Question 1

Assume the following information:
$$\begin{array} { l l r } 
\text { Current spot rate of New Zealand dollar } & = & \$ .41 \
\text { Forecasted spot rate of New Zealand dollar 1 year from now } & = & \$ .43 \
\text { One-year forward rate of the New Zealand dollar } & = & \$ .42 \
\text { Annual interest rate on New Zealand dollars } & = & 8 \% \
\text { Annual interest rate on U.S. dollars } & = & 9 \%
\end{array}$$
Given the information in this question, the return from covered interest arbitrage by U.S. investors with $500,000 to invest is ____%.

Accepted Answer

E

Question 2

Assume the following bid and ask rates of the pound for two banks as shown below:
$\begin{array}{lll} 
& \underline{\text { Bid }} & \underline{\text { Ask }} \
\text { Bank A } & \$ 1.41 & \$ 1.42 \
\text { Bank B } & \$ 1.39 & \$ 1.40
\end{array}$

As locational arbitrage occurs:

Accepted Answer

D

Question 3

Assume that a U.S. firm can invest funds for one year in the U.S. at 12% or invest funds in Mexico at 14%. The spot rate of the peso is $.10 while the one-year forward rate of the peso is $.10. If U.S. firms attempt to use covered interest arbitrage, what forces should occur?

Accepted Answer

If U.S. firms attempt to use covered interest arbitrage, they will borrow in the U.S. at 12% and invest in Mexico at 14%. This will increase the demand for pesos, causing the spot rate of the peso to increase. The forward rate of the peso will also increase, as investors will be willing to pay a premium to lock in the higher future spot rate.

Question 4

Assume that Swiss investors are benefiting from covered interest arbitrage due to a high U.S. interest rate. Which of the following forces results from the act of this covered interest arbitrage?

Accepted Answer

The answer of Assume that Swiss investors are benefiting from...

Question 5

If interest rate parity exists, then ____ is not feasible.

Accepted Answer

Covered interest arbitrage is not feasible if interest rate parity holds, as the parity condition ensures that the returns from investing in different currencies are equal when hedged against exchange rate risk.

Question 6

When using ____, funds are not tied up for any length of time.

Accepted Answer

Locational and triangular arbitrage both involve quick transactions that capitalize on price discrepancies, meaning funds are not tied up for any length of time.

Question 7

Assume that the U.S. investors are benefiting from covered interest arbitrage due to high interest rates on euros. Which of the following forces should result from the act of this covered interest arbitrage?

Accepted Answer

The answer of Assume that the U.S. investors are benefiting...

Question 8

If the interest rate is higher in the U.S. than in the United Kingdom, and if the forward rate of the British pound (in U.S. dollars) is the same as the pound's spot rate, then:

Accepted Answer

The answer of If the interest rate is higher in...

Question 9

Based on interest rate parity, the larger the degree by which the foreign interest rate exceeds the U.S. interest rate, the:

Accepted Answer

Interest rate parity suggests that the currency with the higher interest rate will trade at a forward discount. Therefore, if the foreign interest rate exceeds the U.S. interest rate by a larger degree, the forward discount of the foreign currency will be larger.

Question 10

Assume the following information:
You have $1,000,000 to invest:
$\begin{array} { l l l } 
\text { Current spot rate of pound } & = & \$ 1.30 \
90 \text { - tay forward rate of pound } & = & \$ 1.28 \
\text { 3-month deposit rate in U.S. } & = & 3 \% \
\text { 3-month deposit rate in Great Britain } & = & 4 \%
\end{array}$
If you use covered interest arbitrage for a 90-day investment, what will be the amount of U.S. dollars you will have after 90 days?

Accepted Answer

$1,000,000/$1.30 = 769,231 pounds × (1.04) = 800,000 pounds × 1.28 = $1,024,000

Question 11

When using ____, funds are typically tied up for a significant period of time.

Accepted Answer

Covered interest arbitrage involves borrowing in a low-interest-rate currency, converting to a high-interest-rate currency, and investing in a high-interest-rate financial instrument with the hope of profiting from the interest rate differential. However, to execute this strategy, funds must be tied up for a significant period of time, as the investor must hold the high-interest-rate instrument until maturity to earn the interest.

Question 12

Assume the following information:
U.S. investors have $1,000,000 to invest:
$\begin{array}{lll}
1 \text {-year deposit rate offered on U.S. dollars } & = & 12 \% \
1 \text {-year deposit rate offered on Singapore dollars } & = & 10 \% \
1 \text {-year forward rate of Singapore dollars } & = & \$ .412 \
\text { Spot rate of Singapore dollar } & = & \$ 400
\end{array}$
Given this information:

Accepted Answer

$\begin{aligned} \$ 1,000,000 / \$ .400 & = \mathrm { S } \$ 2,500,000 \times ( 1.1 ) \ & = \mathrm { S } \$ 2,750,000 \times \$ .412 = \$ 1,133,000 \ \text { Yield } = ( \$ 1,133,000 & - \$ 1,000,000 ) / \$ 1,000,000 = 13.3 \% \end{aligned}$
This yield exceeds what is possible domestically.

Question 13

Due to ____, market forces should realign the cross exchange rate between two foreign currencies based on the spot exchange rates of the two currencies against the U.S. dollar.

Accepted Answer

Triangular arbitrage is a process of taking advantage of exchange rate discrepancies between three currencies in the foreign exchange market to create a riskless profit. Due to the law of one price, the cross-exchange rate between two foreign currencies should be in alignment with the ratio of the spot exchange rates of the two currencies with respect to a third currency, usually the U.S. dollar. If the cross-exchange rate deviates from this equilibrium, market forces should realign it through triangular arbitrage.

Question 14

Due to ____, market forces should realign the spot rate of a currency among banks.

Accepted Answer

Locational arbitrage refers to the process of buying a currency at a lower price in one location and selling it at a higher price in another location in the absence of any exchange rate risk. If market forces lead to a discrepancy in the spot rate of a currency among banks, locational arbitrageurs will step in and buy the currency at the lower rate and sell it at the higher rate until the spot rate is realigned across banks. Therefore, due to locational arbitrage, market forces should realign the spot rate of a currency among banks. The other options (forward realignment arbitrage, triangular arbitrage, and covered interest arbitrage) are different types of arbitrage strategies that may not necessarily lead to the realignment of spot rates among banks.

Question 15

In which case will locational arbitrage most likely be feasible?

Accepted Answer

Locational arbitrage involves buying a currency where it is cheapest and selling it where it is most expensive. Thus, if one bank's bid price for a currency is greater than another bank's ask price for the same currency, it implies that the currency is cheaper at one bank, and arbitrageurs can buy from that bank and sell it to the other bank. This will result in a riskless profit as the bid-ask spread will ensure that the trader makes a profit.

Question 16

If the interest rate is lower in the U.S. than in the United Kingdom, and if the forward rate of the British pound is the same as its spot rate:

Accepted Answer

If the interest rate is lower in the U.S. than in the UK, it means that the USD is trading at a forward premium. If the forward rate of the British pound is the same as its spot rate, then there is no arbitrage opportunity for British investors. However, U.S. investors could possibly benefit from covered interest arbitrage by borrowing funds in the U.S. at a lower interest rate, converting them into British pounds, investing them in the UK at a higher interest rate, and then exchanging the pounds back into dollars at the predetermined forward rate. This would result in a profit for the U.S. investors.

Question 17

Assume that the interest rate in the home country of Currency X is a much higher interest rate than the U.S. interest rate. According to interest rate parity, the forward rate of Currency X:

Accepted Answer

According to interest rate parity, if the home country's interest rate is higher than the U.S. interest rate, the forward rate of Currency X should exhibit a discount to offset the interest rate differential.

Question 18

Assume the bid rate of a New Zealand dollar is $.33 while the ask rate is $.335 at Bank X. Assume the bid rate of the New Zealand dollar is $.32 while the ask rate is $.325 at Bank Y. Given this information, what would be your gain if you use $1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the $1,000,000 you started with?

Accepted Answer

SOLUTION:	$1,000,000/$.325 = NZ$3,076,923  $.33 = $1,015,385. Thus, the profit is $15,385.

Question 19

Assume that the U.S. interest rate is 10%, while the British interest rate is 15%. If interest rate parity exists, then:

Accepted Answer

The answer of Assume that the U.S. interest rate is...

Question 20

Due to ____, market forces should realign the relationship between the interest rate differential of two currencies and the forward premium (or discount) on the forward exchange rate between the two currencies.

Accepted Answer

Covered interest arbitrage should lead to a realignment between the interest rate differential of two currencies and the forward premium (or discount) on the forward exchange rate between the two currencies. This is because when there is a discrepancy between the two, investors can borrow in one currency, convert it to another currency, invest it at a higher interest rate, and then hedge the resulting foreign exchange risk with a forward contract. If the forward premium (or discount) is too high (or too low) relative to the interest rate differential, investors will engage in covered interest arbitrage until the two are aligned.

Quiz 7: International Arbitrage and Interest Rate Parity

Assume the following bid and ask rates of the pound for two banks as shown below: $\begin{array}{lll} & \underline{\text { Bid }} & \underline{\text { Ask }} \\\text { Bank A } & \$ 1.41 & \$ 1.42 \\\text { Bank B } & \$ 1.39 & \$ 1.40\end{array}$ As locational arbitrage occurs: