Problem 5: Interest Rate Parity The current US Dollar to Yen exchange rate is 0 = 110. The CCIR US rate is 4% and the CCIR Japanese rate is 2%. Banco Santander is currently willing to offer a one-month forward contract (assuming either the short or long position). The banks problem is to set the forward exchange rate 0, 1/ 12 .

1. If the bank invests $500 M over one month, what is the FV of such investment?

2. Now instead, suppose that the bank takes the $500 M and exchanges that amount into Yen and invest the Yen amount over one month. What is the FV of that investment? 3. If the bank has the option to exchange Yen to USD one month from now at an exchange rate of 0, of Yen for 1 USD, what is the value of 0, 1 /12 that makes the bank indifferent between 1) and 2).

4. Instead of following the no-arbitrage guidelines to price an asset, the bank decides to set the forward price at 0, 1 /12 = 108 (Yen per USD). Michael, once again, decides to trade with the bank and does the following:

i. Borrow an amount $100 over one month. Enter into a one-month contract to sell Yen.

ii. Exchange that amount into Yen at the current rate and the invest the proceeds over one month at the Yen rate. iii. Exchange the Yen into USD at the 0, 1 /12 = 108 rate set by the bank.

iv. Repay the loan in USD. Compute the payoff from this strategy. Is it positive? Negative? Zero? Compute the reverse strategy:

v. Borrow an amount 100 Yen over one month. Enter into a one-month contract to buy Yen.

vi. Exchange that amount into USD at the current rate and the invest the proceeds over one month at the US rate.

vii. Exchange the USD into Yen at the 0, 1 /12 = 108 rate set by the bank. i. Repay the loan in Yen.