RABEA RASHED MANSOOR - 20311562

2. Locational Arbitrage:
. Locational Arbitrage: Is locational arbitrage achievable with given information? Assuming
so, describe the stages required in locational arbitrage and calculate the profit if you had
$1,000,000 to work with. What market factors would obliterate any remaining
opportunities for locational arbitrage?
ANSWER: Yes, you can buy New Zealand dollars for $.40 at Yardley Bank and sell them for
$.401 at Beal Bank. With $1 million on hand, Yardley Bank could buy 2.5 million New
Zealand dollars. These New Zealand dollars might then be sold to Beal Bank for $1,002,500,
making a $2,500 profit.

Because of the high demand for New Zealand dollars at Yardley Bank, the bank's ask price for
the currency will rise. Beal Bank's offer price will be lowered as a result of its substantial sales
of New Zealand dollars. Locational arbitrage will no longer be profitable once Yardley Bank's
ask price is no longer cheaper than Beal Bank's bid price.

6. Covered Interest Arbitrage.

What would the yield (% return) be if a U.S. investor exploited covered interest arbitrage with
this information? (Assume the investor makes a $1,000,000 investment.) What market
dynamics would be present to eliminate any further covered interest arbitrage
opportunities?
ANSWER:
$1,000,000
= C$1,250,000 × (1.04)
$.80
= C$1,300,000 × $.79

= $1,027,000
($1,027,000 – $1,000,000)
Yield = = 2.7%, which exceeds the yield in the U.S. over the 90-
$1,000,000
day period.
The Canadian dollar's spot rate should rise, and its forward rate should fall; in addition, the
Canadian interest rate may fall and the U.S. interest rate may rise.
C. Explain the comparison among IRP, PPP, and IFE theories. Give each example.

IRP PPP IFE

concept IRP refers to the This refers to the It refers that
states where futures situation where the differences in nominal
discounts on high- inflation gap between the interest rates by
yielding currencies two countries is country reflect
accurately offset the accurately offset by the unexpected
interest rate devaluation of the higher differences in
differential between inflation currency. inflation.
the two countries.
Implication Basically, this means When PPP exists If interest rates in a
that investors will customers will be country are higher,
not be able to earn indifferent between that`s a sign of
higher return on purchasing goods in their higher anticipated
investment abroad own country versus inflation. Hence,
than in their own purchasing goods in the according to PPP, the
country. foreign country. higher interest
currency will
depreciate, and
investors will earn
the same return
whether they invest
in the home
country of the
foreign country
Variables Foreign currency Changes in spot rates of The interest rate
futures rates are related currencies and differential between
relative to domestic inflation differences two countries and
and overseas spot between the two percentage change in
rates and interest countries. the spot rate of the
rate differentials. foreign currency.
Examples We can suppose ‘The Big Mac Index’, it if country A's interest
that the current simply works out the rate is 10% and
exchange rate, or price of a Big Mac in country B's interest
spot exchange rate, Country A and Country B, rate is 5%, country B's
between the US and and calculates the PPP currency should
another country is between the two appreciate roughly
$1.2544/1.00. countries. 5% compared to
country A's currency.