PROBLEMS 1. Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months.

he six!month interest rate is " percent per annum in the #nite$ States an$ % percent per annum in &erman'. (urrent)', the spot exchan*e rate is +1.01 per $o))ar an$ the six!month for,ar$ exchan*e rate is +0.-- per $o))ar. he treasurer of IBM $oes not ,ish to .ear an' exchan*e ris/. 0here shou)$ he1she invest to maximi2e the return3 he mar/et con$itions are summari2e$ as fo))o,s4 I$ 5 678 i+ 5 9.:78 S 5 +1.011$8 ; 5 +0.--1$. If $100,000,000 is investe$ in the #.S., the maturit' va)ue in six months ,i)) .e $106,000,000 5 $100,000,000 <1 = .06>. ?)ternative)', $100,000,000 can .e converte$ into euros an$ investe$ at the &erman interest rate, ,ith the euro maturit' va)ue so)$ for,ar$. In this case the $o))ar maturit' va)ue ,i)) .e $10:,:-0,-0- 5 <$100,000,000 x 1.01><1 = .09:><110.--> 9. (urrent)', the spot exchan*e rate is $1.:01@ an$ the three!month for,ar$ exchan*e rate is $1.:A1@. he three!month interest rate is ".07 per annum in the #.S. an$ :."7 per annum in the #.B. ?ssume that 'ou can .orro, as much as $1,:00,000 or @1,000,000. a. Cetermine ,hether the interest rate parit' is current)' ho)$in*. .. If the IRP is not ho)$in*, ho, ,ou)$ 'ou carr' out covere$ interest ar.itra*e3 Sho, a)) the steps an$ $etermine the ar.itra*e profit. c. Exp)ain ho, the IRP ,i)) .e restore$ as a resu)t of covere$ ar.itra*e activities. So)ution4 LetDs summari2e the *iven $ata first4 S 5 $1.:1@8 ; 5 $1.:A1@8 I$ 5 A.078 I@ 5 1.6:7 (re$it 5 $1,:00,000 or @1,000,000. a. <1=I$> 5 1.0A <1=I@><;1S> 5 <1.016:><1.:A11.:0> 5 1.0A"0 hus, IRP is not ho)$in* exact)'. .. <1> Borro, $1,:00,0008 repa'ment ,i)) .e $1,:90,000. <A> Bu' @1,000,000 spot usin* $1,:00,000. <9> Invest @1,000,000 at the poun$ interest rate of 1.6:78 maturit' va)ue ,i)) .e @1,016,:00. <6> Se)) @1,016,:00 for,ar$ for $1,:6A,060
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?r.itra*e profit ,i)) .e $1A,060 c. ;o))o,in* the ar.itra*e transactions $escri.e$ a.ove, he $o))ar interest rate ,i)) rise8 he poun$ interest rate ,i)) fa))8 he spot exchan*e rate ,i)) rise8 he for,ar$ exchan*e rate ,i)) fa)). hese a$Eustments ,i)) continue unti) IRP ho)$s. :. In the issue of Octo.er A9, 1---, the Economist reports that the interest rate per annum is :.-97 in the #nite$ States an$ F0.07 in ur/e'. 0h' $o 'ou thin/ the interest rate is so hi*h in ur/e'3 Base$ on the reporte$ interest rates, ho, ,ou)$ 'ou pre$ict the chan*e of the exchan*e rate .et,een the #.S. $o))ar an$ the ur/ish )ira3 So)ution4 ? hi*h ur/ish interest rate must ref)ect a hi*h expecte$ inf)ation in ur/e'. ?ccor$in* to

internationa) ;isher effect <I;E>, ,e have E<e> 5 i$ ! iLira 5 :.-97 ! F0.07 5 !%6.0F7 he ur/ish )ira thus is expecte$ to $epreciate a*ainst the #.S. $o))ar .' a.out %67. F. <(;? Guestion> Omni ?$visors, an internationa) pension fun$ mana*er, uses the concepts of purchasin* po,er parit' <PPP> an$ the Internationa) ;isher Effect <I;E> to forecast spot exchan*e rates. Omni *athers the financia) information as fo))o,s4 Base price )eve) (urrent #.S. price )eve) (urrent South ?frican price )eve) Base ran$ spot exchan*e rate (urrent ran$ spot exchan*e rate Expecte$ annua) #.S. inf)ation Expecte$ annua) South ?frican inf)ation Expecte$ #.S. one!'ear interest rate Expecte$ South ?frican one!'ear interest rate 100 10: 111 $0.1F: $0.1:" F7 :7 107 "7

(a)cu)ate the fo))o,in* exchan*e rates <H?R an$ #SC refer to the South ?frican an$ #.S. $o))ar, respective)'>.
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a. he current H?R spot rate in #SC that ,ou)$ have .een forecast .' PPP. .. #sin* the I;E, the expecte$ H?R spot rate in #SC one 'ear from no,. c. #sin* PPP, the expecte$ H?R spot rate in #SC four 'ears from no,. So)ution4 a. H?R spot rate un$er PPP 5 I1.0:11.11J<0.1F:> 5 $0.1%::1ran$. .. Expecte$ H?R spot rate 5 I1.1011.0"J <0.1:"> 5 $0.1%0-1ran$. c. Expecte$ H?R un$er PPP 5 I<1.0F>61<1.0:>6J <0.1:"> 5 $0.1F061ran$. -. Cue to the inte*rate$ nature of their capita) mar/ets, investors in .oth the #.S. an$ #.B. reGuire the same rea) interest rate, A.:7, on their )en$in*. here is a consensus in capita) mar/ets that the annua) inf)ation rate is )i/e)' to .e 9.:7 in the #.S. an$ 1.:7 in the #.B. for the next three 'ears. he spot exchan*e rate is current)' $1.:01@. a. (ompute the nomina) interest rate per annum in .oth the #.S. an$ #.B., assumin* that the ;isher effect ho)$s. .. 0hat is 'our expecte$ future spot $o))ar!poun$ exchan*e rate in three 'ears from no,3 c. (an 'ou infer the for,ar$ $o))ar!poun$ exchan*e rate for one!'ear maturit'3 So)ution. a. Komina) rate in #S 5 <1=L> <1=E<M$>> N 1 5 <1.0A:><1.09:> N 1 5 0.0%0- or %.0-7. Komina) rate in #B5 <1=L> <1=E<MO>> N 1 5 <1.0A:><1.01:> N 1 5 0.0606 or 6.067. .. E<S > 5 I<1.0%0->91<1.0606>9J <1.:0> 5 $1.:-061O. c. ; 5 I1.0%0-11.0606J<1.:0> 5 $1.:A-%1O.

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