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Kelly's Tavern serves Shamrock draft beer to its customers. The daily demand for beer is normally distributed, with an average of 20 gallons and a standard deviation of 4 gallons. The lead time required to receive an order of beer from the local distributor is 12 days. Determine the safety stock and reorder point if the restaurant wants to maintain a 90% service level. What would be the increase in the safety stock if a 95% service level were desired?
How does a futures contract differ from a forward contract?
What effects does “marking to market” have on futures contracts?
What are the differences between foreign currency option contracts and forward contracts for foreign currency?
What are you buying if you purchase a U.S. dollar European put option against the Mexican peso with a strike price of MXN10.0/ $ and a maturity of July? (Assume that it is May and the spot rate is MXN10.5/$.)
What are you buying if you purchase a Swiss franc American call option against the U.S. dollar with a strike price of CHF1.30/$ and a maturity of January? (Assume that it is November and the spot rate is CHF1.35/$.)
What is the intrinsic value of a foreign currency call option? What is the intrinsic value of a foreign currency put option?
What does it mean for an American option to be “in the money”?
Why do American option values typically exceed their intrinsic values?
Suppose you go long in a foreign currency futures contract. Under what circumstances is your cumulative payoff equal to that of buying the currency forward?
Your CEO routinely approves changes in the fire insurance policies of your firm to protect the value of its buildings and manufacturing equipment. Nevertheless, he argues that the firm should not buy foreign currency options because, he says, “We don’t speculate in FX markets!” How could you convince him that his positions are mutually inconsistent?
Why do options provide insurance against foreign exchange risks in bidding situations? Why can’t you hedge with a forward contract in a bidding situation?
Suppose that you have a foreign currency receivable (payable). What option strategy places a floor (ceiling) on your domestic currency revenue (cost)?
Describe qualitatively how changing the strike price of the option provides either more or less expensive insurance.
Why does an increase in the strike price of an option decrease the value of a call option and increase the value of a put option?
Why does an increase in the volatility of foreign exchange rates increase the value of foreign currency options?
How does increasing time to maturity affect foreign currency option value?
What is the payoff on an average-rate pound call option against the dollar?
Suppose the current spot rate is $1.29/€. What is your payoff if you purchase a down-and-in put option on the euro with a strike price of $1.31/€, a barrier of $1.25/€, and a maturity of 2 months? When would someone want to do this?
If you sold a Swiss franc futures contract at time t and the exchange rate has evolved as shown here, what would your cash flows havebeen?
Given the following information, how much would you have paid on September 16 to purchase a British pound call option contract with a strike price of 155 and a maturity ofOctober?
Using the data in problem 2, how much would you have paid to purchase an Australian dollar put option contract with a strike price of 65 and an October maturity?
Suppose that you buy a€1,000,000 call option against dollars with a strike price of $1.2750/€. Describe this option as the right to sell a specific amount of dollars for euros at a particular exchange rate of euros per dollar. Explain why this latter option is a dollar put option against the euro.
Assume that today is March 7, and, as the newest hire for Goldman Sachs, you must advise a client on the costs and benefits of hedging a transaction with options. Your client (a small U.S. exporting firm) is scheduled to receive a payment of €6,250,000 on April 20, 44 days in the future. Assume that your client can borrow and lend at a 6% p.a. U.S. interest rate.
a. Describe the nature of your client’s transaction exchange risk.
b. Use the appropriate American option with an April maturity and a strike price of 129¢/€ to determine the dollar cost today of hedging the transaction with an option strategy. The cost of the call option is 3.93¢/€, and the cost of the put option is 1.58¢/€.
c. What is the minimum dollar revenue your client will receive in April? Remember to take account of the opportunity cost of doing the option hedge.
d. Determine the value of the spot rate ($/€) in April that would make your client indifferent ex post to having done the option transaction or a forward hedge. The forward rate for delivery on April 20 is $1.30/€.
Assume that today is September 12. You have been asked to help a British client who is scheduled to pay €1,500,000 on December 12, 91 days in the future. Assume that your client can borrow and lend pounds at 5% p.a.
a. Describe the nature of your client’s transaction exchange risk.
b. What is the option cost for a December maturity and a strike price of £0.72/€ to hedge the transaction? The option premiums per 100 euros are £1.70 for calls and £2.40 for puts.
c. What is the minimum pound cost your client will experience in December?
d. Determine the value of the spot rate (£/€) in December that makes your client indifferent ex post to having done the option transaction or a forward hedge if the forward rate for delivery on December 11 is £0.70/€.
Assume that today is June 11. Your firm is scheduled to pay £500,000 on August 15, 65 days in the future. The current spot is $1.75/£, and the 65-day forward rate is $1.73/£. You can borrow and lend dollars at 7% p.a. Suppose you think options are overpriced because you think the dollar will be in a tight trading range in the near future. You have been thinking about selling an option as a way to reduce the dollar cost of your pound payable.
a. If an August pound option with a strike price of 175¢/£ costs 4.5¢/£ per pound for the call and 4¢/£ for the put, what is the minimum effective exchange rate in August that you will pay? Over what range of future exchange rates will this price be achieved?
b. How much must the pound appreciate before your speculative option strategy ends up costing you more than the forward rate?
Upon arriving for work on Monday, you observe a violation of put–call parity. In particular, the synthetic forward price of dollars per yen is above the current forward rate. How would you capitalize on this information?
Use interest rate parity to demonstrate that you can represent put–call parityas
On April 28, 1995, the Paine Webber Group introduced a new type of security on the NYSE: U.S. dollar increase warrants on the yen. At exercise, each warrant entitled the holder to an amount of U.S. dollars calculated as
Greater of (i) 0 and
(ii) $100 – [$100 × (¥ 83.65/ $ / Spot rate)]
The “spot rate” in the formula refers to the yen /dollar rate on any day during the exercise period, which extended until April 28, 1996. The 1-year forward rate on April 28 was ¥79.72/$, and the spot rate was ¥83.65/$.
a. What view on the future yen/dollar rate do investors in this security hold?
b. This security was issued at a price of $5.50. To see whether the security is fairly priced, which option prices would you want to examine?
How does an interest rate swap work? In particular, what is the notional principal?
What is a currency swap? Describe the structure of and rationale for its cash flows.
What is a credit default swap? What happens in the event of default?
Banks quote interest rate and currency swaps using 6-month LIBOR as a basis for both transactions. How can a bank make money if it does not speculate on movements in either interest rates or exchange rates?
What is the AIC of a bond issue?
What is a comparative advantage in borrowing, and how could it arise?
What is basis point adjustment? Why is it not appropriate simply to add the basis point differential associated with the first currency to the quoted swap rate that the firm will pay?
Discuss the sense in which a 5-year currency swap is a sequence of long-term forward contracts. How do the implicit forward exchange rates in a currency swap differ from the long-term forward exchange rates for those maturities?
What are the determinants of the value of a currency swap as time evolves? Is it possible to close out a swap before it has reached maturity?
General Motors (GM) wants to swap out of $15,000,000 of fixed interest rate debt and into floating interest rate debt for 3 years. Suppose the fixed interest rate is 8.625% and the floating rate is dollar LIBOR. What semiannual interest payments will GM receive, and what will GM pay?
Pfizer is a U.S. firm with considerable euro assets. It is considering entering into a currency swap involving $10 million of its dollar debt for an equivalent amount of euro debt. Suppose the maturity of the swap is 8 years, and the interest rate on Pfizer’s outstanding 8-year dollar debt is 11%. The interest rate on the euro debt is 9%. The current spot exchange rate is $1.35/€. How could a swap be structured?
At the 7-year maturity, U.S. Treasury bonds’ yield to maturity is 7.95% p.a. The Second Bank of Chicago states that it will make fixed interest rate payments on dollars at the yield on Treasury bonds plus 55 basis points in exchange for receiving dollar LIBOR, and it will receive fixed interest rate payments on dollars at the yield on Treasury bonds plus 60 basis points in exchange for paying dollar LIBOR. If you enter into an interest rate swap of $10 million with Second Chicago, what will be your cash flows if you are paying the fixed rate and receiving the floating rate?
The swap desk at UBS is quoting the following rates on 5-year swaps versus 6-month dollar LIBOR:
U.S. Dollars: ....... 8.75% bid and 8.85% offered
Swiss Francs: ....... 5.25% bid and 5.35% offered
You would like to swap out of Swiss franc debt with a principal of CHF25,000,000 and into fixed-rate dollar debt. At what rates will UBS handle the transaction? If the current exchange rate is CHF1.3/$, what would the cash flows be?
Suppose Viacom can issue $100,000,000 of debt at an AIC of 9.42%, whereas Gaz de France can issue $100,000,000 of debt at an AIC of 10.11%. Suppose that the exchange rate is $1.35/€. If Viacom issues euro-denominated bonds equivalent to $100,000,000, its AIC will be 8.27%, whereas if Gaz de France issues such bonds, its all-in cost will be 9.17%. Which firm has a comparative advantage when borrowing euros? Why?
Suppose in problem 5 that because of currency risk, Viacom would prefer to have dollar debt, and Gaz de France would prefer to have euro debt. How could an investment bank structure a currency swap that would allow each of the firms to issue bonds denominated in the currency in which the firm has a comparative advantage while respecting the firms’ preferences about currency risks?
Suppose Sony issues $100,000,000 of 5-year dollar bonds. Nomura will handle the bond issue for a fee of 1.875%. Sony’s bonds will be priced at par if they carry a coupon of 8.5%. As the swap trader for Mitsubishi UFJ (MUFJ), you have been quoting the following rates on 5-year swaps: U.S. Dollars: 8.00% bid and 8.10% offered against the 6-month dollar LIBOR Japanese Yen: 4.50% bid and 4.60% offered against the 6-month dollar LIBOR Sony would like to do the dollar bond issue, but it prefers to have fixed-rate yen debt. If MUFJ gets the proceeds of the dollar bond issue, giving Sony an equivalent amount of yen, and MUFJ agrees to make the dollar interest payments associated with Sony’s dollar bonds, what yen interest payments should MUFJ charge Sony? What is Sony’s all in cost in yen? The current spot exchange rate is ¥98.50/$.
Assume that 1 year has passed since you entered into the transaction described in problem 4. Assume that the new spot exchange rate is CHF1.45/$ and that UBS is now quoting the following interest rates on 4-year swaps: U.S. Dollars: 7.50% bid and 7.60% offered against the 6-month dollar LIBOR Assume that 1 year has passed since you entered into the transaction described in problem 4. Assume that the new spot exchange rate is CHF1.45/$ and that UBS is now quoting the following interest rates on 4-year swaps: U.S. Dollars: 7.50% bid and 7.60% offered against the 6-month dollar LIBOR
Web Question: Go to www22.verizon.com/investor/ app_resources/interactiveannual/2010/mda06.html to find an excerpt of the 2010 Annual Report of Verizon, a large telecommunications company. Determine whether they use interest rate and/or currency swaps and why.
Should China Be Forced to Alter the Value of Its Currency?
Point U.S. politicians frequently suggest that China needs to increase the value of the Chinese Yuan against the U.S. dollar, even though China has allowed the Yuan to float (within boundaries). The U.S. politicians claim that the yuan is the cause of the large U.S. trade deficit with China. This issue is periodically raised not only with currencies tied to the dollar but also with currencies that have a floating rate. Some critics argue that the exchange rate can be used as a form of trade protectionism. That is, a country can discourage or prevent imports and encourage exports by keeping the value of its currency artificially low.
Counter-Point China might counter that its large balance-of-trade surplus with the United States has been due to the difference in prices between the two countries and that it should not be blamed for the high U.S. prices. It might argue that the U.S. trade
Deficit can be partially attributed to the very high prices in the United States, which are necessary to cover the excessive compensation for executives and other employees at U.S. firms. The high prices in the United States encourage firms and consumers to purchase goods from China. Even if China’s yuan is revalued upward, this does not necessarily mean that U.S. firms and consumers will purchase U.S. products. They may shift their purchases from China to Indonesia or other low-wage countries rather than buy more U.S. products. Thus, the underlying dilemma is not China but any country that has lower costs of production than the United States.
Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.
Compare and contrast the fixed, freely floating, and managed fl oat exchange rate systems. What are some advantages and disadvantages of a freely floating exchange rate system versus a fixed exchange rate system?
Assume that Belgium, one of the European countries that uses the euro as its currency, would prefer that its currency depreciate against the U.S. dollar. Can it apply central bank intervention to achieve this objective? Explain.
How can a central bank use direct intervention to change the value of a currency? Explain why a central bank may desire to smooth exchange rate movements of its currency.
How can a central bank use indirect intervention to change the value of a currency?
Assume there is concern that the United States may experience a recession. How should the Federal Reserve influence the dollar to prevent a recession? How might U.S. Exporters react to this policy (favorably or unfavorably)? What about U.S. importing firms?
What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal?
Explain the potential feedback effects of a currency’s changing value on inflation.
Why would the Fed’s indirect intervention have a stronger impact on some currencies than others? Why would a central bank’s indirect intervention have a stronger impact than its direct intervention?
The Hong Kong dollar’s value is tied to the U.S. dollar. Explain how the following trade patterns would be affected by the appreciation of the Japanese yen against the dollar:
(a) Hong Kong exports to Japan and
(b) Hong Kong exports to the United States.
U.S. bond prices are normally inversely related to U.S. inflation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be affected?
If most countries in Europe experience a recession, how might the European Central Bank use direct intervention to stimulate economic growth?
Explain the difference between sterilized and non sterilized intervention.
Suppose that the government of Chile reduces one of its key interest rates. The values of several other Latin American currencies are expected to change substantially against the Chilean peso in response to the news.
a. Explain why other Latin American currencies could be affected by a cut in Chile’s interest rates.
b. How would the central banks of other Latin American countries likely adjust their interest rates? How would the currencies of these countries respond to the central bank intervention?
c. How would a U.S. firm that exports products to Latin American countries be affected by the central bank intervention? (Assume the exports are denominated in the corresponding Latin American currency for each country.)
Should the governments of Asian countries allow their currencies to fl oat freely? What would be the advantages of letting their currencies fl oat freely? What would be the disadvantages?
During the Asian crisis, some Asian central banks raised their interest rates to prevent their currencies from weakening. Yet, the currencies weakened anyway. Offer your opinion as to why the central banks’ efforts at indirect intervention did not work.
Why do foreign market participants attempt to monitor the Fed’s direct intervention efforts? How does the Fed attempt to hide its intervention actions? The media frequently report that “the dollar’s value strengthened against many currencies in response to the Federal Reserve’s plan to increase interest rates.” Explain why the dollar’s value may change even before the Federal Reserve affects interest rates.
Within a few days after the September 11, 2001, terrorist attack on the United States, the Federal Reserve reduced short-term interest rates to stimulate the U.S. economy. How might this action have affected the foreign flow of funds into the United States and affected the value of the dollar? How could such an effect on the dollar have increased the probability that the U.S. economy would strengthen?
Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the U.S. dollar as a result. Explain whether these actions would increase, reduce, or have no effect on:
a. The volume of your subsidiary’s sales in Australia (measured in A$).
b. The cost to your subsidiary of purchasing materials (measured in A$).
c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$). Briefly explain each answer.
Why do you think a country suddenly decides to peg its currency to the dollar or some other currency? When a currency is unable to maintain the peg, what do you think are the typical forces that break the peg?
Assume that the central bank of the country Zakow periodically intervenes in the foreign exchange market to prevent large upward or downward fluctuations in its currency (called the Zak) against the U.S. dollar. Today, the central bank announced that it will no longer intervene in the foreign exchange market. The spot rate of the Zak against the dollar was not affected by this news. Will the news affect the premium on currency call options that are traded on the Zak? Will the news affect the premium on currency put options that are traded on the Zak? Explain.
1. Did the intervention effort by the Thai government constitute direct or indirect intervention? Explain.
2. Did the intervention by the Thai government constitute sterilized or non-sterilized intervention? What is the difference between the two types of intervention? Which type do you think would be more effective in increasing the value of the baht? Why? (Hint: Think about the effect of non-sterilized intervention on U.S. interest rates.)
3. If the Thai baht is virtually fixed with respect to the dollar, how could this affect U.S. levels of inflation? Do you think these effects on the U.S. economy will be more pronounced for companies such as Blades that operate under trade arrangements involving commitments or for firms that do not? How are companies such as Blades affected by a fixed exchange rate?
4. What are some of the potential disadvantages for Thai levels of inflation associated with the floating exchange rate system that is now used in Thailand? Do you think Blades contributes to these disadvantages to a great extent? How are companies such as Blades affected by a freely floating exchange rate?
5. What do you think will happen to the Thai baht’s value when the swap arrangement is completed? How will this affect Blades?<
Recall that Blades, the U.S. manufacturer of roller blades, generates most of its revenue and incurs most of its expenses in the United States. However, the company has recently begun exporting roller blades to Thailand. The company has an agreement with Entertainment Products, Inc., a Thai importer, for a 3-year period. According to the terms of the agreement, Entertainment Products will purchase 180,000 pairs of “Speedos,” Blades’ primary product, annually at a fixed price of 4,594 Thai baht per pair. Due to quality and cost considerations, Blades is also importing certain rubber and plastic components from a Thai exporter. The cost of these components is approximately 2,871 Thai baht per pair of Speedos. No contractual agreement exists between Blades, Inc., and the Thai exporter. Consequently, the cost of the rubber and plastic components imported from Thailand is subject not only to exchange rate considerations but to economic conditions (such as inflation) in Thailand as well.
1. Forecast whether the British pound will weaken or strengthen based on the information provided.
2. How would the performance of the Sports Exports Company be affected by the Bank of England’s policy of flooding the foreign exchange market with British pounds (assuming that it does not hedge its exchange rate risk)?
Jim Logan, owner of the Sports Exports Company, is concerned about the value of the British pound over time because his firm receives pounds as payment for footballs exported to the United Kingdom. He recently read that the Bank of England (the central bank of the United Kingdom) is likely to intervene directly in the foreign exchange market by flooding the market with British pounds.
Was the depreciation of the Asian currencies during the Asian crisis due to trade flows or capital flows? Why do you think the degree of movement over a short period may depend on whether the reason is trade flows or capital flows?
Why do you think the Indonesian rupiah was more exposed to an abrupt decline in value than the Japanese yen during the Asian crisis (even if their economies experienced the same degree of weakness)?
During the Asian crisis, direct intervention did not prevent depreciation of currencies. Offer your explanation for why the interventions did not work.
During the Asian crisis, some local firms in Asia borrowed U.S. dollars rather than local currency to support local operations. Why would they borrow dollars when they really needed their local currency to support operations? Why did this strategy backfire?
The Asian crisis showed that a currency crisis could affect interest rates. Why did the crisis put upward pressure on interest rates in Asian countries? Why did it put downward pressure on U.S. interest rates?
It is commonly argued that high interest rates reflect high expected inflation and can signal future weakness in a currency. Based on this theory, how would expectations of Asian exchange rates change after interest rates in Asia increased? Why? Is the underlying reason logical?
During the Asian crisis, why did the discount of the forward rate of Asian currencies change? Do you think it increased or decreased? Why?
During the Hong Kong crisis, the Hong Kong stock market declined substantially over a 4-day period due to concerns in the foreign exchange market. Why would stock prices decline due to concerns in the foreign exchange market? Why would some countries be more susceptible to this type of situation than others?
On August 26, 1998, the day that Russia decided to let the ruble fl oat freely, the ruble declined by about 50 percent. On the following day, called “Bloody Thursday,” stock markets around the world (including the United States) declined by more than 4 percent. Why do you think the decline in the ruble had such a global impact on stock prices? Was the markets’ reaction rational? Would the effect have been different if the ruble’s plunge had occurred in an earlier time period, such as 4 years earlier? Why?
Normally, a weak local currency is expected to stimulate the local economy. Yet, it appeared that the weak currencies of Asia adversely affected their economies. Why do you think the weakening of the currencies did not initially improve their economies during the Asian crisis?
During the Asian crisis, Hong Kong and China successfully intervened (by raising their interest rates) to protect their local currencies from depreciating. Nevertheless, these countries were also adversely affected by the Asian crisis. Why do you think the actions to protect the values of their currencies affected these countries’ economies? Why do you think the weakness of other Asian currencies against the dollar and the stability of the Chinese and Hong Kong currencies against the dollar adversely affected their economies?
Why do you think the values of bonds issued by Asian governments declined during the Asian crisis? Why do you think the values of Latin American bonds declined in response to the Asian crisis?
Why do you think the depreciation of the Asian currencies adversely affected U.S. firms? (There are at least three reasons, each related to a different type of exposure of some U.S. firms to exchange rate risk.)
During the Asian crisis, the currencies of many Asian countries declined even though their governments attempted to intervene with direct intervention or by raising interest rates. Given that the abrupt depreciation of the currencies was attributed to an abrupt outflow of funds in the financial markets, what alternative Asian government action might have been more successful in preventing a substantial decline in the currencies’ values? Are there any possible adverse effects of your proposed solution?
Does Arbitrage Destabilize Foreign Exchange Markets?
Point Yes. Large financial institutions have the technology to recognize when one participant in the foreign exchange market is trying to sell a currency for a higher price than another participant. They also recognize when the forward rate does not properly reflect the interest rate differential. They use arbitrage to capitalize on these situations, which results in large foreign exchange transactions. In some cases, their arbitrage involves taking large positions in a currency and then reversing their positions a few minutes later. This jumping in and out of currencies can cause abrupt price adjustments of currencies and may create more volatility in the foreign exchange market. Regulations should be created that would force financial institutions to maintain their currency positions for at least one month. This would result in a more stable foreign exchange market.
Counter-Point No. When financial institutions engage in arbitrage, they create pressure on the price of a currency that will remove any pricing discrepancy. If arbitrage did not occur, pricing discrepancies would become more pronounced. Consequently, firms and individuals who use the foreign exchange market would have to spend more time searching for the best exchange rate when trading a currency. The market would become fragmented, and prices could differ substantially among banks in a region, or among regions. If the discrepancies became large enough, firms and individuals might even attempt to conduct arbitrage themselves. The arbitrage conducted by banks allows for a more integrated foreign exchange market, which ensures that foreign exchange prices quoted by any institution are in line with the market.
Who Is Correct? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue.
Explain the concept of locational arbitrage and the scenario necessary for it to be plausible.
Assume the following information:
Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had $1 million to use. What market forces would occur to eliminate any further possibilities of locationalarbitrage?
Explain the concept of triangular arbitrage and the scenario necessary for it to be plausible.
Assume the following information:
Value of Canadian dollar in U.S. dollars ........$.90
Value of New Zealand dollar in U.S. dollars ........$.30
Value of Canadian dollar in New Zealand dollars NZ$3..02
Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect triangular arbitrage, and compute the profit from this strategy if you had $1 million to use. What market forces would occur to eliminate any further possibilities of triangular arbitrage?
Explain the concept of covered interest arbitrage and the scenario necessary for it to be plausible.
Assume the following information:
Spot rate of Canadian dollar ...........= $.80
90-day forward rate of Canadian dollar ........= $.79
90-day Canadian interest rate ............= 4%
90-day U.S. interest rate ..............= 2.5%
Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1 million.) What market forces would occur to eliminate any further possibilities of covered interest arbitrage?
Assume the following information:
Spot rate of Mexican peso ..........= $.100
180-day forward rate of Mexican peso .....= $.098
180-day Mexican interest rate ..........= 6%
180-day U.S. interest rate ...........= 5%
Given this information, is covered interest arbitrage worthwhile for Mexican investors who have pesos to invest? Explain your answer.
The terrorist attack on the United States on September 11, 2001, caused expectations of a weaker U.S. economy. Explain how such expectations could have affected U.S. interest rates and therefore have affected the forward rate premium (or discount) on various foreign currencies.
Explain the concept of interest rate parity. Provide the rationale for its possible existence.
Assume that the existing U.S. one-year interest rate is 10 percent and the Canadian one-year interest rate is 11 percent. Also assume that interest rate parity exists. Should the forward rate of the Canadian dollar exhibit a discount or a premium? If U.S. investors attempt covered interest arbitrage, what will be their return? If Canadian investors attempt covered interest arbitrage, what will be their return?
Why would U.S. investors consider covered interest arbitrage in France when the interest rate on euros in France is lower than the U.S. interest rate?
Assume that the Japanese yen’s forward rate currently exhibits a premium of 6 percent and that interest rate parity exists. If U.S. interest rates decrease, how must this premium change to maintain interest rate parity? Why might we expect the premium to change?
If the relationship that is specified by interest rate parity does not exist at any period but does exist on average, then covered interest arbitrage should not be considered by U.S. firms. Do you agree or disagree with this statement? Explain.
The one-year interest rate in New Zealand is 6 percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is or is not feasible.