International Arbitrage and Interest Rate Parity: Comprehensive Exam Study Guide, Exams of Business Economics

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1. 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. a. forward realignment arbitrage b. triangular arbitrage c. covered interest arbitrage d. locational arbitrage

ANS: C PTS: 1

2. Due to , market forces should realign the spot rate of a currency among banks. a. forward realignment arbitrage b. triangular arbitrage c. covered interest arbitrage d. locational arbitrage

ANS: D PTS: 1

3. 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. a. forward realignment arbitrage b. triangular arbitrage c. covered interest arbitrage d. locational arbitrage

ANS: B PTS: 1

4. If interest rate parity exists, then is not feasible. a. forward realignment arbitrage b. triangular arbitrage c. covered interest arbitrage d. locational arbitrage

ANS: C PTS: 1

5. In which case will locational arbitrage most likely be feasible? a. One bank's ask price for a currency is greater than another bank's bid price for the currency. b. One bank's bid price for a currency is greater than another bank's ask price for the currency. c. One bank's ask price for a currency is less than another bank's ask price for the currency. d. One bank's bid price for a currency is less than another bank's bid price for the currency.

ANS: B PTS: 1

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d. upward pressure on the euro's interest rate.

ANS: B PTS: 1

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12. 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? a. upward pressure on the Swiss franc's spot rate. b. upward pressure on the U.S. interest rate. c. downward pressure on the Swiss interest rate. d. upward pressure on the Swiss franc's forward rate.

ANS: D PTS: 1

13. 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? a. spot rate of peso increases; forward rate of peso decreases. b. spot rate of peso decreases; forward rate of peso increases. c. spot rate of peso decreases; forward rate of peso decreases. d. spot rate of peso increases; forward rate of peso increases.

ANS: A PTS: 1

14. 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? a. $15,385. b. $15,625. c. $22,136. d. $31,250.

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

PTS: 1

15. Based on interest rate parity, the larger the degree by which the foreign interest rate exceeds the U.S. interest rate, the: a. larger will be the forward discount of the foreign currency. b. larger will be the forward premium of the foreign currency. c. smaller will be the forward premium of the foreign currency. d. smaller will be the forward discount of the foreign currency.

ANS: A PTS: 1

16. Assume the following information:

You have $1,000,000 to invest: Current spot rate of pound = $1. 90-day forward rate of pound = $1.

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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? a. $1,024,000. b. $1,030,000. c. $1,040,000. d. $1,034,000. e. none of the above

ANS: A SOLUTION: $1,000,000/$1.30 = 769,231 pounds  (1.04) = 800,000 pounds  1.28 = $1,024,

PTS: 1

17. Assume that the U.S. interest rate is 10%, while the British interest rate is 15%. If interest rate parity exists, then: a. British investors who invest in the United Kingdom will achieve the same return as U.S. investors who invest in the U.S. b. U.S. investors will earn a higher rate of return when using covered interest arbitrage than what they would earn in the U.S. c. U.S. investors will earn 15% whether they use covered interest arbitrage or invest in the U.S. d. U.S. investors will earn 10% whether they use covered interest arbitrage or invest in the U.S.

ANS: D PTS: 1

18. Assume the following information:

U.S. investors have $1,000,000 to invest: 1 - year deposit rate offered on U.S. dollars = 12% 1 - year deposit rate offered on Singapore dollars = 10% 1 - year forward rate of Singapore dollars = $. Spot rate of Singapore dollar = $.

Given this information: a. interest rate parity exists and covered interest arbitrage by U.S. investors results in the same yield as investing domestically. b. interest rate parity doesn't exist and covered interest arbitrage by U.S. investors results in a yield above what is possible domestically. c. interest rate parity exists and covered interest arbitrage by U.S. investors results in a yield above what is possible domestically. d. interest rate parity doesn't exist and covered interest arbitrage by U.S. investors results in a yield below what is possible domestically.

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ANS: B

SOLUTION: $1,000,000/$.400^ = S$2,500,000  (1.1)

= S$2,750,000  $.412 = $1,133,

Yield = ($1,133,000  $1,000,000)/$1,000,000 = 13.3% This yield exceeds what is possible domestically.

PTS: 1

19. Assume the following information:

Current spot rate of New Zealand dollar = $. Forecasted spot rate of New Zealand dollar 1 year from now = $. One-year forward rate of the New Zealand dollar = $. Annual interest rate on New Zealand dollars = 8% Annual interest rate on U.S. dollars = 9%

Given the information in this question, the return from covered interest arbitrage by U.S. investors with $500,000 to invest is %. a. about 11. b. about 9. c. about 11. d. about 11. e. about 10.

ANS: E SOLUTION: $500,000/$.41^ = NZ$1,219,512  (1.08) = NZ$1,317,073  .42 = $553, Yield = ($553,171  $500,000)/$500,000 = 10.63%

PTS: 1

20. Assume the following bid and ask rates of the pound for two banks as shown below:

Bid Ask Bank A $1.41 $1. Bank B $1.39 $1.

As locational arbitrage occurs: a. the bid rate for pounds at Bank A will increase; the ask rate for pounds at Bank B will increase. b. the bid rate for pounds at Bank A will increase; the ask rate for pounds at Bank B will decrease. c. the bid rate for pounds at Bank A will decrease; the ask rate for pounds at Bank B will decrease. d. the bid rate for pounds at Bank A will decrease; the ask rate for pounds at Bank B will increase.

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21. Assume the bid rate of a Singapore dollar is $.40 while the ask rate is $.41 at Bank X. Assume the bid rate of a Singapore dollar is $.42 while the ask rate is $.425 at Bank Z. 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? a. $11,764. b. (^) $11,964. c. $36,585. d. $24,390. e. $18,219.

ANS: D SOLUTION: $1,000,000/$.41 = S2,439,024  $.42 = $1,024,

PTS: 1

22. Based on interest rate parity, the larger the degree by which the U.S. interest rate exceeds the foreign interest rate, the: a. larger will be the forward discount of the foreign currency. b. larger will be the forward premium of the foreign currency. c. smaller will be the forward premium of the foreign currency. d. smaller will be the forward discount of the foreign currency.

ANS: B PTS: 1

23. Assume the following exchange rates: $1 = NZ$3, NZ$1 = MXP2, and $1 = MXP5. Given this information, as you and others perform triangular arbitrage, the exchange rate of the New Zealand dollar (NZ) with respect to the U.S. dollar should , and the exchange rate of the Mexican peso (MXP) with respect to the U.S. dollar should. a. appreciate; depreciate b. depreciate; appreciate c. depreciate; depreciate d. appreciate; appreciate e. remain stable; appreciate

ANS: A PTS: 1

24. Assume the following information:

Spot rate today of Swiss franc = $. 1- year forward rate as of today for Swiss franc = $. Expected spot rate 1 year from now = $. Rate on 1-year deposits denominated in Swiss francs = 7% Rate on 1-year deposits denominated in U.S. dollars = 9%

From the perspective of U.S. investors with $1,000,000, covered interest arbitrage would yield a rate of return of %. a. 5. b. 12.

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c. 15. d. 14. e. 11.

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d. A and B e. None of the above

ANS: E PTS: 1

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28. Assume the U.S. interest rate is 2% higher than the Swiss rate, and the forward rate of the Swiss franc has a 4% premium. Given this information: a. Swiss investors who attempt covered interest arbitrage earn the same rate of return as if they invested in Switzerland. b. U.S. investors who attempt covered interest arbitrage earn a higher rate of return than if they invested in the U.S. c. A and B d. none of the above

ANS: B PTS: 1

29. Assume that British interest rates are higher than U.S. rates, and that the spot rate equals the forward rate. Covered interest arbitrage puts pressure on the pound's spot rate, and pressure on the pound's forward rate. a. downward; downward b. downward; upward c. upward; downward d. upward; upward

ANS: C PTS: 1

30. Assume that interest rate parity holds, and the euro's interest rate is 9% while the U.S. interest rate is 12%. Then the euro's interest rate increases to 11% while the U.S. interest rate remains the same. As a result of the increase in the interest rate on euros, the euro's forward will in order to maintain interest rate parity. a. discount; increase b. discount; decrease c. premium; increase d. premium; decrease

ANS: D PTS: 1

31. Assume the bid rate of a Swiss franc is $.57 while the ask rate is $.579 at Bank X. Assume the bid rate of the Swiss franc is $.560 while the ask rate is $.566 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? a. $7,067. b. $8,556. c. $10,114. d. $12,238.

ANS: A SOLUTION: $1,000,000/$.566 = SF1,766,784  $.57 = $1,007,067. Thus, the profit is $7,067.

PTS: 1

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34. Assume the following information:

Current spot rate of Australian dollar = $. Forecasted spot rate of Australian dollar 1 year from now = $. 1-year forward rate of Australian dollar = $. Annual interest rate for Australian dollar deposit = 9% Annual interest rate in the U.S. = 6%

Given the information in this question, the return from covered interest arbitrage by U.S. investors with $500,000 to invest is %. a. about 6. b. about 9. c. about 7. d. about 8. e. about 5.

ANS: E SOLUTION: $500,000/$.64 (^) = A$781,250  (1.09) = A$851,563  $.62 = $527, Yield = ($527,969  $500,000)/$500,000 = 5.59%

PTS: 1

35. Assume the following bid and ask rates of the pound for two banks as shown below:

Bid Ask Bank C $1.61 $1. Bank D $1.58 $1.

As locational arbitrage occurs: a. the bid rate for pounds at Bank C will increase; the ask rate for pounds at Bank D will increase. b. the bid rate for pounds at Bank C will increase; the ask rate for pounds at Bank D will decrease. c. the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will decrease. d. the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will increase.

ANS: D PTS: 1

36. Assume the bid rate of an Australian dollar is $.60 while the ask rate is $.61 at Bank Q. Assume the bid rate of an Australian dollar is $.62 while the ask rate is $.625 at Bank V. 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? a. $10,003.

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b. $12,063. c. $14,441. d. $16,393. e. $18,219.

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d. converting funds to a foreign currency and investing the funds overseas.

ANS: C PTS: 1

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40. You just received a gift from a friend consisting of 1,000 Thai baht, which you would like to exchange for Australian dollars (A$). You observe that exchange rate quotes for the baht are currently $.023, while quotes for the Australian dollar are $.576. How many Australian dollars should you expect to receive for your baht? a. A$39.93. b. A$25,043.48. c. A$553.00. d. none of the above

ANS: A SOLUTION: (^) $.023/$.576  THB1,000 = A$39.93.

PTS: 1

41. National Bank quotes the following for the British pound and the New Zealand dollar:

Quoted Bid Price Quoted Ask Price Value of a British pound (£) in $ $1.61 $1. Value of a New Zealand dollar (NZ$) in $ $.55 $. Value of a British pound in New Zealand dollars NZ$2.95 NZ$2.

Assume you have $10,000 to conduct triangular arbitrage. What is your profit from implementing this strategy? a. $77.64. b. $197.53. c. $15.43. d. $111.80.

ANS: C SOLUTION: $10,000/$1.62^ = £6,172.84  2. = NZ$18,209.88  $. = $10,015.43. Thus, the profit is $15.43.

PTS: 1

42. Assume the following information:

You have $900,000 to invest: Current spot rate of Australian dollar (A$) = $. 180-day forward rate of the Australian dollar = $. 180-day interest rate in the U.S. = 3.5% 180-day interest rate in Australia = 3.0%

If you conduct covered interest arbitrage, what is the dollar profit you will have realized after 180 days?