Solutions 25 Ignoring transaction costs, does Jim Waugh have an arbitrage opportunity based on these quotes? If there isan arbitrage opportunity, what steps would he take to make an. arbitrage profit, and how much would he profit ifhe has $1,000,000 available for this purpose? 17. Pafisa small country that wishes to control international capital flows, The currency of Pafis the pif. Paf put in place an exchange control whereby all urrent account transac- sions can be transferred using the normal exchange rate, but financial account transac- tions must be transferred at a financial pifrate. In other words, foreigners wishing to in- vest in the assets of Paf must buy them at the financial pif rate, whereas dividends are repatriated at the normal pif rate. The current financial pf rate is 2.8 pifs per dollar or 1.25 dollars per financial pif, The financial rate in dollars/pif quotes ata premium of 25, percent aver the normal rate. a. Assume that the premium of the financial rate stays constant over time. Will a US. iver make the smeretum on intesmentas wil resident of Pt once the aset is resold? b. You hear that the exchange controls may be lifted and that the financial rate may dis- appear: Would this be good news to an oxisting foreign investor? . Would the lifting pf exchange controls and removal of the financial rate be good news toa new foreign investor? 18, Younotice the following $/Espot: 1.46 $/£three months forward: 142 SFr/$ spot: 1.60 SFr/$ three months forward: 1.65 Im the language of currency traders, would the pound be considered “strong” or “weak” relative to the dollar? What about the Swiss franc? exchange ratesin the newspaper: 19, The spot dollar to pound exchange rate is §/£ = 1.4570-1.4876. The sicmonth forward dollar to pound exchange rateis 8/£ = [.4408-1.4434, a. [s the pound trading at a discount or ata premium relative to the dollar in the for- ward market? b, Compute the annualized forward discount or premium on the pound relative to the dollar? 20. The spot Swiss franc to dollar exchange rate is SFr/$ = 1.5960-70. The threemonth forward Swiss franc to dollar exchange rate is SFr/$ = '.5932-62. a. Is the Swiss frane trading at adiscount or at a premium relative to the dollar in the forward market? b. Compute the annualized forward discount or premium on the Swiss franc relative to the dollar? Solutions 1. Since the value ofthe British pound in USS. dollars has gone down, it has depreciated with respect to the U.S, dolla. Therefore, the British will have 1o spend more British pounds to purchase U'S. goods. Aecordingly, the correctanswerrs (c)26 Chapter 1. Foreign Exchange 2 v0, Since the number of Australian dollars needed to purchase one U.S. dollar has de- creased from 1,60 to 1.50, the Australian dollar has appreciated with respect to the U.S. dollar. Therefore, the Australians will have to spend fewer Australian dollars to pur- chase U.S. goods. Accordingly the correct answer is (2) ‘The value of the dollar in Swiss francs has gone up from about |.20 to about 1.60. ‘Therefore, the dollar has appreciated relative to the Swiss franc, and the dollarsneeded ‘by Americans to purchase Swiss goods have decreased. Thus, the statements correct. a, One baht was worth 1/25 oF 0.04 dollars earlier. Itis worth 1/30 oF 0.0888 dollars, now. Thus, the baht has depreciated with respect to the dollar Percentage change in the dollarvalue of babt = ((0.0883 - 0.04) /0.04).00% = ~16.7%. b. One dolla was worth 25 bahts earlier and is worth 30 bats now. Percentage change in the value of dollar = ((80 ~ 25)/25)100% = 20.0%, 7. The increase in$/£ exchange rate implies that the pound has appreciated with respect to the dolla. This is unfavorableto the trader since the trader has short position in pounds, Bank’ liability in dollars initially was 5,000,000 X 1.45 ~ 87,250,000 Bank’ liability in dollars now is 5,000,000 * 1.51 = $7,550,000 ‘Thus, the bank's liability has increased by $800,000 ‘Three crossexchange ates need to be computed: SFr/€, ¥/€, SFr/¥. a, SEr/€ = Shr/$ X $/€ ~ SFr L.5971/$ x §0.9119/€ = 14564 b, W/€ ~¥/8X §/€ = ¥128.17/8 x $0.9119/€ = 116.88, c. SEL/¥ = SBr/$ x $/¥ = (SFr/$)/(¥/3) = (SFr 1.5971/$)/(¥ 128.17/$) = 0.0125 ‘These quotations mean that Bank A is willing to buy a euro for 1.1210 dollars ‘bid rate) ‘or tose one for 1.1215 dollars ‘ask rate). Bank B's $/€ bid rate is 1.12125 itsask rate is 1.1217. That is, Bank B is willing to buy a euro for 1.1212 dotlars oF to sell one for 1.1317 dollars 3. The percentage spread is considerably higher for the Polish zloty than for the British pound. The market for the Polish zloty is much less liquid than the market for the British pound, There is lot more competition herween marker makers for the British pound than for the Polish zloty, Consequently, the percentage spread is considerably higher for the Polish zloty than for the British pound, ‘These quotes are unreasonable because they deviate from Bank A to Bank B by more than the spread; for example, Bank A's ask rate (121.25) is smaller than Bank B's bid rate (121.30). There is, therefore, an arbitrage opportunity. One can buy Bank A’s dol- Jars for 121.25 yen per dollar, sell these dollars to Bank B for 121.30 yen per dollar, and thereby make a profit of 0.05 yen per dollar traded. This is riskless, instantaneous op- ‘ration that requires no intial investment. ‘The SFr/€ quotation is obtained as follows. In obtaining this quotation, we keep in mind that SFr/€ = SF+/$ x §/€, and that thepice for each transaction (bid or ask is, the ane that it more advantageous to he trae. ‘The SFr/€ bid price is the number of Swiss francs that a trader is willing to pay for fone euro. This transaction (buy suro—sell Swiss francs) is equivalent to selling Swiss1 12, Solutions 27 francs to buy dollars (ata bid vate of !4100), and then selling those dollars to buy euros {ata bid rate of 1.1610), Mathematically, she transaction sas follows (bid SFr/$) X (bid §/€) = 1.4100 1.1610 = 1.6370 ‘The SF1/€ ask price is the number of Swiss francs that a trader is asking for one curv. This transaction isell euros—buy Swiss francs) s equivalent to buying Swiss francs with dollars (at an ask rate of 1.4120) and simultaneously purchasing these dollars against euros [at an ask rate of 1.1615). Mathematically this can be expressed as ollows: (ask SFr/$) % (ask §/€) = 1.4120 x 1.1615 = 1.6400 So the resulting quotation by the trader's, SFr/€ © 1.6370 ~ 1.6400 ‘The SFr/AS quotation is obtained as follows. {n obtaining “his quotation, we keep in mind that SFr/A$ = SFr/$ /AS/S, and that the price (bid or ask) for each transaction is the one that s more advantageous to the bank. ‘The SFr/AS bid price is the number of SFr the bank ‘willing to pay to buy one AS. ‘This ransaction (buy A$—sell SFr) is equivalent to selling SFr to buy dollars ‘at a 3id rate of 1.5960) and then selling those ‘dollars to buy AS ‘at an ask cate of 1.8235). Mathematically, she transaction fas follows: bid SF+/A$ = tid SFr/$)/(ask A$/8) = 1.5960/1.8955 = 0.8759 The SFr/A$ ask price isthe aumber of SFr that the bank is asking for one AS, This transaction (sell AS—buy SFr) is equivalent to duying SFr with dollars at an ask rate af 1.5970) and simultaneously purchasing these dollars against AS (at a bid rate of 1.8225). Thismay be expressed as ‘llows: ask SPr/AS = lask SFr/$) /(bid AS/S) = 1.5970/1.8925= 9.8768 The resulting quotation by the bank is SFr/AS = 0.8752-0.8763 The A$/SFr quotation is obtained as follows. In obtaining this quotation, xe éeep in mind that A8/SFr = 48/8 / SFr/$, nd that the price ibid or ask) for each transaction isthe one thats more advantageous tothe bank. The A8/SFr bid price is the number af A$ the bank is willing 0 pa¥’t0 buy one SFr, This transaction (buy SFt—sell AS) is equivalent to selling AS 10 buy dollars fata aid rate of 1.8995) and then selling those dollars to uy SFr lat an ask rate of 1.3970) Mathematically, the ransaction is as follows bid 48 /SFr = (bid A$/$) /(ask SFr/8) = 1,8225/1.5970 = 1.1412 The AS/SFr ask price isthe number of A$ that :he bank is asking ‘or one SFr. This, ‘transaction ‘sell SFr—buy AS) 's equivalent to buying AS with dollars ‘at an ask rate of 1.8985) and simultaneously purchasing these dollars against 5Fr lat a bid rate of 1.5060). This may be expressed a8 follows: ask A$/SFr = (ask AS/$)/ (bid SFr/$) = 1.8295/1.5960 = 1.142528 Chapter 1. Foreign Exchange ‘The resulting quotation by the bank is AS/SFr= 1.1412 ~ 1.1495, 13, The bid C$/¥ rate would be the inverse of the ask ¥/CS rate, and the ask C$/¥ rate would be the inverse of the bid ¥/CS rate, Therefore, Did C$/¥ ~ 1 / ask¢¥/CS) ~ 1/82.5750 = 0.01211 ask 6§/¥ = 1 / bid (¥/C8) ~ 1/82.5150 ~ 001212 ‘Thus, the quoteis CS/¥ = 0.01211-0.01212. 14, a, There would be no arbitrage opportunities if crossrate Dkr/SFr = DKr/$ $/SFr. Because SFr/$ =1.65,8/SFr = (/L¢ 9.6061. So, there would be no arbitrage opportunities if the croserate DKr/SFr = DKr 8.25/$ x $ 0.6061/SFr = Dkr5/SFt. b, In the Dkr 5.20/SFr croserate, one SFr is worth DKr5.20. The implicit rate com- ‘puted in part (a) above indicates that one SFr should be worth DKr5. Therefore, the ‘SFris overvalued with respect tothe DKr-at the exchange rate of Dkr 3.20/SFr. 15, The implicit crosszate between yen and pound is ¥/€= ¥/$ X $/£ = 128.17 X L457 186.74. However, Midland bank is quoting a lower rate of ¥183/£. So, triangular arbi- tage is possible. Im the crossrate of ¥183/£ quoted by Midland, one pound is worth 188 yen, whereas the croserate based on the direct rates implies that one pound is worth 186.74 yen. Thus, pound is undervalued relative tothe yen in the crossrate quoted by Midland, and your strategy for triangular arbitrage should be based on using yen to buy pounds from Midland, Accordingly, the steps you would take for an arbitrage profit are as fol- lows. 4, Sell dollars to get yen: Sell $1,000,000 to get $1,000,000 x ¥198.17/$ = ¥128,170,000. ii. Use yen to buy pounds: Sell ¥128,170,000 to buy ¥128,170,000 / ¥183/8 = +£700,382.51 iil, Sell pounds for dollars: Sell £700,382.51 for £700,38251 « $1.4570/£ = $1,020,457.32. ‘Thus, your arbitrage profitis $1,020,457.52 ~ $1,000,000 = $20,457.52. 16, a, The implicit croserate between Australian dollars and Swiss francs is A$/SFr = AS/ §-X §/SFr = (AS/$)/(SFr/$) = 1.8215/1.5971 = 1.1405. However, the quoted crosstate is higher at AS1.1450/SFr. 80, triangular arbitrage is possible. >. In the quoted crossrate of AS11450 /Str one Swiss francis worth AS11450, whereas the erossrate based on the direct rates implies that one Swiss franc is worth ‘AS11405. Thus, the Swiss franc is overvalued relative to the AS in the quoted cross rate, and Jim Waugh’s strategy for triangular arbitrage should be based on selling Swiss francs to buy A$as per the quoted crossrate, Accordingly the steps fim Waugh ‘would take for an arbitrage profit ate as follows i. Sell dollars to get Swiss francs: Sell $1,000,000 to get $1,000,000 X SFr.5971/ $= 811,597,100.0. 18, 19, Solutions 29 fi, Sell Swiss francs to buy Australian dollars: Sell SFr1,597,100 to buy SFr1,597,100 X ASI.1450/SFr = A$1,828,679.50 iii, Sell Australian dollars for dollars: Sell AS1,828,679.50 for AS1,828,679.50/ ASLE215/$ = $1,003,941.53, ‘Thus, your arbitrage profits $1,003,941.53 ~ $1,000,000 = $3,941.53. 4 The American investor has paid a25 percent premium over the price paid bya do- mestic investor. Yet, he receives the same dividends as the domestic investor ‘Therefore, hisinvestment bears smaller yield than it would fora domestic investor. b, Lifting of the exchange controls would be bad ews toan existing foreign investorin Paf, since her asset could only be repatriated atthe normal pifrate (1.00), while she had bought atthe financial rate (1.95) Lifting ofthe exchange controls would be good news to foreign investors planning to invest in Pafin the future, because they would no longer have to pay the 25 per cent premium when buying assets in Pa ‘The value of the £ in $ is worth less three months forward than itis now. Thus, the £ is trading ata forward discount relative to the S. Therefore, the £ is “weak” relative to the §. Because a § is worth SFr. 60 now hut worth SFr1.65 threw months forward, the 8 is “strong” relative to the SFr. That is, the SFrs “weak” relative to the 8. ‘The midpoint the spot dollar to pound exchange rate is §/£ = 1.4573. The. of the six month forward dollar to pound exchange rateis §/£ = 1.4421 a Based on the midpoints, the dollar value of a pound is 1.4578 now and only 1.4421 six months forward. Thus, the pound is worth less six months forward than now. ‘That is, the pound is trading at a discount relative to the dollar in the forward market. . Difference between midpoints of the forward and spot rates = 0.0152. idpoint Annualized discount (238) forward market. ) Annualized premium