Solutions: SAMPLE 1: EXAM 4: FINA 4500

Short Questions / Problems Section: (84 points)

Q1. (12 points) The table below presents bid-ask quotes for euros from several currency dealers around
the world.
Currency Dealer in Hong Kong Zurich New York London
Bid/Ask Quotes for euros $0.9563-71 $0.9571-76 $.9569-75 $0.9560-70

a) In order to take advantage of locational arbitrage, a currency speculator should: (i) Buy euros from
the London dealer at the ask price, (ii) Sell euros to the Zurich dealer at the bid price
b) Calculate the maximum profit a currency speculator, with access to $2,500,000, can make in one
round trip transaction: $ 2,500,000 / 0.9570 = E 2,612,330.20 ; E 2,612,330.20 X 0.9571 = 2,500,261.23
; Locational arbitrage profit = $261.23
c) If all traders try to maximize profits, then the:
(i) Zurich dealer’s bid price will decrease ; (ii) London dealer’s ask price will increase

Q2. (12 points) The table below presents quotes and cross-quotes on DM and SF.
Price for FF in Price for SF in Price for SF in
New York (in $) Chicago (in $) Zurich (in FF)
$ 0.25 for 1 FF $ 0.75 for 1 SF FF 2.90 for 1 SF

a) Please identify correctly the three steps which will create triangular arbitrage profit:
First step, convert: $ to FF; Second step, convert: FF to SF; Third step, convert: SF to $
b) If the speculator has access to $10,000,000, calculate the maximum profit in one triangular
transaction: $10,000,000 / 0.25 = FF 40,000,000; FF 40,000,000 / 2.90 = SF 13,793,103.45 ;
SF 13,793,103.45 X 0.75 = $ 10,344,827.59 ; Triangular arbitrage profit = $344,827.59
c) How will the prices of each dealer adjust (circle the appropriate words):
The dollar price of FF for the New York dealer will increase; The FF price of SF for the Zurich
dealer will increase; The dollar price of SF for the Chicago dealer will decrease

Q3. (20 points) Please use the exact, not the approximate formula to answer all questions in this section.
Suppose you have a credit line of $10,000,000 in the US and BP 8,000,000 in UK, and that you can
borrow and lend at the prevailing rates of interest in these two countries. Current spot rate of BP =
$1.25; Expected spot rate for BP, one year from now = $1.23 ; Interest rate in the U.S. = 5.00%; Interest
rate in the UK = 7.00%
a) Calculate the covered rate of return, if the 1-year current forward rate for BP is $1.24
FP = (1.24 - 1.25) / 1.25 = = 0.-0.008; Rc = (1 - 0.008)*(1+ 0.075) - 1 = 6.144 %
b) If the current 1-year forward rate for BP is $1.24 and you wanted to set up a covered interest rate
arbitrage, you would: borrow in: US + invest in: UK
c) Based on the previous question, calculate your covered interest arbitrage profit (after paying off the
loan) in dollars: (0.06144 - 0.05) * 10,000,000 = $114,400
d) Based on the previous question, which of the following forces should result from covered interest
arbitrage? Upward pressure on the BP’s spot rate; Downward on the BP’s forward rate
Upward pressure on the U.S. interest rate ; Downward pressure on the UK interest rate
e) Calculate the covered rate of return, if the 1-year current forward rate for BP is $1.22
FP = (1.22 - 1.25) / 1.25 = = 0.-0.024; Rc = (1 - 0.024)*(1+ 0.075) - 1 = 4.432 %
f) If the current 1-year forward rate for BP is $1.22 and you wanted to set up a covered interest rate
arbitrage, you would: borrow in: UK + invest in: US
g) Based on the previous question, which of the following forces should result from covered interest
arbitrage? Downward pressure on the BP’s spot rate ;Upward on the BP’s forward rate
Downward pressure on the U.S. interest rate; Upward pressure on the UK interest rate
h) What should be the current forward premium for BP according to Interest Rate Parity?
FP = (1.05 / 1.07) -1 = -1.869%

Q4. (16 points) Please use the exact, not the approximate formula to answer all questions in this
section. Suppose the annual inflation rate in the US is expected to be 6 %, while it is expected to be 2.5
% in Australia. The current spot rate (on 4/15/03) for the Australian Dollar (AD) is $0.85

a) According to Purchasing Power Parity, estimate the expected percentage change in the value of the
AD during a one-year period: (1.06 / 1.025) - 1 = 3.415 %
b) According to Purchasing Power Parity, estimate expected value of the AD on 3/25/2001.
0.85 ( 1 + 0.03415) = $ 0.8790
c) Suppose the value of the AD is $0.865 on 4/15/04, which country has experienced gain in real
purchasing power? : US
d) If the real rate of interest is expected to be 3% both in US and Australia, use the Fisher model to
calculate the nominal rate of interest in USA: (1.03) * (1.06) - 1 = 9.18%

Q5. (16 points) Please use the exact, not the approximate formula to answer all questions in this
section: Current spot rate of euro = $0.9950 ; Expected spot rate of euro, one year from now = $0.9775 ;
Current 1-year forward rate for euro = $0.9808 ; 1-year interest rate in the U.S. = 4.5% ; 1-year interest
rate in the euro zone = 6.8%
a) Calculate the covered rate of return: FP = (0.9808 - 0.9950) / 0.9950 = - 0.1427;
Rc = (1 - 0.01427)*(1+ 0.068) - 1 = 5.2758%
b) Calculate the uncovered rate of return from the US point of view: % change in SR = (0.9775 -
0.9950) / 0.9950 = -0.01759; Ru = (1 - 0.01759)*(1+ 0.068) - 1 = 4.9216 %
c) If you could borrow and invest at the prevailing rates of interest in both countries, then you should
(choose one): Borrow in US dollars and invest in euros
d) Based on the prevailing rates of interest and FX market prices in both countries, the IFE suggests that
there will be an (i) upward pressure on the current spot rate for euros (ii) downward pressure on the spot
rate for euros, one year latter
e) Based on IFE, calculate the expected spot price of euros one year from now: (1.045 / 1.068) - 1 = -
0.02154; SR1 = 0.9950 (1 - 0.02154) = $ 0.9736

Q6. (8 Points)
Please fill in the blanks with the most appropriate phrases from the phrases listed below:
1. According to the International Fisher Effect, the difference between the domestic and foreign
interest rates has an effect on the percentage difference between the current spot exchange rate
and future spot exchange rate
2. According to the Purchasing Power Parity Theory, the difference between the domestic and
foreign inflation rates has an effect on the percentage difference between the current spot exchange
rate and future spot exchange rate
3. According to the Fisher Effect, the sum of the real rate and inflation premium has an effect on
the nominal rate of interest
4. According to the Interest Rate Parity Theory, the difference between the domestic and foreign
interest rates has an effect on the forward premium or discount

Multiple Choice Section: (8 X 2 = 16 points):

1. According to the IFE, if British interest rates exceed U.S. interest rates: the British pound will
depreciate against the dollar

2. Assume the nominal US interest rate is 3% and the nominal Swiss rate is 6%. The real rate of
interest in both country is 2%. According to the International Fisher Effect, the swiss franc will
depreciate by about 3%

3. According to the International Fisher Effect, if Country X has a much lower nominal rate than
other countries, its inflation rate will likely be lower than other countries, and it currency will
strengthen.

4. Given a home country and foreign country, Purchasing Power Parity (PPP) suggests that:
home currency will depreciate if the current home inflation rate exceeds the current
foreign inflation rate.

5. In which case will locational arbitrage most likely be feasible?

One bank’s bid price for a currency is greater than another bank’s ask price for the
currency.

6. Given a home country and a foreign country, purchasing power parity suggests that:
a. the inflation rates of both countries will be the same
b. the nominal interest rates of both countries will be the same
c. both a and b
d. none of the above

7. According to the International Fisher Effect, if investors in all countries require the same real
rate of return, the differential in nominal interest rate among any two countries:
is due to their inflation differential

8. If interest rate parity exists, then,

covered interest arbitrage is not feasible.