FIN351 Chapter 6 - Tutorial problem sets from textbook. PDF

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Chapter 6 1 Penang Island Resort. Theresa Nunn is planning a 30-day vacation on Pulau Penang, Malaysia, one year from now. The present charge for a luxury suite plus meals in Malaysian ringgit (RM) is RM 1,000/day. The Malaysian ringgit presently trades at RM 5 /GBP. She determines that the pound co...

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Chapter 6 1.Pulau Penang Island Resort. Theresa Nunn is planning a 30-day vacation on Pulau Penang, Malaysia, one year from now. The present charge for a luxury suite plus meals in Malaysian ringgit (RM) is RM 1,000/day. The Malaysian ringgit presently trades at RM 5.2522 /GBP. She determines that the pound cost today for a 30-day stay would be about GBP 6,000. The hotel informs her that any increase in its room charges will be limited to an increase in the Malaysian cost of living. Malaysian inflation is expected to be 3% per annum, while U.K. inflation is expected to be 1%. a) How many pounds might Theresa expect to need one year hence to pay for her 30-day vacation? Charge for a luxury suite plus meals in Malaysian ringgit (RM)

RM 1,000 per day

Spot rate

RM 5.2522 /GBP

Pound cost today for a 30-day stay

GBP 6,000

Malaysian inflation expected to be

3%

U.K. inflation expected to be

1%

Using Purchasing Power Parity: Expected spot rate in one year = Spot rate x [ (1+ RM inflation) / (1+ GBP inflation)] = RM 5.2522/GBP x [ (1+0.03)/ (1+0.01)] = RM 5.356204/GBP Hotel charges expected to be paid one year from now for a 30-day stay (in Malaysian ringgit) = Pound cost today x spot rate x (1 + RM inflation) = [GBP 6,000 x RM 5.2522/GBP] x (1 + 0.03)

= RM 32,475.90 Hotel charges expected to be paid one year from now for a 30-day stay (in British pound) = Hotel charges in RM / Expected spot rate = RM 32,475.90 / RM 5.356204/GBP = GBP 6,060 Therefore, the hotel charges have increased in British Pound after one year. b) B  y what percent will the pound cost have gone up? Why? Original cost

GBP 6,000

New cost

GBP 6,060

Therefore, the percentage change in GBP cost = [ (New - Old) / Old ] x 100% = [ (GBP 6,060 - GBP 6,000) / GBP 6,000] x 100% = 1% The pound cost has risen by the UK inflation rate. This is a result of Theresa’s estimation of the future suite costs and the exchange rate changing in proportion to inflation (relative purchasing power parity).

7. Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars and Japanese yen. He faced the following exchange rate and interest rate quotes. Is CIA profit possible? How so? Arbitrage funds available Spot rate (¥/$) 180-day forward rate (¥/$) 180-day U.S. dollar interest rate 180-day Japanese yen interest rate

$5,000,000 118.60 117.80 4.8% (2.4%) 3.4% (1.7%)

US dollar interest Gain on interest : $5,000,000 * (1 + 0.024) = $5,120,000 Convert USD to Yen 180-day forward : $5,240,000 * ¥117.80/$ : ¥603,136,000 Yen interest rate Convert USD to Yen spot rate : $5,000,000 / (¥118.60/$) = ¥593,000,000 Gain on interest : ¥593,000,000 * (1 + 0.017) = ¥603,081,000 Profit : ¥603,136,000 - ¥603,081,000 = ¥55,000 / $466.89 $5,000,000 ➝ ➝ ➝ ➝ ➝ ➝ 1.024 ➝ ➝ ➝ ➝ ➝ ➝ $5,120,000 ↓ ↓ ↓ ↓ ↓ ↓ Spot rate (118.60¥/$) ➝ ➝ 180 day ➝ ➝ Forward rate (117.80¥/$) ↓ ↓ ↓ ↓ ↓ ↓ ¥593,000,000 ➝ ➝ ➝ ➝ ➝ 1.017 ➝ ➝ ➝ ➝ ➝ ➝ ¥603,081,000

Takeshi generates a CIA profit of ¥55,000/$466.89 by investing in the higher interest rate currency, which is the USD, and simultaneously selling USD proceeds forward into Yen at a forward premium.

8. Takeshi Kamada, Credit Suisse (Tokyo), observes that the ¥/$ spot rate has been holding steady, and that both dollar and yen interest rates have remained relatively fixed over the past week. Takeshi wonders if he should try an uncovered interest arbitrage (UIA) and thereby save the cost of forward cover. Many of Takeshi’s research associates—and their computer models—are predicting the spot rate to remain close to ¥118/$ for the coming 180 days. Analyse the UIA potential using data below: Arbitrage funds available Spot rate (¥/$) 180-day forward rate (¥/$) 180-day U.S. dollar interest rate 180-day Japanese yen interest rate

$5,000,000 118.60 117.80 4.8% (2.4%) 3.4% (1.7%)

Interest rate differential (i - i*) Forward premium/discount on yen

= -0.007 = (118/118.6) -1 = 0.005 Since interest rate differential is greater than forward premium, invest in the higher yielding currency ($). Start: $5,000,000

Dollar interest: 2.4%

End: $5,120,000 End: $5,110,856 Profit: 9,144

Spot: ¥118.60/$

180-day period

Expected spot: ¥118/$

Start: ¥593,000,000

Yen interest: 1.7%

End: ¥604,160,000

17. Chamonix Chateau Rentals. You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are negotiating the rental of a chateau. The chateau’s owner wishes to preserve his real income against both inflation and exchange rate changes, and so the present weekly rent of €9,800 (Christmas season) will be adjusted upward or downward for any change in the French cost of living between now and then. You are basing your budgeting on purchasing power parity(PPP).French inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is expected to be 2.5%. The current spot rate is $1.360/€. What should you budget as the U.S. dollar cost of the 1-week rental? Spot exchange rate ($/€) $1.3620

Expected U.S. inflation for coming year 2.500% Expected French inflation for coming year 3.500% Current chateau nominal weekly rent (€) 9,800.00

Forward Rate Estimation Exchange Rate:$1.3620/€ Inflation Rate:U.S.=2.5% p.a. French=3.5% p.a. Expected Forward Exchange Rate Forward Rate: $1.3620/€ ✕ ( 1+0.025/1+0.035) = $1.3488/€

Nominal monthly rent one year from now (€) = Current chateau nominal weekly rent (€) year)

(1+ Expected French inflation for coming

= €9,800 ✕ (1+3.5%) = €10,143 Rental cost one year from now ($) = Nominal monthly rent one year from now (€) = €10,143 ✕ $1.3488/€ = $13,680.88

Expected Forward Exchange Rate...