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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%

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

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

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

Actual exchange rate (Ps/$)

PPP exchange rate (Ps/$)

Percentage overvaluation (positive) or undervaluation (negative)

3.20

1.17

-63.307%

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).

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%

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

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 ($)

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%

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

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.

3.000%

START

$

5,000,000.00

Spot (kr/$)

6.1720

kr 30,860,000.00

1.0075

END

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.

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.

4.000%

$

5,000,000.00

Spot (kr/$)

6.1720

kr 30,860,000.00

START

1.0100

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.

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.

4.800%

START

$

1,000,000.00

Spot (SFr./$)

1.2810

SFr. 1,281,000.00

1.0120

END

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%

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.

4.750%

START

$1,000,000

Spot (SFr./$)

1.3392

SFr. 1,339,200.00

1.011875

END

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.

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.

4.450%

18,093,600.00

Spot (Nok/$)

6.0312

3,000,000.00

Borrow US$

START

1.0111250

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%

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