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Reading 19: Foreign Exchange Parity Relations - LOS L ~ Q

Q4. Bowman also knows that if the forward rate is higher than what interest rate parity indicates, the appropriate strategy would be to borrow:

A)   dollars, convert to pounds at the forward rate, and lend the pounds.

B)   dollars, convert to pounds at the spot rate, and lend the pounds.

C)   pounds, convert to dollars at the spot rate, and lend the dollars.

Q5. Based on the information above, Bowman would like to calculate the forward rate implied by interest rate parity. The answer is:

A)   1.82 $/₤.

B)   1.88 $/₤.

C)   1.67 $/₤.

Q6. A junior colleague asks Bowman for the mathematical equation that describes interest rate parity. Which of the following equations most accurately describes interest rate parity? (S0 is the spot exchange rate expressed in dollars per unit of foreign currency, F0,T is the forward exchange rate, and rUS and rFX are the risk-free rates in the U.S. and foreign country.)

A)   S1 = F0,t [(1+rUS) / (1+rFX)].

B)   F0,t = S0 [(1+rFX) / (1+rUS)].

C)   F0,t = S0 [(1+rUS) / (1+rFX)].

答案和详解如下:

Q4. Bowman also knows that if the forward rate is higher than what interest rate parity indicates, the appropriate strategy would be to borrow:

A)   dollars, convert to pounds at the forward rate, and lend the pounds.

B)   dollars, convert to pounds at the spot rate, and lend the pounds.

C)   pounds, convert to dollars at the spot rate, and lend the dollars.

Correct answer is B)

If the forward rate is higher than what interest rate parity indicates, the appropriate strategy would be: borrow dollars, convert to pounds at the spot rate, and lend the pounds.

Q5. Based on the information above, Bowman would like to calculate the forward rate implied by interest rate parity. The answer is:

A)   1.82 $/₤.

B)   1.88 $/₤.

C)   1.67 $/₤.

Correct answer is A)

Given the above relationship, interest rate parity does not hold.

(If interest parity held, 1.70 = 1.85 × (1.08 / 1.10), but 1.85 × (1.08 / 1.10) = 1.82).

Therefore, an arbitrage opportunity exists.

To determine whether to borrow dollars or pounds, express the foreign rate in hedged US$ terms (by manipulating the equation for IRP). We get:

(1.70 / 1.85) × 1.10 = 1.0108, which is less than 1.08 (U.S. rate), so we should start by borrowing British pounds and lending U.S. dollars.

Arbitrage steps:

(1)

Today:

 

 

a.

borrow 5,000 @ 10%

 

b.

buy $9,250 with the proceeds of the loan. (5000 × 1.85)

 

c.

lend $9,250 @ 8%

 

d.

buy 5,500 one year in the future @ 1.70 $/₤. This guarantees your

 

 

loan repayment of 5,000 × 1.1 = 5,500.

 

 

 

(2)

One year later, close out your position:

 

a.

Collect the proceeds of your loan: $9,990 = $9,250 × 1.08

 

b.

Buy 5,500 with your forward contract→cost = 5,500 × 1.70 = $9,350

 

c.

Pay off your loan of 5,500

 

d.

Reap your profits: $9,990 − $9,350 = $640

Q6. A junior colleague asks Bowman for the mathematical equation that describes interest rate parity. Which of the following equations most accurately describes interest rate parity? (S0 is the spot exchange rate expressed in dollars per unit of foreign currency, F0,T is the forward exchange rate, and rUS and rFX are the risk-free rates in the U.S. and foreign country.)

A)   S1 = F0,t [(1+rUS) / (1+rFX)].

B)   F0,t = S0 [(1+rFX) / (1+rUS)].

C)   F0,t = S0 [(1+rUS) / (1+rFX)].

Correct answer is C)

Interest Rate Parity

Interest rates between countries and their exchange rates (spot and futures) must be in equilibrium at all times or else there will be arbitrage opportunities. Interest rate parity says that:

F0,t = S0 [(1+rUS) / (1+rFX)]

Where:

S0

=

the current exchange rate in the spot market

F0,t

=

the current exchange rate in the forward of futures market

rUS

=

the risk-free interest rate in the U.S.

rFX

=

the risk-free interest rate in the foreign market

Note: the above currency quotes are expressed in $/FX

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