EFB240Workshop 10Solutionsin 192 PDF

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EFB240 Workshop 10 Solutions Madura Chapter 6 Questions 6. Implications of IFE Explain the international Fisher effect. What is the rationale for the existence of the IFE? What are the implications of the IFE for companies with excess cash that consistently invest in foreign Treasury bills? Explain why the IFE may not hold. ANSWER: The IFE suggests that a currency’s value will adjust in accordance with the differential in interest rates between two countries. The rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a high anticipated inflation. Thus, the inflation will place downward pressure on the currency’s value if it occurs. The implications are that a company that consistently purchases foreign Treasury bills will on average earn a similar return as on domestic Treasury bills. The IFE may not hold because exchange rate movements react to other factors in addition to interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that IFE may not hold.

7. Implications of IFE Assume Australian interest rates are generally above foreign interest rates. What does this suggest about the future strength or weakness of the Australian dollar based on the IFE? Should Australian investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in Australian securities if they believe in the IFE? ANSWER: The IFE would suggest that the Australian dollar will depreciate over time if Australian interest rates are currently higher than foreign interest rates. Consequently, foreign investors who purchased Australian securities would on average receive a similar yield as what they receive in their own country, and Australian investors that purchased foreign securities would on average receive a yield similar to Australian rates.

8. Real interest rate. One assumption made in developing the IFE is that all investors in all countries have the same real interest rate. What does this mean? ANSWER: The real return is the nominal return minus the inflation rate. If all investors require the same real return, then the differentials in nominal interest rates should be solely due to differentials in anticipated inflation among countries. Madura Chapter 7 Questions 1. Locational Arbitrage. Explain the concept of locational arbitrage and the scenario necessary for it to be plausible. ANSWER: Locational arbitrage can occur when the spot rate of a given currency varies among locations. Specifically, the ask rate at one location must be lower than the bid rate at another location. The disparity in rates can occur since information is not always immediately available to all banks. If a disparity does exist, locational arbitrage is possible; as it occurs, the spot rates among locations should become realigned.

2. Locational Arbitrage. Assume the following information:

Bank of India National Australia Bank Bid price of Indian Rupee

A$0.01964 A$0.01936

Ask price of Indian Rupee

A$0.01980 A$0.01942

Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage and compute the profit from this arbitrage if you had A$1 million to use. What market forces would occur to eliminate any further possibilities of locational arbitrage? ANSWER: Yes. One could purchase Indian rupee at Australia National Bank for A$0.01942 and sell them to Bank of India for A$0.01964. With A$1 million available, 51,493,306 Indian rupees (A$1,000,000/ A$0.01942) could be purchased at National Australia Bank. These Indian rupees could then be sold to Bank of India for A$1,011,328 (51,493,306 x A$0.01964) , thereby generating a profit of A$11,328. The large demand for Indian rupees at National Australia Bank will force this bank’s ask price on Indian rupees to increase. The large sales of Indian rupees to Bank of India will force its bid price down. Once the ask price of National Australia Bank is no longer less than the bid price of Bank of India, locational arbitrage will no longer be beneficial.

3. Triangular Arbitrage. Explain the concept of triangular arbitrage and the scenario necessary for it to be plausible. ANSWER: Triangular arbitrage is possible when the actual cross exchange rate between two currencies differs from what it should be. The appropriate cross rate can be determined given the values of the two currencies with respect to some other currency.

4. Triangular arbitrage. Assume the following information: Value of Hong Kong dollar in Australian dollars Value of New Zealand dollar in Australian dollars Value of New Zealand dollar in Hong Kong dollars

Quoted Price A$0.1553 A$0.8939 HK$5.4077

Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect triangular arbitrage and compute the profit from this strategy if you had A$1 million to use. What market forces would occur to eliminate any further possibilities of triangular arbitrage? ANSWER: Yes. The appropriate cross exchange rate should be 1 New Zealand dollar = 5.76 [(A$0.8939/NZ$)/(A$0.1553/HK$)] Hong Kong dollars. Thus, the actual value of the New Zealand dollars in terms of Hong Kong dollars is less than what it should be. One could obtain Hong Kong dollars with Australian dollars, sell the Hong Kong dollars for New Zealand dollars and then exchange New Zealand dollars for Australian dollars. With A$1,000,000, this strategy would generate A$1,064,400 thereby representing a profit of A$64,400. [A$1,000,000/A$0.1553 = HK$6,439,150/HK$5.4077) = NZ$1,190,737 × A$0.8939= A$1,064,400] The value of the Hong Kong dollar with respect to the Australian dollar would rise. The value of the Hong Kong dollar with respect to the New Zealand dollar would decline. The value of the New Zealand dollar with respect to the Australian dollar would fall.

5. Covered Interest Arbitrage. Explain the concept of covered interest arbitrage and the scenario necessary for it to be plausible. ANSWER: Covered interest arbitrage involves the short-term investment in a foreign currency that is covered by a forward contract to sell that currency when the investment matures. Covered interest arbitrage is plausible when the forward premium does not reflect the interest rate differential between two countries specified by the interest rate parity formula. If transactions costs or other considerations are involved, the excess profit from covered interest arbitrage must more than offset these other considerations for covered interest arbitrage to be plausible.

25. Testing Interest Rate Parity. Describe a method for testing whether interest rate parity exists. Why are transactions costs, currency restrictions, and differential tax laws important when evaluating whether covered interest arbitrage can be beneficial? ANSWER: At any point in time, identify the interest rates of the U.S. versus some foreign country. Then determine the forward rate premium (or discount) that should exist according to interest rate parity. Then determine whether this computed forward rate premium (or discount) is different from the actual premium (or discount). Even if interest rate parity does not hold, covered interest arbitrage could be of no benefit if transactions costs or tax laws offset any excess gain. In addition, currency restrictions enforced by a foreign government may disrupt the act of covered interest arbitrage.

57. Comparing Parity Theories. Compare and contrast interest rate parity, purchasing power parity (PPP), and the international Fisher effect (IFE). ANSWER: Interest rate parity can be evaluated using data at any one point in time to determine the relationship between the interest rate differential of two countries and the forward premium (or discount). PPP suggests a relationship between the inflation differential of two countries and the percentage change in the spot exchange rate over time. IFE suggests a relationship between the interest rate differential of two countries and the percentage change in the spot exchange rate over time. IFE is based on nominal interest rate differentials, which are influenced by expected inflation. Thus, the IFE is closely related to PPP.

Interest rate parity forces the forward rates to contain a large discount due to the high interest rates in Latin America, which reflects a disadvantage of hedging these currencies. The decision to hedge makes more sense if the expected degree of depreciation exceeds the degree of the forward discount. Also, keep in mind that some remittances cannot be perfectly hedged anyway because the amount of future remittances is uncertain.

Additional Questions Q1. Assuming the following information, calculate the amount of arbitrage profit that can be made on a borrowing of $1,000,000 AUD. Spot AUD = 0.60 GBP One Year Forward AUD = 0.60 GBP Australian Interest Rate = 3% pa British Interest Rate = 4% pa

ANSWER: Strategy – Covered Interest Arbitrage As interest rates lower in Australia and spot and forward rates the same, borrow in AUD and invest in Britain. Now Borrow in AUD $1m AUD at 3% to repay $1.03m AUD in one year (1m x 1.03) Convert to GBP $1m AUD x 0.60 becomes 0.6m GBP Invest in GBP interest rate 0.6m GBP at 4% to receive 0.624m GBP (0.6m x 1.04) Use forward contract to sell GBP in one year 0.624m GBP converts to $1.04m AUD (0.624m/0.60) In One Year Collect 0.624m GBP from investment Convert 0.624m GBP to $1.04m AUD via forward contract Repay AUD loan plus interest of $1.03m AUD Arbitrage Profit $1.04m AUD - $1.03m AUD = $0.01m AUD = $10 000 AUD

Q2. Assuming the following information, calculate the amount of arbitrage profit that can be made on a borrowing of $10,000,000 AUD or $8,000,000 USD. Spot AUD = 0.80 USD One Year Forward AUD = 0.88 USD Australian Interest Rate = 3% pa USA Interest Rate = 5% pa ANSWER: (1 + i )/(1 + i ) = 1.05/1.03 = 1.0792 f d But F/S = .88/.80 = 1.1 As interest rate differential is less than forward differential, it is better to borrow internationally (USD) and invest domestically (AUD).

Strategy – Covered Interest Arbitrage Now Borrow in USD $8m USD at 5% to repay $8.4m USD in one year (8m x 1.05) Convert to AUD $8m USD/0.80 becomes $10m AUD Invest in AUD interest rate $10m AUD at 3% to receive $10.3m AUD (10m x 1.03) Use forward contract to sell AUD in one year $10.3m AUD converts to $9.064m USD (10.3m x .88) In One Year Collect $10.3m AUD from investment Convert $10.3m AUD to $9.064m USD via forward contract Repay USD loan plus interest of $8.4m USD Arbitrage Profit $9.064m USD - $8.4m USD = $0.664m USD = $664 000 USD

Q3. Assuming the following information, calculate the anticipated spot rate in one year. Spot AUD = 1.1 NZD Australian Inflation Rate = 2% pa New Zealand Inflation Rate = 1.4% pa ANSWER: Expected Spot in one year = S x (1 + inflation )/(1 + inflation ) f d = 1.1 x 1.014/1.02 = 1.0935 NZD Hence due to the higher inflation, the AUD is expected to depreciate against the NZD.

Q4. Assuming the following information, calculate the anticipated spot rate in one year. Spot AUD = 17 Czech Koruna Australian Interest Rate = 3% pa Czech Interest Rate = 2% pa ANSWER: Expected Spot in one year = S x (1 + i )/(1 + i ) f d = 17 x 1.02/1.03 = 16.835 Czech Koruna Hence due to the higher interest rate, the AUD is expected to be lower against the Czech Koruna in one year.

Q5. Discuss in your groups how a cryptocurrency such as Bitcoin works and whether it will become a significant means of foreign exchange in the future....