Ch006-International-Parity-Relationships-and

Eun/Resnick4e62Eun&Resnick4eCHAPTER6InternationalParityRelationshipsandForecastingForeignExchangeRatesInterestRateParityCoveredInterestArbitrageInterestRateParityandExchangeRateDeterminationReasonsforDeviationsfromInterestRateParityPurchasingPowerParityPPPDeviationsandtheRealExchangeRateInternationalFinanceinPractice:BigMacCurrenciesEvidenceonPurchasingPowerParityFisherEffectsForecastingExchangeRatesEfficientMarketApproachFundamentalApproachTechnicalApproachPerformanceoftheForecastersSummaryMINICASE:TurkishLiraandPurchasingPowerParityAppendix6A:PurchasingPowerParityandExchangeRateDetermination1Anarbitrageisbestdefinedas:a)AlegalconditionimposedbytheCFTC.b)Theactofsimultaneouslybuyingandsellingthesameorequivalentassetsorcommoditiesforthepurposeofmakingreasonableprofits.c)Theactofsimultaneouslybuyingandsellingthesameorequivalentassetsorcommoditiesforthepurposeofmakingguaranteedprofits.d)NoneoftheaboveAnswer:c)InterestRateParity2InterestRateParity(IRP)isbestdefinedas:a)Whenagovernmentbringsitsdomesticinterestrateinlinewithothermajorfinancialmarketsb)Whenthecentralbankofacountrybringsitsdomesticinterestrateinlinewithitsmajortradingpartnersc)Anarbitrageconditionthatmustholdwheninternationalfinancialmarketsareinequilibriumd)NoneoftheaboveAnswer:c)3WhenInterestRateParity(IRP)doesnotholda)thereisusuallyahighdegreeofinflationinatleastonecountryb)thefinancialmarketsareinequilibriumc)thereareopportunitiesforcoveredinterestarbitraged)bandcEun/Resnick4e63Answer:c)4AformalstatementofIRPisa)$€1($/€)($/€)1iFSib)€$1($/€)($/€)1iFSic)$€1($/€)($/€)($/€)1iFSSid)$€($/€)($/€)FSiiAnswer:a)Rationale:Equation6.1:$€1($/€)($/€)1iFSiCoveredInterestArbitrage5Supposethattheone-yearinterestrateis5.0percentintheUnitedStates,thespotexchangerateis$1.20/€,andtheone-yearforwardexchangerateis$1.16/€.Whatmustone-yearinterestratebeintheeurozone?a)5.0%b)1.09%c)8.62%d)Noneoftheabove.Answer:c)Rationale:equation6.1:$€€€1($/€)$1.16/€1.0511.0862($/€)1$1.20/€1iFiSii6Supposethattheone-yearinterestrateis3.0percentintheItaly,thespotexchangerateis$1.20/€,andtheone-yearforwardexchangerateis$1.18/€.Whatmustone-yearinterestratebeintheUnitedStates?a)1.2833%b)1.0128%c)4.75%d)Noneoftheabove.Answer:a)Rationale:equation6.1:$$$€11($/€)$1.18/€11.0128($/€)1$1.20/€1.03iiFiSiEun/Resnick4e647Acurrencydealerhasgoodcreditandcanborroweither$1,000,000or€800,000foroneyear.Theone-yearinterestrateintheU.S.isi$=2%andintheeurozonetheone-yearinterestrateisi€=6%.Thespotexchangerateis$1.25=€1.00andtheone-yearforwardexchangerateis$1.20=€1.00.Showhowtorealizeacertainprofitviacoveredinterestarbitrage.a)Borrow$1,000,000at2%.Trade$1,000,000for€800,000;investati€=6%;translateproceedsbackatforwardrateof$1.20=€1.00,grossproceeds=$1,017,600.b)Borrow€800,000ati€=6%;translatetodollarsatthespot,investintheU.S.ati$=2%foroneyear;translate€848,000backintoeuroattheforwardrateof$1.20=€1.00.Netprofit$2,400.c)Borrow€800,000ati€=6%;translatetodollarsatthespot,investintheU.S.ati$=2%foroneyear;translate€850,000backintoeuroattheforwardrateof$1.20=€1.00.Netprofit€2,000.d)Answersc)andb)arebothcorrectAnswer:d)Rationale:b)istrue:$1.25Grossproceedsindollars=€800,000(1.02)$1,020,000€1.00costineuro=€848,000€800,000(1.06)$1.20costindollars=€848,000$1,017,600€1.00netprofitindollars=$1,020,000$1,017,600$2,400c)isalsotrue:$1.25€1.00€800,000(1.02)€850,000€1.00$1.20€850,000€800,000(1.06)€2,000There’snothingintheproblemtosuggestthatprofitshavetobeinaparticularcurrency.8SupposethatyouarethetreasurerofIBMwithanextraUS$1,000,000toinvestforsixmonths.YouareconsideringthepurchaseofU.S.T-billsthatyield1.810%(that’sasixmonthrate,notanannualratebytheway)andhaveamaturityof26weeks.Thespotexchangerateis$1.00=¥100,andthesixmonthforwardrateis$1.00=¥110.TheinterestrateinJapan(onaninvestmentofcomparablerisk)is13percent.Whatisyourstrategy?a)take$1m,investinU.S.T-billsb)take$1m,translateintoyenatthespot,investinJapan,repatriateyouryenearningsbackintodollarsatthespotrateprevailinginsixmonths.c)take$1m,translateintoyenatthespot,investinJapan,hedgewithashortpositionintheforwardcontractd)take$1m,translateintoyenattheforwardrate,investinJapan,hedgewithashortpositioninthespotcontractAnswer:c)Eun/Resnick4e659AU.S.-basedcurrencydealerhasgoodcreditandcanborrow$1,000,000foroneyear.Theone-yearinterestrateintheU.S.isi$=2%andintheeurozonetheone-yearinterestrateisi€=6%.Thespotexchangerateis$1.25=€1.00andtheone-yearforwardexchangerateis$1.20=€1.00.Showhowtorealizeacertaindollarprofitviacoveredinterestarbitrage.a)Borrow$1,000,000at2%.Trade$1,000,000for€800,000;investati€=6%;translateproceedsbackatforwardrateof$1.20=€1.00,grossproceeds=$1,017,600.b)Borrow€800,000ati€=6%;translatetodollarsatthespot,investintheU.S.ati$=2%foroneyear;translate€848,000backintoeuroattheforwardrateof$1.20=€1.00.Netprofit$2,400.c)Borrow€800,000ati€=6%;translatetodollarsatthespot,investintheU.S.ati$=2%foroneyear;translate€850,000backintoeuroattheforwardrateof$1.20=€1.00.Netprofit€2,000.d)Answersc)andb)arebothcorrectAnswer:b)Ratio