21. forward rate between Swiss francs and U.S. dollars is 1.8 SF/$ and the current spot rate is 1.90 SF/$. The Swiss interest rate is 8.02% and the
A) Borrow domestic currency.
B) No arbitrage opportunity exists.
C) Borrow foreign currency.
D) Lend foreign currency.
22.ume an investor living in
Spot rate ( | 30.73000 |
Forward rate ( | 31.50000 |
Domestic ( | 6.50% |
Foreign ($) interest rate (%) | 5.20% |
Which of the following is closest to the correct answer?
A) Borrow $. Arbitrage profits are $13,340.
B) Borrow
C) There are no arbitrage profits.
D) Borrow domestic. Arbitrage profits are $39,685.
21. forward rate between Swiss francs and U.S. dollars is 1.8 SF/$ and the current spot rate is 1.90 SF/$. The Swiss interest rate is 8.02% and the
A) Borrow domestic currency.
B) No arbitrage opportunity exists.
C) Borrow foreign currency.
D) Lend foreign currency.
The correct answer was C)
Borrow foreign if 1 + rD> [(1 + rF)(forward rate)]/spot rate
1 + 0.0802 > [(1 + 0.1102)(1.8)]/1.9
1.0802 > 1.99836/1.9
1.0802 > 1.0518 therefore borrow foreign (dollars) and lend domestic (francs).
Alternatively, U.S. rate is 11.02 - 8.02 = 3% higher and USD is at (1.8 - 1.9)/1.9 = 5.3% discount since USD will fall more than the extra 3% interest, better to lend francs.
22.ume an investor living in
Spot rate ( | 30.73000 |
Forward rate ( | 31.50000 |
Domestic ( | 6.50% |
Foreign ($) interest rate (%) | 5.20% |
Which of the following is closest to the correct answer?
A) Borrow $. Arbitrage profits are $13,340.
B) Borrow
C) There are no arbitrage profits.
D) Borrow domestic. Arbitrage profits are $39,685.
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 + rdomestic) - [((1 + rforeign) * ForwardDC/FC) / SpotDC/FC] = 0
§ If this condition holds with the financial data above, there are no arbitrage opportunities: (1 + 0.06500) - [((1 + 0.05200) * 31.5000) / 30.73000] = 1.06500 - 1.07836 = -0.01336
§ 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 negative, so borrow domestic.
§ Rule 2: See table below. (Rule 2 is an alternative to Rule 1).
(rd – rf) < (Forward – Spot) / Spot | Borrow Domestic |
(rd – rf) > (Forward – Spot) / Spot | Borrow Foreign |
Here, (0.06500 – 0.05200) compared to (31.5000 – 30.73000) / 30.73000 0.013000 < 0.02506, borrow domestic.
Step 3: Conduct Arbitrage and Calculate Profits.
Step | Description | Rate | Calculation | Result |
a | Borrow Domestic | | ||
b | Exchange | Spot | = MUR 1,000,000 / 30.73000 | $ 32,541 |
c | Lend $ at Foreign ( | | = $ 32,541 * (1.05200) | $ 34,233 |
d | Contract to sell proceeds fwd1 | Fwd | = $ 34,233 * 31.50000 | |
e | Calculate loan payoff2 | | = | |
f | Calculate profit (d-e) | | |
Note: 1 This is the amount you will have available to repay the loan. 2 This is the amount you need to repay.
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