1. Assume the current U.S. dollar-British spot rate is 0.6993£/$. If the current nominal one-year interest rate in the U.S. is 5% and the comparable rate in Britain is 6%, what is the approximate forward exchange rate for 360 days?A) 1.42£/$B) 1.43£/$C) 0.6993£/$D) 0.7060£/$E) 0.6927£/$Answer: D

2: You are given the following exchange rate quotes in Sydney:USD/AUD 0.5366AUD/EUR 1.6428USD/EUR 0.8782

Calculate the US dollar profit, if any, on a three-point arbitrage.A*: USD0.0038 for every 1 USD investedB: USD0.2320 for every 1 USD investedC: USD1.0043 for every 1 USD investedD: NilE. USD0.01873 for every 1 USD invested

3. If the gross domestic return is higher than the gross covered foreign return then:A: the interest parity forward rate is lower than the actual forward rate.B: the interest rate differential is lower than the forward spread.C*: the interest parity forward rate is higher than the actual forward rate.D: the forward discount is higher than the interest rate differential in favor of the

domestic currency assets.E: none of the above.

4. If the net foreign return is lower than the domestic interest rate then:A: the interest parity forward rate is lower than the actual forward rate.B*: the interest parity forward rate is higher than the actual forward rate.C: the interest rate differential is lower than the forward spread.D: the forward discount is higher than the interest differential in favor of the home

currency assets.E: none of the above.

5. If the interest rate differential is three per cent while the forward spread is one per cent then:A: there is a qualitative violation of CIP.B*: there is a quantitative violation of CIP.C: there are both a qualitative and quantitative violation of CIP.D: nothing definite can be stated based on this information only.E: none of the above

6. If the interest rate differential and the forward spread are positive and equal then:A: the foreign currency should offer a higher interest rate and sell at a forward

discount.B: the foreign currency should offer a higher interest rate and sell at a forward

premium.C: the domestic currency should offer a higher interest rate and sell at a forward

premium.

D*: the domestic currency should offer a higher interest rate and sell at a forward discount.

E: A and C.7. If the interest rate differential and the forward spread are negative and equal then:

A: the foreign currency should offer a higher interest rate and sell at a forward premium.

B: the domestic currency should offer a higher interest rate and sell at a forward premium.

C: the domestic currency should offer a higher interest rate and sell at a forward discount.

D: none of the aboveE*: the foreign currency should offer a higher interest rate and sell at a forward

discount.8. If the interest rate differential and the forward spread are positive but the former is lower

than the latter:A: the foreign currency should offer a higher interest rate and sell at a forward

discount.B: the foreign currency should offer a higher interest rate and sell at a forward

premium.C: the domestic currency should offer a higher interest rate and sell at a forward

premium.D*: the domestic currency should offer a higher interest rate and sell at a forward

discount.E: A and C.

9. Under which of the following conditions will outward arbitrage be triggered?A: The interest rate differential and forward spread are positive and the differential

is greater than the spread.B: The interest rate differential and forward spread are negative and the absolute

value of the interest differential is lower than the absolute value of the spread.C*: The interest rate differential and forward spread are positive and the interest

differential is lower than the spread.D: The interest rate differential is positive while the spread is negative.E: B and C.

10. Under which of the following conditions will inward arbitrage be triggered?A: The interest rate differential and forward spread are positive and the differential

is lower than the spread.B*: The interest rate differential and forward spread are negative and the absolute

value of the interest differential is lower than the absolute value of the spread.C: The interest rate differential and forward spread are negative and the absolute

value of the interest differential is greater than the absolute value of the spread.D: The interest rate differential is negative while the spread is positive.E: none of the above.

11. Outward covered arbitrage does not cause:A: a rise in the domestic interest rate.B: a fall in the foreign interest rate.C: a fall in the forward exchange rate.D*: a fall in the spot exchange rate.E: C and D.

12: Inward covered arbitrage does not cause:A: a fall in the domestic interest rate.B: a rise in the foreign interest rate.

C*: a rise in the spot exchange rate.D: a rise in the forward exchange rate.E: D and C.

13. Which of the following statements is true with respect to the CIP hypothesis?A: The CIP hypothesis describes the equilibrium relationship between the spot

exchange rate, the forward exchange rate, domestic interest rates and foreign interest rates.

B: The CIP hypothesis describes the equilibrium relationship between the actual and the interest parity forward rate.

C: The CIP hypothesis was originally developed by Keynes in the 1920s.D: The CIP hypothesis describes the equilibrium relationship between the forward

discount (premium) on the home (foreign) currency and the gross real interest rate differentials.

E: All of the above are true except D.

For questions 15-18, you are given the following information:

Spot exchange rate (AUD/USD) 1.7662Australian three-month interest rate 4.85% paU.S. three-month interest rate 1.41% pa

14. If CIP holds, what will be the three-month forward exchange rate (AUD/USD), according to the precise CIP formula?A: AUD/USD 1.8261B: AUD/USD 1.7083C: AUD/USD 1.7814D*: AUD/USD 1.7813E: AUD/USD 1.8268

15. If CIP holds, what will be the interest differential on domestic and foreign assets, according to the precise CIP formula?A*: 0.00857B: 0.00860C: 0.01213D: 0.00353E: 0.00290

16. If CIP holds, what will be the gross interest differential on domestic and foreign assets, according to the precise CIP formula? A: 1.01213B: 1.00353C*: 1.00857D: 1.00123E: none of the above.

17: If CIP holds, what should be the AUD/USD three-month forward exchange rate, according to the approximate CIP formula?A: AUD/USD 1.8261B: AUD/USD 1.7083C*: AUD/USD 1.7814D: AUD/USD 1.7813E: AUD/USD 1.8268

18. If the positive interest rate differential in favor of the domestic currency is higher than the forward spread, then

A*: the investors around the world are motivated to move their capital funds from the foreign financial markets towards the domestic financial markets.

B: the investors around the world are motivated to move their capital funds from the domestic financial markets towards the foreign financial markets.

C: the investors are around the world are not motivated to move their funds in either direction.

D: All the above are incorrect.E: A and B.

19. If the positive interest rate differential in favor of the foreign currency is lower than the forward spread, thenA: the investors around the world are motivated to move their capital funds from the

domestic financial markets towards the foreign financial markets.B: the investors are around the world are not motivated to move their funds in either

direction.C*: the investors around the world are motivated to move their capital funds from the

foreign financial markets towards the domestic financial markets.D: All the above are incorrect.E: B and C.

20. If the domestic interest rate is lower than the foreign interest rate, thenA: capital funds will always tend to move out of the home country.B*: capital funds will tend to move out of the home country if the home currency

sells at a discount.C: capital funds will not tend to move in either direction.D: All the above are the correct.E: capital funds will tend to move out of the home country if the home currency

sells at a premium.21. If the domestic interest rate is lower than the foreign interest rate, then

A: capital funds will always tend to move out of the home country.B*: capital funds will not tend to move out of the home country unless the interest

differential in favor of the foreign currency is much bigger than the premium on the domestic currency.

C: capital funds will not tend to move in either direction.D: All the above are the correct.E: A and B.

Chicago Bank expects the exchange rate the New Zealand dollar to appreciate from its present level $0.50 to $0.52 in 30 days. The bank is able to borrow $20 million or NZ$40 million on a short-term basis from other bank. Because brokers sometimes serve as intermediaries between banks, the lending rate differs from the borrowing rate. Short-term interest rates (annualized) in the interbank market at which Chicago bank can lend or borrow are as follows:Currency Lending Rate Borrowing RateUS dollars 6.72% 7.20%New Zealand dollars 6.48% 6.96%

Suppose Chicago bank borrows $20 million for 30 days, convert the $20 million to New Zealand dollar to lend in the New Zealand dollar for 30 days and convert the proceeds from the New Zealand dollar loan repayment at the expected spot exchange rate to repay the dollars borrowed to close out its positions on Day 30.

A) Calculate the total US dollar amount necessary to repay the loan.B) Calculate the total New Zealand dollar proceeds that the bank will receive on Day 30.C) Determine whether the bank would make speculative profit or loss.

A. Borrow $20 million at 7.2% for a month

$20(1+0.072/12) = $20,120,000

This is the loan with interest payments to be paid back to a US bank one month later.

B. Convert the funds borrowed ($20) into New Zealand dollar at the spot rate of 1/S to obtain

$20/0.5 = NZ$40 million

Invest NZ$40 million in New Zealand at monthly interest rate of 6.48% to obtain

NZ$40(1+0.0648/12) = N$40, 216,000

C. Sell the proceeds from investment denominated in the New Zealand dollar for the US dollar at the 1-month future spot rate of $0.52 to obtain $20, 912, 320.

Profit = $20, 912, 320 - $20,120,000 = $792,320

(ii) What happens if the Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days?

There is a loss: $19, 303, 680 - $20,120,000 = -$816, 320

22. You are given the following information:Spot exchange rate (AUD/EUR) 1.60One-year forward rate (AUD/EUR) 1.62One-year interest rate on the Australian dollar 8.5%One-year interest rate on the euro 6.5%

(a) Is there any violation of CIP? (b) Calculate the covered margin (going short on the AUD).(c) Calculate the interest parity forward rate and compare it with the actual forward rate.(d) Calculate the forward spread and compare it with the interest differential.(e) What would arbitragers do?(f) If arbitrage is initiated, suggest some values for the interest and exchange rates after it has stopped and equilibrium has been reached.

Solution

(a) Since the forward exchange rate is higher than the spot rate, the EUR is selling at a

premium. Because it offers a lower interest rate, there is no ‘qualitative’ violation of CIP,

in the sense that the low interest currency sells at a premium, not at a discount. Whether

or not there is a ‘quantitative’ violation of CIP can only be known by answering the

following parts of the problem.

(b) The covered margin (going short on the AUD) is calculated as

Since the covered margin is not equal to zero, there is a violation of CIP.

(c) The interest parity forward rate is calculated as

which is higher than the actual forward rate, implying deviations from CIP.

(d) The forward spread and the interest rate differential are calculated as

= 2%

The forward spread and interest rate differential are unequal but have the same sign,

implying a quantitative violation of CIP.

(e) Arbitragers will borrow the euro, convert it into Australian dollars and invest the

proceeds at 8.5 per cent for one year. Upon the maturity of the investment, the proceeds

will be converted back into the euro at the forward rate. The covered margin in this case

is 0.75 percentage points (2 – 1.25).

(f) Arbitrage will come to an end when . If interest rates are unchanged, then the

spot rate must fall to 1.5876. At this rate the covered margin is zero either way (you may

want to confirm this for yourself).