Reading 18- LOS g (Part 2)～ Q16－20

16.ce is asked to calculate the one-year forward $/ rate that would preclude profits from covered interest arbitrage between the U.S. dollar and the Euro?

A)   $0.8082/Euro.

B)   $0.7925/Euro.

C)   $0.8110/Euro.

D)   $0.8073/Euro.

The correct answer was D)

Interest rate parity implies that, in order to prevent covered interest arbitrage, the one-year forward $/ rate should be equal to $0.8000(1.10)/(1.09) = $0.8073.

17.ume an investor living in Japan can borrow in the domestic yen (JPY) or in the foreign U.S. dollar (USD). Given the following information, determine whether an arbitrage opportunity exists. If so, how much would the investor profit by borrowing JPY 58,175,000 or the equivalent in USD? (Assume a period of one year.)

A)   An arbitrage opportunity results in a profit of JPY 27,963.

B)   No arbitrage opportunity.

C)   An arbitrage opportunity results in a profit of JPY 292,825.

D)   An arbitrage opportunity results in a profit of JPY 25,170.

The correct answer was C)

Step 1: Determine whether an arbitrage opportunity exists.

We can arrange the formula for covered interest rate parity to look like:

(1 + r_domestic) - [((1 + r_foreign) x Forward_DC/FC) / Spot_DC/FC] = 0

If this condition holds with the financial data above, there are no arbitrage opportunities.

(1 + 0.01500) - [((1 + 0.04000) x 112.99000) / 116.35000] = 1.01500 - 1.00997 = 0.00503

Since the no arbitrage condition does not hold, we move on to:

Step 2: Borrow Domestic or Foreign?

The sign on the result of step 1 is positive, so borrow foreign.

Step 3: Arbitrage Process

18.ume an investor living in Italy can borrow in the domestic lira (ITL) or in the foreign French franc (FRF). Given the following information, determine whether an arbitrage opportunity exists. If so, how much would the investor profit by borrowing ITL 44,280,000 or the equivalent in FRF? (Assume a period of one year & state the profit in domestic currency terms).

A)   An arbitrage opportunity results in a profit of ITL 1,424,774.

B)   No arbitrage opportunity.

C)   An arbitrage opportunity results in a profit of ITL 2,250.

D)   An arbitrage opportunity results in a profit of ITL 58,725.

The correct answer was D)

Step 1: Determine whether an arbitrage opportunity exists.

We can arrange the formula for covered interest rate parity (CIP) to look like:

(1 + r_domestic) - [((1 + r_foreign) x Forward_DC/FC) / Spot_DC/FC] = 0

If this condition holds with the financial data above, there are no arbitrage opportunities.

(1 + 0.05000) - [((1 + 0.03500) * 299.10000) / 295.20000] = 1.05000 - 1.04867 = 0.00133

Since the no arbitrage condition does not hold, we move on to:

Step 2: Borrow domestic or foreign?

Using the rules discussed previously:

Rule 1: The sign on the result of question 1 is positive - borrow foreign.

Rule 2: Borrow foreign.

Step 3: Arbitrage Process

19.(r_D - r_F) > Forward premium, which is (Forward D/F) - Spot(D/F) / Spot(D/F), then:

A)   arbitrage opportunities don't exist.

B)   borrow foreign currency and lend out domestic currency.

C)   borrow domestic currency and lend out foreign currency.

D)   you cannot determine if arbitrage opportunities exist with the data given.

The correct answer was B)

If (r_D - r_F) > Forward premium, which is (Forward D/F) - Spot(D/F) / Spot(D/F), then you would borrow foreign currency and lend out local currency. If the domestic rate is high relative to the hedged foreign rate, you would borrow foreign currency units and then sell them for domestic currency units at the spot rate, lend these domestic currency units at the domestic interest rate and simultaneously sell just enough domestic currency forward so that you can repay your foreign loan.

20.sume an investor living in the United States can borrow in $ or in the Thai baht (THB). Given the following information, determine whether an arbitrage opportunity exists. If so, how much would the arbitrageur profit by borrowing $1,000,000 or the equivalent in baht? (Assume a period of one year and state the profit in domestic currency terms.) 

A)   Borrow $. Arbitrage profits are $36,349.

B)   Borrow baht. Arbitrage profits are $36,349.

C)   There are no arbitrage profits.

D)   Borrow foreign. Arbitrage profits are $65,622.

The correct answer was B)

Step 1: Determine whether an arbitrage opportunity exists.

§ We can arrange the formula for covered interest rate parity (CIP) to look like: (1 + r_domestic) - [((1 + r_foreign) * Forward_DC/FC) / Spot_DC/FC] = 0

§ If this condition holds with the financial data above, there are no arbitrage opportunities. (1 + 0.04500) - [((1 + 0.06000) * 0.02200) / 0.02312] = 1.04500 - 1.00865 = 0.03635

§ Since the no arbitrage condition does not hold, we move on to:

Step 2: Borrow Domestic or Foreign?

§ Rule 1: If the sign on the result of Step 1 is negative, borrow domestic. If the sign is positive, borrow foreign. Here, the sign is positive, so borrow foreign.

§ Rule 2: See table below.

Here, (0.04500 – 0.06000) compared to (0.02200 – 0.02312) / 0.02312

-0.01500> -0.04844, borrow foreign.

Step 3: Conduct arbitrage and calculate profits

Note: ¹ This is the amount you will have available to repay the loan. ² This is the amount you need to repay.