Tutorial 6

1
Question 1
a) Define interest rate parity. What is the
relationship between interest rate parity and
forward rates?

b) Define the terms covered interest
arbitrage and uncovered interest arbitrage .
What is the differences between these two
transaction?
2
a) Interest rate parity (IRP)

Is the differences in the national interest rates for securities
of similar risk and maturity should be equal. So when
IRP is hold , there is no covered interest and arbitrage
profit.(profit=Costs )

3
The relationship between IRP and forward rates
If the HC have high interest than FC .When HC is at forward discount
that is F>S. HC is expected to depreciate against the FC . If so ,HC
interest rate should be higher than the FC to compensate for the
expected depreciation of the HC. If not nobody will hold HC
securities

If HC low interest than FC , when HC is at forward premium that is F<S
, This has indicate that the forward exchange rate will deviate from
the spot rate as long as of the 2 countries are not same

4
When IRP hold , we able to in different between our
investing money in HC and FC with forward hedging.

If IPR violated, we will better off by investing in HC
(FC) if (1+i$)is greater (LESS) than (F/S)(1+i).
When need borrow , we will choose to borrow the
currency interest rate is lower.
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b) Coverage interest arbitrage (CIA) is an arbitrage
trading strategy whereby an investor capitalize on
the interest rate differential between two countries
by using two a forward contract to cover exchange
rate risk.

Uncovered interest arbitrage (UIA) wherein investors
borrow in currency exhibiting relatively low interest
rates and convert the proceeds into the currency
which offer higher interest rates
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The differences
CIA have the similar way like IRP even the spot and forward
exchange market not always state in equilibrium but it have the
opportunity for low riskless arbitrage exist and have a higher return
on a cover forward basis by entering the contract to hedging the risk.

UIA-it has high risk high return because they buy in lower price and
sell in high price at the future spot rate without entering any forward
contract.
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Question
2
Peter Solskjaer is a foreign exchange dealer for a bank in
Manchester. He has 2,000,000 (or its Singapore dollar
equivalent) for a short-term money market investment. He
wonders if he should invest in pounds sterling or make a
covered interest arbitrage investment in the Singapore dollar.
He faces the following rates.

Spot exchange rate S$ 2.9880/
3-month forward rate S$ 3.0000/
3-month UK interest rate 3% p.a.
3-month Singapore interest rate 5% p.a.

Which countrys money market do you recommend Solskjaer
to invest? Why? Calculate the arbitrage profit or loss in ?

8
90 days
Pound money market
Singapore dollar money market
2,000,000 2,015,000
2,016,900
S = S$ 2.9880/
S$ 5,976,000 S$ 6,050,700
F
90
= S$ 3.0000/
x 1.0125
x 1.0075
Start
End
i

= 3% per annum
(0.0075 % per 90 days)
1 + (0.03 x 90/360)
i
S$
= 5% per annum
(1.25% per 90 days)
1 + (0.05 x 90/360)
Profit of
1900
Arbitrage
potential
9
Question 3
Mary Smith is a foreign exchange dealer for a bank in New York
City. She has $1,000,000 (or its Swiss franc equivalent) for a short-
term money market investment and wonder if she should invest
in U.S. dollars or make a covered interest arbitrage investment in
the Swiss franc. She faces the following rates.
Spot exchange rate SF 1.6000/$
3-month forward rate SF 1.5800/$
3-month US interest rate 8% p.a.
3-month Swiss interest rate 6% p.a.

(a) Where do you recommend Ms Smith to invest? Why?
Calculate the arbitrage profit/loss?

10
US interest rate 8% p.a.
Start
$1,000,000 x1.02 $1,020,000 Arbitrage
1+(0.08x90/360) $1,164,556.96 Potential

Dollar money market
S= SF 1.6000/$ F= SF1.5800/$




Swiss franc market
SF 1,600,000 X1.15 SF 1,840,000
1 + (0.06x90/360)
Swiss interest rate 6% p.a.

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90 Days
CIA profit
$1,164,556.96 - $1,020,000 = $144,556.96

CIA annualised rate of return
= (1+($144,556/$1,000,000)360/90 -1
=0.716 =71.6%


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Question 4

Walcott Ltd, a Belgian company with subsidiaries all over
Southeast Asia, has been funding its Kuala Lumpur subsidiary
primarily with euros debt because of the cost and availability
of euros capital as opposed to Ringgit Malaysia (RM) funds.
The Finance Director of Walcott (Malaysia) Sdn. Bhd. is
considering a one-year bank loan for 1,800,000. The current
spot exchange rate is RM 4.1000/, and the euro-based
interest is 6.80% for the one year period.

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(a) assume expected inflation
rates of 5% and 2% in malaysia
and europe for the coming year
respectively. according to
purchasing power parity, what
would the effective cost of funds
be in rm terms?
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Malaysia Inflation Rate is 5%
Europe Inflation Rate is 2%
Spot Exchange Rate is RM 4.10/

Answer (4a)

360
=RM 4.10/ X
1+0.05
1+0.02

= RM 4.22/
15
(b) if walcott (malaysia) sdn.
bhd. could borrow from public
bank berhad at 8.30% per
annum, is this option more cost
effective than part (i) above?


16
Euro-based Interest 6.80%
Borrow from Public Bank Berhad at 8.30% per annum

Answer (5b)
Step 1
1,800,000 X 1.068 = 1922400

Step 2
1,800,000 X RM 4.10/ = RM7,380,000


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Step 3
RM 7,380,000 X 1.083 = RM 7,992,540

Step 4
RM 7,992,540 RM 4.10/ = 1,949,400

Conclusion
(b) Is more cost effective than (a) because it generates higher return.
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Question 5.
(a) When will an opportunity for locational arbitrage profits arise?

Locational arbitrage arise when a banks buying price (bid price) is
higher than another banks selling price (ask price) for the same
currency

Eg: Bid Ask

Bank A $.635/NZ$ $.640
Bank B $.645 $.650

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Question 5
(b) Podolski Swiensteiger holds MZ$ 500,000. Given the following
quotes, what is the amount of locational arbitrage profits in NZ$
terms that he could earn?
Bid Ask
Kiwi Bank NZ$1.3530/$ NZ$1.3580/$
Auckland Bank NZ$1.3400/$ NZ$1.3450/$


1
st
: NZ$ 500,000 invest in $ @ NZ$1.3450/$ from Auckland Bank
so, NZ$ 500,000 / NZ$1.3450 = $371747.212

2
nd
: sell $371747.212 @ NZ$1.3530/$ to Kiwi Bank
so, $371747.212 x NZ$1.3530 = NZ$502973.978

3th: NZ$502973.978 NZ$ 500,000 = NZ$2973.978 (locational
arbitrage profit)





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Question 6

Suppose that the current spot exchange rate is 1.06/$ and
the three-month forward exchange rate is 1.02/$. The three-
month interest rate is 5.6 percent per annum in the United
States and 5.40 percent per annum in France. Assume that you
can borrow up to $1,000,000 or 1,060,000.
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22
Current Spot Rate, 1.06 / $
3 months Forward exchange rate , 1.02/$
Interest rate in US = 5.6 p.a. (5.6 %
90
360
= 1.4%)
Interest rate in France = 5.4 p.a. (5.4%
90
360
= 1.35%)
Money $ 1,000,000 or 1,060,000
(a)Show how to realize a certain profit via covered
interest arbitrage, assuming that you want to realize
profit in terms of U.S. dollars. Also determine the size
of your arbitrage profit.
Answer 6(a)
Step1
A : Numerator : France : FC :
B : Denominator : US : HC : $

Step2
Interest Differential =

$

= 5.4% - 5.6%
= -0.2%
Step 3
/ $ (Indirect Quote) FC/HC
f
FC
=


X
360

X 100
=
1.061.02
1.02

360
90
100
= 15.69% (forward premium for euro(Currency A), forward
discount for dollar(Currency B) )
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Step 4
Interest Differential < Forward Discount on US dollar
-0.2 < -15.69%
(Invest in France ) (Borrow from US $)
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Borrow US dollar rate = 5.6 % per annum
90 days
Dollar money market
Euro money market
$1,000,000 $1,014,000
$1,053,245
$ 39,245
S= 1.06/$
1,060,000 1,074,310
F
90
= 1.02/$
x 1.0135
x 1.014
Start
End
Invest Euro currency rate = 5.4% per annum
Borrow
Earn
Profit
25
(b) Assume that you want to realize
profit in terms of euros. Show the covered
arbitrage process and determine the
arbitrage profit in euros.
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Step1
A : Denominator : US : FC : $
B : Numerator : France : HC :

Step2
Interest Differential =

$

= 5.4% - 5.6%
= -0.2%
Step 3
/ $ (direct Quote) HC/FC
f
FC
=


X
360

X 100

=
1.021.06
1.06

360
90
100

= -15.09% (forward discount for dollar (Currency B) )
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Step 4
Interest Differential < Forward Discount on Currency France
-0.2 < -15.09%
(Invest in France ) (Borrow from US $)

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Borrow US dollar rate = 5.6 % per annum
90 days
Dollar money market
Euro money market
$1,000,000 $1,014,000
$1,053,245
$ 39,245
S= 1.06/$
1,060,000 1,074,310
F
90
= 1.02/$
x 1.0135
x 1.014
Start
End
Invest Euro currency rate = 5.4% per annum
Borrow
Earn
Profit
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