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Problem 7.

1 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 three-
piece luggage set. There are retail 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 purchase.

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's time if PPP holds true. The US inflation rate
is 1.15% and the Australian inflation rate is 3.13%.

Assumptions Value
Price of 3-Piece Luggage set in US$ 850.00
Price of 3-Piece Luggage set in A$ 930.00
Spot exchange rate, (A$/$) 1.0941
US inflation for year (per annum) 1.15%
Australian inflation for year (per annum) 3.13%

a. Is the spot rate accurate given both luggage prices?

Price of 3-Piece Luggage set in US$ 850.00


Price of 3-Piece Luggage set in A$ 930.00
Spot rate as determined by PPP 1.0941
Spot rate = Price in A$ / Price in US$

b. What should be the price of the luggage set in A$ in 1 year if PPP holds?

Beginning spot rate (A$/$) 1.0941


Australian inflation 3.13%
US inflation 1.15%
PPP exchange rate 1.1155

Price of 3-Piece Luggage set in US$ 850.00


PPP exchange rate 1.1155
Price of 3-piece luggage set in Sydney (A$) 948.19

However, purchasing power parity is not always an accurate predictor of exchange rate
movements, particularly in the short term.
Problem 7.2 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 will the dollar cost have gone up? Why?

Assumptions Value
Charge for suite plus meals in Malaysian ringgit (RM) 1,045.00
Spot exchange rate (RM/$) 3.1350
US$ cost today for a 30 day stay $10,000.00

Malaysian ringgit inflation rate expected to be 2.750%


U.S. dollar inflation rate expected to be 1.250%

a. How many dollars might you expect to need one year hence for your 30-day vacation?

Spot exchange rate (ringgit per US$) 3.1350


Malaysian ringgit inflation rate expected to be 2.750%
U.S. dollar inflation rate expected to be 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/$) 3.181444

Hotel charges expected to be paid one year from now for a 30-day stay (RM) 32,212.13

US dollars needed on the basis of these two expectations: $10,125.00

b. By what percent has the dollar cost gone up? Why?

New dollar cost $10,125.00


Original dollar cost $10,000.00
Percent change in US$ cost 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).
Problem 7.3 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 $2.65. The exchange rate
between Croatian kunas (kn) and U.S. dollars is kn5.6288/$. According to purchasing power
parity, is the Croatian kuna overvalued or undervalued?

Assumptions Value
Spot exchange rate (Kn/$) 5.6288
Price of vanilla latte in Zagreb (kn) 25.70
Price of vanilla latte in NYC ($) 2.65

Actual price of Croatian latte in USD 4.57


Implied PPP of Croatian latte in USD 9.70
Percentage overvaluation (positive) or undervaluation (negative) 112.408%
Problem 7.4 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 yen/U.S. dollar (/$) exchange rate one year from now.

Assumptions Value
Forecast annual rate of inflation for Japan 1.100%
Forecast annual rate of inflation for United States 5.900%
One-year interest rate for Japan 4.700%
One-year interest rate for United States 9.500%
Spot exchange rate (/$) 89.00
One-year forward exchange rate (/$) 84.90

a.
Approximate Form

Forecast change in
Forward rate as spot exchange rate Purchasing
an unbiased 4.8% power
predictor (E) (Dollar expected to weaken) parity (A)





Forward premium Forecast difference
on foreign currency International in rates of inflation
4.8% Fisher Effect (C) -4.8%
(Japanese yen at a premium) (US higher than Japan)




Interest rate Difference in nominal Fisher
parity (D) interest rates effect (B)
-4.8%
(higher in United States)

As is 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 (/$) 89.00
One-year forward exchange rate (/$) 84.90
Forecasted change in exchange rates 4.8%

(Current Spot Rate - Forward Exchange Rate) / (Forward Exchange Rate)


Problem 7.5 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 Value
Spot exchange rate, fixed peg, early January 2002 (Ps/$) 1.0000
Spot exchange rate, January 29, 2003 (Ps/$) 3.2000
US inflation for year (per annum) 2.20%
Argentine inflation for year (per annum) 20.00%

a. What should have been the exchange rate in January 2003 if PPP held?

Beginning spot rate (Ps/$) 1.00


Argentine inflation 20.00%
US inflation 2.20%
PPP exchange rate 1.17

b. By what percentage was the Argentine peso undervalued on an annualized basis?

Actual exchange rate (Ps/$) 3.20


PPP exchange rate (Ps/$) 1.17
Percentage overvaluation (positive) or undervaluation (negative) -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 7.6 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 be the dollar price of a Corolla at the end of the year?
d. Assuming 75% pass-through, what will be the dollar price of a Corolla at the end of the year?

Steps Value
Initial spot exchange rate (/$) 87.60
Initial price of a Toyota Corolla () 2,150,000
Expected US dollar inflation rate for the coming year 3.400%
Expected Japanese yen inflation rate for the coming year 0.000%
Desired rate of pass through by Toyota 75.000%

a. What was the export price for the Corolla at the beginning of the year?
Year-beginning price of a Corolla () 2,150,000
Spot exchange rate (/$) 87.60
Year-beginning price of a Corolla ($) $ 24,543.38

b. What is the expected spot rate at the end of the year assuming PPP?
Initial spot rate (/$) 87.60
Expected US$ inflation 3.40%
Expected Japanese yen inflation 0.00%
Expected spot rate at end of year assuming PPP (/$) 84.72

c. Assuming complete pass through, what will the price be in US$ in one year?
Price of Corolla at beginning of year () 2,150,000
Japanese yen inflation over the year 0.000%
Price of Corolla at end of year () 2,150,000
Expected spot rate one year from now assuming PPP (/$) 84.72
Price of Corolla at end of year in ($) $ 25,377.85

d. Assuming partial pass through, what will the price be in US$ in one year?
Price of Corolla at end of year () 2,150,000
Amount of expected exchange rate change, in percent (from PPP) 3.400%
Proportion of exchange rate change passed through by Toyota 75.000%
Proportional percentage change 2.550%
Effective exchange rate used by Toyota to price in US$ for end of year 85.422
Price of Toyota at end of year ($) $ 25,169.24
Problem 7.7 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 Value Yen Equivalent


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

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 $) -1.400%


Forward premium on the yen 1.358%
CIA profit potential -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 1.0240 $ 5,120,000







Spot (/$) ---------------> 180 days ----------------> Forward-180 (/$)
118.60 117.80


603,136,000
593,000,000.00 1.0170 603,081,000
Japanese yen 55,000
3.400%
START Japanese yen interest rate (180 days) END

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 7.8 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 Value Yen Equivalent


Arbitrage funds available $5,000,000 593,000,000
Spot rate (/$) 118.60
180-day forward rate (/$) 117.80
Expected spot rate in 180 days (/$) 118.00
180-day U.S. dollar interest rate 4.800%
180-day Japanese yen interest rate 3.400%

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 $) -1.400%


Expected gain (loss) on the spot rate 1.017%
UIA profit potential -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 1.0240 $5,120,000






Expected Spot Rate
Spot (/$) ---------------> 180 days ----------------> in 180 days (/$)
118.60 118.00


604,160,000
593,000,000.00 1.0170 603,081,000
Japanese yen 1,079,000
3.400%
START Japanese yen interest rate (180 days) END

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 7.9 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 Value
Arbitrage funds available $5,000,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
US dollar 3-month interest rate 3.000%
Danish kroner 3-month interest rate 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$) 2.000%


Forward discount on the krone -1.678%
CIA profit potential 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)


START 3.000% END

$ 5,000,000.00 1.0075 $ 5,037,500.00


5,041,263.31
$ 3,763.31



Spot (kr/$) ---------------> 90 days ----------------> Forward-90 (kr/$)
6.1720 6.1980



kr 30,860,000.00 1.0125 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 7.10 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 Value kr Equivalent


Arbitrage funds available $5,000,000 kr 30,860,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
US dollar 3-month interest rate 4.000% a)
Danish kroner 3-month interest rate 5.000% 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$) 1.000%


Forward discount on the krone -1.678%
CIA profit potential -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 1.0100 $ 5,050,000.00







Spot (kr/$) ---------------> 90 days ----------------> F-90 (kr/$)
6.1720 6.1980


kr 31,299,900.00
kr 30,860,000.00 1.0125 kr 31,245,750.00
kr 54,150.00
5.000%
START Danish kroner interest (3-month) 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 7.11 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 Value kr Equivalent


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


Forward discount on the krone -1.678%
CIA profit potential 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 END
$5,000,000 1.0075 $ 5,037,500.00
$ 5,053,710.87
$ 16,210.87



Spot (kr/$) ---------------> 90 days ----------------> F-90 (kr/$)
6.1720 6.1980



kr 30,860,000.00 1.0150 kr 31,322,900.00

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 7.12 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 Value SFr. Equivalent


Arbitrage funds available $1,000,000 SFr. 1,281,000
Spot exchange rate (SFr./$) 1.2810
3-month forward rate (SFr./$) 1.2740
U.S. dollar 3-month interest rate 4.800%
Swiss franc3-month interest rate 3.200%

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 $) -1.600%


Forward premium on the Swiss franc 2.198%
CIA profit potential 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)


START 4.800% END

$ 1,000,000.00 1.0120 $ 1,012,000.00


1,013,538.46
$ 1,538.46



Spot (SFr./$) ---------------> 90 days ----------------> Forward-90 (SFr./$)
1.2810 1.2740



SFr. 1,281,000.00 1.0080 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 riskless investment is: 0.62%
Problem 7.13 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 Value SFr. Equivalent


Arbitrage funds available $1,000,000 SFr. 1,281,000
Spot exchange rate (SFr./$) 1.2810
3-month forward rate (SFr./$) 1.2740
Expected spot rate in 90 days (SFr./$) 1.2700
U.S. dollar 3-month interest rate 4.800%
Swiss franc3-month interest rate 3.200%

Since Casper is in the US market (starting point), if he were to undertake uncovered interest arbitrage he would 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 U.S. dollar interest rate (3-month) END


4.800%

$ 1,000,000 1.0120 $ 1,012,000.00


$ 1,012,029.16
$ 29.16



Spot (SFr/$) ---------------> 90 days ----------------> Expected Spot (SFr/$)
1.2810 1.2759



SFr. 1,281,000 1.0080 SFr. 1,291,248

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 7.14 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 enter into a
covered interest arbitrage (CIA) investment?

Assumptions Value SFr. Equivalent


Arbitrage funds available $1,000,000 SFr. 1,339,200
Spot exchange rate (SFr./$) 1.3392
3-month forward rate (SFr./$) 1.3286
U.S. dollar 3-month interest rate 4.750%
Swiss franc 3-month interest rate 3.625%

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 $) -1.125%


Forward premium on the Swiss franc 3.191%
CIA profit 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)


START 4.750% END

$1,000,000 1.011875 $ 1,011,875.00


1,017,113.13
$ 5,238.13



Spot (SFr./$) ---------------> 90 days ----------------> F-90 (SFr./$)
1.3392 1.3286



SFr. 1,339,200.00 1.0090625 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 riskless 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 7.15 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 $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 Value Krone Equivalent
Arbitrage funds available $3,000,000 18,093,600
Spot exchange rate (Nok/$) 6.0312
3-month forward rate (Nok/$) 6.0186
U.S. dollar 3-month interest rate 5.000%
Norwegian krone 3-month interest rate 4.450%

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 $) -0.550%


Forward premium on the krone 0.835%
CIA profit 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 1.0111250 18,294,891.30







Spot (Nok/$) ---------------> 90 days ----------------> Forward-90 (Nok/$)
6.0312 6.0186


$ 3,039,710.25
$ 3,000,000.00 1.01250000 $ 3,037,500.00
Borrow US$ $ 2,210.25

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


Problem 7.16 Separated by the Atlantic

Separated by more than 3,000 nautical miles and five time zones, money and foreign exchange markets in
both London and New York are very efficient. The following information has been collected from the
respective areas:

Assumptions London New York


Spot exchange rate ($/) 1.3264 1.3264
One-year Treasury bill rate 3.900% 4.500%
Expected inflation rate Unknown 1.250%

a. What do the financial markets suggest for inflation in Europe next year?
b. Estimate today's one-year forward exchange rate between the dollar and the euro.

a. What do the financial markets suggest for inflation in Europe next year?

According to the Fisher effect, real interest rates should be the same in both Europe and the US.

Since the nominal rate = [ (1+real) x (1+expected inflation) ] - 1:

1 + real rate = (1 + nominal) / (1 + expected inflation)


1 + nominal rate 103.900% 104.500%
1 + expected inflation ? 101.250%
So 1 + real = 103.210% 103.210%
and therefore the real rate in the US is: 3.210%

The expected rate of inflation in Europe is then: 0.669%

b. Estimate today's one-year forward exchange rate between the dollar and the euro.

Spot exchange rate ($/) 1.3264


US dollar one-year Treasury bill rate 4.500%
European euro one-year Treasury bill rate 3.900%
One year forward rate ($/) 1.3341
Problem 7.17 Chamonix Chateau Rentals

You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are
negotiating over 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 upwards or downwards 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 $1.3620/. What should you budget as the U.S. dollar
cost of the one week rental?

Assumptions Value
Spot exchange rate ($/) $1.3620
Expected US inflation for coming year 2.500%
Expected French inflation for coming year 3.500%
Current chateau nominal weekly rent () 9,800.00

Forecasting the future rent amount and exchange rate: Value

Purchasing power parity exchange rate forecast ($/) 1.3488

Spot (one year) = Spot x ( 1 + US$ inflation ) / ( 1 + French inflation )

Nominal monthly rent, in euros, one year from now 10,143.00

Rent now x ( 1 + inflation France )

Cost of rent one year from now in US dollars $ 13,681.29

Rent one year from now / PPP forecasted spot rate

Note: students may inquire as to whether the euro, a currency for a multitude of countries which
may actually have substantial differencies in inflation locally, really will react to inflationary
pressures and differentials as PPP would predict. A good question.
Problem 7.18 East Asiatic Company -- Thailand

The East Asiatic Company (EAC), a Danish company with subsidiaries all over Asia, has been funding its Bangkok
subsidiary primarily with U.S. dollar debt, because of the cost and availability of dollar capital, as opposed to with
Thai baht-denominated (B) debt. The treasurer of EAC-Thailand is considering a one-year bank loan for $250,000.
The current spot rate is B32.06/$, and the dollar-based interest is 6.75% for the one year period. One year loans are
12.00% interest in baht.

a. Assuming expected inflation rates of 4.3% and 1.25% in Thailand and the United States, repectively, for the
coming year, according to purchasing power parity, what would the effective cost of funds be in Thai baht terms?

b. If EAC's foreign exchange advisers believe strongly that the Thai government wants to push the value of the
baht down against the dollar by 5% over the coming year (to promote its export competitiveness in dollar
markets), what might the effective cost of funds end up being in baht terms?

c. If EAC could borrow Thai baht at 13% per annum, would this be cheaper than either part (a) or part (b) above?

Assumptions Value
Current spot rate, Thai baht/$ 32.06
Expected Thai inflation 4.300%
Expected dollar inflation 1.250%
Loan principal in U.S. dollars $250,000
Thai baht interest rate, 1-year loan 12.000%
US dollar interest rate, 1-year loan 6.750%

First, it is necessary to forecast the future spot exchange rate for the baht/$.

PPP forecast of Thai baht/$ 33.0258

Different expectations of the future spot exchange rate, either PPP for part a), or an expected devaluation for
part b), allow the isolation of exactly how many Thai baht would be required to repay the dollar loan.

U.S. dollar borrowing rate (one year)


6.750%

$ 250,000 1.06750 $ 266,875







Spot (Baht/$) ---------------> 360 days ----------------> Expected Spot (Baht/$)
32.0600 33.0258



8,015,000.00 8,813,760.38
Thai baht Baht needed to repay
12.000% U.S. dollar loan
Thai baht borrowing rate (one year)

Implied cost = (Repaid/Initial proceeds) - 1 9.966%

a) Assuming a purchasing power parity forecast of the future spot rate, B33.0258/$, it will take 8,813,760 baht to
repay the U.S. dollar loan. The implied cost of funds, in baht terms, is 9.966%.

b) Assuming a future spot rate for the baht that is 5% weaker than the current spot rate (B32.06/$ ( 1 - .05), or
B33.7474/$), the implied cost is 12.369%. (This is found by plugging in this new forecast spot rate in the expected
spot rate cell on the right-hand side of the box.)
Current 32.0600
Pct Chg -5.00%
New spot = old spot ( 1 - .05) Forecast 33.7474

c) Part a and part b are both cheaper than borrowing at 12.00%. However, both are highly risky given that the future
spot rate is not known until a full year has passed.
Problem 7.19 Maltese Falcon

The infamous solid gold falcon, initially intended as a tribute by the Knights of Rhodes to the King of Spain in
appreciation for his gift of the island of Malta to the order in 1530, has recently been recovered. The falcon is 14
inches in height and solid gold, weighing approximately 48 pounds. Gold prices in late 2002 and early 2003, primarily
as a result of increasing political tensions, have risen to $440/ounce. The falcon is currently held by a private investor
in Istanbul, who is actively negotiating with the Maltese government on the falcon's purchase and prospective return to
its island home. The sale and payment are to take place in March 2004, and the parties are negotiating over the price
and currency of payment. The investor has decided, in a show of goodwill, to base the sales price only on the falcon's
specie value -- its gold value.

The current spot exchange rate is 0.39 Maltese lira (ML) per U.S. dollar. Maltese inflation is expected to be about
8.5% for the coming year, while U.S. inflation, on the heels of a double-dip recession, is expected to come in at only
1.5%. If the investor bases value in the U.S. dollar, would he be better off receiving Maltese lira in one year --
assuming purchasing power parity, or receiving a guaranteed dollar payment assuming a gold price of $420 per ounce?

March 2003 March 2004


Weight of falcon, in pounds 48 48
Total number of ounces in weight 768 768
Price of gold, $/ounce $ 440.00 $ 420.00
Falcon value based on price of gold $ 337,920.00 $ 322,560.00

The purchasing power parity forecast of the Maltese lira/dollar exchange rate:

Current spot rate, Maltese lira/$ 0.3900


Expected Maltese inflation 8.500%
Expected dollar inflation 1.500%
PPP forecast of Maltese lira/$ 0.4169

If the investor bases his gross sales proceeds in U.S. dollars, the guaranteed dollar payment at $420/ounce yields a
larger amount ($322,560) than accepting Maltese lira, assuming PPP ($316,116).

Investor Receives
in March 2004
Current Value Assuming PPP
$ 337,920 $ 316,116





Spot (ML/$) ---------------> 360 days ----------------> Expected Spot (ML/$)
0.3900 0.4169



131,788.80 131,788.80
Maltese lira
Problem 7.20 Malaysian Risk

Clayton Moore is the manager of an international money market fund managed out of London. Unlike many money
funds that guarantee their investors a near risk-free investment with variable interest earnings, Clayton Moore's fund is
a very aggressive fund that searches out relatively high interest earnings around the globe, but at some risk. The fund
is pound-denominated. Clayton is currently evaluating a rather interesting opportunity in Malaysia. Since the Asian
Crisis of 1997, the Malaysian government enforced a number of currency and capital restrictions to protect and
preserve the value of the Malaysian ringgit. The ringgit was fixed to the U.S. dollar at RM3.80/$ for seven years. In
2005, the Malaysian government allowed the currency to float against several major currencies. The current spot rate
today is RM3.13485/$. Local currency time deposits of 180-day maturities are earning 8.900% per annum. The
London eurocurrency market for pounds is yielding 4.200% per annum on similar 180-day maturities. The current spot
rate on the British pound is $1.5820/, and the 180-day forward rate is $1.5561/.

Assumptions Values
Principal investment, British pounds 1,000,000.00
Spot exchange rate ($/) $ 1.5820
180-day forward rate ($/) $ 1.5561
Malaysian ringgit 180-day yield 8.900%
Spot exchange rate, Malaysian ringgit/$ 3.1384

The initial pound investment implicitly passes through the dollar into Malaysian ringgit. The ringgit is fixed
against the dollar, hence the ending Malaysian ringgit/$ rate is the same as the current spot rate. The pound,
however, is not fixed to either the dollar or ringgit. Clayton Moore can purchase a forward against the dollar,
allowing him to cover the dollar/pound exchange rate.

Return = (Proceeds/Initial investment) - 1 6.188%

Initial Investment Investment Proceeds


1,000,000.00 1,061,884.84



British pounds versus US dollars
Spot ($/) ---------------> 180 days ----------------> Fwd-180 ($/)
1.5820 1.5561



$ 1,582,000 U.S. dollar values $ 1,652,399



Malaysian ringgit versus US dollars
Spot (M$/$) ---------------> 180 days ----------------> Expected Spot (M$/$)
3.1384 3.1384



4,964,948.80 1.0445 5,185,889.02
Malaysian ringgit Ringgit proceeds
8.900%
Malaysian ringgit deposit rate (180 days)

If Clayton Moore invests in the Malaysian ringgit deposit, and accepts the uncovered risk associated with the RM/$
exchange rate (managed by the government), and sells the dollar proceeds forward, he should expect a return of
6.188% on his 180-day pound investment. This is better than the 4.200% he can earn in the euro-pound market.

Interestingly, if Clayton chose to NOT sell the dollars forward, and accepted the uncovered risk of the $/ exchange
rate as well, he may or may not do better than 6.188%. For example, if the spot rate remained unchanged at $1.5820/,
Clayton's return would only be 4.450%. This demonstrates that much of the added return Clayton is earning is arising
from the forward rate itself, and not purely from the nominal interest differentials.
Problem 7.21 The Beer Standard

In 1999 the Economist reported the creation of an index, or standard, for the evaluation of African currency values using the local prices of beer. Beer was
chosen as the product for comparison because McDonald's had not peneterated the African continent beyond South Africa, and beer met most of the same
product and market characteristics required for the construction of a proper currency index. Investec, a South African investment banking firm, has replicated
the process of creating a measure of purchasing power parity (PPP) like that of the Big Mac Index of the Economist, for Africa.

The index compares the cost of a 375 milliliter bottle of clear lager beer across sub-Sahara Africa. As a measure of PPP the beer needs to be relatively
homogeneous in quality across countries, needs to possess substantial elements of local manufacturing, inputs, distribution, and service, in order to actually
provide a measure of relative purchasing power. The beers are first priced in local currency (purchased in the taverns of the local man, and not in the high-
priced tourist centers), then converted to South African rand. The prices of the beers in rand are then compared to form one measure of whether the local
currencies are undervalued (-%) or overvalued (+%) versus the South African rand. Use the data in the exhibit and complete the calculation of whether the
individual currencies are under- or over-valued.

Beer Prices Spot Under- or


Name of local In local In Implied rate over-valued
Country Beer currency currency rand PPP rate (3/15/99) to rand (%)
South Africa Castle Rand 2.30 ---- ---- ---- ----
Botswana Castle Pula 2.20 2.94 0.96 0.75 27.9%
Ghana Star Cedi 1,200.00 3.17 521.74 379.10 37.6%
Kenya Tusker Shilling 41.25 4.02 17.93 10.27 74.6%
Malawi Carlsberg Kwacha 18.50 2.66 8.04 6.96 15.6%
Mauritius Phoenix Rupee 15.00 3.72 6.52 4.03 61.8%
Namibia Windhoek N$ 2.50 2.50 1.09 1.00 8.7%
Zambia Castle Kwacha 1,200.00 3.52 521.74 340.68 53.1%
Zimbabwe Castle Z$ 9.00 1.46 3.91 6.15 -36.4%

Notes:
1. Beer price in South African rand = Price in local currency / spot rate on 3/15/99.
2. Implied PPP exchange rate = Price in local currency / 2.30.
3. Under- or over-valued to rand = Implied PPP rate / spot rate on 3/15/99.