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Problem 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 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) per day
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

Value
1,045.00
3.1350
$10,000.00
2.750%
1.250%

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

3.1350
2.750%
1.250%

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:

3.181444
32,212.13
$10,125.00

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%

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).

per day

Problem 6.2 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)

Value
1.0000
3.2000
2.20%
20.00%

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

1.00
20.00%
2.20%
1.17

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)

3.20
1.17
-63.307%

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).

Problem 6.4 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)

Value
850.00
930.00
1.0941
1.15%
3.13%

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$

850.00
930.00
1.0941

b. 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

Problem 6.5 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/$)
Price of vanilla latter in Zagreb (kn)
Price of vanilla latter in NYC ($)

Actual price of Croatian latte in USD


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

Value
5.6288
25.70
2.65

4.57
9.70
112.408%

Problem 6.6 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

Value
87.60
2,150,000
2.200%
0.000%
75.000%

a. What was the export price for the Corolla at the beginning of the year?
Year-beginning price of an Corolla ()
Spot exchange rate (/$)
Year-beginning price of a Corolla ($)

2,150,000
87.60
24,543.38

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 ($)

87.60
2.20%
0.00%
85.71

2,150,000
0.000%
2,150,000
85.71
25,083.33

2,150,000
2.200%
75.000%
1.6500%
86.178
24,948.34

-2.2%
-1.61%
86.19

Problem 6.9 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.

U.S. dollar interest rate (3-month)


3.000%

START
$

5,000,000.00

Spot (kr/$)
6.1720

kr 30,860,000.00

1.0075

END

---------------> 90 days ---------------->

1.0125

5,037,500.00
5,041,263.31
$
3,763.31

Forward-90 (kr/$)
6.1980

kr 31,245,750.00

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 6.10 Copenhagen Covered (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
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

START

1.0100

---------------> 90 days ---------------->

1.0125

5.000%
Danish kroner interest (3-month)

5,050,000.00

F-90 (kr/$)
6.1980

kr 31,299,900.00
kr 31,245,750.00
kr 54,150.00
END

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 6.12 Casper Landsten -- CIA (A)


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.

U.S. dollar interest rate (3-month)


4.800%

START
$

1,000,000.00

Spot (SFr./$)
1.2810

SFr. 1,281,000.00

1.0120

END

---------------> 90 days ---------------->

1.0080

1,012,000.00
1,013,538.46
$
1,538.46

Forward-90 (SFr./$)
1.2740

SFr. 1,291,248.00

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 6.14 Casper Landsten -- Thirty 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.

U.S. dollar interest rate (3-month)


4.750%

START
$1,000,000

Spot (SFr./$)
1.3392

SFr. 1,339,200.00

1.011875

END

---------------> 90 days ---------------->

1.0090625

1,011,875.00
1,017,113.13
$
5,238.13

F-90 (SFr./$)
1.3286

SFr. 1,351,336.50

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 6.15 Statoil of Norway's Arbitrage


Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency
and petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market,
it considers the U.S. dollar as its functional currency, not the Norwegian krone. Ari Karlsen is a currency trader for
Statoil, and has immediate use of either $3 million (or the Norwegian krone equivalent). He is faced with the
following market rates, and wonders whether he can make some arbitrage profits in the coming 90 days.
Assumptions
Arbitrage funds available
Spot exchange rate (Nok/$)
3-month forward rate (Nok/$)
U.S. dollar 3-month interest rate
Norwegian krone 3-month interest rate

Value
$3,000,000
6.0312
6.0186
5.000%
4.450%

Krone Equivalent
18,093,600

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 Nok - i $)
Forward premium on the krone
CIA profit

-0.550%
0.835%
0.285%

This tells Ari Karlsen he should borrow U.S. dollars and invest in the lower yielding currency, the Norwegian
krone, selling the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.

Norwegian krone interest rate (3-month)


4.450%

18,093,600.00

Spot (Nok/$)
6.0312

3,000,000.00
Borrow US$

START

1.0111250

---------------> 90 days ---------------->

1.01250000

5.000%
U.S. dollar interest rate (3-month)

18,294,891.30

Forward-90 (Nok/$)
6.0186

$
3,039,710.25
$
3,037,500.00
$
2,210.25

END

Ari Karlsen can make $2,210.25 for Statoil on each $3 million he invests in this covered interest arbitrage (CIA)
transaction. Note that this is a very slim rate of return on an investment of such a large amount.
Annualized rate of return:

0.2947%