1.China’s nominal interest rates, along with the inflation rate, have been declining over the past five years as a result of governmental efforts to privatize state-owned enterprises and monetary austerity controls over its economy. Over the long run, the Chinese yuan would be expected to:

A)   depreciate relative to countries with high interest rates.

B)   appreciate relative to countries with low inflation.

C)   appreciate relative to countries with high interest rates.

D)   depreciate relative to countries with high inflation.

2.Bob Bowman, CFA, is an analyst who has been recently assigned to the currency trading desk at Ridgeway Securities, a hedge fund management firm based in New York. Ridgeway’s stellar reputation as a top tier hedge fund manager has been built upon many years of its portfolio outperforming both the market and its peer group. Ridgeway’s portfolio is globally diversified, with less than 35 percent of its assets currently invested in U.S. securities. Ridgeway seeks to enhance its portfolio returns through the active use of currency futures that correspond to its investments. From time to time, Ridgeway will also take advantage of arbitrage opportunities that arise in the currency markets.

In his new position, Bowman will be reporting to the head currency trader, Jane Anthony. Among Bowman’s new responsibilities, he will be performing an ongoing analysis of global currency rates. His analysis is expected to include projections of future exchange rates and a sensitivity analysis of exchange rates in a variety of interest rate scenarios. Using his projections as a starting point, he will then be expected to suggest possible trading strategies for Ridgeway. Bowman knows that his analysis will begin with the underlying principles of the five basic international parity relationships. However, he does realize that certain principles will be more useful than others when applied to a “real-world” situation. To test his knowledge of the subject, Anthony has asked Bowman to prepare a presentation on the interrelationships between exchange rates, interest rates, and inflation rates. For the presentation, Bowman will need to prepare a brief analysis of current market conditions and formulate some basic trading strategies based upon his projections. He also will need to demonstrate his ability to calculate predicted spot rates for currencies, given some basic inflation rate and interest rate assumptions.

Bowman begins his task by gathering the following current market statistics:

·  1 year U.S. Interest Rates = 8%

·  1 year U.K. Interest Rates = 10%

·  1 year $/₤ forward rate = 1.70

·  Current $/₤ spot rate = 1.85

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

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

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

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

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

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

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

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

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

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

4.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)   1.67 $/₤.

C)   1.88 $/₤.

D)   1.89 $/₤.

5.A junior colleague asks Bowman for the mathematical equation that describes interest rate parity. Which of the following equations CORRECTLY describes interest rate parity? (S₀ is the spot exchange rate expressed in dollars per unit of foreign currency, F_0,T is the forward exchange rate, and r_US and r_FX are the risk-free rates in the U.S. and foreign country.)

A)   F_0,t = S₀ [(1+r_FX) / (1+r_US)].

B)   F_0,t = S₀ [(1+r_US) / (1+r_FX)].

C)   S₀ = F_0,t [(1+r_US) / (1+r_FX)].

D)   S₁ = F_0,t [(1+r_US) / (1+r_FX)].

答案和详解如下：

1.China’s nominal interest rates, along with the inflation rate, have been declining over the past five years as a result of governmental efforts to privatize state-owned enterprises and monetary austerity controls over its economy. Over the long run, the Chinese yuan would be expected to:

A)   depreciate relative to countries with high interest rates.

B)   appreciate relative to countries with low inflation.

C)   appreciate relative to countries with high interest rates.

D)   depreciate relative to countries with high inflation.

The correct answer was C)

According to uncovered interest rate parity, countries with high nominal interest rates should experience a depreciation of their currency in the long run, while countries with low nominal interest rates should experience an appreciation of their currency in the long run.

2.Bob Bowman, CFA, is an analyst who has been recently assigned to the currency trading desk at Ridgeway Securities, a hedge fund management firm based in New York. Ridgeway’s stellar reputation as a top tier hedge fund manager has been built upon many years of its portfolio outperforming both the market and its peer group. Ridgeway’s portfolio is globally diversified, with less than 35 percent of its assets currently invested in U.S. securities. Ridgeway seeks to enhance its portfolio returns through the active use of currency futures that correspond to its investments. From time to time, Ridgeway will also take advantage of arbitrage opportunities that arise in the currency markets.

In his new position, Bowman will be reporting to the head currency trader, Jane Anthony. Among Bowman’s new responsibilities, he will be performing an ongoing analysis of global currency rates. His analysis is expected to include projections of future exchange rates and a sensitivity analysis of exchange rates in a variety of interest rate scenarios. Using his projections as a starting point, he will then be expected to suggest possible trading strategies for Ridgeway. Bowman knows that his analysis will begin with the underlying principles of the five basic international parity relationships. However, he does realize that certain principles will be more useful than others when applied to a “real-world” situation. To test his knowledge of the subject, Anthony has asked Bowman to prepare a presentation on the interrelationships between exchange rates, interest rates, and inflation rates. For the presentation, Bowman will need to prepare a brief analysis of current market conditions and formulate some basic trading strategies based upon his projections. He also will need to demonstrate his ability to calculate predicted spot rates for currencies, given some basic inflation rate and interest rate assumptions.

Bowman begins his task by gathering the following current market statistics:

·  1 year U.S. Interest Rates = 8%

·  1 year U.K. Interest Rates = 10%

·  1 year $/₤ forward rate = 1.70

·  Current $/₤ spot rate = 1.85

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

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

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

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

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

The correct answer was A)

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

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

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

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

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

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

The correct answer was 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.

4.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)   1.67 $/₤.

C)   1.88 $/₤.

D)   1.89 $/₤.

The correct answer was 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.

5.A junior colleague asks Bowman for the mathematical equation that describes interest rate parity. Which of the following equations CORRECTLY describes interest rate parity? (S₀ is the spot exchange rate expressed in dollars per unit of foreign currency, F_0,T is the forward exchange rate, and r_US and r_FX are the risk-free rates in the U.S. and foreign country.)

A)   F_0,t = S₀ [(1+r_FX) / (1+r_US)].

B)   F_0,t = S₀ [(1+r_US) / (1+r_FX)].

C)   S₀ = F_0,t [(1+r_US) / (1+r_FX)].

D)   S₁ = F_0,t [(1+r_US) / (1+r_FX)].

The correct answer was B)

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:

F_0,t = S₀ [(1+r_US) / (1+r_FX)]

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.