Question 1

The interest rate in South Africa is 8 percent. The interest rate in the United States is 5 percent. The South African forward rate should exhibit a premium of about 3 percent.

Accepted Answer

The relationship between interest rates and forward rate premiums or discounts is determined by the interest rate parity theory, which suggests that the difference in interest rates between two countries will be equal to the difference between the spot exchange rate and the forward exchange rate. However, this does not directly translate to the forward rate exhibiting a premium or discount equal to the interest rate differential. Other factors such as market expectations, inflation rates, and economic conditions also play a role in determining forward rates.

Question 2

If interest rate parity (IRP) does not hold, there is still the possibility that covered interest arbitrage is not worthwhile because of such factors as transaction costs, currency restrictions, and differential tax laws.

Accepted Answer

Even if IRP does not hold, covered interest arbitrage may not be profitable due to other factors such as transaction costs, currency restrictions, and differential tax laws.

Question 3

If interest rate parity (IRP) exists, then foreign investors will earn the same returns as U.S. investors.

Accepted Answer

False

Question 4

Assume that the real interest rate in the United States and in the United Kingdom is 3 percent. The expected annual inflation in the United States is 3 percent, while in the United Kingdom it is 4 percent. The forward rate on the pound should exhibit a premium of about 1 percent.

Accepted Answer

The answer of Assume that the real interest rate in...

Question 5

If interest rate parity (IRP) exists, then the rate of return achieved from covered interest arbitrage should be equal to the rate available in the foreign country.

Accepted Answer

The answer of If interest rate parity (IRP) exists, then...

Question 6

Locational arbitrage explains why spot exchange rates among banks at different locations normally will not differ by a significant amount.

Accepted Answer

Locational arbitrage refers to the practice of exploiting small differences in exchange rates among different locations. In this process, market participants buy currency at a low exchange rate in one location and then sell it in another location where the exchange rate is higher. The resulting transactions help to reduce any discrepancies in exchange rates among different locations. As a result, spot exchange rates among banks at different locations normally will not differ by a significant amount.

Question 7

The larger the degree by which the foreign interest rate exceeds the home interest rate, the larger will be the forward discount of the foreign currency specified by the interest rate parity (IRP) formula.

Accepted Answer

According to the interest rate parity formula, if the foreign interest rate is higher than the home interest rate, the forward discount of the foreign currency will increase. So, the larger the degree of difference between the two rates, the larger will be the forward discount of the foreign currency.

Question 8

Arbitrage involves capitalizing on a discrepancy in quoted prices in an attempt to make a profit, but it entails substantial risk.

Accepted Answer

Arbitrage typically involves exploiting price discrepancies between markets to make a profit with minimal risk, as the strategy usually involves simultaneous buying and selling to hedge against market movements.

Question 9

Capitalizing on discrepancies in quoted prices involving no risk and no investment of funds is referred to as interest rate parity.

Accepted Answer

Interest rate parity is a theory that explains the relationship between interest rates and currency exchange rates, ensuring that arbitrage opportunities due to interest rate differentials are minimized or eliminated. Capitalizing on discrepancies in quoted prices with no risk and no investment is referred to as arbitrage, not interest rate parity.

Question 10

If interest rate parity (IRP) exists, then triangular arbitrage will not be possible.

Accepted Answer

Interest rate parity (IRP) relates to the relationship between interest rates and exchange rates, while triangular arbitrage involves exploiting discrepancies between three currencies. They are separate concepts, and the existence of IRP does not necessarily prevent triangular arbitrage opportunities.

Question 11

The equilibrium state in which covered interest arbitrage is no longer possible is called interest rate parity (IRP).

Accepted Answer

Interest rate parity (IRP) is a condition in which the covered interest rate differential between two currencies is equal to the ratio of the spot exchange rate and the forward exchange rate. When IRP holds true, covered interest arbitrage is no longer possible. Therefore, the statement "The equilibrium state in which covered interest arbitrage is no longer possible is called interest rate parity (IRP)" is true.

Question 12

Locational arbitrage is focused on capitalizing on the difference in nominal interest rates in two different locations.

Accepted Answer

Locational arbitrage exploits differences in exchange rates in different money markets, not differences in nominal interest rates.

Question 13

The yield curve for the United States normally has an upward slope, meaning that the annualized interest rate is higher for longer terms to maturity.

Accepted Answer

This is typically the case, as investors demand a higher return for tying up their money for a longer period of time.

Question 14

Interest rate parity (IRP) states that the foreign currency's forward rate premium or discount is roughly equal to the interest rate differential between the United States and the foreign country.

Accepted Answer

Interest rate parity is a theory that states that the difference between the forward exchange rate and the spot exchange rate should be equal to the difference between the interest rates of the two countries. This relationship is based on the idea that investors should be indifferent between investing in one currency or another, as the return should be the same due to the interest rate differential being reflected in the forward exchange rate.

Question 15

Triangular arbitrage tends to force a relationship between the interest rates of two countries and their forward exchange rate premium or discount.

Accepted Answer

Triangular arbitrage involves taking advantage of discrepancies between three currencies in the foreign exchange market, not directly influencing the relationship between interest rates of two countries and their forward exchange rate premium or discount.

Question 16

Locational arbitrage involves investing in a foreign country and covering against exchange rate risk by engaging in forward contracts.

Accepted Answer

Locational arbitrage involves taking advantage of price differences for the same asset in different markets, not investing in foreign countries and hedging against exchange rate risk.

Question 17

Assume locational arbitrage is possible and involves two different banks. The realignment that would occur due to market forces would increase one bank's ask rate and would decrease the other bank's bid rate.

Accepted Answer

Locational arbitrage involves taking advantage of price differences between different locations. If one bank is offering a higher bid rate and another bank is offering a lower ask rate, an arbitrage opportunity exists. This would cause market forces to realign, increasing the bank's ask rate and decreasing the other bank's bid rate to eliminate the price discrepancy.

Question 18

From the U.S. perspective, an example of a cross exchange rate is the exchange rate between a non-U.S. country and the United States.

Accepted Answer

A cross exchange rate is the exchange rate between two currencies, neither of which is the official currency of the country in which the exchange rate quote is given.

Question 19

For locational arbitrage to be possible, one bank's ask rate must be higher than another bank's bid rate for a currency.

Accepted Answer

For locational arbitrage to be possible, one bank's ask rate must be lower than another bank's bid rate for a currency, allowing a trader to buy low and sell high.

Question 20

Triangular arbitrage involves 3 transactions that must be executed at a single bank.

Accepted Answer

Triangular arbitrage involves taking advantage of discrepancies in exchange rates between three different currencies. This can be done at different banks or financial institutions, not necessarily a single bank.

Quiz 7: International Arbitrage and Interest Rate Parity