Homework 4 PDF

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Homework 4 is also all multiple choice and focuses on Chapter 6. Only questions, no answers....

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FINANCE 405 Homework 4 This homework focuses on Chapter 6. You need to work individually. You must hand in one copy of your answers. Please show your work and provide explanations where relevant. Your answers must be summarized in a write-up with details of calculations, explanations, tables and charts (if applicable). No credits will be given if you only report the final answers. You need to make sure that your hand-writing is legible. The due date is Feb 27 before class starts.

Name (print): __________________________________ UMass ID: _____________________________________

1. An arbitrage is best defined as A. A legal condition imposed by the CFTC. B. The act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making reasonable profits. C. The act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making guaranteed profits. D. None of the above 2. When Interest Rate Parity (IRP) does not hold A. there is usually a high degree of inflation in at least one country. B. the financial markets are in equilibrium. C. there are opportunities for covered interest arbitrage. D. both b) and c) 3. Suppose you observe a spot exchange rate of $1.50/€. If interest rates are 5% APR in the U.S. and 3% APR in the euro zone, what is the no-arbitrage 1-year forward rate? A. €1.5291/$ B. $1.5291/€ C. €1.4714/$ D. $1.4714/€ 4. Suppose that the one-year interest rate is 5.0 percent in the United States; the spot exchange rate is $1.20/€; and the one-year forward exchange rate is $1.16/€. What must one-year interest rate be in the euro zone to avoid arbitrage? A. 5.0% B. 6.09% C. 8.62% D. None of the above 5. Covered Interest Arbitrage (CIA) activities will result in A. an unstable international financial markets. B. restoring equilibrium quite quickly. C. a disintermediation. D. no effect on the market. 6. Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and that the spot exchange rate is $1.12/€ and the one-year forward exchange rate, is $1.16/€. Assume that an arbitrageur can borrow up to $1,000,000. A. This is an example where interest rate parity holds. B. This is an example of an arbitrage opportunity; interest rate parity does NOT hold. C. This is an example of a Purchasing Power Parity violation and an arbitrage opportunity. D. None of the above 7. Suppose that you are the treasurer of IBM with an extra US$1,000,000 to invest for six months. You are considering the purchase of U.S. T-bills that yield 1.810% (that's a six month rate, not an annual rate by the way) and have a maturity of 26 weeks. The spot exchange rate is

$1.00 = ¥100, and the six month forward rate is $1.00 = ¥110. The interest rate in Japan (on an investment of comparable risk) is 13 percent. What is your strategy? A. Take $1m, invest in U.S. T-bills. B. Take $1m, translate into yen at the spot, invest in Japan, and repatriate your yen earnings back into dollars at the spot rate prevailing in six months. C. Take $1m, translate into yen at the spot, invest in Japan, hedge with a short position in the forward contract. D. Take $1m, translate into yen at the forward rate, invest in Japan, hedge with a short position in the spot contract. 8. Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in Germany, and that the spot exchange rate is $1.60/€ and the forward exchange rate, with oneyear maturity, is $1.58/€. Assume that an arbitrager can borrow up to $1,000,000 or €625,000. If an astute trader finds an arbitrage, what is the net cash flow in one year? A. $238.65 B. $14,000 C. $46,207 D. $7,000 9. If the interest rate in the U.S. is i $ = 5 percent for the next year and interest rate in the U.K. is i £ = 8 percent for the next year, uncovered IRP suggests that A. the pound is expected to depreciate against the dollar by about 3 percent. B. the pound is expected to appreciate against the dollar by about 3 percent. C. the dollar is expected to appreciate against the pound by about 3 percent. D. both a) and c) 10. Although IRP tends to hold, it may not hold precisely all the time A. due to transactions costs, like the bid ask spread. B. due to asymmetric information. C. due to capital controls imposed by governments. D. both a) and c) 11. As of today, the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail for the next year in the U.S. is 2% and 3% in the euro zone. What is the one-year forward rate that should prevail? A. €1.00 = $1.2379 B. €1.00 = $1.2623 C. €1.00 = $0.9903 D. $1.00 = €1.2623 12. If the annual inflation rate is 5.5 percent in the United States and 4 percent in the U.K., and the dollar depreciated against the pound by 3 percent, then the real exchange rate, assuming that PPP initially held, is A. 0.07 B. 0.9849

C. -0.0198 D. 4.5 13. Generally unfavorable evidence on PPP suggests that A. substantial barriers to international commodity arbitrage exist. B. tariffs and quotas imposed on international trade can explain at least some of the evidence. C. shipping costs can make it difficult to directly compare commodity prices. D. all of the above 14. Forward parity states that A. any forward premium or discount is equal to the expected change in the exchange rate. B. any forward premium or discount is equal to the actual change in the exchange rate. C. the nominal interest rate differential reflects the expected change in the exchange rate. D. an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country. 15. Good, inexpensive, and fairly reliable predictors of future exchange rates include A. today's exchange rate. B. current forward exchange rates (e.g. the six-month forward rate is a pretty good predictor of the spot rate that will prevail six months from today). C. esoteric fundamental models that take an econometrician to use and no one can explain. D. both a) and b) 16. According to the technical approach, what matters in exchange rate determination is A. the past behavior of exchange rates. B. the velocity of money. C. the future behavior of exchange rates. D. the beta.

Assume that you are a retail customer

Please note that your answers are worth zero points if they do not include currency symbols ($, €)

17. If you borrowed €1,000,000 for one year, how much money would you owe at maturity?

18. If you borrowed $1,000,000 for one year, how much money would you owe at maturity?

19. If you had borrowed $1,000,000 and traded for euro at the spot rate, how many € do you receive?

20. If you had €1,000,000 and traded it for USD at the spot rate, how many USD will you get?

21. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward BID exchange rate in $ per € that that satisfies IRP from the perspective of a customer.

22. USING YOUR PREVIOUS ANSWERS and a bit more work, find the 1-year forward ASK exchange rate in $ per € that that satisfies IRP from the perspective of a customer.

23. There is one profitable arbitrage at these prices. What is it? Please fill the table below. Actions at T=0

Actions at T=1...