土豆妮

The U.S. interest rate is 4%, the Jordan interest rate is 7% and the $/JOD spot rate is 2.0010. What is the $/JOD forward rate that satisfies interest rate parity?

A) $1.9450 / JOD.

B) $0.5142 / JOD.

C) $1.0936 / JOD.

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Forward(DC/FC) = Spot (DC/FC)[(1 + r domestic) / (1 + r foreign)]

(2.0010)(1.04/1.07)

(2.0010)(0.972)

= 1.9450

土豆妮

A resident of China can invest in Chinese yuan at 5.5% or in Egyptian pounds at 6%. The current spot rate is 80 CY/EGP. What is the one-year forward rate expressed in CY/EGP?

A) 79.6226.

B) 80.3792.

C) 88.9876.

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Forward (DC/FC) = Spot (DC/FC)[(1 + r_domestic) / (1 + r_foreign)]

(80 CY/EGP)[(1 + 0.055) / (1 + 0.06)]

(80)(0.99528)

= 79.6226

土豆妮

An investor can invest in Tunisian dinar at r = 6.25% or in Swiss francs at r = 5.15%. She is a resident of Tunisia and the current spot rate is CHF:TND 0.8105. What is the approximate one-year forward rate expressed in CHF:TND?

A) 0.8016.

B) 0.8194.

C) 0.8215.

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The approximate forward premium/discount is given by the interest rate differential. This differential is: 6.25% ? 5.15% = 1.10%. Since Tunisia has higher interest rates, its currency will be at a discount in the forward market. This discount equals: 0.011 × 0.8105 = 0.0089. Since the exchange rate is quoted in CHF:TND, as a depreciating currency, it will take more TND to buy one CHF. The forward rate is thus: 0.8105 + 0.0089 = CHF:TND 0.8194. In other words, the CHF is stronger in the forward market.

土豆妮

 

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

A) borrow domestic currency and lend out foreign currency.

B) arbitrage opportunities don't exist.

C) borrow foreign currency and lend out domestic currency.

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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 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.

土豆妮

Suppose that the current interest rates in the U.S. and the European Union are 13.665% and 8.500%, respectively. Also, the spot rate for the dollar is 1.1975 US$/euro, and the 1-year forward rate is 1.2545 US$/euro. If $100 is invested, what is the total arbitrage profit that a U.S. investor could earn?

A) No arbitrage profit can be made.

B) $5.7000.

C) $23.0670.

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Interest rate parity requires that:
(Forward/Spot) = [(1+r_D)/(1+r_F)]
(1.2545/1.1975) = [1.13665/1.085]
So, interest rate parity holds and no arbitrage opportunity exists.

Alternately:

(1 + 0.13665) = [(1 + 0.085)(1.2545) / 1.1975]

1.13665 = [(1.085)(1.2545) / 1.1975]

1.13665 = 1.36113 / 1.1975

1.13665 = 1.13665, therefore no arbitrage profit can be made.

土豆妮

If 1 + the domestic interest rate < (1 + the foreign interest rate × the forward rate) / spot rate, an investor seeking arbitrage profits should borrow:

A) foreign, convert to domestic, lend out domestic, and convert back to foreign.

B) domestic, convert to foreign, borrow foreign, and convert back to domestic.

C) domestic, lend out foreign, and convert back to domestic.

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If 1 + r_D < (1 + r_F)(forward rate) / spot rate, then borrow domestic, lend out foreign, and convert back to domestic.

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) Lend foreign currency.

C) Borrow foreign currency.

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Borrow foreign if 1 + r_D> [(1 + r_F)(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.

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) $0.0011.

C) $0.0075.

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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.

土豆妮

Given currency quotes in FCC, if:  1 + rDC <	(1 +rFC)(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_DC), 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 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 pounds.

C) Borrow dollars.

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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.