Problem 6.

2 Argentine Float

The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In
January 2002 the Argentine peso was floated. On January 29, 2003 it was trading at Ps3.20/$.
During that one year period Argentina's inflation rate was 20% on an annualized basis. Inflation in
the United States during that same period was 2.2% annualized.

a. What should have been the exchange rate in January 2003 if PPP held?
b. By what percentage was the Argentine peso undervalued on an annualized basis?
c. What were the probable causes of undervaluation?

Assumptions Value
Spot exchange rate, fixed peg, early January 2002 (Ps/$) 1.0000
Spot exchange rate, January 29, 2003 (Ps/$) 3.2000
US inflation for year (per annum) 2.20%
Argentine inflation for year (per annum) 20.00%

a. What should have been the exchange rate in January 2003 if PPP held?

Beginning spot rate (Ps/$) 1.00

Argentine inflation 20.00%
US inflation 2.20%
PPP exchange rate 1.17

b. By what percentage was the Argentine peso undervalued on an annulized basis?

Actual exchange rate (Ps/$) 3.20

PPP exchange rate (Ps/$) 1.17
Percentage overvaluation (positive) or undervaluation (negative) -63.307%

c. What were the probable causes of undervaluation?

The rapid decline in the value of the Argentine peso was a result of not only inflation,
but also a severe crisis in the balance of payments (see Chapter 4).
Problem 6.5 Starbucks (Croatia)

Starbucks opened its first store in Zagreb, Croatia in October 2010. The price of a tall vanilla latte
in Zagreb is 25.70kn. In New York City, the price of a tall vanilla latte is $2.65. The exchange
rate bewteen Croatian kunas (kn) and U.S. dollars is kn5.6288/$. According to purchasing power
parity, is the Croatian kuna overvalued or undervalued?

Assumptions Value
Spot exchange rate (Kn/$) 5.6288
Price of vanilla latter in Zagreb (kn) 25.70
Price of vanilla latter in NYC ($) 2.65

Actual price of Croatian latte in USD 4.57

Implied PPP of Croatian latte in USD 9.70
Percentage overvaluation (positive) or undervaluation (negative) 112.408%
Problem 6.6 Hyundai’s-Pass Through

Assume that the export price of a Hyundai Sonata from Seoul, South Korea is W23,460,000. It exports the car to
Malaysia. The exchange rate is W279.48/RM. The forecast inflation rate in Malaysia is 2.0% per year and in South Korea
it is 1.5% per year. Use these data to answer the following questions on exchange rate pass-through.

a. What was the export price for the Sonata at the beginning of the year expressed in Malaysian ringgit?
b. Assuming purchasing power parity holds, what should the exchange rate at the end of the year?
c. Assuming 100% exchange rate pass-through, what will be the Malaysian ringgit price of a Sonata at the end of the year?
d. Assuming 60% exchange rate pass-through, what will be the Malaysian ringgit price of a Sonata at the end of the year?

Steps Value
Initial spot exchange rate (KRW/MYR) 279.48
Initial price of a Hyundai Sonata (KRW) 23,460,000
Expected Malaysian ringgit inflation rate for the coming year 2.000%
Expected Korean won inflation rate for the coming year 1.500%
Desired rate of pass through by Hyundai 60.000%

a. What was the export price for the Sonata at the beginning of the year?
Year-beginning price of an Corolla (KRW) 23,460,000
Spot exchange rate (KRW/MYR) 279.48
Year-beginning price of a Sonata (MYR) MYR 83,941.61

b. What is the expected spot rate at the end of the year assuming PPP?
Initial spot rate (KRW/MYR) 279.48
Expected Malaysian ringgit inflation 2.00%
Expected Korean won inflation 1.50%
Expected spot rate at end of year assuming PPP (KRW/MYR) 278.11

c. Assuming complete pass through, what will the price be in MYR in one year?
Price of Sonata at beginning of year (KRW) 23,460,000
Korean won inflation over the year 1.500%
Price of Sonata at end of year (KRW) 23,811,900
Expected spot rate one year from now assuming PPP (KRW/MYR) 278.11
Price of Sonata at end of year in (KRW) MYR 85,620.44

d. Assuming partial pass through, what will the price be in MYR in one year?
Price of Sonata at end of year (KRW) 23,811,900
Amount of expected exchange rate change, in percent (from PPP) 0.493%
Proportion of exchange rate change passed through by Hyundai 60.000%
Proportional percentage change 0.296%
Effective exchange rate used by Hyundai to price in Malaysian ringgit for end of year 278.656
Price of Sonata at end of year (MYR) MYR 85,452.55
Problem 6.7 Kamada: CIA Japan (A)

Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage
possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars
and Japanese yen. He faced the following exchange rate and interest rate quotes.

Assumptions Value Yen Equivalent

Arbitrage funds available $5,000,000 593,000,000
Spot rate (¥/$) 118.60
180-day forward rate (¥/$) 117.80
180-day U.S. dollar interest rate 4.800%
180-day Japanese yen interest rate 3.400%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i ¥ - i $) -1.400%

Forward premium on the yen 1.358%
CIA profit potential -0.042%

This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to
lock-in a covered interest arbitrage (CIA) profit.

U.S. dollar interest rate (180 days)

4.800%

$ 5,000,000 → → 1.0240 → → $ 5,120,000

↑ ↓
↑ ↓
↑ ↓
↑ ↓
↑ ↓
Spot (¥/$) ---------------> 180 days ----------------> Forward-180 (¥/$)
118.60 117.80
↑ ↓
↑ ↓
↑ 603,136,000
593,000,000.00 → → 1.0170 → → 603,081,000
Japanese yen 55,000
3.400%
START Japanese yen interest rate (180 days) END

Takeshi Kamada generates a CIA profit by investing in the higher interest rate currency, the dollar, and
simultaneously selling the dollar proceeds forward into yen at a forward premium which does not completely negate
the interest differential.
Problem 6.11 Copenhagen Covered ( C )

Heidi Høi Jensen is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note
that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make
CIA profit one way or another.)

Assumptions Value kr Equivalent

Arbitrage funds available $5,000,000 kr 30,860,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
US dollar 3-month interest rate 3.000% b)
Danish kroner 3-month interest rate 6.000% b)

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$) 3.000%

Forward discount on the krone -1.678%
CIA profit potential 1.322%

This tells Heidi Høi Jensen that she should borrow US dollars and invest in the HIGHER interest rate currency, the
kroner, gaining on the re-exchange of kroner for dollars at the end of the period.

U.S. dollar interest rate (3-month)

3.000%
START END
$5,000,000 → → 1.0075 → → $ 5,037,500.00
↓ $ 5,053,710.87
↓ $ 16,210.87
↓ ↑
↓ ↑
↓ ↑
Spot (kr/$) ---------------> 90 days ----------------> F-90 (kr/$)
6.1720 6.1980
↓ ↑
↓ ↑
↓ ↑
kr 30,860,000.00 → → 1.0150 → → kr 31,322,900.00

6.000%
Danish kroner interest (3-month)

b) If the Danish kroner interest rate increases to 6.00%, while the U.S. dollar interest rate stays at 3.00% and spot and
forward rates remain the same, Heidi Høi Jensen's CIA profit is $16,210.87.
Problem 6.15 Statoil's Arbitrage

Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and
petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it considers
the U.S. dollar as its functional currency, not the Norwegian krone. Ari Karlsen is a currency trader for Statoil, and has
immediate use of either $3 million (or the Norwegian krone equivalent). He is faced with the following market rates, and
wonders whether he can make some arbitrage profits in the coming 90 days.

Assumptions Value Krone Equivalent

Arbitrage funds available $3,000,000 18,093,600
Spot exchange rate (Nok/$) 6.0312
3-month forward rate (Nok/$) 6.0186
U.S. dollar 3-month interest rate 5.000%
Norwegian krone 3-month interest rate 4.450%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than
the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i Nok - i $) -0.550%

Forward premium on the krone 0.835%
CIA profit 0.285%

This tells Ari Karlsen he should borrow U.S. dollars and invest in the lower yielding currency, the Norwegian krone, selling
the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.

Norwegian krone interest rate (3-month)

4.450%

18,093,600.00 → → 1.0111250 → → 18,294,891.30

↑ ↓
↑ ↓
↑ ↓
↑ ↓
↑ ↓
Spot (Nok/$) ---------------> 90 days ----------------> Forward-90 (Nok/$)
6.0312 6.0186
↑ ↓
↑ ↓
↑ $ 3,039,710.25
$ 3,000,000.00 → → 1.01250000 → → $ 3,037,500.00
Borrow US$ $ 2,210.25

5.000%
START U.S. dollar interest rate (3-month) END

Ari Karlsen can make $2,210.25 for Statoil on each $3 million he invests in this covered interest arbitrage (CIA) transaction.
Note that this is a very slim rate of return on an investment of such a large amount.

Annualized rate of return: 0.2947%