Exercises

Exercises

1.Single-choice questions

(1)Interest Rate Parity (IRP)is best defined as________.

a.when a government brings its domestic interest rate in line with other major financial markets

b.when the central bank of a country brings its domestic interest rate in line with its major trading partners

c.an arbitrage condition that must hold when international financial markets are in equilibrium

d.None of the above.

(2)When Interest Rate Parity (IRP)does not hold,________.

a.there is usually a high degree of inflation in at least one country

b.the financial markets are in equilibrium

c.there are opportunities for covered interest arbitrage

d.b and c

(3)Suppose that the one-year interest rate is 5.0 percent in the United States, the spot exchange rate is $1.20/€, and the one-year forward exchange rate is $1.16/€.What must one-year interest rate be in the euro zone?

a.5.0%  b.1.09%  c.8.62%  d.None of the above.

(4)Suppose that the one-year interest rate is 3.0 percent in Italy, the spot exchange rate is $1.20/€, and the one-year forward exchange rate is $1.18/€.What must one-year interest rate be in the United States?

a.1.2833%  b.1.0128%  c.4.75%  d.None of the above.

(5)A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year.The one-year interest rate in the US is i$ = 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 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 US at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00.Net profit=$2,400.

c.Borrow €800,000 at i€ = 6%; translate to dollars at the spot; invest in the US at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00.Net profit=€2,000.

d.Answers c and b are both correct.

(6)Suppose that you are the treasurer of IBM with an extra US$1,000,000 to invest for six months.You are considering the purchase of US T-bills that yield 1.810% (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, invest in US T-bills.

b.Take $1m, translate into yen at the spot, invest in Japan, repatriate your yen earnings back into dollars at the spot rate prevailing in six months.

c.Take $1m, translate into yen at the spot, invest in Japan, hedge with a short position in the forward contract.

d.Take $1m, translate into yen at the forward rate, invest in Japan, hedge with a short position in the spot contract.

(7)A US-based currency dealer has good credit and can borrow $1,000,000 for one year.The one-year interest rate in the US is i$ = 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 dollar 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 US at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00.Net profit = $2,400.

c.Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the US at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00.Net profit = €2,000.

d.Answers c and b are both correct.

(8)An Italian currency dealer has good credit and can borrow €800,000 for one year.The one-year interest rate in the US 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 US at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00.Net profit = $2,400.

c.Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the US at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00.Net profit = €2,000.

d.Answers c and b are both correct.

(9)Suppose that you are the treasurer of IBM with an extra US$1,000,000 to invest for six months.You are considering the purchase of US T-bills that yield 1.810% (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.What must the interest rate in Japan (on an investment of comparable risk)be before you are willing to consider investing there for six months?

a.11.991%  b.1.12%  c.7.45%  d.-7.45%

(10)Covered Interest Arbitrage (CIA)activities will result in________.

a.an unstable international financial markets

b.restoring equilibrium quite quickly

c.a disintermediation

d.no effect on the market

(11)Suppose that the one-year 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 one-year forward exchange rate is $1.16/€.Assume that an arbitrageur can borrow up to $1,000,000.

a.This is an example where interest rate parity holds.

b.This is an example of an arbitrage opportunity; interest rate parity does not hold.

c.This is an example of a Purchasing Power Parity violation and an arbitrage opportunity.

d.None of the above.

(12)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.What is the net cash flow in one year if an astute trader finds an arbitrage?

a.$10,690  b.$15,000  c.$46,207  d.$21,964.29

(13)Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and the one-year forward exchange rate is $1.16/€.What must the spot exchange rate be?

a.$1.1768/€   b.$1.1434/€. c.$1.12/€   d.None of the above.

(14)A higher US interest rate (i$ ↑)will result in________.

a.a stronger dollar

b.a lower spot exchange rate (expressed as foreign currency per US dollar)

c.both a and b

d.None of the above.

(15)If the interest rate in the US is i$ = 5 percent for the next year and interest rate in the UK 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 appreciate against the dollar by about 3 percent

c.the dollar is expected to appreciate against the pound by about 3 percent

d.Answers a and c are both correct.

(16)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.Yes, borrow $1,000 at 5%; trade for € at the ask spot rate $1.01 = €1.00; invest €990.10 at 5.5%; hedge this with a forward contract on €1,044.55 at $0.99 = €1.00; receive $1,034.11.

b.Yes, borrow €1,000 at 6%; trade for $ at the bid spot rate $1.00 = €1.00; invest $1,000 at 4.5%; hedge this with a forward contract on €1,045 at $1.00 = €1.00.

c.No; the transactions costs are too high.

d.None of the above.

(17)If IRP fails to hold,________.

a.pressure from arbitragers should bring exchange rates and interest rates back into line

b.it may fail to hold due to transactions costs

c.it may be due to government-imposed capital controls

d.All of the above.

(18)Although IRP tends to hold, it may not hold precisely all the time________.

a.due to transactions costs, like the bid ask spread

b.due to asymmetric information

c.due to capital controls imposed by governments

d.a and c

(19)If a foreign county experiences a hyperinflation,________.

a.its currency will depreciate against stable currencies

b.its currency may appreciate against stable currencies

c.its currency may be unaffected—it’s difficult to say

d.None of the above.

(20)As of today, the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail for the next year in the US is 2% and 3% in the euro zone.What is the one-year forward rate that should prevail?

a.€1.00 = $1.2379  b.€1.00 = $1.2623

c.€1.00 = $0.9903  d.$1.00 = €1.2623

(21)Purchasing Power Parity (PPP)theory states that:

a.The exchange rate between currencies of two countries should be equal to the ratio of the countries’ price levels.

b.As the purchasing power of a currency sharply declines (due to hyperinflation)that currency will depreciate against stable currencies.

c.The prices of standard commodity baskets in two countries are not related.

d.a and b.

(22)If the annual inflation rate is 5.5 percent in the United States and 4 percent in the UK, and the dollar depreciated against the pound by 3 percent, then the real exchange rate, assuming that PPP initially held, is________.

a.0.07  b.0.98  c.-0.0198  d.4.5

(23)An increase in the current account deficit will place________pressure on the home currency value, other things equal.

a.upward  b.downward  c.no   d.upward or downward

(24)The “J curve” effect describes:

a.the continuous long-term inverse relationship between a country’s current account balance and the country’s growth in gross national product.

b.the short run tendency for a country’s balance of trade to deteriorate even while its currency is depreciating.

c.the tendency for exporters to initially reduce the price of goods when their own currency appreciates.

d.the reaction of a country’s currency to initially depreciate after the country’s inflation rate declines.

(25)A large increase in the income level in France along with no growth in the US income level is normally expected to cause (assuming no change in interest rates or other factors)a(n)________in French demand for US goods, and the French franc should________.

a.increase; depreciate     b.increase; appreciate

c.depreciate; depreciate     d.depreciate; appreciate

(26)If US inflation suddenly increased while German inflation stayed the same, there would be________.

a.an increased US demand for marks and an increased supply of marks for sale

b.a decreased US demand for marks and an increased supply of marks for sale

c.a decreased US demand for marks and an decreased supply of marks for sale

d.an increased US demand for marks and an decreased supply of marks for sale

2.Fill in the blanks

(1)If inflation in a foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal (        ).

(2)Covered interest arbitrage involves the short term investment in a foreign currency that is covered by a (        )to sell that currency when the investment matures.

(3)(        )of RMB reduces inflows since the foreign demand for our goods is reduced and foreign competition is increased.

(4)(        )suggests a relationship between the inflation differential of two countries and the percentage change in the spot exchange rate over time.

(5)IFE is based on nominal interest rate (    ), which are influenced by expected inflation.

(6)Transaction exposure is a subset of economic exposure.Economic exposure includes any form by which the firm’s (        )will be affected.

3.Noun explanation

(1)Spot exchange rate

(2)Forward exchange rate

(3)Triangular arbitrage

(4)Hedging

(5)Speculating

4.Essay questions

(1)What’s the foreign exchange arbitrage?

(2)What’s the covered interest parity?

(3)Assume that the spot exchange rate of the British pound is $1.90.How will this spot rate adjust in two years if the United Kingdom experiences an inflation rate of 7 percent per year while the United States experiences an inflation rate of 2 percent per year?

(4)Assume that the spot exchange rate of the Singapore dollar is $0.70.The one year interest rate is 11 percent in the United States and 7 percent in Singapore.What will the spot rate be in one year according to the IFE?

(5)Assume that XYZ Co.has net receivables of 100,000 Singapore dollars in 90 days.The spot rate of the S$ is $0.50 and the Singapore interest rate is 2% over 90 days.Suggest how the US firm could implement a money market hedge.

(6)What is foreign exchange risk?

(7)Talk about the differences among the three types of foreign exchange risk.

(8)What’s Purchasing Power Parity?

(9)What are the differences between UIP and CIP?