IBF301 – CHAPTER 6

PRACTICE
1. Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for
six months. The six-month interest rate is 8 percent per annum in the United States and 7
percent per annum in Germany. Currently, the spot exchange rate is €1.01 per dollar and the
six-month forward exchange rate is €0.99 per dollar. The treasurer of IBM does not wish to bear
any exchange risk. Where should he/she invest to maximize the return?

2. While you were visiting London, you purchased a Jaguar for £35,000, payable in three
months. You have enough cash at your bank in New York City, which pays 0.35% interest per
month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£
and the three-month forward exchange rate is $1.40/£. In London, the money market interest
rate is 2.0% for a three-month investment. There are two alternative ways of paying for your
Jaguar.

(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.

(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months
so that the maturity value becomes equal to £35,000.

Evaluate each payment method. Which method would you prefer? Why?

3. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is
$1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in
the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.

a. Determine whether the interest rate parity is currently holding.

b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the
steps and determine the arbitrage profit.

c. Explain how the IRP will be restored as a result of covered arbitrage activities.

4. Currently, the spot exchange rate is $0.85/A$ and the one-year forward exchange rate

is $0.81/A$. One-year interest is 3.5% in the United States and 4.2% in Australia.
You may borrow up to $1,000,000 or A$1,176,471, which is equivalent to $1,000,000
at the current spot rate.
IBF301 – CHAPTER 6

a. Determine if IRP is holding between Australia and the United States.

b. If IRP is not holding, explain in detail how you would realize certain profit in U.S. dollar
terms.
c. Explain how IRP will be restored as a result of arbitrage transactions you carry out above.

5. Suppose that the current spot exchange rate is €0.80/$ and the three-month forward
exchange rate is €0.7813/$. The three-month interest rate is 5.60 percent per annum in the
United States and 5.40 percent per annum in France. Assume that you can borrow up to
$1,000,000 or €800,000.

a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to
realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit.

b. Assume that you want to realize profit in terms of euros. Show the covered arbitrage process
and determine the arbitrage profit in euros.

6. In the October 23, 1999 issue, the Economist reports that the interest rate per annum is
5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in
Turkey? Based on the reported interest rates, how would you predict the change of the
exchange rate between the U.S. dollar and the Turkish lira?

7. As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is
R$1.95/$. The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year
period is 2.6% and 20.0%, respectively. What would you forecast the exchange rate to be at
around November 1, 2000?

8. (CFA question) Omni Advisors, an international pension fund manager, uses the concepts of
purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot
exchange rates. Omni gathers the financial information as follows:

Base price level 100

Current U.S. price level 105
Current South African price level 111
Base rand spot exchange rate $0.175
Current rand spot exchange rate $0.158
Expected annual U.S. inflation 7%
Expected annual South African inflation 5%
IBF301 – CHAPTER 6

Expected U.S. one-year interest rate 10%

Expected South African one-year interest rate 8%

Calculate the following exchange rates (ZAR and USD refer to the South African rand and U.S.
dollar, respectively).
a. The current ZAR spot rate in USD that would have been forecast by PPP.
b. Using the IFE, the expected ZAR spot rate in USD one year from now.
c. Using PPP, the expected ZAR spot rate in USD four years from now.

9. Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange
rate is €1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow
at most €1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot
exchange rate.
a. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that
you are a euro-based investor. Also determine the size of the arbitrage profit.
b. Discuss how the interest rate parity may be restored as a result of the above
transactions.

c. Suppose you are a pound-based investor. Show the covered arbitrage process and
determine the pound profit amount.

10. Due to the integrated nature of their capital markets, investors in both the U.S. and U.K.
require the same real interest rate, 2.5%, on their lending. There is a consensus in capital
markets that the annual inflation rate is likely to be 3.5% in the U.S. and 1.5% in the U.K. for the
next three years. The spot exchange rate is currently $1.50/£.

a. Compute the nominal interest rate per annum in both the U.S. and U.K., assuming that the
Fisher effect holds.
b. What is your expected future spot dollar-pound exchange rate in three years from now?
c. Can you infer the forward dollar-pound exchange rate for one-year maturity?

11. After studying Iris Hamson’s credit analysis, George Davies is considering whether he can
increase the holding period return on Yucatan Resort’s excess cash holdings (which are held in
pesos) by investing those cash holdings in the Mexican bond market. Although Davies would be
IBF301 – CHAPTER 6

investing in a peso-denominated bond, the investment goal is to achieve the highest holding
period return, measured in U.S. dollars, on the investment.

Davies finds the higher yield on the Mexican one-year bond, which is considered to be
free of credit risk, to be attractive but he is concerned that depreciation of the peso will reduce
the holding period return, measured in U.S. dollars. Hamson has prepared selected economic
and financial data, given in Exhibit 3-1, to help Davies make the decision.

Selected Economic and Financial Data for U.S. and Mexico

Expected U.S. Inflation Rate 2.0% per year

Expected Mexican Inflation Rate 6.0% per year
U.S. One-year Treasury Bond Yield 2.5%
Mexican One-year Bond Yield 6.5%

Nominal Exchange Rates

Spot 9.5000 Pesos = U.S. $ 1.00

One-year Forward 9.8707 Pesos = U.S. $ 1.00

Hamson recommends buying the Mexican one-year bond and hedging the foreign currency
exposure using the one-year forward exchange rate. She concludes: “This transaction will result
in a U.S. dollar holding period return that is equal to the holding period return of the U.S. one-
year bond.”

a. Calculate the U.S. dollar holding period return that would result from the transaction
recommended by Hamson. Show your calculations. State whether Hamson’s conclusion
about the U.S. dollar holding period return resulting from the transaction is correct or
incorrect. After conducting his own analysis of the U.S. and Mexican economies, Davies
expects that both the U.S. inflation rate and the real exchange rate will remain constant over
the coming year. Because of favorable political developments in Mexico, however, he
expects that the Mexican inflation rate (in annual terms) will fall from 6.0 percent to 3.0
percent before the end of the year. As a result, Davies decides to invest Yucatan Resorts’
cash holdings in the Mexican one-year bond but not to hedge the currency exposure.
IBF301 – CHAPTER 6

b. Calculate the expected exchange rate (pesos per dollar) one year from now. Show your
calculations. Note: Your calculations should assume that Davies is correct in his
expectations about the real exchange rate and the Mexican and U.S. inflation rates.
c. Calculate the expected U.S. dollar holding period return on the Mexican one-year bond.
Show your calculations. Note: Your calculations should assume that Davies is correct in his
expectations about the real exchange rate and the Mexican and U.S. inflation rates.

12. James Clark is a foreign exchange trader with Citibank. He notices the following quotes.

Spot exchange rate SFr1.2051/$

Six-month forward exchange rate SFr1.1922/$

Six-month $ interest rate 2.5% per year

Six-month SFr interest rate 2.0% per year

a. Is the interest rate parity holding? You may ignore transaction costs.
b. Is there an arbitrage opportunity? If yes, show what steps need to be taken to make
arbitrage profit. Assuming that James Clark is authorized to work with $1,000,000, compute
the arbitrage profit in dollars.

13. Suppose you conduct currency carry trade by borrowing $1 million at the start of each year
and investing in New Zealand dollar for one year. One-year interest rates and the exchange rate
between the U.S. dollar ($) and New Zealand dollar (NZ$) are provided below for the period
2000 – 2009. Note that interest rates are one-year interbank rates on January 1st each year, and
that the exchange rate is the amount of New Zealand dollar per U.S. dollar on December 31
each year. The exchange rate was NZ$1.9088/$ on January 1, 2000. Fill out the columns (4) –
(7) and compute the total dollar profits from this carry trade over the ten-year period. Also,
assess the validity of uncovered interest rate parity based on your solution of this problem. You
are encouraged to use Excel program to tackle this problem.
IBF301 – CHAPTER 6

(1) (2) (3) (4) (5) (6) (7)

Year iNZ$ i$ SNZ$/$ iNZ$ - i$ eNZ$/$ (4)-(5) $ Profit

2000 6.53 6.50 2.2599

2001 6.70 6.00 2.4015
2002 4.91 2.44 1.9117
2003 5.94 1.45 1.5230
2004 5.88 1.46 1.3845
2005 6.67 3.10 1.4682
2006 7.28 4.84 1.4182
2007 8.03 5.33 1.2994
2008 9.10 4.22 1.7112
2009 5.10 2.00 1.3742

Data source: Datastream.