Problem Set (Parity Conditions 2)

1. In early 1989, Japanese interest rates were about 4 percentage points below U.S. rates. The
wide difference between Japanese and U.S. interest rates prompted some U.S. real estate
developers to borrow in yen to finance their projects. Comment on this strategy.
ANSWER: The U.S. developers were gambling that the 400 basis points differential did not
reflect market expectations of dollar depreciation, which is what the international Fisher
effect would argue for. In other words, the developers were committing the economist’s
unpardonable sin of comparing apples (dollar interest rates) with oranges (yen rates). This
policy also makes no sense from a currency risk standpoint since the developers had dollar
cash inflows (from the real estate rentals on their developments) and yen cashout flows on
the mortgages, exposing them to considerable exchange risk. A rise in the value of the yen
could conceivably cost them more than the savings on the lower yen interest rates.
Moreover, this rise was quite likely since the international Fisher effect says that
international differences in interest rates can be traced to expected changes in exchange rates,
with low interest rate currencies expected to appreciate against high interest rate currencies.
This is indeed what happened in the case of the yen.

2. Suppose today’s exchange rate is $0.62/DM. The 6-month interest rates on dollars and DM
are 6% and 3%, respectively. The 6-month forward rate is $0.6185. A foreign exchange
advisory service has predicted that the DM will appreciate to $0.64 within six months.
d. How would you use forward contracts to profit in the above situation?
ANSWER: By buying DM forward for six months and selling it in the spot market, you can
lock in an expected profit of $.0215 (0.64-.6185) per DM bought forward. This is a
semiannual percentage return of 3.48% (.0215/.6185).

a. How would you use money market instruments (borrowing and lending) to profit?
ANSWER: By borrowing dollars at 6% (3% semiannually), converting them to DM in the
spot market, investing the DM at 3% (1.5% semiannually), selling the DM proceeds at an
expected price of $.64/DM, and repaying the dollar loan, you will earn an expected
semiannual return of 1.77%.

The return per dollar borrowed = (1/0.62) x 1.015 x .64 – 1.03 = 1.77%

b. Which alternatives (forward contracts or money market instruments) would you prefer?
Why?
ANSWER: The return per dollar in the forward market is substantially higher than the
return using the money market speculation. Other things being equal, therefore, the forward
market speculation would be preferred.

3. Discuss the implications of the interest rate parity for the exchange rate determination.
ANSWER: Assuming that the forward exchange rate is roughly an unbiased predictor of the
future spot rate, IRP can be written as:
St = [(1+i*)/(1 + i)] E [St+1|It].
The exchange rate is thus determined by the relative interest rates, and the expected future
spot rate, conditional on all the available information, It, as of the present time. One thus can

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 say that expectation is self-fulfilling. Since the information set will be continuously updated
as news hits the market, the exchange rate will exhibit a highly dynamic, random behavior.

4. Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for six
months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in
Germany. Currently, the spot exchange rate is DM 1.60 per dollar and the six-month forward
exchange rate is DM 1.56 per dollar. The treasurer of IBM does not wish to bear any
exchange risk. Where should he/she invest to maximize the return?
ANSWER: The market conditions are summarized as follows:
i$ = 4%; iDM =3%; S = DM1.60/$; F = DM1.56/$.
If $1,000,000 is invested in the U.S., the maturity value in six months will be $1,040,000
=$1,000,000 (1 +.04). Alternatively, $1,000,000 can be converted into DM and invested at
the German interest rate, with the DM maturity value sold forward. In this case, the dollar
maturity value will be
$1.056,410 = ($1,000,000 x 1.60) (1 + .03) (1/1.56)
Clearly, it is better to invest $1,000,000 in Germany with exchange risk hedging.

5. While you were visiting London, you purchased a Jaguar for £35,000, payable in three
months. You have enough cash at your bank in New York City, which pays 0.35% interest
per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is
$1.45/£ and the three-month forward exchange rate is $1.40/£. In London, the money market
interest rate is 2.0% for a three-month investment. There are two alternative ways of paying
for your Jaguar.
a. Keep the funds at your bank in the U.S. and buy £35,000 forward.
b. Buy a certain pound amount spot today and invest the amount in the U.K. for three
months so that the maturity value becomes equal to £35,000.
Evaluate each payment method. Which method would you prefer? Why?

ANSWER: For option a, when you buy £35,000 forward, you will need $49,000 in three
months to fulfill the forward contract. The present value of $49,000 is computed as follows:
$49,000/(1.0035)3 = $48,489.
Thus, the cost of a Jaguar as of today is $48, 489.

For option B, the present value of £35,000 forward is £34,314 = £35,000/ (1.02). To buy
£34,314 today, it will cost $49,755 = 34,314 x 1.45. Thus the cost of a Jaguar as of today is
$49,755.

You should definitely choose to use “option a,” and save $1,266, which is the difference
between $49,755 and $48,489.

6. Currently, the spot exchange rate is $1.50/£ and the three-month forward Exchange rate is
$1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in
the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.

Let’s summarize the given data first:

S= $1.50/£; F = $1.52/£; i$ =2.0%; i₤ =1.45%

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 Credit = $1,500,000 or £1,000,000.

a. Determine whether the interest rate parity is currently holding.

ANSWER: Note (1 + i$) =1.02 and (1 + i₤)(F/S) =(1.0145)(1.52/1.5) = 1.0280
Thus, IRP is not holding exactly.

b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all
the steps and determine the arbitrage profit.
ANSWER: The steps that lead to arbitrage profit are
(1) Borrow $1,5000,000; repayment will be $1,530,000
(2) Buy £1,000,000 spot using $1,500,000
(3) Invest £1,000,000 at the pound interest rate of 1.45%; maturity value will be
£1,014,500.
(4) Sell £1,014,500 forward for $1,542,040
The arbitrage profit will be $12,040

c. Explain how the IRP will be restored as a result of covered arbitrage activities.
ANSWER: Following the arbitrage transactions described above,
(1) The dollar interest rate will rise;
(2) The pound interest rate will fall;
(3) The spot exchange rate will rise;
(4) The forward exchange rate will fall.
These adjustments will continue until IRP holds.

7. On checking the Reuters screen, you see the following exchange rate and interest rate quotes:

Currency 90-day interest rates Spot rates 90-day forward rates

Pound 7 7/16 - 5/16% ¥159.9696-9912/£ ¥145.5731-8692/£
Yen 2 3/8 - 1/4%

a. Can you find an arbitrage opportunity?

ANSWER: There are two alternatives; (1) Borrow yen at 2 3/8%, convert the yen into
pounds at the spot ask rate of ¥159.9912/£, invest the pounds at 7 5/16% and sell the
expected proceeds forward for yen at the forward bid rate of ¥145.5731/£ or (2) borrow
pounds at 7 7/16%, convert the pounds into yen at the spot bid rate of ¥159.9696/£, invest the
yen at 2 ¼%, and sell the proceeds forward for pounds at the forward ask rate of
¥145.8962/£. The first alternative will yield a loss of -¥7.94 per ¥100 borrowed, indicating
that this is not a profitable arbitrage opportunity:
(100/159.9912) x (1.0183) x 145.5731 – 100 x 1.0059 = -7.94
Switching to alternative 2, the return per £100 borrowed is £8.42, indicating that this is a
very profitable arbitrage opportunity:
100 x 159.9696 x 1.0056/145.8692 – 100x 1.0186 = 8.42.
b. What steps must you take to capitalize on it?
ANSWER: The steps to be taken have already been outlined in the answer to part a.

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 c. What is the profit per £1,000,000 arbitraged?
ANSWER: Based on the answer to part a, the profit is £84,200 (8.42 x 10,000)

8. Define the concept of a "real interest rate." Discuss several ways to measure a real interest
rate.
ANSWER: The real interest rate (r) is the nominal cost of funds (i) net of inflation (p). The
real interest rate could be measured ex ante, based on an expected rate of inflation, or ex post
using a realized rate of inflation. The expected rate of inflation could be forecast in various
ways to extract a real interest rate. A realized rate of inflation could be measured by the
consumer price index, the producer price index, or more specialized consumption bundles
again leading to different real interest rate measures. The exact formula for the real interest
rate is: r = (i - p)/(1+p). Since inflation rates are often small, especially over short periods,
an approximation for the real rate is often used: r = i - p.

9. Define the Fisher Effect and the Fisher International Effect (Uncovered Interest Parity). How
are these effects similar and how are they different?
ANSWER: The Fisher Effects states that the nominal interest rate reflects a real interest rate
and an anticipated rate of inflation. The Fisher International Effect (Uncovered Interest
Parity) states that the nominal interest rate differential between two countries reflects the
anticipated rate of currency depreciation of the exchange rate. The two Fisher effects are
similar in that they both claim that interest rates reflect anticipations of future economic
events. The two Fisher effects are different since the first Fisher Effect applies to a single
economy, while the second Fisher International Effects applies to two economies.

10. Discuss the impact of transaction costs on the Interest Rate Parity condition?
ANSWER: When transaction costs are present, the Interest Rate Parity condition need no
longer hold exactly. Deviations are large as, but not larger than, transaction costs may exist,
forming a neutral band around the parity line.

11. “We can measure the deviation from Interest Rate Parity on an ex ante basis, but we can only
measure the deviations from the Fisher International Effect on an ex post basis.” True or
False? Discuss.
ANSWER: Deviations from Interest Rate Parity are computed using four prices (S, F, i$, and
iforeign) that can be observed before executing a trade. Deviations from Fisher International
also involve four pieces (S, E(St+n), i$, and iforeign). But the expected future spot rate cannot
be observed before hand. We only observe that actual future spot rate, St+n, on an ex post
basis.

12. Empirical evidence shows that there are sometimes deviations from Interest Rate Parity and
the Fisher International Effect. What kind of threats and opportunities does this open up for
financial managers?
ANSWER: Deviations from either parity condition offer opportunities to a financial
manager. If Interest Rate Parity is violated, the manager can hope to identify moments with

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 profitable arbitrage opportunities. The manager may also identify periods when one-way
arbitrage is profitable. Deviation from the Interest Rate Parity makes synthetic US$
borrowing or swap-driven bond issues attractive to managers. If the Fisher Interest Effect is
violated, the manager needs to know the mean, volatility and time pattern of deviations. If
deviations is non-zero and volatility is low, the manager may be attracted to a speculatively
strategy (such as borrowing in the low interest rate currency and investing in the high interest
rate currency, expecting that the interest differential will more than compensate for the
exchange rate change). But if deviations have a high volatility, managers will need to weigh
the risk-return tradeoff.

13. In the case of a pegged exchange system, when would an interest rate differential appear
between government securities of the two countries?
ANSWER: An interest rate differential between two currencies that are locked together in a
pegged rate agreement may signify that there is some additional risk (of taxation, capital
controls, higher inflation, and/or currency depreciation) in the higher interest rate currency.
High Italian lire interest rates versus the DM in 1992 , and high Mexican peso interest rates
versus the US$ in 1994 are examples where this interpretation of greater risk was justified.

14. Suppose the US and UK three-month interest rates are respectively 6% and 8% per annum
and that the spot rate is $1.55/£.

a. Calculate the forward premium (or discount) on the £ expressed on a per annum basis.
ANSWER: Forward Premium = (i$ /4 - i£/4) / (1 + i£/4) = (0.06/4 – 0.08/4) / (1 + 0.08/4) =
-0.004902; which implies –1.96% per annum. £ is at a forward discount.

b. What value of the three-month forward rate establishes Interest Rate Parity?
ANSWER: (F-S)/S = (i$ /4 - i£/4) / (1 + i£/4); which implies F = S + S * (i$/4 - /4)/(1 + /4).
Thus F = $1.55/£ + $1.55/£ *(-0.004902) = $1.542402/£.

15. Suppose that spot rate is $0.20/FF. Then US one-year rate is 6%. The forward rate is
$0.1923/FF.

a. What is the current one-year French interest rate that will satisfy that Interest Rate Parity?
ANSWER: F/S = (1 + i$) / (1 + iFF); so iF = (1 + i$) S/F – 1; iF = 1.06 * 0.20/.1923 – 1 =
10.24%

b. Suppose the one-year French interest rate is 12% instead. What kind of arbitrage would
you perform to take advantage of this opportunity?
ANSWER: An interest rate of 12% is greater than the rate that results in interest rate parity.
Arbitrage with a capital outflow to FF: borrow $ at 6%, buy FF spot, invest FF at 12%, sell
FF forward for US$.

c. Suppose the US tax rate on capital gains and the tax rate on interest earned and paid are
respectively 15% and 40%. What is the new forward rate (F’) that would satisfy IRP on
an after tax basis?

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ANSWER: (F’ – S)/S = (i$ - iFF) / (1 + iFF) * (1 – ty)/(1 – tk); F’ = 0.194570 $/FF; or
5.139535 FF/$

d. Suppose all the variables took the values from part(a). Would there be any arbitrage
opportunity on an after-tax basis?
ANSWER: On after tax basis, there is an arbitrage profit opportunity by moving capital from
FF to US$: borrow FF at 10.24%, sell FF spot at $0.20/FF, invest US$ at 6.0%, buy FF
forward at $0.1923/FF..