Answers to End of Chapter 7 Questions

45. IRP Relationship. Assume that interest rate parity (IRP) exists. Assume this information is
provided by today’s Wall Street Journal.

Spot rate of Swiss franc = $.80

6-month forward rate of Swiss franc = $.78
12-month forward rate of Swiss franc = $.81
Assume that the annualized U.S. interest rate is 7% for a six-month maturity and a 12-month maturity. Do you think the Swiss interest rate for a 6-month maturity is greater than, equal to, or less than the U.S. interest rate for a 6-month maturity? Explain.

ANSWER: Since the 6-month forward rate contains a discount, the Swiss 6-month interest rate must be higher than the U.S. 6-month interest rate.

46. Impact of Arbitrage on Forward Rate. Assume that the annual U.S. interest rate is currently
8 percent and Japan’s annual interest rate is currently 7 percent. The spot rate of the Japanese yen is $.01. The one-year forward rate of the Japanese yen is $.01. Assume that as covered interest arbitrage occurs, the interest rates are not affected, and the spot rate is not affected. Explain how the one-year forward rate of the yen will change in order to restore interest rate parity, and why it will change [your explanation should specify which type of investor (Japanese or U.S.) would be engaging in covered interest arbitrage and whether these investors are buying or selling yen forward, and how that affects the forward rate of the yen.]

ANSWER: Japanese investors will be able to engage in covered interest rate arbitrage and take advantage of higher interest rates that exist in US. They will exchange yen for dollars in the spot market, and invest dollars at 8%. They will also buy one-year yen forward contracts. Due to Japanese investors taking advantage of interest rate arbitrage, a large number of yen forward contracts will be bought. This will cause an upward pressure on the one-year forward yen rate.

47. Profit from Triangular Arbitrage. The bank is willing to buy dollars for 0.9 euros per dollar.
It is willing to sell dollars for .91 euros per dollar.

You can sell Australian dollars (A$) to the bank for $.72.

You can buy Australian dollars from the bank for $.74.

The bank is willing to buy Australian dollars (A$) for 0.68 euros per A$.

The bank is willing to sell Australian dollars (A$) for 0.70 euros per A$.

You have $100,000. Estimate your profit or loss if you were to attempt triangular arbitrage by converting your dollars to Australian dollars, and then convertubg Australian dollars to euros, and then converting euros to U.S. dollars.

ANSWER:
$100,000/$.74=A$135,135

A$135,135 x .68 = 91,892 euros.

91,892 euros/.91 = $100,980

Gain = $100,980 - $100,000 = $980