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CFA Level II Item-set Solution
Study Session 4
June 2017
A is incorrect. The type of client, individual or institutional, should not have an effect on the
size of the spread quoted.
B is incorrect. The trade will take place when the London FX trading center is open, that is,
the interbank FX market will be relatively liquid. Thus should narrow the spread quoted by
the dealer.
At settlement, Smart will need to purchase CAD 5 million under the original forward contract
and sell CAD 5 million under the offsetting forward contract; the CAD will net to zero.
However the USD will not net to zero because the forward rate has changed since contract
initiation. At settlement Smart will receive CAD 5 million and pay out USD 5,022,097.23
(5,000,000/0.9956) under the original forward contract and sell CAD 5 million and receive
USD 4,974,678.88 (5,000,000/1.00509) under the new contract.
The difference between the USD received and paid is - USD 47,418.35 (USD 4,974,678.88
USD 5,022,097.23). This represents an outflow because the original contract was long the
CAD (or short the USD) and the CAD subsequently depreciated (or the USD appreciated,
because the all-in forward rate increased from 0.9956 to 1.00509). The present value of this
outflow is calculated as follows:
USD 47,418.35
= 47,397.81
60
1 + 0.0026 360
!"#
= !"#
= 105.438 0.01222180*
= 1.2886
*The JPY/USD rate is calculated as the inverse of the USD/JPY rate. Since the bid is the
lower of the two inverse amounts, 0.01222180 and 0.01222210, the bid-offer spread is
0.01222180/0.01222210.
Based on the interbank-implied cross rate of 1.2886/1.2887, the dealer is posting an offer rate
to sell the USD cheaply, at a rate below the interbank market bid (1.2816 vs. 1.2886,
respectively). Therefore, a triangular arbitrage would involve buying USD from the dealer
selling it in the interbank market.
A is incorrect. The dealers offer of 1.4862 is lower than the interbank bid of 1.4863. It is
possible to buy USD from the dealer and sell it in the interbank market and earn a profit.
C is incorrect. The dealer bid of 1.4867 is higher than the interbank offer of 1.4865. It is
possible to buy USD from the interbank and sell it to the dealer.
A is most likely correct. As stated in the preceding paragraph, Eorias domestic currency
should depreciate because of its current account deficit.
C is most likely correct. Relatively long lags can occur between changes in exchange rates,
the ultimate adjustment in traded good prices and the eventual impact on import demand,
export demand, and the underlying current account imbalance.
B is most likely correct. A tight fiscal policy will put downward pressure on domestic interest
rates. With a decrease in Belares yield, the interest rate differential, iH iL, should decline.