Reading 18- LOS e ～ Q11－16

11．ch of the following statements about foreign exchange quotes is most accurate?

A)   If the KPW goes from 2 KPW/USD to 1.75 KPW/USD the dollar has appreciated.

B)   The ask price (KPW/USD) is what the bank will sell a KPW for.

C)   The bid price (KPW/USD) is what the bank will buy a KPW for.

D)   Standard interbank dealer quotes are foreign currency over the U.S. dollar.

The correct answer was D)

The asking price is what the bank will sell a dollar for. The bid price is what the bank will buy a dollar for. In regular interbank transactions the dollar is always in the denominator (European terms), the dollar depreciated while the KPW appreciated.

12．the forward exchange rate is 2 and the spot rate is 1.9 when the foreign rate of return is 12 percent and the domestic return is 10 percent, which of the following statements would be most accurate?

A)   There are no arbitrage possibilities presented here.

B)   Arbitrage is possible here, investors should borrow domestic, lend foreign.

C)   Arbitrage is possible here, investors should borrow foreign, lend domestic.

D)   The arbitrage possibilities cannot be determined with the data given.

The correct answer was B)

Question 1: Is there an arbitrage opportunity?

If the result of the following formula (derived from rearranging the interest rate parity condition) is not equal to 0, there is an arbitrage opportunity.

(1 + r_domestic) - [((1 + r_foreign) * Forward_DC/FC)) / Spot_DC/FC] = ?

Here, ( 1 + 0.10 ) - [ (( 1 + 0.12 ) * 2.0_DC/FC ) / 1.9_DC/FC ] = ( 1.10 - 1.18 ) = -0.08, which is not equal to 0. Arbitrage opportunities exist.

Question 2: Borrow Domestic (local) or Foreign? Here are some "rules" regarding where to start the arbitrage (where to borrow). These rules only work if there are no transaction costs and only if the currency is quoted in DC/FC terms.

Rule 1: If the sign on the result of question 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.

Here, borrow domestic.

Summary: To take advantage of arbitrage opportunities, borrow domestic and lend foreign.

13．ch of the following statements about exchange rates is FALSE?

A)   In a perfect world, triangular currency arbitrage keeps exchange rates in equilibrium.

B)   The gain or loss on a forward contract is directly related to the current spot rate.

C)   Because of transactions costs there will be a trading band around exchange rates where arbitrage will not occur.

D)   Arbitrage cannot work effectively in the presence of government regulations hampering the flow of funds across borders.

The correct answer was B)

The gain or loss on a forward contract is unrelated to the spot rate. Gains or losses are measured relative to the forward contract rate, not the spot rate. Forward contracts call for delivery of a specified amount of a currency quoted against the dollar on a specific future date.

14．ch of the following statements about exchange rates is most accurate?

A)   Given the bid-ask spread between pesos and dollars is 6.0000-6.0025, and the bid-ask spread between pounds and dollars is 2.0000-2.0015, then the bid/ask spread between pesos and pounds is 2.875-2.934.

B)   A bid of 8.000 pesos/dollar, means the bank will sell you a dollar for 8 pesos.

C)   Spot exchange rates, forward exchange rates, and interest rates are only loosely linked.

D)   The bid-ask spread is a function of breadth, depth, and volatility of the market for a currency.

The correct answer was D)

When the bank bids they are buying and you are selling. Spot exchange rates, forward exchange rates, and interest rates are closely linked. The bid-ask spread between pesos and pounds is 6.0000/2.0015 = 2.9978 and 6.0025/2.0000 = 3.0013.

15．ong Kong company needs to pay one of its suppliers 8,000,000 Indian rupees 90 days from now. The company is worried that rupees will appreciate during this time and decides to partially hedge its exchange rate risk by entering a contract to purchase half of the rupees 90 days into the future for a price of 5.9364 INR/HKD. The current exchange rate is 5.7921 INR/HKD.

90 days later, the exchange rate is 5.8764 INR/HKD. What is the gain/loss of entering this forward contract?

A)   9,906 HKD.

B)   6,880 HKD.

C)   -6,880 HKD.

D)   -9,906 HKD.

The correct answer was B)

By entering into the forward contract, the company gained (4,000,000/5.9364 – 4,000,000/5.8764) = 6,880 HKD.

16．a recent vacation, John Dorn exchanged $100 U.S. for euros. Dorn did not spend any of the euros, so at the end of the trip, he exchanged the euros back for dollars. If the bid-ask quote for euros during this perios was 1.04-1.13, how much dollars did Dorn have at the end of the trip?

A)   $95.

B)   $100.

C)   $92.

D)   $108.

The correct answer was C)

$100(bid 1.04 /USD) = $104

$104/(ask 1.13/USD) = $92