80
6-month forward rate of pound=$1.82
12-month forward rate of pound=$1.78
a. Is the annualized 6-month U.S. risk-free interest rate above, below, or equal to the British risk-free interest rate?

b. Is the 12-month U.S. risk-free interest rate above, below, or equal to the British risk-free interest rate?

ANSWER:
a. The 6-month U.S. risk-free interest rate must be above the 6-month British risk-free interest rate, since the forward rate of the pound has a premium.

b. The 12-month U.S. risk-free interest rate must be below the 12-month British risk-free interest rate, since the forward rate of the pound has a discount.

40. Interpreting Forward Rate Information. Assume that interest rate parity exists. The 6-month
forward rate of the Swiss franc has a premium while the 12-month forward rate of the Swiss franc has a discount. What does this tell you about the relative level of Swiss interest rates versus U.S. interest rates?

ANSWER: The 6-month Swiss interest rate must be lower than the 6-month U.S. interest rate. The 12-month Swiss interest rate must be higher than the 12-month U.S. interest rate.

41. IRP and Speculation in Currency Futures. Assume that interest rate parity exists. The spot rate
of the Argentine peso is $.40. The one-year interest rate in the U.S. is 7% versus 12% in Argentina. Assume the futures price is equal to the forward rate. An investor purchased futures contracts on Argentine pesos, representing a total of 1,000,000 pesos. Determine the total dollar amount of profit or loss from this futures contract based on the expectation that the Argentine peso will be worth $.42 in one year.

ANSWER:
Forward premium = (1 + .07)/ (1 + .12) -1 = -.04464

Forward rate = $.40 x (1 - .044640) = $.38214
Profit = ($.42 - $.38214) x 1,000,000 = $37,860