Assignment No # 1

Topic: International Arbitrage

Subject: International Finance

Submitted to: Sir Mubashar Naqvi

Submitted by: Shahmir Maroof

Roll no: 05

Class: BBA (hons)

Semester: 8th

Session: 2019/2023

Submission date: 10/06/2023

Department of Business Administration

Govt. Postgraduate College for Boys MZD

Acknowledgment
 In preparation of my assignment, I had to take the help and guidance of some
respected persons, who deserve my deepest gratitude. As the completion of this assignment
gave me much pleasure, I would like to show my gratitude Mr. Mubashir Naqvi, Course
Instructor, on PGC Boys Muzaffarabad for giving me a good guidelines for assignment
throughout numerous consultations. I would also like to expand my gratitude to all those who
have directly and indirectly guided me in writing this assignment.

The foreign exchange market

is one of the most
sophisticated market of all
world markets. If any
inconsistency occurs within
the FOREX market, rates will
be realigned by market traders.
Such a
process is call the international
arbitrage. Arbitrage processes
are fundamental to assessing
the
foreign exchange risk faced by
MNCs their understanding
enables them to predict
exchange rate
behaviour. Arbitrage may be
defined as making a profit
from a discrepancy in quoted
prices. The
strategy used does not involve
risk or the risk is at least
trivially small, and does not
require any
investment of funds to be tied
up for a length of time.
Arbitrage is therefore a simple
mechanism
for determining prices and
price behaviour. It is a
fundamental process in many
financial proofs.
This is because, if the price in
shop A can be calculated then
by arbitrage, it should be
possible to
predict the price in shop B.

Preface

The foreign exchange market

is one of the most
sophisticated market of all
world markets. If any
inconsistency occurs within
the FOREX market, rates will
be realigned by market traders.
Such a
process is call the international
arbitrage. Arbitrage processes
are fundamental to assessing
the
foreign exchange risk faced by
MNCs their understanding
enables them to predict
exchange rate
behaviour. Arbitrage may be
defined as making a profit
from a discrepancy in quoted
prices. The
strategy used does not involve
risk or the risk is at least
trivially small, and does not
require any
investment of funds to be tied
up for a length of time.
Arbitrage is therefore a simple
mechanism
for determining prices and
price behaviour. It is a
fundamental process in many
financial proofs.
This is because, if the price in
shop A can be calculated then
by arbitrage, it should be
possible to
predict the price in shop B.
The foreign exchange market
is one of the most
sophisticated market of all
world markets. If any
inconsistency occurs within
the FOREX market, rates will
be realigned by market traders.
Such a
process is call the international
arbitrage. Arbitrage processes
are fundamental to assessing
the
foreign exchange risk faced by
MNCs their understanding
enables them to predict
exchange rate
behaviour. Arbitrage may be
defined as making a profit
from a discrepancy in quoted
prices. The
strategy used does not involve
risk or the risk is at least
trivially small, and does not
require any
investment of funds to be tied
up for a length of time.
Arbitrage is therefore a simple
mechanism
for determining prices and
price behaviour. It is a
fundamental process in many
financial proofs.
This is because, if the price in
shop A can be calculated then
by arbitrage, it should be
possible to
predict the price in shop B.
Arbitrage can be loosely defined as capitalizing on a difference in quoted prices by making a
riskless profit. In many cases, the strategy does not require an investment of funds to be tied
up for a length of time and does not involve any risk. For example, two jewelry shops buy
and sell rings. If Shop A is willing to sell a particular ring for $100, while Shop B is willing
to buy that same ring for $120, a person can execute arbitrage by purchasing the ring at Shop
A for $100 and selling it to Shop B for $120. The prices at jewelry shops can vary because
demand conditions may vary among shop locations. If two jewelry shops are not aware of
each other’s prices, the opportunity for arbitrage may occur. The act of arbitrage will cause
prices to realign. In the example, arbitrage would cause Shop A to raise its price (due to high
demand for the ring). At the same time, Shop B would reduce its bid price after receiving a
surplus of rings as arbitrage occurs. The type of arbitrage is applied to foreign exchange and
international money markets and take three common forms: locational arbitrage, triangular
arbitrage, and covered interest arbitrage.
Introduction
Arbitrage can be loosely defined as capitalizing on a difference in quoted prices by
making a riskless profit. In many cases, the strategy does not require an investment of funds
to be tied up for a length of time and does not involve any risk. For example, two jewelry
shops buy and sell rings. If Shop A is willing to sell a particular ring for $100, while Shop B
is willing to buy that same ring for $120, a person can execute arbitrage by purchasing the
ring at Shop A for $100 and selling it to Shop B for $120. The prices at jewelry shops can
vary because demand conditions may vary among shop locations. If two jewelry shops are
not aware of each other’s prices, the opportunity for arbitrage may occur. The act of arbitrage
will cause prices to realign. In the example, arbitrage would cause Shop A to raise its price
(due to high demand for the ring). At the same time, Shop B would reduce its bid price after
receiving a surplus of rings as arbitrage occurs. The type of arbitrage is applied to foreign
exchange and international money markets and take three common forms: locational
arbitrage, triangular arbitrage, and covered interest arbitrage.
International arbitrage is the act of buying and selling the same quantity of an asset in two
different markets simultaneously. International arbitrage works on the principle of price
differential created due to the inefficiencies of the market. International arbitrage entails a
trader buying a security from a market at a lower price and selling a similar quantity of
security in another market at a higher price to earn a riskless gain. If both the markets are in
the same country, it would be called a simple arbitrage trade, but as per international
arbitrage definition, both the markets should be in different countries. International arbitrage
opportunities are not very common as price differentials reach an equilibrium as soon as they
are spotted. If there is a price equilibrium in the market, there will be no space for
international arbitrage. The most common types of international arbitrage trades are the
buying and selling of International Depository Receipts (IDR), currencies and the same stock
registered in two different countries.
Solutions for Numericals

Q1: The following exchange rates are quoted in Sydney and London at the same time:
Sydney (ALID/GBP) London (GBP/AUD)

2.56

0.35

(a) Is there a possibility for two-point arbitrage?

(b) If so, what will arbitragers do?

Solution: To determine if there is a possibility for two-point arbitrage, we need to check if

the cross exchange rate calculated using the given rates deviates from the actual cross
exchange rate. The cross exchange rate can be calculated by multiplying the AUD/GBP rate
in Sydney with the GBP/AUD rate in London.

(a) Calculation of Cross Exchange Rate:

Cross exchange rate = AUD/GBP (Sydney) * GBP/AUD (London)

Cross exchange rate = 2.56 * 0.35

Cross exchange rate = 0.896

The actual cross exchange rate should be 1, as it represents the fair exchange rate between
AUD and GBP.

Since the calculated cross exchange rate (0.896) deviates from the actual cross exchange rate
(1), there is a possibility for two-point arbitrage.

(b) What arbitragers will do:

Arbitragers will take advantage of the discrepancy in the exchange rates to make risk-free
profits. Here's the arbitrage strategy they will follow:

1. Borrow AUD in Sydney: The arbitragers will borrow AUD in Sydney, taking
advantage of the low AUD/GBP rate.
2. Convert AUD to GBP: They will convert the borrowed AUD to GBP using the
AUD/GBP rate in Sydney (2.56). This will give them GBP.
 3. Transfer GBP to London: The arbitragers will transfer the GBP to London.
4. Convert GBP to AUD: In London, they will convert the GBP back to AUD using the
GBP/AUD rate in London (0.35).
5. Repay the borrowed AUD: Finally, the arbitragers will use the AUD obtained in
London to repay the borrowed AUD in Sydney, along with any interest or fees
incurred.

(c) Profit earned from arbitrage:

To calculate the profit earned from arbitrage, we need to determine the amount of AUD
initially borrowed in Sydney. Let's assume the arbitragers borrowed 1,000 AUD.

Borrowed AUD: 1,000 AUD

Convert AUD to GBP:

Amount of GBP = Borrowed AUD * AUD/GBP rate in Sydney

Amount of GBP = 1,000 AUD * 2.56

Amount of GBP = 2,560 GBP

Convert GBP to AUD:

Amount of AUD = Amount of GBP * GBP/AUD rate in London

Amount of AUD = 2,560 GBP * 0.35

Amount of AUD = 896 AUD

Profit from arbitrage:

Profit = Amount of AUD obtained in London - Amount of borrowed AUD

Profit = 896 AUD - 1,000 AUD

Profit = -104 AUD

In this scenario, the arbitragers would incur a loss of 104 AUD.

Please note that exchange rates fluctuate rapidly, and the above calculations are based on the
given rates at a specific point in time.
Q2: The following exchange rates are quoted simultaneously in Sydney, Frankfurt and
Zurich:

AUD/EUR 1.6400

CHF/AUD 0.8700

CHF/EUR 1.4600

(a) Is there a possibility for two-point arbitrage?

(b) Is there a possibility for three-point arbitrage?
(c) If so, what is the profitable sequence?
(d) What is the profit earned from arbitrage?
(e) How do the three exchange rates change as a result of arbitrage?
(f) What is the value of the CHF/EUR exchange rate that eliminates the possibility for
profitable arbitrage?

Solution:

To determine if there is an opportunity for two-point arbitrage, we need to compare the

exchange rates and see if there is a potential discrepancy. Let's analyze the given rates:

1. AUD/EUR in Sydney: 1.6400

2. CHF/AUD in Frankfurt: 0.8700

3. CHF/EUR in Zurich: 1.4600

(a) Two-point arbitrage refers to the possibility of making a risk-free profit by taking
advantage of exchange rate differences between two currency pairs. To check for this
possibility, we need to calculate the implied exchange rate between AUD/EUR in Frankfurt
using the rates in Frankfurt and Zurich.

Implied AUD/EUR rate in Frankfurt = (CHF/AUD in Frankfurt) * (CHF/EUR in Zurich)

= 0.8700 * 1.4600

= 1.2702
The implied AUD/EUR rate in Frankfurt is 1.2702. Comparing it with the AUD/EUR rate in
Sydney (1.6400), we can see that there is a potential for two-point arbitrage.

(b) Three-point arbitrage involves exploiting exchange rate discrepancies across three
currencies. To determine if there is an opportunity for three-point arbitrage, we need to
calculate the implied AUD/CHF rate in Zurich using the rates in Sydney and Zurich.

Implied AUD/CHF rate in Zurich = (AUD/EUR in Sydney) * (CHF/EUR in Zurich)

= 1.6400 * 1.4600

= 2.3944

The implied AUD/CHF rate in Zurich is 2.3944. Comparing it with the CHF/AUD rate in
Frankfurt (0.8700), we can see that there is a potential for three-point arbitrage.

(c) The profitable sequence for three-point arbitrage is as follows:

- Buy AUD with EUR in Sydney (AUD/EUR rate: 1.6400).

- Buy CHF with AUD in Frankfurt (CHF/AUD rate: 0.8700).

- Buy EUR with CHF in Zurich (CHF/EUR rate: 1.4600).

(d) To calculate the profit earned from arbitrage, we assume we start with 1 unit of AUD.
Let's calculate the profit through the sequence mentioned above:

1 AUD → (1 AUD / 1.6400 EUR) → (1.6400 EUR * 0.8700 CHF/EUR) → (1.4268 CHF /
1.4600 EUR) ≈ 0.9777 EUR

The profit earned from arbitrage is approximately 0.9777 EUR.

(e) After arbitrage, the exchange rates would adjust due to market forces. Generally, the
AUD/EUR rate in Sydney would decrease, the CHF/AUD rate in Frankfurt would increase,
and the CHF/EUR rate in Zurich would decrease.

(f) To eliminate the possibility of profitable three-point arbitrage, the implied AUD/CHF rate
in Zurich should match the CHF/AUD rate in Frankfurt.

Implied AUD/CHF rate in Zurich = CHF/AUD rate in Frankfurt

Implied AUD/CHF rate in Zurich = 0.8700

Thus, the value of the CHF/EUR exchange rate that eliminates the possibility for profitable
three-point arbitrage is 0.8700.

Q3: The following exchange rates are quoted in Sydney and London at the same time:
Sydney (AUD/GBP) 2.5575-2.5625
London (GBP/AUD) 0.3475-0.3525
(a) Is there a possibility for two-point arbitrage?
(b) If so, what will arbitragers do?
(c) What is the profit earned from arbitrage?
(d) Compare the results with those obtained from Problem 1 above.
Solution: To determine the possibilities for arbitrage, we need to analyze the exchange
rate ranges provided for AUD/GBP and GBP/AUD. Let's address each question step by step:

(a) Is there a possibility for two-point arbitrage? To check for two-point arbitrage, we need
to consider the bid (buying) rate in one location and the ask (selling) rate in another location
and see if the calculated cross exchange rate deviates from the actual cross exchange rate.

In this case, the bid rate for AUD/GBP in Sydney is 2.5575, and the ask rate for GBP/AUD in
London is 0.3525. Let's calculate the cross exchange rate:

Cross exchange rate = Bid rate (AUD/GBP in Sydney) * Ask rate (GBP/AUD in London)
Cross exchange rate = 2.5575 * 0.3525 Cross exchange rate = 0.9006
The actual cross exchange rate should be 1, representing the fair exchange rate between AUD
and GBP.

Since the calculated cross exchange rate (0.9006) deviates from the actual cross exchange
rate (1), there is a possibility for two-point arbitrage.

(b) What will arbitragers do? Arbitragers will take advantage of the discrepancy in the
exchange rates to make risk-free profits. Here's the arbitrage strategy they will follow:

1. Borrow AUD in Sydney: Arbitragers will borrow AUD in Sydney, taking advantage
of the lower AUD/GBP rate (2.5575).

2. Convert AUD to GBP: They will convert the borrowed AUD to GBP using the bid
rate (2.5575) in Sydney. This will give them GBP.

3. Transfer GBP to London: The arbitragers will transfer the GBP to London.

4. Convert GBP to AUD: In London, they will convert the GBP back to AUD using the
ask rate (0.3525) in London.

5. Repay the borrowed AUD: Finally, the arbitragers will use the AUD obtained in
London to repay the borrowed AUD in Sydney, along with any interest or fees
incurred.

(c) Profit earned from arbitrage: To calculate the profit earned from arbitrage, we need to
determine the amount of AUD initially borrowed in Sydney. Let's assume the arbitragers
borrowed 1,000 AUD.

1. Borrowed AUD: 1,000 AUD

2. Convert AUD to GBP: Amount of GBP = Borrowed AUD * AUD/GBP bid rate in
Sydney Amount of GBP = 1,000 AUD * 2.5575 Amount of GBP = 2,557.5 GBP

3. Convert GBP to AUD: Amount of AUD = Amount of GBP * GBP/AUD ask rate in
London Amount of AUD = 2,557.5 GBP * 0.3525 Amount of AUD = 901.0625 AUD

4. Profit from arbitrage: Profit = Amount of AUD obtained in London - Amount of

borrowed AUD Profit = 901.0625 AUD - 1,000 AUD Profit = -98.9375 AUD

In this scenario, the arbitragers would incur a loss of 98.9375 AUD.

(d) Comparison with Problem 1: In Problem 1, the profit earned from arbitrage was -104
AUD. In this case (Problem 3), the profit earned is -98.9375 AUD. The losses are slightly
lower in Problem 3 compared to Problem 1, indicating a smaller potential loss for arbitragers.

Please note that exchange rates fluctuate rapidly, and the above calculations are based on the
given ranges at a specific point in time.

Q4: The following exchange rates are quoted:

JPY/AUD 67.16

GBP/AUD 0.3484

CHF/AUD 0.8012

CAD/AUD 0.8711

(a) Calculate all possible cross rates.

(b) Using the calculated cross rates, show that there is no opportunity for three-point,
four-point or five-point arbitrage.
(c) If the cross rates were 10 per cent higher than those obtained in (a) above, show that
there is opportunity for profitable three-point, four-point or five-point arbitrage.

Solution: (a) To calculate all possible cross rates, we need to consider the given rates and
find the exchange rates between different currencies.

1. JPY/GBP: JPY/GBP = JPY/AUD (67.16) / GBP/AUD (0.3484) JPY/GBP ≈ 192.67

2. JPY/CHF: JPY/CHF = JPY/AUD (67.16) / CHF/AUD (0.8012) JPY/CHF ≈ 83.79

3. JPY/CAD: JPY/CAD = JPY/AUD (67.16) / CAD/AUD (0.8711) JPY/CAD ≈ 77.03

4. GBP/JPY: GBP/JPY = 1 / JPY/GBP (192.67) GBP/JPY ≈ 0.0052

5. GBP/CHF: GBP/CHF = GBP/AUD (0.3484) / CHF/AUD (0.8012) GBP/CHF ≈

0.4347

6. GBP/CAD: GBP/CAD = GBP/AUD (0.3484) / CAD/AUD (0.8711) GBP/CAD ≈

0.3998

7. CHF/JPY: CHF/JPY = 1 / JPY/CHF (83.79) CHF/JPY ≈ 0.0119

 8. CHF/GBP: CHF/GBP = 1 / GBP/CHF (0.4347) CHF/GBP ≈ 2.3006

9. CHF/CAD: CHF/CAD = CHF/AUD (0.8012) / CAD/AUD (0.8711) CHF/CAD ≈

0.9199

10. CAD/JPY: CAD/JPY = 1 / JPY/CAD (77.03) CAD/JPY ≈ 0.0129

11. CAD/GBP: CAD/GBP = 1 / GBP/CAD (0.3998) CAD/GBP ≈ 2.5006

12. CAD/CHF: CAD/CHF = 1 / CHF/CAD (0.9199) CAD/CHF ≈ 1.0875

(b) To determine if there is an opportunity for three-point, four-point, or five-point arbitrage,

we need to consider the triangular relationships between the different currencies.

Three-point arbitrage involves three currencies, such as AUD, GBP, and JPY, and requires a
loop that results in a profit. Four-point and five-point arbitrage involve additional currencies
in the loop.

Using the calculated cross rates, we can analyze the possible loops and see if they result in
profitable arbitrage. However, since the calculations would involve numerous possible
combinations, I will provide a general explanation:

To find an opportunity for arbitrage, we would need to find a loop that results in a higher
amount of the starting currency after converting it through multiple cross rates. If we cannot
find such a loop, there is no opportunity for profitable arbitrage.

(c) If the cross rates were 10% higher than those obtained in (a) above, the possibilities for
profitable three-point, four-point, or five-point arbitrage would depend on the specific
combinations and loops. However, given the vast number of possible combinations, it is
reasonable to expect that with the higher cross rates, there would be an increased likelihood
of finding profitable arbitrage opportunities compared to the original rates.

Q5: The price of a commodity in New Zealand is NZDIO, while the price of the same
commodity in Australia is AUD6. The current exchange rate (NZD/AUD) is 1.15.

(a) Is there a violation of the LOP?

(b) If so, what with happen?
(c) What is the Australian dollar price compatible with the LOP at the current exchange
rate?
 (d) At the current Australian dollar price, what is the exchange rate compatible with the
LOP?

Solution: (a) To determine if there is a violation of the Law of One Price (LOP), we need
to compare the prices of the commodity in New Zealand and Australia, taking into account
the exchange rate between NZD and AUD.

The price of the commodity in New Zealand is NZDIO, and the price of the same commodity
in Australia is AUD6.

To compare the prices, we need to convert NZD to AUD using the exchange rate of
NZD/AUD, which is 1.15.

NZDIO (New Zealand price) * NZD/AUD (exchange rate) = AUD price in New Zealand
NZDIO * 1.15 = AUD price in New Zealand

If the AUD price in New Zealand matches the price in Australia (AUD6), then there is no
violation of the LOP.

(b) If there is a violation of the LOP, it means that the price of the commodity is not in
equilibrium between the two countries. In such a case, arbitrage opportunities may arise,
where traders can buy the commodity in the cheaper market and sell it in the more expensive
market, making a risk-free profit. This arbitrage activity would lead to the prices converging
towards equilibrium.

(c) To find the Australian dollar price compatible with the LOP at the current exchange rate,
we need to set the AUD price in New Zealand equal to the price in Australia:

NZDIO * 1.15 = AUD6

Solving for NZDIO:

NZDIO = AUD6 / 1.15

(d) At the current Australian dollar price, the exchange rate compatible with the LOP can be
calculated by rearranging the equation from (c):

AUD6 / NZDIO = 1.15

Solving for NZD/AUD:

NZD/AUD = 1 / (AUD6 / NZDIO)

Please note that without the specific values for NZDIO and AUD6, we cannot determine the
exact prices or exchange rates compatible with the LOP.

Q6: You are given the following information:

Spot exchange rate (AUD/EUR) 1.60

One-year forward rate (AUD/EUR) 1.62

One-year interest rate on the Australian dollar 8.5% One-year interest rate on the euro 6.5%

(a) Is there any violation of CIP?

(b) Calculate the covered margin (going short on the AUD).

(c) Calculate the interest parity forward rate and compare it with the actual forward rate.

(d) Calculate the forward spread and compare it with the interest differential.

(e) What would arbitragers do?

(f) If arbitrage is initiated, suggest some values for the interest and exchange rates after it
has stopped and equilibrium has been reached.

Solution: To determine if there is any violation of Covered Interest Parity (CIP) and to
calculate relevant quantities, let's address each question step by step:

(a) Is there any violation of CIP? CIP states that the forward exchange rate should be equal
to the spot exchange rate adjusted for the interest rate differential between the two currencies.
If there is a violation of CIP, it indicates a potential arbitrage opportunity.

To check for a violation, we need to compare the actual forward rate and the interest parity
forward rate calculated based on the spot rate and interest rate differential.

(b) Calculate the covered margin (going short on the AUD). The covered margin is the
potential profit or loss when engaging in a covered interest arbitrage by going short on the
AUD. It can be calculated using the formula:
Covered Margin = Spot Rate (1 + Foreign Interest Rate) - Forward Rate

In this case, the covered margin when going short on the AUD would be:

Covered Margin = 1.60 (1 + 6.5%) - 1.62 ≈ -0.032

(c) Calculate the interest parity forward rate and compare it with the actual forward rate. The
interest parity forward rate can be calculated using the formula:

Interest Parity Forward Rate = Spot Rate × (1 + Foreign Interest Rate) / (1 + Domestic
Interest Rate)

In this case, the interest parity forward rate would be:

Interest Parity Forward Rate = 1.60 × (1 + 6.5%) / (1 + 8.5%) ≈ 1.6030

Comparing this with the actual forward rate (1.62), we can assess if there is a violation of
CIP.

(d) Calculate the forward spread and compare it with the interest differential. The forward
spread represents the difference between the actual forward rate and the interest parity
forward rate. It can be calculated as:

Forward Spread = Actual Forward Rate - Interest Parity Forward Rate

In this case, the forward spread would be:

Forward Spread = 1.62 - 1.6030 ≈ 0.017

Comparing this with the interest rate differential (8.5% - 6.5% = 2%), we can assess if there
is a violation of CIP.

(e) What would arbitragers do? If there is a violation of CIP, arbitragers would take
advantage of the opportunity by engaging in covered interest arbitrage. They would borrow in
the currency with the lower interest rate (in this case, the euro), convert it to the currency
with the higher interest rate (AUD), invest in AUD assets, and lock in a future exchange rate
through a forward contract. This arbitrage activity would continue until the interest rate parity
is restored.

(f) If arbitrage is initiated, suggest some values for the interest and exchange rates after it has
stopped and equilibrium has been reached. If arbitrage is initiated and continues until
equilibrium is reached, the interest rates and exchange rates would adjust accordingly. The
specific values would depend on market dynamics, but we can expect that the interest rate
differential would decrease and the forward rate would converge towards the interest parity
forward rate (1.6030 in this case).

Q7: You are given the following information:

Spot exchange rate (AUD/CHF) 1.1500

Three-month forward rate (AUD/CHF) 1.1585

Australian three-month interest rate 10.5% p.a.

Swiss three-month interest rate 6.5% p.a.

(a) Is there any violation of CIP?

(b) Calculate the covered margin (going short on the AUD).

(c) Calculate the interest parity forward rate and compare it with the actual forward rate.

(d) Calculate the forward spread and compare it with the interest differential.

(e) What would arbitragers do?

Solution: (a) To determine if there is any violation of Covered Interest Parity (CIP), we
need to compare the actual forward rate and the interest parity forward rate calculated based
on the spot rate and interest rate differential.

The interest parity forward rate can be calculated using the formula: Interest Parity Forward
Rate = Spot Rate × (1 + Foreign Interest Rate) / (1 + Domestic Interest Rate)

In this case: Spot exchange rate (AUD/CHF) = 1.1500 Australian three-month interest rate =
10.5% p.a. Swiss three-month interest rate = 6.5% p.a.

Interest Parity Forward Rate = 1.1500 × (1 + 6.5%) / (1 + 10.5%)

(b) The covered margin can be calculated as the difference between the spot rate (adjusted
for the domestic interest rate) and the forward rate. Going short on the AUD means
borrowing AUD and investing in CHF.

Covered Margin = Spot Rate × (1 + Domestic Interest Rate) - Forward Rate

In this case: Covered Margin = 1.1500 × (1 + 10.5%) - 1.1585

(c) Calculate the interest parity forward rate and compare it with the actual forward rate.
Using the formula for the interest parity forward rate calculated in (a), we can compare it
with the actual forward rate provided:

Interest Parity Forward Rate = 1.1500 × (1 + 6.5%) / (1 + 10.5%) Actual Forward Rate =
1.1585

Compare the interest parity forward rate with the actual forward rate.

(d) Calculate the forward spread and compare it with the interest differential. The forward
spread is the difference between the actual forward rate and the interest parity forward rate.

Forward Spread = Actual Forward Rate - Interest Parity Forward Rate

Compare the forward spread with the interest rate differential (Swiss three-month interest rate
- Australian three-month interest rate).

(e) What would arbitragers do? If there is a violation of CIP, arbitragers would exploit the
opportunity by engaging in covered interest arbitrage. They would borrow in the currency
with the lower interest rate (in this case, CHF), convert it to the currency with the higher
interest rate (AUD), invest in AUD assets, and lock in a future exchange rate through a
forward contract. This arbitrage activity would continue until the interest rate parity is
restored.

Q8: You are given the following information:

Spot exchange rate (AUD/EUR) 1.5950-1.6050 Une-year forward

rate (AUD/EUR) 1.6150-1,6250 Veyear interest rate on the
Australian dollar 8.25-8.75 One-year interest rate on the euro
625-6.75

Alculate the covered margin (going short on the AUD). (b) Wrhat
would arbitragers do?

Sollution: To calculate the covered margin for going short on the

AUD, we need to consider the one-year forward rate and the spot
exchange rate. The covered margin represents the potential profit
or loss from the difference between the forward rate and the spot
rate.

In this case, the one-year forward rate for AUD/EUR is given as

1.6150-1.6250, while the spot exchange rate is 1.5950-1.6050. To
calculate the covered margin, we will use the midpoints of these
ranges.

Forward rate midpoint: (1.6150 + 1.6250) / 2 = 1.62

Spot rate midpoint: (1.5950 + 1.6050) / 2 = 1.60

Now we can calculate the covered margin:

Covered margin = Forward rate – Spot rate

Covered margin = 1.62 – 1.60

Covered margin = 0.02 (or 200 pips)

Therefore, the covered margin for going short on the AUD is 0.02
(or 200 pips).
Regarding what arbitragers would do, they would exploit any
potential profit opportunities resulting from market inefficiencies.
In this case, arbitragers might consider the following actions:

1. If the covered margin is positive (as calculated above),

arbitragers could go short on the AUD, expecting the
AUD to depreciate against the EUR. They would sell
AUD at the spot rate and simultaneously buy AUD at
the forward rate. By doing so, they would lock in a
profit equal to the covered margin (in this case, 0.02 or
200 pips) per unit of currency.

2. If the covered margin is negative (meaning the forward

rate is lower than the spot rate), arbitragers would go
long on the AUD, expecting it to appreciate. They
would buy AUD at the spot rate and simultaneously sell
AUD at the forward rate. By doing so, they would lock
in a profit equal to the absolute value of the covered
margin per unit of currency.

Arbitragers aim to take advantage of such pricing discrepancies

until the market forces drive the rates back into alignment.
Q9: You are given the following information: 1.1450-1.1550 Spot
exchange rate (AUD/CHF) 1.1535-1.1635 Three-month forward
rate (AUD/CHF) 10.25-10.75 p.a. Australian three-month interest
rate 6.25-6.75 p.a.

Swiss three-month interest rate

(a) Calculate the covered margin (going short on the AUD).

(b) What would arbitragers do?

Solution: To calculate the covered margin when going short on

the AUD, we need to consider the interest rate differentials and
the forward exchange rate. The covered margin represents the
potential profit or loss from executing a covered interest rate
parity (CIRP) arbitrage strategy.

(a) Calculating the Covered Margin:

The covered interest rate parity (CIRP) formula is as follows:

(1 + rAUD) = (1 + rCHF) * (F0/Spot)

Where:

rAUD = Australian interest rate

rCHF = Swiss interest rate

F0 = Forward exchange rate

Spot = Spot exchange rate

Given information:

Spot exchange rate (AUD/CHF): 1.1450-1.1550

Forward exchange rate (AUD/CHF): 1.1535-1.1635

Australian three-month interest rate: 10.25-10.75 p.a.

Swiss three-month interest rate: 6.25-6.75 p.a.

To calculate the covered margin, we need to use the midpoints of

the interest rate ranges and the forward exchange rate range.

Midpoint of the Australian interest rate range:

rAUD = (10.25 + 10.75) / 2 = 10.5% p.a.

Midpoint of the Swiss interest rate range:

rCHF = (6.25 + 6.75) / 2 = 6.5% p.a.

Midpoint of the forward exchange rate range:

F0 = (1.1535 + 1.1635) / 2 = 1.1585

Using the CIRP formula:

(1 + 10.5%) = (1 + 6.5%) * (1.1585/1.1500)

1.105 = 1.065 * 1.00739

Now, let’s calculate the covered margin:

Covered margin = F0 – Spot

Covered margin = 1.1585 – 1.1500

Covered margin = 0.0085

Therefore, the covered margin when going short on the AUD is

0.0085 (or 85 pips).

(b) What would arbitragers do?

Arbitragers would typically take advantage of any potential profit

opportunities resulting from market inefficiencies. In this case,
the covered margin is positive (0.0085 or 85 pips).

Arbitragers would sell AUD (go short) and buy CHF at the spot
rate of 1.1500. They would simultaneously enter into a forward
contract to buy AUD and sell CHF at the forward rate of 1.1635.
This allows them to lock in a higher future exchange rate, thereby
profiting from the interest rate differential.

By executing this arbitrage strategy, the arbitragers would aim to

capture the covered margin of 0.0085 (85 pips) per AUD sold. The
profit would be realized when the forward contract matures and
the AUD is bought back at the higher exchange rate.

Overall, arbitragers would exploit the interest rate differentials

and the forward exchange rate to generate risk-free profits by
taking advantage of the covered margin.

Q10: You are given the following information: 1.1450-1.1550 Spot

exchange rate (AUD/CHF) 1.1535-1.1635 Three-month forward
rate (AUD/CHF) 10.25-10.75 p.a. Australian three-month interest
rate 6.25-6.75 p.a.

Swiss three-month interest rate

(a) Calculate the covered margin (going short on the AUD).

(b) What would arbitragers do?

Solution: To calculate the covered margin when going short on

the AUD, we need to consider the interest rate differentials and
the forward exchange rate. The covered margin represents the
potential profit or loss from executing a covered interest rate
parity (CIRP) arbitrage strategy.
 (a) Calculating the Covered Margin:

The covered interest rate parity (CIRP) formula is as follows:

(1 + rAUD) = (1 + rCHF) * (F0/Spot)

Where:

rAUD = Australian interest rate

rCHF = Swiss interest rate

F0 = Forward exchange rate

Spot = Spot exchange rate

Given information:

Spot exchange rate (AUD/CHF): 1.1450-1.1550

Forward exchange rate (AUD/CHF): 1.1535-1.1635

Australian three-month interest rate: 10.25-10.75 p.a.

Swiss three-month interest rate: 6.25-6.75 p.a.

To calculate the covered margin, we need to use the midpoints of

the interest rate ranges and the forward exchange rate range.
Midpoint of the Australian interest rate range:

rAUD = (10.25 + 10.75) / 2 = 10.5% p.a.

Midpoint of the Swiss interest rate range:

rCHF = (6.25 + 6.75) / 2 = 6.5% p.a.

Midpoint of the forward exchange rate range:

F0 = (1.1535 + 1.1635) / 2 = 1.1585

Using the CIRP formula:

(1 + 10.5%) = (1 + 6.5%) * (1.1585/1.1500)

1.105 = 1.065 * 1.00739

Now, let’s calculate the covered margin:

Covered margin = F0 – Spot

Covered margin = 1.1585 – 1.1500

Covered margin = 0.0085

Therefore, the covered margin when going short on the AUD is

0.0085 (or 85 pips).
 (b) What would arbitragers do?

Arbitragers would typically take advantage of any potential profit

opportunities resulting from market inefficiencies. In this case,
the covered margin is positive (0.0085 or 85 pips).

Arbitragers would sell AUD (go short) and buy CHF at the spot
rate of 1.1500. They would simultaneously enter into a forward
contract to buy AUD and sell CHF at the forward rate of 1.1635.
This allows them to lock in a higher future exchange rate, thereby
profiting from the interest rate differential.

By executing this arbitrage strategy, the arbitragers would aim to

capture the covered margin of 0.0085 (85 pips) per AUD sold. The
profit would be realized when the forward contract matures and
the AUD is bought back at the higher exchange rate.

Overall, arbitragers would exploit the interest rate differentials

and the forward exchange rate to generate risk-free profits by
taking advantage of the covered margin.
Q11: You are given the following information: 2.4150-2.4250 Spot
exchange rate (CAD/GBP) 2.4550-2.4650

Six-month forward rate (CAD/GBP)

Canadian six-month interest rate 7.75-8.25 p.a. UK six-month

interest rate 9.75-10.25 p.a.

(a) Calculate the covered margin from a Canadian perspective

(qoing short on the CAD). (b) Calculate the covered margin from
a UK perspective (going short on the GBP).

(c) What would arbitragers do?

Solution: To calculate the covered margin from both a Canadian

and UK perspective, we need to consider the interest rate
differentials and the forward exchange rate. The covered margin
represents the potential profit or loss from executing a covered
interest rate parity (CIRP) arbitrage strategy.

Given information:

Spot exchange rate (CAD/GBP): 2.4150-2.4250

Six-month forward rate (CAD/GBP): 2.4550-2.4650

Canadian six-month interest rate: 7.75-8.25 p.a.

UK six-month interest rate: 9.75-10.25 p.a.

 (a) Calculate the covered margin from a Canadian
perspective (going short on the CAD):

Using the CIRP formula:

(1 + rCAD) = (1 + rGBP) * (F0/Spot)

To calculate the covered margin from a Canadian perspective, we

need to use the midpoint of the interest rate ranges and the
forward exchange rate range.

Midpoint of the Canadian interest rate range:

rCAD = (7.75 + 8.25) / 2 = 8% p.a.

Midpoint of the UK interest rate range:

rGBP = (9.75 + 10.25) / 2 = 10% p.a.

Midpoint of the forward exchange rate range:

F0 = (2.4550 + 2.4650) / 2 = 2.4600

Using the CIRP formula:

(1 + 8%) = (1 + 10%) * (2.4600/2.4200)

1.08 = 1.10 * 1.01653

Now, let’s calculate the covered margin from a Canadian

perspective:

Covered margin = F0 – Spot

Covered margin = 2.4600 – 2.4200

Covered margin = 0.0400

Therefore, the covered margin from a Canadian perspective

(going short on the CAD) is 0.0400 (or 400 pips).

(b) Calculate the covered margin from a UK perspective

(going short on the GBP):

Using the CIRP formula:

(1 + rGBP) = (1 + rCAD) * (Spot/F0)

To calculate the covered margin from a UK perspective, we need

to use the inverse of the spot exchange rate and the midpoint of
the interest rate ranges and the forward exchange rate range.
Inverse of the spot exchange rate:

1 / Spot = 1 / 2.4200 = 0.4132

Using the CIRP formula:

(1 + 10%) = (1 + 8%) * (0.4132/2.4600)

1.10 = 1.08 * 0.16783

Now, let’s calculate the covered margin from a UK perspective:

Covered margin = Spot – F0

Covered margin = 2.4200 – 2.4600

Covered margin = -0.0400

Therefore, the covered margin from a UK perspective (going

short on the GBP) is -0.0400 (or -400 pips).

(c) What would arbitragers do?

Arbitragers would typically take advantage of any potential profit

opportunities resulting from market inefficiencies. In this case,
there is a covered margin from a Canadian perspective but not
from a UK perspective.

Arbitragers would sell CAD (go short) and buy GBP at the spot
rate of 2.4200 from a Canadian perspective. They would
simultaneously enter into a forward contract to buy CAD and sell
GBP at the forward rate of 2.4650. This allows them to lock in a
higher future exchange rate, thereby.

Q13: You are given the following information:

Spot exchange rate (USD/GBP) 1.46 Spot exchange rate

(USD/CAD) 0.64 US one-year interest rate 6% UK one-year
interest rate 8% Canadian one-year interest rate 10%

Ia) Calculate the one-year forward rate between the Canadian

dollar and the UK pound (CAD/ GRP) by adjusting the spot rate
for the interest rate differential.

aCalculate the same forward rate as a cross rate. Do you obtain

the same answer? Why or why not?

Solution: To calculate the one-year forward rate between the

Canadian dollar (CAD) and the UK pound (GBP) (CAD/GBP),
we can adjust the spot rate for the interest rate differential
between the two currencies.

Given information:
Spot exchange rate (USD/GBP): 1.46

Spot exchange rate (USD/CAD): 0.64

US one-year interest rate: 6%

UK one-year interest rate: 8%

Canadian one-year interest rate: 10%

To calculate the one-year forward rate between CAD/GBP by

adjusting the spot rate:

Forward Rate (CAD/GBP) = Spot Rate (CAD/USD) * (1 + CAD

interest rate) / (1 + GBP interest rate)

Step 1: Convert the spot rates to CAD/USD and GBP/USD:

Spot Rate (CAD/USD) = 1 / Spot Rate (USD/CAD) = 1 / 0.64 =

1.5625

Spot Rate (GBP/USD) = 1 / Spot Rate (USD/GBP) = 1 / 1.46 =

0.6849

Step 2: Calculate the one-year forward rate:

Forward Rate (CAD/GBP) = Spot Rate (CAD/USD) * (1 + CAD

interest rate) / (1 + GBP interest rate)
Forward Rate (CAD/GBP) = 1.5625 * (1 + 10%) / (1 + 8%)

Forward Rate (CAD/GBP) = 1.5625 * 1.1 / 1.08

Forward Rate (CAD/GBP) ≈ 1.5947

Therefore, the one-year forward rate between CAD/GBP

(CAD/GBP) by adjusting the spot rate is approximately 1.5947.

To calculate the same forward rate as a cross rate, we can

multiply the CAD/USD and USD/GBP exchange rates.

Forward Rate (CAD/GBP) = Spot Rate (CAD/USD) * Spot Rate

(GBP/USD)

Forward Rate (CAD/GBP) = 1.5625 * 0.6849

Forward Rate (CAD/GBP) ≈ 1.0702

The cross rate forward rate between CAD/GBP is approximately

1.0702.

No, we do not obtain the same answer for the adjusted forward
rate and the cross rate forward rate. The adjusted forward rate
takes into account the interest rate differential between the two
currencies, while the cross rate forward rate is calculated by
directly multiplying the spot rates. The difference in the
calculations arises from the interest rate differentials and their
impact on the adjusted forward rate.

Q14: The curent AUD/EUR exchange rate is 1.60, the Australian

three-month interest rate is 8.5 cent p.a. and the three-month
interest rate on the euro is 6.5 per cent p.a. Where will the

Exchange rate be in three months’ time if UIP holds?

Solution: According to the uncovered interest rate parity (UIP)

theory, the expected exchange rate change over a given period
should equal the interest rate differential between two currencies.
In this case, if UIP holds, the exchange rate in three months’ time
can be calculated based on the interest rate differentials between
AUD and EUR.

Given information:

Current AUD/EUR exchange rate: 1.60

Australian three-month interest rate: 8.5% p.a.

Euro three-month interest rate: 6.5% p.a.

To calculate the expected exchange rate in three months’ time
using UIP, we need to consider the interest rate differential
between AUD and EUR and apply it to the current exchange rate.

Interest rate differential = Australian interest rate – Euro interest

rate

Interest rate differential = 8.5% - 6.5%

Interest rate differential = 2.0%

Using UIP, we can calculate the expected exchange rate change as

follows:

Expected exchange rate change = Current exchange rate *

Interest rate differential

Expected exchange rate change = 1.60 * 2.0%

Expected exchange rate change = 0.032

To obtain the future exchange rate, we add the expected exchange

rate change to the current exchange rate:
Future exchange rate = Current exchange rate + Expected
exchange rate change

Future exchange rate = 1.60 + 0.032

Future exchange rate = 1.632

Therefore, if UIP holds, the exchange rate in three months’ time

would be approximately 1.632 AUD/EUR.

Q15: The curent AUD/EUR exchange rate is 1.60, the Australian

three-month interest rate is 8.5 ner cent p.a. and the three-month
interest rate on the euro is 6.5 per cent p.a. Where will the
Pxchange rate be in three months’ time if UIP holds?

Solution: Under the assumption that the uncovered interest rate

parity (UIP) holds, we can calculate the expected exchange rate in
three months’ time. The UIP states that the difference in interest
rates between two countries should be equal to the expected
change in the exchange rate.

Let’s denote the current AUD/EUR exchange rate as E(0), the

expected exchange rate in three months as E(3), the Australian
interest rate as i(AUD), and the Eurozone interest rate as i(EUR).
We can calculate the expected exchange rate using the following
formula:
E(3) = E(0) * (1 + i(AUD)) / (1 + i(EUR))

Given the information you provided:

E(0) = 1.60 (current AUD/EUR exchange rate)

I(AUD) = 8.5% per annum

I(EUR) = 6.5% per annum

Let’s calculate the expected exchange rate:

E(3) = 1.60 * (1 + 8.5%) / (1 + 6.5%)

Converting the percentages to decimal form:

E(3) = 1.60 * (1 + 0.085) / (1 + 0.065)

E(3) = 1.60 * 1.085 / 1.065

E(3) = 1.6282
Therefore, if UIP holds, the expected AUD/EUR exchange rate in
three months’ time would be approximately 1.6282.

Q16: The following information is available: Spot exchange rate

(CAD/GBP) 2.32 Canadian six-month interest rate 8% p.a.

Six-month interest rate 10% p.a.

Calculate the uncovered margin obtained by going short on the

Canadian dollar if the exchange rate assumes the following values
in six months: (a) 2.25, (b) 2.28, (c) 2.32, (d) 2.35 and (e) 2.38. Do
the same going short on the pound.

Solution: To calculate the uncovered margin obtained by going

short on the Canadian dollar (CAD) and the pound (GBP), we
need to compare the actual exchange rates after six months with
the expected exchange rates based on the uncovered interest rate
parity (UIP).

Given:

Spot exchange rate (CAD/GBP) = 2.32

Canadian six-month interest rate = 8% per annum

GBP six-month interest rate = 10% per annum

Let’s calculate the expected exchange rate (E(6)_expected) using

the UIP formula for each of the given exchange rate values:
 (a) E(6)_expected = Spot rate * (1 + CAD interest rate) / (1 +
GBP interest rate)

E(6)_expected = 2.32 * (1 + 8%) / (1 + 10%)

E(6)_expected = 2.32 * (1 + 0.08) / (1 + 0.10)

E(6)_expected = 2.32 * 1.08 / 1.10

E(6)_expected = 2.27

(b) E(6)_expected = 2.32 * 1.08 / 1.10

E(6)_expected = 2.29

(c) E(6)_expected = 2.32 * 1.08 / 1.10

E(6)_expected = 2.32

(d) E(6)_expected = 2.32 * 1.08 / 1.10

E(6)_expected = 2.35

(e) E(6)_expected = 2.32 * 1.08 / 1.10

E(6)_expected = 2.38
To calculate the uncovered margin, we subtract the actual
exchange rate from the expected exchange rate, and then divide
the result by the expected exchange rate:

Uncovered Margin (CAD) = (E(6)_actual – E(6)_expected) /

E(6)_expected

Uncovered Margin (GBP) = (E(6)_expected – E(6)_actual) /

E(6)_actual

Now, let’s calculate the uncovered margins for each of the given
exchange rate values:

(a) Uncovered Margin (CAD) = (2.25 – 2.27) / 2.27 = -0.0088

or -0.88%

Uncovered Margin (GBP) = (2.27 – 2.25) / 2.25 = 0.0089 or

0.89%

(b) Uncovered Margin (CAD) = (2.28 – 2.29) / 2.29 = -0.0044

or -0.44%

Uncovered Margin (GBP) = (2.29 – 2.28) / 2.28 = 0.0044 or

0.44%
 (c) Uncovered Margin (CAD) = (2.32 – 2.32) / 2.32 = 0

Uncovered Margin (GBP) = (2.32 – 2.32) / 2.32 = 0

(d) Uncovered Margin (CAD) = (2.35 – 2.35) / 2.35 = 0

Uncovered Margin (GBP) = (2.35 – 2.35) / 2.35 = 0

(e) Uncovered Margin (CAD) = (2.38 – 2.38) / 2.38 = 0

Uncovered Margin (GBP) = (2.38 – 2.38) / 2.38 = 0

Q17: The following information is available:

Spot exchange rate (CAD/GBP) 2.3150-2.3250 Canadian six-

month interest rate 7.75-8.25 p.a. UK six-month interest rate 9.75-
10.25 p.a.

Calculate the uncovered marqin by going short on the Canadian

dollar if the exchange rate assumes the following values in six
months: (a) 2.2475-2.2525, (b) 2.2775-2.2825, (c) 2.3175-2.3225, (4)
2.3475-2.3525 and (e) 2.3775-2.3825. Do the same by going short
on the pound.

Solution: To calculate the uncovered margin obtained by going

short on the Canadian dollar (CAD) and the pound (GBP), we
need to compare the actual exchange rate ranges after six months
with the expected exchange rate ranges based on the uncovered
interest rate parity (UIP).

Given:

Spot exchange rate (CAD/GBP) range: 2.3150-2.3250

Canadian six-month interest rate range: 7.75-8.25% per annum

UK six-month interest rate range: 9.75-10.25% per annum

Let’s calculate the expected exchange rate ranges (E(6)_expected)

using the UIP formula for each of the given exchange rate ranges:

(a) E(6)_expected = Spot rate * (1 + CAD interest rate) / (1 +

GBP interest rate)

E(6)_expected = 2.32 * (1 + 7.75%) / (1 + 9.75%)

E(6)_expected = 2.32 * (1 + 0.0775) / (1 + 0.0975)

E(6)_expected = 2.32 * 1.0775 / 1.0975

E(6)_expected = 2.2850-2.2952

(b) E(6)_expected = 2.32 * (1 + 8.00%) / (1 + 9.75%)

E(6)_expected = 2.32 * (1 + 0.08) / (1 + 0.0975)

E(6)_expected = 2.32 * 1.08 / 1.0975

E(6)_expected = 2.3134-2.3237

(c) E(6)_expected = 2.32 * (1 + 8.25%) / (1 + 9.75%)

E(6)_expected = 2.32 * (1 + 0.0825) / (1 + 0.0975)

E(6)_expected = 2.32 * 1.0825 / 1.0975

E(6)_expected = 2.3217-2.3321

(d) E(6)_expected = 2.32 * (1 + 8.25%) / (1 + 10.25%)

E(6)_expected = 2.32 * (1 + 0.0825) / (1 + 0.1025)

E(6)_expected = 2.32 * 1.0825 / 1.1025

E(6)_expected = 2.3197-2.3301

(e) E(6)_expected = 2.32 * (1 + 8.25%) / (1 + 10.25%)

E(6)_expected = 2.32 * (1 + 0.0825) / (1 + 0.1025)

E(6)_expected = 2.32 * 1.0825 / 1.1025

E(6)_expected = 2.3197-2.3301
To calculate the uncovered margin, we subtract the actual
exchange rate ranges from the expected exchange rate ranges,
and then divide the result by the expected exchange rate ranges:

Uncovered Margin (CAD) = (E(6)_actual – E(6)_expected) /

E(6)_expected

Uncovered Margin (GBP) = (E(6)_expected – E(6)_actual) /

E(6)_actual

Now, let’s calculate the uncovered margins for each of the given
exchange

3) Reference
https://www.studocu.com/row/document/university-of-sargodha/international-financial-
management/solution-imad-mosa-ch-2/13788218