土豆妮

The interest rates in the U.S. and Great Britain are 7.23% and 6.94% respectively. The forward rate is 1.70$/? and the spot rate is 1.73$/?. Which currency would an investor borrow, if any, to make an arbitrage profit?

A) Lending pounds.

B) Borrow dollars.

C) Borrow pounds.

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Use the following formula to determine if an arbitrage opportunity exists and which currency to borrow.

if 1 + r_D > [(1 + r_F)(Forward rate)] / Spot rate then borrow foreign.

1.0723 > [(1.0694)(1.70)] / 1.73

1.0723 > 1.81798 / 1.73

1.0723 > 1.0509, therefore borrow foreign (pounds).

Alternatively, the dollar is appreciating. [(1.73 ? 1.70) / 1.70] = 1.76% and the $U.S. interest rate is higher. Clearly, investing in $U.S. (and borrowing pounds) is the way to go.

土豆妮

The annual interest rate is 8.02% in Mexico and 7.45% in Canada. The spot peso-dollar exchange rate is 569.87 MXN/CAD, and the one-year forward rate is 526.78 MXN/CAD. If an arbitrage opportunity exists, how much would a person living in Mexico make borrowing 15,000,000 pesos or the equivalent in Canadian dollars?

A) 1,292,410 pesos.

B) 1,284,230 pesos.

C) 1,304,207 pesos.

土豆妮

The annual interest rate is 8.02% in Mexico and 7.45% in Canada. The spot peso-dollar exchange rate is 569.87 MXN/CAD, and the one-year forward rate is 526.78 MXN/CAD. If an arbitrage opportunity exists, how much would a person living in Mexico make borrowing 15,000,000 pesos or the equivalent in Canadian dollars?

A) 1,292,410 pesos.

B) 1,284,230 pesos.

C) 1,304,207 pesos.

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Note that peso is at a forward premium (less pesos per CAD in the future) and that peso interest rate is higher. Therefore it is clear there are arbitrage profits from lending in pesos and borrowing CAD.

First convert to Canadian dollars to determine the amount of interest due at the end of the year. (15,000,000 MXN) × (CAD/569.87 MXN) = 26,321.79 CAD.

26,321.79 CAD × 0.0745 = 1,960.97 CAD interest due at the end of the year.

Lend out pesos 15,000,000 pesos × 1.0802 = 16,203,000 pesos received at the end of the year.

Convert to Canadian dollars (16,203,000 MXN) × (CAD/526.78 MXN) = 30,758.57 CAD.

Subtract the original loan amount and interest: 30,758.57 ? 26,321.79 (original loan) ? 1,960.97 (interest) = 2,475.81 CAD profit.

Convert the remainder back to pesos: (2,475.81 CAD) × (526.78 MXN/CAD) = 1,304,207.19 peso profit.

土豆妮

If (r_D ? r_F) < Forward premium, which is (Forward (D/F) ? Spot(D/F)) / Spot (D/F), then:

A) borrow local currency and lend out foreign currency to earn arbitrage profits.

B) borrow foreign currency and lend out local currency to earn arbitrage profits.

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

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If (r_D ? r_F) < Forward premium, which is (Forward D/F) ? Spot(D/F) / Spot(D/F), then you would borrow domestic currency and lend out foreign currency. The domestic rate is low relative to the hedged foreign rate. You would borrow domestic currency units and convert them to foreign currency at the current spot rate, lend at the foreign currency interest rate, and simultaneously sell just enough foreign currency units forward to convert your foreign loan proceeds.

土豆妮

If:  1 + rD <	(1 +rF)(forward rate)	funds will:
	spot rate

A) flow in and out of the domestic country.

B) flow into the domestic country.

C) flow out of the domestic country.

土豆妮

If:  1 + rD <	(1 +rF)(forward rate)	funds will:
	spot rate

A) flow in and out of the domestic country.

B) flow into the domestic country.

C) flow out of the domestic country.

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This equation is Interest Rate Parity rearranged! If the term on the left (1 + r_domestic), is less than the term on the right, it means that the domestic rate is low relative to the hedged foreign rate. Therefore, there is a profitable arbitrage from borrowing the domestic currency and lending at the foreign interest rate.

Because we lend in the foreign market, we say that the funds flow out of the domestic economy.

土豆妮

The spot rate for the dollar is 0.1432 $/ADF. Andorran and U.S. interest rates are 6.6% and 7.2%, respectively. If the 1-year forward rate is 0.1430 $/ADF, a U.S. investor could earn an arbitrage dollar profit per ADF of:

A) $0.0010.

B) $0.0075.

C) $0.0011.

土豆妮

The spot rate for the dollar is 0.1432 $/ADF. Andorran and U.S. interest rates are 6.6% and 7.2%, respectively. If the 1-year forward rate is 0.1430 $/ADF, a U.S. investor could earn an arbitrage dollar profit per ADF of:

A) $0.0010.

B) $0.0075.

C) $0.0011.

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Let us first check if an arbitrage opportunity exists. Applying the interest rate parity theorem, we have:

Forward rate = 0.1432 × 1.072/1.066 = 0.1440 $/ADF > 0.1430 $/ADF (quoted forward rate)

This implies that an arbitrage opportunity exists. The inequality implies that ADF is mispriced (weak) in the forward market or is underpriced relative to the dollar. We should buy ADF in the forward market and sell the dollar in the spot market. This requires that we borrow in Andorra and convert the francs into dollars at the spot rate. Invest the proceeds in U.S. securities @ 7.2%, and simultaneously enter into a forward transaction where we sell the dollars for ADF @ 0.1430 $/ADF. Assuming that we borrow 1 ADF today and convert it into dollars, we will have 0.1432 dollars to invest at 7.2% for one year. After one year we will have 0.1432 × 1.072 = 0.1535 dollars. At that point, we will owe an Andorran bank 1 × 1.066 or 1.066 ADF, including interest. We will need to convert enough dollars at the forward rate to pay off this loan. At the forward contract rate, we will need to convert 1.066 × 0.1430 = 0.1524 dollars into ADF to pay off our obligation. This will leave us with an arbitrage profit of 0.1535 ? 0.1524 = 0.0011 dollars.

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土豆妮

If (r_D ? r_F) < Forward premium, which is (Forward (D/F) ? Spot(D/F)) / Spot (D/F), then:

A) borrow local currency and lend out foreign currency to earn arbitrage profits.

B) borrow foreign currency and lend out local currency to earn arbitrage profits.

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

土豆妮

The 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 U.S. rate is 11.02%. Assume you can borrow francs or dollars and you live in Switzerland. If an arbitrage opportunity exists, how can you take advantage of it?

A) Borrow domestic currency.

B) Borrow foreign currency.

C) Lend foreign currency.