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# Problem 7.

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

Actual price of Croatian latte in USD Implied PPP of Croatian latte in USD Percentage overvaluation (positive) or undervaluation (negative)

## Problem 7.2 Crisis at the Heart of Carnaval

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 Spot exchange rate, fixed peg, early January 2002 (Ps/\$) Spot exchange rate, January 29, 2003 (Ps/\$) US inflation for year (per annum) Argentine inflation for year (per annum) a. What should have been the exchange rate in January 2003 if PPP held? Beginning spot rate (Ps/\$) Argentine inflation US inflation PPP exchange rate b. By what percentage was the Argentine peso undervalued on an annulized basis? Actual exchange rate (Ps/\$) PPP exchange rate (Ps/\$) Percentage overvaluation (positive) or undervaluation (negative) 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). 3.20 1.17 -63.307% 1.00 20.00% 2.20% 1.17 Value 1.0000 3.2000 2.20% 20.00%

## Problem 7.3 Traveling Down Under

Terry Lamoreaux has homes in both Sydney, Australia and Phoenix, Arizona. He travels between the two cities at least twice a year. Because of his frequent trips he wants to buy some new, high quality luggage. He's done his research and has decided to go with a Briggs & Riley brand threepiece luggage set. There are retails stores in both Phoenix and Sydney. Terry was a finance major and wants to use purchasing power parity to determine if he is paying the same price no matter where he makes his purcahse. a. If the price of the 3-piece luggage set in Phoenix is \$850 and the price of the same 3-piece set in Sydney is \$930, using purchasing power parity, is the price of the luggage truly equal if the spot rate is A\$1.0941/\$? b. If the price of the luggage remains the same in Phoenix one year from now, determine what the price of the luggage should be in Sydney in one-year time if PPP holds true. The US Inflation rate is 1.15% and the Australian inflation rate is 3.13%. Assumptions Price of 3-Piece Luggage set in US\$ Price of 3-Piece Luggage set in A\$ Spot exchange rate, (A\$/\$) US inflation for year (per annum) Australian inflation for year (per annum) a. Is the spot rate accurate given both luggage prices? Price of 3-Piece Luggage set in US\$ Price of 3-Piece Luggage set in A\$ Spot rate as determined by PPP Spot rate = Price in A\$ / Price in US\$ a. What should be the price of the luggage set in A\$ in 1-year if PPP holds? Beginning spot rate (A\$/\$) Australian inflation US inflation PPP exchange rate Price of 3-Piece Luggage set in US\$ PPP exchange rate Price of 3-piece luggage set in Sydney (A\$) However, purchasing power parity is not always an accurate predictor of exchange rate movements, particularly in the short-term. 1.0941 3.13% 1.15% 1.1155 850.00 1.1155 948.19 850.00 930.00 1.0941 Value 850.00 930.00 1.0941 1.15% 3.13%

## Problem 7.4 Takeshi Kamada -- CIA Japan

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

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 \$) Forward premium on the yen CIA profit potential -1.400% 1.358% -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 Spot (/\$) 118.60 593,000,000.00 Japanese yen START 1.0240 \$ 5,120,000 Forward-180 (/\$) 117.80 603,136,000 603,081,000 55,000 END

1.0170

## 3.400% Japanese yen interest rate (180 days)

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 7.5 Takeshi Kamada -- UIA Japan

Takeshi Kamada, Credit Suisse (Tokyo), observes that the /\$ spot rate has been holding steady, and 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 118.00/\$ for the coming 180 days. Using the same data as in the previous problem, analyze the UIA potential. Assumptions Arbitrage funds available Spot rate (/\$) 180-day forward rate (/\$) Expected spot rate in 180 days (/\$) 180-day U.S. dollar interest rate 180-day Japanese yen interest rate Value \$5,000,000 118.60 117.80 118.00 4.800% 3.400% Yen Equivalent 593,000,000

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 \$) Expected gain (loss) on the spot rate UIA profit potential -1.400% 1.017% -0.383%

This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to potentially gain on an uncovered basis (UIA).

U.S. dollar interest rate (180 days) 4.800% \$5,000,000 Spot (/\$) 118.60 593,000,000.00 Japanese yen START 1.0240 \$5,120,000 Expected Spot Rate in 180 days (/\$) 118.00 604,160,000 603,081,000 1,079,000 END

1.0170

## 3.400% Japanese yen interest rate (180 days)

a) Takeshi Kamada generates an uncovered interest arbitrage (UIA) profit of 1,079,000 if his expectations about the future spot rate, the one in effect in 180 days, prove correct. b) The risk Takeshi is taking is that the actual spot rate at the end of the period can theoretically be anything, better or worse for his speculative position. He in fact has very little "wiggle room," as they say. A small movement will cost him a lot of money. If the spot rate ends up any stronger than about 117.79/\$ (a smaller number), he will lose money. (Verify by inputting 117.70/\$ in the expected spot rate cell under assumptions.)

## Problem 7.6 Japanese/United States parity conditions

Derek Tosh is attempting to determine whether US/Japanese financial conditions are at parity. The current spot rate is a flat 89.00/\$, while the 360-day forward rate is 84.90/\$. Forecast inflation is 1.100% for Japan, and 5.900% for the US. The 360-day euro-yen deposit rate is 4.700%, and the 360-day euro-dollar deposit rate is 9.500%. a. Diagram and calculate whether international parity conditions hold between Japan and the United States. b. Find the forecasted change in the Japanese yes/U.S. dollar (/\$) exchange rate one year from now. Assumptions Forecast annual rate of inflation for Japan Forecast annual rate of inflation for United States One-year interest rate for Japan One-year interest rate for United States Spot exchange rate (/\$) One-year forward exchange rate (/\$) Value 1.100% 5.900% 4.700% 9.500% 89.00 84.90

a.
Approximate Form

## Forward rate as an unbaised predictor (E)

Forecast change in spot exchange rate 4.8% (Dollar expected to weaken) International Fisher Effect (C)

Forward premium on foreign currency 4.8% (Japanese yen at a premium) Interest rate parity (D)

Forecast difference in rates of inflation -4.8% (US higher than Japan) Fisher effect (B)

## Difference in nominal interest rates -4.8% (higher in United States)

As is the always the case with parity conditions, the future spot rate is implicitly forecast to be equal to the forward rate, the implied rate from the international Fisher effect, and the rate implied by purchasing power parity. According to Yazzie's calculations, the markets are indeed in equilibrium -- parity.

b.
Spot exchange rate (/\$) One-year forward exchange rate (/\$) Forcasted change in exchange rates 89.00 84.90 4.8%

## Problem 7.7 Corolla Exports and Pass-Through

Assume that the export price of a Toyota Corolla from Osaka, Japan is 2,150,000. The exchange rate is 87.60/\$. The forecast rate of inflation in the United States is 2.2% per year and is 0.0% per year in Japan. Use this data to answer the following questions on exchange rate pass through. a. What was the export price for the Corolla at the beginning of the year expressed in U.S. dollars? b. Assuming purchasing power parity holds, what should the exchange rate be at the end of the year? c. Assuming 100% pass-through of exchange rate, what will the dollar price of a Corolla be at the end of the year? d. Assuming 75% pass-through, what will the dollar price of a Corolla be at the end of the year? Steps Initial spot exchange rate (/\$) Initial price of a Toyota Corolla () Expected US dollar inflation rate for the coming year Expected Japanese yen inflation rate for the coming year Desired rate of pass through by Toyota a. What was the export price for the Corolla at the beginning of the year? Year-beginning price of an Corolla () Spot exchange rate (/\$) Year-beginning price of a Corolla (\$) b. What is the expected spot rate at the end of the year assuming PPP? Initial spot rate (/\$) Expected US\$ inflation Expected Japanese yen inflation Expected spot rate at end of year assuming PPP (/\$) c. Assuming complete pass through, what will the price be in US\$ in one year? Price of Corolla at beginning of year () Japanese yen inflation over the year Price of Corolla at end of year () Expected spot rate one year from now assuming PPP (/\$) Price of Corolla at end of year in (\$) d. Assuming partial pass through, what will the price be in US\$ in one year? Price of Corolla at end of year () Amount of expected exchange rate change, in percent (from PPP) Proportion of exchange rate change passed through by Toyota Proportional percentage change Effective exchange rate used by Toyota to price in US\$ for end of year Price of Toyota at end of year (\$) Value 87.60 2,150,000 3.400% 0.000% 75.000%

## Problem 7.8 Copenhagen Covered (A)

Heidi Hi Jensen, a foreign exchange trader at J.P. Morgan Chase, can invest \$5 million, or the foreign currency equivalent of the bank's short term funds, in a covered interest arbitrage with Denmark. Using the following quotes can Heidi make covered interest arbitrage (CIA) profit? Assumptions Arbitrage funds available Spot exchange rate (kr/\$) 3-month forward rate (kr/\$) US dollar 3-month interest rate Danish kroner 3-month interest rate Value \$5,000,000 6.1720 6.1980 3.000% 5.000%

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\$) Forward discount on the krone CIA profit potential 2.000% -1.678% 0.322%

This tells Heidi Hi Jensen that he should borrow dollars and invest in the higher yielding currency the Danish kroner, for CIA profit.

1.0125

## 5.000% Danish kroner interest (3-month)

Heidi Hi Jensen generates a covered interest arbitrage (CIA) profit because she is able to generate an even higher interest return in Danish kroner than she "gives up" by selling the proceeds forward at the forward rate.

## Problem 7.9 Copenhagen Covered (B) --- Part a

Heidi Hi 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 Arbitrage funds available Spot exchange rate (kr/\$) 3-month forward rate (kr/\$) US dollar 3-month interest rate Danish kroner 3-month interest rate Value \$5,000,000 6.1720 6.1980 4.000% 5.000% kr Equivalent kr 30,860,000

a) a)

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\$) Forward discount on the krone CIA profit potential 1.000% -1.678% -0.678%

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

U.S. dollar interest rate (3-month) 4.000% \$ 5,000,000.00 Spot (kr/\$) 6.1720 kr 30,860,000.00 1.0100 \$ 5,050,000.00 F-90 (kr/\$) 6.1980 kr 31,299,900.00 kr 31,245,750.00 kr 54,150.00 END

1.0125

START

## 5.000% Danish kroner interest (3-month)

a) Heidi Hi Jensen generates a covered interest arbitrage profit of kr54,150 because, although U.S. dollar interest rates are lower, the U.S. dollar is selling forward at a premium against the Danish krone.

## Problem 7.10 Copenhagen Covered (B) --- Part b

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

b) 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\$) Forward discount on the krone CIA profit potential 3.000% -1.678% 1.322%

This tells Heidi Hi 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 \$5,000,000 Spot (kr/\$) 6.1720 kr 30,860,000.00 1.0075 \$ \$ \$ END 5,037,500.00 5,053,710.87 16,210.87 F-90 (kr/\$) 6.1980 kr 31,322,900.00

1.0150

## 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 Hi Jensen's CIA profit is \$16,210.87.

## Problem 7.11 Casper Landsten -- CIA

Casper Landsten is a foreign exchange trader for a bank in New York. He has \$1 million (or its Swiss franc equivalent) for a short term money market investment and wonders if he should invest in U.S. dollars for three months, or make a covered interest arbitrage investment in the Swiss franc. He faces the following quotes: Assumptions Arbitrage funds available Spot exchange rate (SFr./\$) 3-month forward rate (SFr./\$) U.S. dollar 3-month interest rate Swiss franc3-month interest rate Value \$1,000,000 1.2810 1.2740 4.800% 3.200% SFr. Equivalent SFr. 1,281,000

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 SFr. - i \$) Forward premium on the Swiss franc CIA profit potential -1.600% 2.198% 0.598%

This tells Casper Landsten he should borrow U.S. dollars and invest in the LOWER yielding currency, the Swiss franc, in order to earn covered interest arbitrage (CIA) profits.

1.0080

## 3.200% Swiss franc interest rate (3-month)

a) Casper Landsten makes a net profit, a covered interest arbitrage profit, of \$1,538.46 on each million he invests in the Swiss franc market (by going around the box). He should therefore take advantage of it and perform covered interest arbitrage. b) Assuming a \$1 million investment for the 90-day period, the annual rate of return on this near risk-less investment is:

0.62%

## Problem 7.12 Casper Landsten -- UIA

Casper Landsten, using the same values and assumptions as in the previous question, now decides to seek the full 4.800% return available in US dollars by not covering his forward dollar receipts -- an uncovered interest arbitrage (UIA) transaction. Assess this decision. Assumptions Arbitrage funds available Spot exchange rate (SFr./\$) 3-month forward rate (SFr./\$) Expected spot rate in 90 days (SFr./\$) U.S. dollar 3-month interest rate Swiss franc3-month interest rate Value \$1,000,000 1.2810 1.2740 1.2700 4.800% 3.200% SFr. Equivalent SFr. 1,281,000

Since Casper is in the US market (starting point), if he were to undertake uncovered interest arbitrage he would be first exchange dollars for Swiss francs, investing the Swiss francs for 90 days, and then exchanging the Swiss franc proceeds (principle and interest) back into US dollars at whatever the spot rate of exchange is at that time. In this case Casper will have to -- at least in his mind -- make some assumption as to what the exchange rate will be at the end of the 90 day period.

START

END

1.0080

## 3.200% Swiss franc interest rate (3-month)

If Casper assumed the spot rate at the end of 90 days were the same as the current spot rate (SFr1.2810/\$), the UIA transaction would not make much sense. The lower Swiss franc interest rate would yield final dollar proceeds of only \$1,008,000, a full \$4,000 less than simply investing in the US (straight across the top of the box). For an UIA transaction to result in higher dollar proceeds at the end of the 90 day period, the ending spot rate of exchange would have to be SF1.2759/\$ or less (a stronger and stronger Swiss franc resulting in more and more US dollars when exchanged). Should Casper do it? Well, depends on his bank's policies on uncovered transactions, and his beliefs on the future spot exchange rate. But, given that he is invested in a foreign currency with a lower interest rate, not a higher one, so he is placing all of his 'bets' on the exchange rate, it is not a speculation for the weak of heart.

## Problem 7.13 Casper Landsten -- 30 days later

One month after the events described in the previous two questions, Casper Landsten once again has \$1 million (or its Swiss franc equivalent) to invest for three months. He now faces the following rates. Should he again ener into a covered interest arbitrage (CIA) investment? Assumptions Arbitrage funds available Spot exchange rate (SFr./\$) 3-month forward rate (SFr./\$) U.S. dollar 3-month interest rate Swiss franc3-month interest rate Value \$1,000,000 1.3392 1.3286 4.750% 3.625% SFr. Equivalent SFr. 1,339,200

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 SFr. - i \$) Forward premium on the Swiss france CIA profit -1.125% 3.191% 2.066%

This tells Casper Landsten he should borrow U.S. dollars and invest in the lower yielding currency, the Swiss franc, and then sell the Swiss franc principal and interest forward three months locking in a CIA profit.

1.0090625

## 3.625% Swiss franc interest rate (3-month)

Yes, Casper should undertake the covered interest arbitrage transaction, as it would yield a risk-less profit (exchange rate risk is eliminated with the forward contract, but counterparty risk still exists if one of his counterparties failed to actually make good on their contractual commitments to deliver the forward or pay the interest) of \$5,238.13 on each \$1 million invested.

## Problem 7.14 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 RM1,045/day. The Malaysian ringgit presently trades at RM3.1350/\$. She figures out the dollar cost today for a 30-day stay would be \$10,000. The hotel informed her that any increase in its room charges will be limited to any increase in the Malaysian cost of living. Malaysian inflation is expected to be 2.75% per annum, while U.S. inflation is expected to be only 1.25%.

a. How many dollars might Theresa expect to need one year hence to pay for her 30-day vacation? b. By what percent has the dollar cost gone up? Why? Assumptions Charge for suite plus meals in Malaysian ringgit (RM) Spot exchange rate (RM/\$) US\$ cost today for a 30 day stay Malaysian ringgit inflation rate expected to be U.S. dollar inflation rate expected to be a. How many dollars might you expecte to need one year hence for your 30-day vacation? Spot exchange rate (ringgit per US\$) Malaysian ringgit inflation rate expected to be U.S. dollar inflation rate expected to be Spot (expected in 1 year) = Spot x ( 1 + RM inflation) / ( 1 + US inflation) Expected spot rate one year from now based on PPP (RM/\$) Hotel charges expected to be paid one year from now for a 30-day stay (RM) US dollars needed on the basis of these two expectations: b. By what percent has the dollar cost gone up? Why? New dollar cost Original dollar cost Percent change in US\$ cost \$10,125.00 \$10,000.00 1.250% 3.181444 32,212.13 \$10,125.00 3.1350 2.750% 1.250% Value 1,045.00 3.1350 \$10,000.00 2.750% 1.250%

The dollar cost has risen by the US dollar 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).