Answers to End of Chapter 7 Questions

42. Profit from Covered Interest Arbitrage. Today, the one-year U.S. interest rate is 4%,
while the one-year interest rate in Argentina is 17%. The spot rate of the Argentine peso (AP) is $.44. The one-year forward rate of the AP exhibits a 14% discount. Determine the yield (percentage retrun on investment) to an investor from Argentina who engages in covered interest arbitrage.

ANSWER:
Forward rate of Argentine peso = $.44 x (1 - .14) = $.3784.

Assume Argentine investors invest AP100,000. [You can start with any assumed amount.]

AP100,000 euros x $.44 = $44,000

Invest in U.S.: $44,000 x (1.04) =$45,760

Convert back to AP: $45,760/.3784 = AP120,930.

Yield = (AP120,930 - AP100,000)/AP100,000 = 20.930%.

43. Assessing Whether IRP Exists. Assume zero transactions costs. As of now, the Japanese one-year interest rate is 3 percent, and the U.S. one-year interest rate is 9 percent. The spot rate of the Japanese yen is $.0090 and the one-year forward rate of the Japanese yen is $.0097.

a. Determine whether interest rate parity exists, or whether the quoted forward rate is quoted too high or too low.

b. Based on the information provided in (a), is covered interest arbitrage feasible for U.S. investors, for Japanese investors, for both types of investors, or for neither type of investor?

ANSWER:

a. (1 + .09)/(1 + .03) -1 = ..05825 if IRP exists.
If IRP exists, the forward rate should be [1 + (.05825)] x $.009 = $.00952
The quoted forward rate is too high. IRP does not exist.

b. U.S. investors could engage in covered interest arbitrage by exchanging dollars for yen today and then selling yen forward.

44. Change in Forward Rate Due to Arbitrage. Earlier this morning, the annual U.S. interest rate
was 6 percent and Mexico’s annual interest rate was 8 percent. The spot rate of the Mexican peso was $.16. The one-year forward rate of the peso was $.15. Assume that as covered interest arbitrage occurred this morning, the interest rates were not affected, and the spot rate was not affected, but the forward rate was affected, and consequently interest rate parity now exists. Explain which type of investor (Mexican or U.S.) engaged in covered interest arbitrage, whether they were buying or selling pesos forward, and how that affected the forward rate of the peso.

ANSWER:
Forward rate premium should = (1 + .06)/(1 + .08) -1 = -.01852 if IRP existed.

If IRP exists, the forward rate should be [1 + (-.01852)] x $.16 = $.1570.

The quoted forward rate is too low. So Mexican investors engaged in covered interest arbitrage by exchanging pesos for dollars today and then buying pesos forward.