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Strayer University Octavia Henry International Finance-FIN535003016*201103 Instructor’s Name: Tim E. Price Assignment Issue Date: May 2, 2011 Assignment Due Date: May 8, 2011

S.com Financial Dictionary.Exchange Rate Behavior 2 1. converting it back to the original currency within a short time span.09% One-year Australian interest rate = 7. 2010. 2011) In the U.00% Determine whether triangular arbitrage is feasible and. (Investopedia. the cross exchange rate is the relationship between two non-dollar currencies. they only last for a matter of seconds. if so.28 One-year forward rate of A$ = $.58004 One-year U. converting it again to a third currency and.70 Cross exchange rate: £1 = A$2. Also Triangular arbitrage does not tie up any of your funds therefore any profits are received immediately.596 Spot rate of Australian dollar (A$) = $. As an employee of the foreign exchange department for a large company . Therefore .S.00% One-year British interest rate = 9. interest rate = 8. how it should be conducted to make a profit. (Madura. finally. 205) A triangular arbitrage opportunity only comes about when the two currencies exchange rates do not match up. you have been given the following information: Beginning of Year Spot rate of £ = $1. p. Triangular arbitrages do not happen very often and when they do occur. Triangular arbitrage is the process of converting one currency to another.71 One-year forward rate of £ = 1.

596 = = 2. Using the information in question 1.596 . determine whether covered interest arbitrage is feasible and.58004 .596 $1. In order to see if interest rate parity does not exist we would need to determine the forward amount premium for the pound and the Australian dollar. p.S S = -1 = $1. 209) In simpler terms covered interest arbitrage means to capitalize on the difference between interest rates between two countries (interest arbitrage) while hedging your position against exchange rate risk (covered).28 Spot rate of A$ $. if so. Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract.$1. how it should be conducted to make a profit.Exchange Rate Behavior 3 Triangular arbitrage is not feasible because the cross exchange rate between £ and A$ is properly specified: Proper Cross exchange rate = Spot rate of £ $1. Also covered interest arbitrage is only possible when interest rate parity does not exist.7 2.08 1. Forward Premium Currency that Should Exist Actual Forward Premium Pound (£) p= 1 + i h -1 1 + i f 1. (Madura. 2010.0909 p = F.

S S 1.com Financial Dictionary. Although the U. investors will receive 1 percent less interest on the Australian investment. Conversely. they would receive an increase of 1.01428 Interest rate parity exists for the British pound. investors would profit from the difference by using covered interest arbitrage.S. The forward premium they would get when selling A$ at the end of one year more than offsets the interest rate differential.01 = –.70 = .01 Australian Dollar (A$) p = 1 + i 1 + i h f -1 p = F. use the International Fisher Effect (IFE) theory to forecast the annual percentage change in the British pound’s value over the year.S. interest rate parity does not exist for the A$. The actual forward premium is more than it is suppose to be.428 percent more than they initially paid for the A$ when they sell it. The IFE theory states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. (Investopedia.70 $.$. Based on the information in question 1 for the beginning of the year.Exchange Rate Behavior 4 = –. 2011) The Fisher effect suggests that the nominal interest rate contains two . U. 3.07 -1 .08 1.0093 = .71 .

the pound’s value is in equilibrium. based on the IFE. . the currency with a higher interest rate reflects higher expected inflation. (Madura.1% As a result. Using this information and the information provided in question 1. The currency adjustment will offset the differential in interest rates. 243) In other words the IFE suggests that given two currencies. p. The IFE is the application of the Fisher effect to two countries in order to derive the expected change in the exchange rate. Assume that at the beginning of the year.08 1 + . which will place downward pressure on the value of that currency (based on purchasing power parity). Assume that any change in the pound’s value due to the inflation differential has occurred by the end of the year.01 or . 4.Exchange Rate Behavior 5 components: (1) expected inflation rate and (2) real rate of interest. determine how the pound’s value changed over the year.S. ef = 1 1 + ih + if -1 = 1 + . while the U.0909 -1 ~ -. This means that the real rate of interest is the nominal interest rate minus the expected inflation rate. 2010. Assume that over the year the British inflation rate is 6 percent. inflation rate is 4 percent. the pound is projected to depreciate by 1 percent over the year.

Exchange Rate Behavior 6 5. Explain the type of direct intervention that would place downward pressure on the value of the pound. . Assume that the pound’s depreciation over the year was attributed directly to central bank intervention.

Mason: Cengage Learning.Exchange Rate Behavior 7 Bibliography Madura. J. International Financial Mangement. . (2010).

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