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Question 1
a) Define interest rate parity. What is the
relationship between interest rate parity and
forward rates?

b) Define the terms covered interest
arbitrage and uncovered interest arbitrage .
What is the differences between these two
transaction?
a) Interest rate parity (IRP)

Is the differences in the national interest rates
for securities of similar risk and maturity
should be equal. So when IRP is hold ,
there is no covered interest and arbitrage
profit.(profit=Costs )

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The relationship between IRP and forward rates
If the HC have high interest than FC .When HC is at
forward discount that is F>S. HC is expected to
depreciate against the FC . If so ,HC interest rate
should be higher than the FC to compensate for the
expected depreciation of the HC. If not nobody will
hold HC securities

If HC low interest than FC , when HC is at forward
premium that is F<S , This has indicate that the
forward exchange rate will deviate from the spot rate
as long as of the 2 countries are not same

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When IRP hold , we able to in different between our
investing money in HC and FC with forward
hedging.

If IPR violated, we will better off by investing in HC
(FC) if (1+i$)is greater (LESS) than (F/S)(1+i).
When need borrow , we will choose to borrow the
currency interest rate is lower.
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b) Coverage interest arbitrage (CIA) is an arbitrage
trading strategy whereby an investor capitalize on
the interest rate differential between two countries
by using two a forward contract to cover exchange
rate risk.

Uncovered interest arbitrage (UIA) wherein investors
borrow in currency exhibiting relatively low interest
rates and convert the proceeds into the currency
which offer higher interest rates
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The differences
CIA have the similar way like IRP even the spot and
forward exchange market not always state in
equilibrium but it have the opportunity for low
riskless arbitrage exist and have a higher return on a
cover forward basis by entering the contract to
hedging the risk.

UIA-it has high risk high return because they buy in
lower price and sell in high price at the future spot
rate without entering any forward contract.
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8
Peter Solskjaer is a foreign exchange dealer for a bank
in Manchester. He has 2,000,000 (or its Singapore
dollar equivalent) for a short-term money market
investment. He wonders if he should invest in pounds
sterling or make a covered interest arbitrage investment
in the Singapore dollar. He faces the following rates.

Spot exchange rate S$ 2.9880/
3-month forward rate S$ 3.0000/
3-month UK interest rate 3% p.a.
3-month Singapore interest rate 5% p.a.

Which countrys money market do you recommend
Solskjaer to invest? Why? Calculate the arbitrage profit
or loss in ?

90 days
Pound money market
Singapore dollar money market
2,000,000
2,015,000
2,016,900
S = S$ 2.9880/
S$ 5,976,000 S$ 6,050,700
F
90
= S$ 3.0000/
x 1.0125
x 1.0075
Start
End
i

= 3% per annum
(0.0075 % per 90 days)
1 + (0.03 x 90/360)
i
S$
= 5% per annum
(1.25% per 90 days)
1 + (0.05 x 90/360)
Profit
of
1900
Arbitrag
e
potential
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Question 3
Mary Smith is a foreign exchange dealer for a bank in New
York City. She has $1,000,000 (or its Swiss franc equivalent)
for a short-term money market investment and wonder if
she should invest in U.S. dollars or make a covered interest
arbitrage investment in the Swiss franc. She faces the
following rates.
Spot exchange rate SF 1.6000/$
3-month forward rate SF 1.5800/$
3-month US interest rate 8% p.a.
3-month Swiss interest rate 6% p.a.

(a) Where do you recommend Ms Smith to invest?
Why? Calculate the arbitrage profit/loss?

US interest rate 8% p.a.
Start
$1,000,000 x1.02 $1,020,000 Arbitrage
1+(0.08x90/360) $1,164,556.96 Potential

Dollar money market
S= SF 1.6000/$ F= SF1.5800/$




Swiss franc market
SF 1,600,000 X1.15 SF 1,840,000
1 + (0.06x90/360)
Swiss interest rate 6% p.a.

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90 Days
CIA profit
$1,164,556.96 - $1,020,000
= $144,556.96

CIA annualised rate of return
= (1+($144,556/$1,000,000)360/90 -1
=0.716 =71.6%


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Question 4

Walcott Ltd, a Belgian company with
subsidiaries all over Southeast Asia, has
been funding its Kuala Lumpur subsidiary
primarily with euros debt because of the
cost and availability of euros capital as
opposed to Ringgit Malaysia (RM) funds.
The Finance Director of Walcott (Malaysia)
Sdn. Bhd. is considering a one-year bank
loan for 1,800,000. The current spot
exchange rate is RM 4.1000/, and the euro-
based interest is 6.80% for the one year
period.

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Malaysia Inflation Rate is 5%
Europe Inflation Rate is 2%
Spot Exchange Rate is RM 4.10/

Answer (4a)

360
=RM 4.10/ X
1+0.05
1+0.02

= RM 4.22/
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Euro-based Interest 6.80%
Borrow from Public Bank Berhad at 8.30% per
annum

Answer (5b)
Step 1
1,800,000 X 1.068 = 1922400

Step 2
1,800,000 X RM 4.10/ = RM7,380,000


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Step 3
RM 7,380,000 X 1.083 = RM 7,992,540

Step 4
RM 7,992,540 RM 4.10/ = 1,949,400

Conclusion
(b) Is more cost effective than (a) because it
generates higher return.
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Question 5.
(a) When will an opportunity for locational arbitrage profits
arise?

Locational arbitrage arise when a banks buying price (bid
price) is higher than another banks selling price (ask price) for
the same currency

Eg: Bid Ask

Bank A $.635/NZ$ $.640
Bank B $.645 $.650

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Question 5
(b) Podolski Swiensteiger holds MZ$ 500,000. Given the following
quotes, what is the amount of locational arbitrage profits in NZ$
terms that he could earn?
Bid Ask
Kiwi Bank NZ$1.3530/$ NZ$1.3580/$
Auckland Bank NZ$1.3400/$ NZ$1.3450/$


1
st
: NZ$ 500,000 invest in $ @ NZ$1.3450/$ from Auckland Bank
so, NZ$ 500,000 / NZ$1.3450 = $371747.212

2
nd
: sell $371747.212 @ NZ$1.3530/$ to Kiwi Bank
so, $371747.212 x NZ$1.3530 = NZ$502973.978

3th: NZ$502973.978 NZ$ 500,000 = NZ$2973.978 (locational
arbitrage profit)





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Question 6

Suppose that the current spot exchange rate
is 1.06/$ and the three-month forward
exchange rate is 1.02/$. The three-month
interest rate is 5.6 percent per annum in the
United States and 5.40 percent per annum in
France. Assume that you can borrow up to
$1,000,000 or 1,060,000.
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Current Spot Rate, 1.06 / $
3 months Forward exchange rate , 1.02/$
Interest rate in US = 5.6 p.a. (5.6 %
90
360
= 1.4%)
Interest rate in France = 5.4 p.a. (5.4%
90
360
= 1.35%)
Money $ 1,000,000 or 1,060,000
(a)Show how to realize a certain profit via
covered interest arbitrage, assuming that you
want to realize profit in terms of U.S. dollars.
Also determine the size of your arbitrage profit.
Answer 6(a)
Step1
A : Numerator : France : FC :
B : Denominator : US : HC : $

Step2
Interest Differential =

$

= 5.4% - 5.6%
= -0.2%
Step 3
/ $ (Indirect Quote) FC/HC
f
FC
=


X
360

X 100
=
1.061.02
1.02

360
90
100
= 15.69% (forward premium for euro(Currency A), forward
discount for dollar(Currency B) )
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Step 4
Interest Differential < Forward Discount on US
dollar
-0.2 < -15.69%
(Invest in France ) (Borrow from US $)
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Borrow US dollar rate = 5.6 % per annum
90 days
Dollar money market
Euro money market
$1,000,000 $1,014,000
$1,053,245
$ 39,245
S= 1.06/$
1,060,000 1,074,310
F
90
= 1.02/$
x 1.0135
x 1.014
Start
End
Invest Euro currency rate = 5.4% per annum
Borrow
Earn
Profit
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(b) Assume that you want to realize
profit in terms of euros. Show the
covered arbitrage process and
determine the arbitrage profit in euros.
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Step1
A : Denominator : US : FC : $
B : Numerator : France : HC :

Step2
Interest Differential =

$

= 5.4% - 5.6%
= -0.2%
Step 3
/ $ (direct Quote) HC/FC
f
FC
=


X
360

X 100

=
1.021.06
1.06

360
90
100

= -15.09% (forward discount for dollar (Currency B) )
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Step 4
Interest Differential < Forward Discount on Currency
France
-0.2 < -15.09%
(Invest in France ) (Borrow from US $)

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Borrow US dollar rate = 5.6 % per annum
90 days
Dollar money market
Euro money market
$1,000,000 $1,014,000
$1,053,245
$ 39,245
S= 1.06/$
1,060,000 1,074,310
F
90
= 1.02/$
x 1.0135
x 1.014
Start
End
Invest Euro currency rate = 5.4% per annum
Borrow
Earn
Profit
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