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Problem 6.

1 Pulau Penang Island Resort

Theresa Nunn is planning a 30-day vacation on Pulau Penang, Malaysia, one year from now. The present charge
for a luxury suite plus meals in Malaysian ringgit (RM) is RM1,000/day. The Malaysian ringgit presently trades
at RM5.2522/GBP. She determines that the pound cost today for a 30-day stay would be about GBP6,000. The
hotel informs her that any increase in its room charges will be limited to an increase in the Malaysian cost of
living. Malaysian inflation is expected to be 3% per annum, while U.K. inflation is expected to be 1%.

a. How many pounds might Theresa expect to need one year hence to pay for her 30-day vacation?
b. By what percent will the pound cost have gone up? Why?

Assumptions Value
Charge for suite plus meals in Malaysian ringgit (RM) 1,000.00
Spot exchange rate (MYR/GBP) 5.2522
GBP cost today for a 30 day stay $5,711.89

Malaysian ringgit inflation rate expected to be 3.000%


GBP inflation rate expected to be 1.000%

a. Theresa might expect to need one year hence to pay for her 30-day vacation in GBP

Spot exchange rate (ringgit per GBP) 5.2522


Malaysian ringgit inflation rate expected to be 3.000%
GBP inflation rate expected to be 1.000%

Spot (expected in 1 year) = Spot x ( 1 + RM inflation) / ( 1 + GBP inflation)

Expected spot rate one year from now based on PPP (RM/$) 5.356204

Expected hotel charges to be paid one year from now for a 30-day stay in MYR 30,900.00

GBP needed on the basis of these two expectations: $5,769.01

b. Percept change in GBP cost

New dollar cost $5,769.01


Original dollar cost $5,711.89
Percent change in US$ cost 1.000%

The GBP cost has risen by the UK inflation rate. This is a result of your estimation of the future GBP costs and
the exchange rate changing in proportion to inflation (relative purchasing power parity).
Problem 6.2 Argentine Tears

The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In
January 2002 the Argentine peso was floated. On January 29, 2003 it was trading at Ps3.20/$.
During that one year period Argentina's inflation rate was 20% on an annualized basis. Inflation in
the United States during that same period was 2.2% annualized.

a. What should have been the exchange rate in January 2003 if PPP held?
b. By what percentage was the Argentine peso undervalued on an annualized basis?
c. What were the probable causes of undervaluation?

Assumptions Value
Spot exchange rate, fixed peg, early January 2002 (Ps/$) 1.0000
Spot exchange rate, January 29, 2003 (Ps/$) 3.2000
US inflation for year (per annum) 2.20%
Argentine inflation for year (per annum) 20.00%

a. What should have been the exchange rate in January 2003 if PPP held?

Beginning spot rate (Ps/$) 1.00


Argentine inflation 20.00%
US inflation 2.20%
PPP exchange rate 1.17

b. By what percentage was the Argentine peso undervalued on an annulized basis?

Actual exchange rate (Ps/$) 3.20


PPP exchange rate (Ps/$) 1.17
Percentage overvaluation (positive) or undervaluation (negative) -63.307%

c. What were the probable causes of undervaluation?

The rapid decline in the value of the Argentine peso was a result of not only inflation,
but also a severe crisis in the balance of payments (see Chapter 4).
Problem 6.3 Japanese/United States Parity Conditions

William Leon is attempting to determine whether Japanese and Australian financial conditions are at parity. The current spot rate is a flat
¥108.33/A$, while the one-year forward rate is ¥106.50/A$. Forecast inflation is 5.00% for Japan and 6.80% for the Australia. The one-year
Japanese yen deposit rate is 7.85%, and the one-year Australian dollar deposit rate is 9.70%.

a. Diagram and calculate whether international parity conditions hold between Japan and Australia.
b. Find the forecasted change in the Japanese yen/Australian dollar (¥/A$) exchange rate one year from now.

Assumptions Value
Forecast annual rate of inflation for Japan 5.000%
Forecast annual rate of inflation for Australia 6.800%
One-year interest rate for Japan 7.850%
One-year interest rate for Australia 9.700%
Spot exchange rate (¥/A$) 108.33
One-year forward exchange rate (¥/A$) 106.50

a.
Approximate Form

Forecast change in
Forward rate as spot exchange rate Purchasing
an unbaised ↔ ↔ 1.7% ↔ ↔ power
predictor (E) (Australian dollar expected to weaken) parity (A)
↕ ↕
↕ ↕ ↕
↕ ↕ ↕
↕ ↕ ↕

Forward premium ↕ Forecast difference
on foreign currency International in rates of inflation
1.7% Fisher Effect (C) -1.8%
(Japanese yen at a premium) ↕ (Australia higher than Japan)

↕ ↕ ↕
↕ ↕ ↕

Interest rate ↔ ↔ Difference in nominal ↔ ↔ Fisher
parity (D) interest rates effect (B)
-1.9%
(higher in Australia)

As is the always the case with parity conditions, the future spot rate is implicitly forecast to be equal to the forward rate, the implied rate
from the international Fisher effect, and the rate implied by purchasing power parity. According to the calculations, the markets are indeed
in equilibrium -- parity -- and the future spot rate is projected to be JPY106.50/AUD..

b.
Spot exchange rate (¥/A$) 108.33
One-year forward exchange rate (¥/A$) 106.50
Forcasted change in exchange rates 1.7%

(Current Spot Rate - Forward Exchange Rate) / (Forward Exchange Rate)


Problem 6.4 Sydney to Phoenix

Terry Lamoreaux has homes in both Sydney, Australia and Phoenix, United States. He travels
between the two cities at least twice a year. Because of his frequent trips he wants to buy some new,
high quality luggage. He's done his research and has decided to go with a Briggs & Riley brand
three-piece luggage set. There are retails stores in both Phoenix and Sydney. Terry was a finance
major and wants to use purchasing power parity to determine if he is paying the same price no
matter where he makes his purcahse.

a. If the price of the 3-piece luggage set in Phoenix is $850 and the price of the same 3-piece set in
Sydney is $930, using purchasing power parity, is the price of the luggage truly equal if the spot
rate is A$1.0941/$?

b. If the price of the luggage remains the same in Phoenix one year from now, determine what the
price of the luggage should be in Sydney in one-year time if PPP holds true. The US Inflation rate
is 1.15% and the Australian inflation rate is 3.13%.

Assumptions Value
Price of 3-Piece Luggage set in US$ 850.00
Price of 3-Piece Luggage set in A$ 930.00
Spot exchange rate, (A$/$) 1.0941
US inflation for year (per annum) 1.15%
Australian inflation for year (per annum) 3.13%

a. Is the spot rate accurate given both luggage prices?

Price of 3-Piece Luggage set in US$ 850.00


Price of 3-Piece Luggage set in A$ 930.00
Spot rate as determined by PPP 1.0941
Spot rate = Price in A$ / Price in US$

b. What should be the price of the luggage set in A$ in 1-year if PPP holds?

Beginning spot rate (A$/$) 1.0941


Australian inflation 3.13%
US inflation 1.15%
PPP exchange rate 1.1155

Price of 3-Piece Luggage set in US$ 850.00


PPP exchange rate 1.1155
Price of 3-piece luggage set in Sydney (A$) 948.19

However, purchasing power parity is not always an accurate predictor of exchange rate
movements, particularly in the short-term.
Problem 6.5 Starbucks in Croatia

Starbucks opened its first store in Zagreb, Croatia in October 2010. The price of a tall vanilla latte
in Zagreb is 25.70kn. In New York City, the price of a tall vanilla latte is $2.65. The exchange rate
bewteen Croatian kunas (kn) and U.S. dollars is kn5.6288/$. According to purchasing power
parity, is the Croatian kuna overvalued or undervalued?

Assumptions Value
Spot exchange rate (Kn/$) 5.6288
Price of vanilla latter in Zagreb (kn) 25.70
Price of vanilla latter in NYC ($) 2.65

Actual price of Croatian latte in USD 4.57


Implied PPP of Croatian latte in USD 9.70
Percentage overvaluation (positive) or undervaluation (negative) 112.408%
Problem 6.6 Corolla Exports and Pass-Through

Assume that the export price of a Toyota Corolla from Osaka, Japan is ¥2,150,000. The exchange rate is ¥87.60/$. The
forecast rate of inflation in the United States is 2.2% per year and is 0.0% per year in Japan. Use this data to answer the
following questions on exchange rate pass through.

a. What was the export price for the Corolla at the beginning of the year expressed in U.S. dollars?
b. Assuming purchasing power parity holds, what should the exchange rate be at the end of the year?
c. Assuming 100% pass-through of exchange rate, what will the dollar price of a Corolla be at the end of the year?
d. Assuming 75% pass-through, what will the dollar price of a Corolla be at the end of the year?

Steps Value
Initial spot exchange rate (¥/$) 87.60
Initial price of a Toyota Corolla (¥) 2,150,000
Expected US dollar inflation rate for the coming year 2.200%
Expected Japanese yen inflation rate for the coming year 0.000%
Desired rate of pass through by Toyota 75.000%

a. What was the export price for the Corolla at the beginning of the year?
Year-beginning price of an Corolla (¥) 2,150,000
Spot exchange rate (¥/$) 87.60
Year-beginning price of a Corolla ($) $ 24,543.38

b. What is the expected spot rate at the end of the year assuming PPP?
Initial spot rate (¥/$) 87.60
Expected US$ inflation 2.20%
Expected Japanese yen inflation 0.00%
Expected spot rate at end of year assuming PPP (¥/$) 85.71

c. Assuming complete pass through, what will the price be in US$ in one year?
Price of Corolla at beginning of year (¥) 2,150,000
Japanese yen inflation over the year 0.000%
Price of Corolla at end of year (¥) 2,150,000
Expected spot rate one year from now assuming PPP (¥/$) 85.71
Price of Corolla at end of year in ($) $ 25,083.33

d. Assuming partial pass through, what will the price be in US$ in one year?
Price of Corolla at end of year (¥) 2,150,000
Amount of expected exchange rate change, in percent (from PPP) 2.200%
Proportion of exchange rate change passed through by Toyota 75.000%
Proportional percentage change 1.650%
Effective exchange rate used by Toyota to price in US$ for end of year 86.178
Price of Toyota at end of year ($) $ 24,948.34
Problem 6.7 Takeshi Kamada -- CIA Japan (A)

Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage
possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars
and Japanese yen. He faced the following exchange rate and interest rate quotes.

Assumptions Value Yen Equivalent


Arbitrage funds available $5,000,000 593,000,000
Spot rate (¥/$) 118.60
180-day forward rate (¥/$) 117.80
180-day U.S. dollar interest rate 4.800%
180-day Japanese yen interest rate 3.400%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i ¥ - i $) -1.400%


Forward premium on the yen 1.358%
CIA profit potential -0.042%

This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to
lock-in a covered interest arbitrage (CIA) profit.

U.S. dollar interest rate (180 days)


4.800%

$ 5,000,000 → → 1.0240 → → $ 5,120,000


↑ ↓
↑ ↓
↑ ↓
↑ ↓
↑ ↓
Spot (¥/$) ---------------> 180 days ----------------> Forward-180 (¥/$)
118.60 117.80
↑ ↓
↑ ↓
↑ 603,136,000
593,000,000.00 → → 1.0170 → → 603,081,000
Japanese yen 55,000
3.400%
START Japanese yen interest rate (180 days) END

Takeshi Kamada generates a CIA profit by investing in the higher interest rate currency, the dollar, and simultaneously
selling the dollar proceeds forward into yen at a forward premium which does not completely negate the interest
differential.
Problem 6.8 Takeshi Kamada -- UIA Japan (B)

Takeshi Kamada, Credit Suisse (Tokyo), observes that the ¥/$ spot rate has been holding steady, and both dollar and
yen interest rates have remained relatively fixed over the past week. Takeshi wonders if he should try an uncovered
interest arbitrage (UIA) and thereby save the cost of forward cover. Many of Takeshi's research associates -- and their
computer models -- are predicting the spot rate to remain close to ¥118.00/$ for the coming 180 days. Using the same
data as in the previous problem, analyze the UIA potential.

Assumptions Value Yen Equivalent


Arbitrage funds available $5,000,000 593,000,000
Spot rate (¥/$) 118.60
180-day forward rate (¥/$) 117.80
Expected spot rate in 180 days (¥/$) 118.00
180-day U.S. dollar interest rate 4.800%
180-day Japanese yen interest rate 3.400%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i ¥ - i $) -1.400%


Expected gain (loss) on the spot rate 1.017%
UIA profit potential -0.383%

This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to
potentially gain on an uncovered basis (UIA).

U.S. dollar interest rate (180 days)


4.800%

$5,000,000 → → 1.0240 → → $5,120,000


↑ ↓
↑ ↓
↑ ↓
↑ ↓
↑ Expected Spot Rate
Spot (¥/$) ---------------> 180 days ----------------> in 180 days (¥/$)
118.60 118.00
↑ ↓
↑ ↓
↑ 604,160,000
593,000,000.00 → → 1.0170 → → 603,081,000
Japanese yen 1,079,000
3.400%
START Japanese yen interest rate (180 days) END

a) Takeshi Kamada generates an uncovered interest arbitrage (UIA) profit of ¥1,079,000 if his expectations about the
future spot rate, the one in effect in 180 days, prove correct.

b) The risk Takeshi is taking is that the actual spot rate at the end of the period can theoretically be anything, better or
worse for his speculative position. He in fact has very little "wiggle room," as they say. A small movement will cost
him a lot of money. If the spot rate ends up any stronger than about 117.79/$ (a smaller number), he will lose money.
(Verify by inputting ¥117.70/$ in the expected spot rate cell under assumptions.)
Problem 6.9 Copenhagen Covered (A)

Heidi Høi Jensen, a foreign exchange trader at J.P. Morgan Chase, can invest $5 million, or the foreign currency
equivalent of the bank's short term funds, in a covered interest arbitrage with Denmark. Using the following quotes
can Heidi make covered interest arbitrage (CIA) profit?

Assumptions Value
Arbitrage funds available $5,000,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
US dollar 3-month interest rate 3.000%
Danish kroner 3-month interest rate 5.000%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$) 2.000%


Forward discount on the krone -1.678%
CIA profit potential 0.322%

This tells Heidi Høi Jensen that he should borrow dollars and invest in the higher yielding currency the Danish kroner,
for CIA profit.

U.S. dollar interest rate (3-month)


START 3.000% END

$ 5,000,000.00 → → 1.0075 → → $ 5,037,500.00


↓ 5,041,263.31
↓ $ 3,763.31
↓ ↑
↓ ↑
↓ ↑
Spot (kr/$) ---------------> 90 days ----------------> Forward-90 (kr/$)
6.1720 6.1980
↓ ↑
↓ ↑
↓ ↑
kr 30,860,000.00 → → 1.0125 → → kr 31,245,750.00

5.000%
Danish kroner interest (3-month)

Heidi Høi Jensen generates a covered interest arbitrage (CIA) profit because she is able to generate an even higher
interest return in Danish kroner than she "gives up" by selling the proceeds forward at the forward rate.
Problem 6.10 Copenhagen Covered (B)

Heidi Høi Jensen is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note
that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make
CIA profit one way or another.)

Assumptions Value kr Equivalent


Arbitrage funds available $5,000,000 kr 30,860,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
US dollar 3-month interest rate 4.000% a)
Danish kroner 3-month interest rate 5.000% a)

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$) 1.000%


Forward discount on the krone -1.678%
CIA profit potential -0.678%

This tells Heidi that she should borrow Danish kroner and invest in the LOWER interest rate currency, the dollar,
gaining on the re-exchange of dollars for kroner at the end of the period.

U.S. dollar interest rate (3-month)


4.000%

$ 5,000,000.00 → → 1.0100 → → $ 5,050,000.00


↑ ↓
↑ ↓
↑ ↓
↑ ↓
↑ ↓
Spot (kr/$) ---------------> 90 days ----------------> F-90 (kr/$)
6.1720 6.1980
↑ ↓
↑ ↓
↑ kr 31,299,900.00
kr 30,860,000.00 → → 1.0125 → → kr 31,245,750.00
kr 54,150.00
5.000%
START Danish kroner interest (3-month) END

a) Heidi Høi Jensen generates a covered interest arbitrage profit of kr54,150 because, although U.S. dollar interest
rates are lower, the U.S. dollar is selling forward at a premium against the Danish krone.
Problem 6.11 Copenhagen Covered ( C )

Heidi Høi Jensen is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note
that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make
CIA profit one way or another.)

Assumptions Value kr Equivalent


Arbitrage funds available $5,000,000 kr 30,860,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
US dollar 3-month interest rate 3.000% b)
Danish kroner 3-month interest rate 6.000% b)

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$) 3.000%


Forward discount on the krone -1.678%
CIA profit potential 1.322%

This tells Heidi Høi Jensen that she should borrow US dollars and invest in the HIGHER interest rate currency, the
kroner, gaining on the re-exchange of kroner for dollars at the end of the period.

U.S. dollar interest rate (3-month)


3.000%
START END
$5,000,000 → → 1.0075 → → $ 5,037,500.00
↓ $ 5,053,710.87
↓ $ 16,210.87
↓ ↑
↓ ↑
↓ ↑
Spot (kr/$) ---------------> 90 days ----------------> F-90 (kr/$)
6.1720 6.1980
↓ ↑
↓ ↑
↓ ↑
kr 30,860,000.00 → → 1.0150 → → kr 31,322,900.00

6.000%
Danish kroner interest (3-month)

b) If the Danish kroner interest rate increases to 6.00%, while the U.S. dollar interest rate stays at 3.00% and spot and
forward rates remain the same, Heidi Høi Jensen's CIA profit is $16,210.87.
Problem 6.12 Casper Landsten -- CIA (A)

Casper Landsten is a foreign exchange trader for a bank in New York. He has $1 million (or its Swiss franc equivalent)
for a short-term money market investment and wonders whether he should invest in U.S. dollars for 90 days or make a
covered interest arbitrage (CIA) investment in the Swiss franc. He faces the following quotes:

Assumptions Value SFr. Equivalent


Arbitrage funds available $1,000,000 SFr. 950,200
Spot exchange rate (CHF/USD) 0.9502
3-month forward rate (CHF/USD) 0.9410
USD 3-month interest rate 3.800%
Swiss franc 3-month interest rate 5.300%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i CHF. - i USD 1.500%


Forward premium on the Swiss franc 3.911%
CIA profit potential 5.411%

This tells Casper he should invest in the higher yeilding CHF in order to earn covered interest arbitrage (CIA) profits.

U.S. dollar interest rate (3-month)


START 3.80% END

$ 1,000,000.00 → → 1.0095 → → $ 1,009,500.00


↓ 1,023,156.38
↓ $ 13,656.38
↓ ↑
↓ ↑
↓ ↑
Spot (CHF/USD) ---------------> 90 days ----------------> Forward-90 (CHF/USD)
0.9502 0.9410
↓ ↑
↓ ↑
↓ ↑
SFr. 950,200.00 → → 1.0133 → → SFr. 962,790.15

5.30%
Swiss franc interest rate (3-month)

a) Casper Landsten makes a net profit, a covered interest arbitrage profit, of $1,538.46 on each million he invests in
the Swiss franc market (by going around the box). He should therefore take advantage of it and perform covered
interest arbitrage.

b) Assuming a $1 million investment for the 90-day period, the annual rate of return on
this near risk-less investment is: 5.46%
Problem 6.13 Casper Landsten -- UIA (B)

Using the same values and assumptions as in Problem 12, Casper Landsten decides to seek the full 3.80% return
available in U.S. dollars by not covering his forward dollar receipts—an uncovered interest arbitrage (UIA)
transaction. Assess this decision.

Assumptions Value SFr. Equivalent


Arbitrage funds available $1,000,000 SFr. 950,200
Spot exchange rate (CHF/USD) 0.9502
3-month forward rate (CHF/USD) 0.9410
Expected spot rate in 90 days (CHF/USD) 1.2700
USD 3-month interest rate 3.800%
Swiss franc 3-month interest rate 5.300%

Since Casper is in the US market (starting point), if he were to undertake uncovered interest arbitrage he would be
first exchange dollars for Swiss francs, investing the Swiss francs for 90 days, and then exchanging the Swiss franc
proceeds (principle and interest) back into US dollars at whatever the spot rate of exchange is at that time. In this case
Casper will have to -- at least in his mind -- make some assumption as to what the exchange rate will be at the end of
the 90 day period.

START U.S. dollar interest rate (3-month) END


3.80%

$ 1,000,000 → → 1.0095 → → $ 1,009,500.00


$ 1,009,531.46
↓ $ 31.46
↓ ↑
↓ ↑
↓ ↑
Spot (CHF/USD) ---------------> 90 days ----------------> Expected Spot (CHF/USD)
0.9502 0.9537
↓ ↑
↓ ↑

CHF 950,200 → → 1.0133 → → CHF 962,790

5.30%
Swiss franc interest rate (3-month)

If Casper assumed the spot rate at the end of 90 days will be CHF0.9537/USD (the IRP implied 3-month forward rate),
the UIA transaction would produce the full 3.80% return available in USD.

For UIA transaction to result in higher USD proceeds at the end of the 3-month period, the ending spot rate of
exchange would have to be less than CHF0.9537/USD (a stronger CHF will result in more USD when the final
exhchange is made).

Should Casper do it? Well, depends on his bank's policies on uncovered transactions, and his beliefs on the future spot
exchange rate. But, given that he is invested in a foreign currency with a lower interest rate, not a higher one, so he is
placing all of his 'bets' on the exchange rate, it is not a speculation for the weak of heart.
Problem 6.14 Casper Landsten -- Thirty Days Later

One month after the events described in Problems 12 and 13, Casper Landsten once again has $1 million (or its Swiss
franc equivalent) to invest for 90 days. He now faces the following foreign exchange and interest rates. Should he
again enter into a CIA investment?

Assumptions Value SFr. Equivalent


Arbitrage funds available $1,000,000 SFr. 945,200
Spot exchange rate (CHF/USD) 0.9452
3-month forward rate (CHF/USD) 0.9410
US dollar 3-month interest rate 6.800%
Swiss franc 3-month interest rate 4.300%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i CHF - i USD -2.500%


Forward premium on the Swiss france 1.785%
CIA profit -0.715%

This tells Casper Landsten he should borrow U.S. dollars and invest in the lower yielding currency, the Swiss franc,
and then sell the Swiss franc principal and interest forward three months locking in a CIA profit.

U.S. dollar interest rate (3-month)


START 6.80% END

$1,000,000 → → 1.017000 → → $ 1,017,000.00


↓ 1,015,261.32
↓ $ (1,738.68)
↓ ↑
↓ ↑
↓ ↑
Spot (CHF/USD) ---------------> 90 days ----------------> F-90 (CHF/USD)
0.9452 0.9410
↓ ↑
↓ ↑
↓ ↑
CHF 945,200.00 → → 1.0107500 → → CHF 955,360.90

4.30%
Swiss franc interest rate (3-month)

Casper can make a covered interest arbitrage profit of USD1,738.68 on each million USD-equaivalent Swiss franc (by
going around the box). He should therfore take advantafe of it and perform covered interest arbitrage.
Problem 6.15 Statoil of Norway's Arbitrage

Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and
petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it considers the
U.S. dollar as its functional currency, not the Norwegian krone. Ari Karlsen is a currency trader for Statoil, and has
immediate use of either $3 million (or the Norwegian krone equivalent). He is faced with the following market rates, and
wonders whether he can make some arbitrage profits in the coming 90 days.

Assumptions Value Krone Equivalent


Arbitrage funds available $3,000,000 18,093,600
Spot exchange rate (Nok/$) 6.0312
3-month forward rate (Nok/$) 6.0186
U.S. dollar 3-month interest rate 5.000%
Norwegian krone 3-month interest rate 4.450%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change
in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the
forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i Nok - i $) -0.550%


Forward premium on the krone 0.835%
CIA profit 0.285%

This tells Ari Karlsen he should borrow U.S. dollars and invest in the lower yielding currency, the Norwegian krone, selling
the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.

Norwegian krone interest rate (3-month)


4.450%

18,093,600.00 → → 1.0111250 → → 18,294,891.30


↑ ↓
↑ ↓
↑ ↓
↑ ↓
↑ ↓
Spot (Nok/$) ---------------> 90 days ----------------> Forward-90 (Nok/$)
6.0312 6.0186
↑ ↓
↑ ↓
↑ $ 3,039,710.25
$ 3,000,000.00 → → 1.01250000 → → $ 3,037,500.00
Borrow US$ $ 2,210.25

5.000%
START U.S. dollar interest rate (3-month) END

Ari Karlsen can make $2,210.25 for Statoil on each $3 million he invests in this covered interest arbitrage (CIA) transaction.
Note that this is a very slim rate of return on an investment of such a large amount.

Annualized rate of return: 0.2947%


Problem 6.16 Separated by the Atlantic

The separation of over 3,000 nautical miles and five time zones, money and foreign exchange markets in both
London and New York are very efficient. The following information has been collected from the respective
areas:

Assumptions London New York


Spot exchange rate ($/€) 1.3264 1.3264
One-year Treasury bill rate 3.900% 4.500%
Expected inflation rate Unknown 1.250%

a. What do the financial markets suggest for inflation in Europe next year?
b. Estimate today's one-year forward exchange rate between the dollar and the euro.

a. What do the financial markets suggest for inflation in Europe next year?

According to the Fisher effect, real interest rates should be the same in both Europe and the US.

Since the nominal rate = [ (1+real) x (1+expected inflation) ] - 1:

1 + real rate = (1 + nominal) / (1 + expected inflation)


1 + nominal rate 103.900% 104.500%
1 + expected inflation ? 101.250%
So 1 + real = 103.210% ← 103.210%
and therefore the real rate in the US is: 3.210%

The expected rate of inflation in Europe is then: 0.669%

b. Estimate today's one-year forward exchange rate between the dollar and the euro.

Spot exchange rate ($/€) 1.3264


US dollar one-year Treasury bill rate 4.500%
European euro one-year Treasury bill rate 3.900%
One year forward rate ($/€) 1.3341
Problem 6.17 Chamonix Chateau Rentals

You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are
negotiating over the rental of a chateau. The chateau's owner wishes to preserve his real income
against both inflation and exchange rate changes, and so the present weekly rent of €9,800
(Christmas season) will be adjusted upwards or downwards for any change in the French cost of
living between now and then. You are basing your budgeting on purchasing power parity (PPP).
French inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is
expected to be 2.5%. The current spot rate is $1.3620/€. What should you budget as the U.S. dollar
cost of the one week rental?

Assumptions Value
Spot exchange rate ($/€) $1.3620
Expected US inflation for coming year 2.500%
Expected French inflation for coming year 3.500%
Current chateau nominal weekly rent (€) € 9,800.00

Forecasting the future rent amount and exchange rate: Value

Purchasing power parity exchange rate forecast ($/€) 1.3488

Spot (one year) = Spot x ( 1 + US$ inflation ) / ( 1 + French inflation )

Nominal monthly rent, in euros, one year from now 10,143.00

Rent now x ( 1 + inflation France )

Cost of rent one year from now in US dollars $ 13,681.29

Rent one year from now / PPP forecasted spot rate

Note: students may inquire as to whether the euro, a currency for a multitude of countries which
may actually have substantial differencies in inflation locally, really will react to inflationary
pressures and differentials as PPP would predict. A good question.
Problem 6.18 East Asiatic Company -- Thailand

The East Asiatic Company (EAC), a Danish company with subsidiaries all over Asia, has been funding its Bangkok
subsidiary primarily with U.S. dollar debt because of the cost and availability of dollar capital as opposed to Thai
baht-denominated (B) debt. The treasuer of EAC-Thailand is considering a one-year bank loan for $250,000. The
current spot rate is B32.06/$, and the dollar-based interest is 6.75% for the one year period. One year loans are 12.00%
in baht.

a. Assuming expected inflation rates of 4.3% and 1.25% in Thailand and the United States, repectively, for the
coming year, according to purchase power parity, what would the effective cost of funds be in Thai baht terms?

b. If EAC's foreign exchange advisers believe strongly that the Thai government wants to push the value of the
baht down against the dollar by 5% over the coming year (to promote its export competitiveness in dollar
markets), what might the effective cost of funds end up being in baht terms?

c. If EAC could borrow Thai baht at 13% per annum, would this be cheaper than either part (a) or part (b) above?

Assumptions Value
Current spot rate, Thai baht/$ 32.06
Expected Thai inflation 4.300%
Expected dollar inflation 1.250%
Loan principal in U.S. dollars $250,000
Thai baht interest rate, 1-year loan 12.000%
US dollar interest rate, 1-year loan 6.750%

First, it is necessary to forecast the future spot exchange rate for the baht/$.

PPP forecast of Thai baht/$ 33.0258

Different expectations of the future spot exchange rate, either PPP for part a), or an expected devaluation for
part b), allow the isolation of exactly how many Thai baht would be required to repay the dollar loan.

U.S. dollar borrowing rate (one year)


6.750%

$ 250,000 → → 1.06750 → → $ 266,875


↓ ↓
↓ ↓
↓ ↓
↓ ↓
↓ ↓
Spot (Baht/$) ---------------> 360 days ----------------> Expected Spot (Baht/$)
32.0600 33.0258
↓ ↓
↓ ↓

8,015,000.00 8,813,760.38
Thai baht Baht needed to repay
12.000% U.S. dollar loan
Thai baht borrowing rate (one year)

Implied cost = (Repaid/Initial proceeds) - 1 9.966%

a) Assuming a purchasing power parity forecast of the future spot rate, B33.0258/$, it will take 8,813,760 baht to
repay the U.S. dollar loan. The implied cost of funds, in baht terms, is 9.966%.

b) Assuming a future spot rate for the baht which is 5% weaker than the current spot rate (B32.06/$ ÷ ( 1 - .05), or
B33.7474/$), the implied cost is 12.369%. (This is found by plugging in this new forecast spot rate in the expected
spot rate cell on the right-hand-side of the box.)
Current 32.0600
Pct Chg -5.00%
New spot = old spot ÷ ( 1 - .05) Forecast 33.7474

c) Part a and part b are both cheaper than borrowing at 12.00%. However, both are highly risky given that the future
spot rate is not known until a full year has passed.
Problem 6.19 Maltese Falcon

Imagine that the mythical solid gold falcon, initially intended as a tribute by the Knights of Malta to the King of Spain
in appreciation for his gift of the island of Malta to the order in 1530, has recently been recovered. The falcon is 14
inches high and solid gold, weighing approximately 48 pounds. Assume that gold prices have risen to $440/ounce,
primarily as a result of increasing political tensions. The falcon is currently held by a private investor in Istanbul, who
is actively negotiating with the Maltese government on its purchase and prospective return to its island home. The sale
and payment are to take place one year from now in March 2004, and the parties are negotiating over the price and
currency of payment. The investor has decided, in a show of goodwill, to base the sales price only on the falcon's
specie value – its gold value.

The current spot exchange rate is 0.39 Maltese lira (ML) per 1.00 U.S. dollar. Maltese inflation is expected to be about
8.5% for the coming year, while U.S. inflation, on the heels of a double-dip recession, is expected to come in at only
1.5%. If the investor bases value in the U.S. dollar, would he be better off receiving Maltese lira in one year (assuming
purhcasing power parity), or receiving a guaranteed dollar payment (assuming a gold price of $420 per ounce)?

Now In One Year


Weight of falcon, in pounds 48 48
Total number of ounces in weight 768 768
Price of gold, $/ounce $ 440.00 $ 420.00
Falcon value based on price of gold $ 337,920.00 $ 322,560.00

The purchasing power parity forecast of the Maltese lira/dollar exchange rate:

Current spot rate, Maltese lira/$ 0.3900


Expected Maltese inflation 8.500%
Expected dollar inflation 1.500%
PPP forecast of Maltese lira/$ 0.4169

If the investor bases his gross sales proceeds in U.S. dollars, the guaranteed dollar payment at $420/ounce yields a
larger amount ($322,560) than accepting Maltese lira assuming PPP ($316,116).

Investor Receives
in March 2004
Current Value Assuming PPP
$ 337,920 $ 316,116
↓ ↑
↓ ↑
↓ ↑
↓ ↑
↓ ↑
Spot (ML/$) ---------------> 360 days ----------------> Expected Spot (ML/$)
0.3900 0.4169
↓ ↑
↓ ↑
↓ ↑
131,788.80 131,788.80
Maltese lira
Problem 6.20 Malaysian Risk

Clayton Moore is the manager of an international money market fund managed out of London. Unlike many money
funds that guarantee their investors a near risk-free investment with variable interest earnings, Clayton Moore's fund is
a very aggressive fund that searches out relatively high interest earnings around the globe, but at some risk. The fund
is pound-denominated. Clayton is currently evaluating a rather interesting opportunity in Malaysia. Since the Asian
Crisis of 1997, the Malaysian government enforced a number of currency and capital restrictions to protect and
preserve the value of the Malaysian ringgit. The ringgit was fixeded to the U.S. dollar at RM3.80/$ for seven years.
In 2005, the Malaysian government allowed the currency to float against several major currencies. The current spot
rate today is RM3.13485/$. Local currency time deposits of 180-day maturities are earning 8.900% per annum. The
London eurocurrency market for pounds is yielding 4.200% per annum on similar 180-day maturities. The current spot
rate on the British pound is $1.5820/£, and the 180-day forward rate is $1.5561/£.

Assumptions Values
Principal investment, British pounds £1,000,000.00
Spot exchange rate ($/£) $ 1.5820
180-day forward rate ($/£) $ 1.5561
Malaysian ringgit 180-day yield 8.900%
Spot exchange rate, Malaysian ringgit/$ 3.1384

The initial pound investment implicitly passes through the dollar into Malaysian ringgit. The ringgit is fixed
against the dollar, hence the ending Malaysian ringgit/$ rate is the same as the current spot rate. The pound,
however, is not fixed to either the dollar or ringgit. Clayton Moore can purchase a forward against the dollar,
allowing him to cover the dollar/pound exchange rate.

Return = (Proceeds/Initial investment) - 1 6.188%

Initial Investment Investment Proceeds


£1,000,000.00 £1,061,884.84
↓ ↑
↓ ↑
↓ ↑
↓ British pounds versus US dollars ↑
Spot ($/£) ---------------> 180 days ----------------> Fwd-180 ($/£)
1.5820 1.5561
↓ ↑
↓ ↑
↓ ↑
$ 1,582,000 U.S. dollar values $ 1,652,399
↓ ↑
↓ ↑
↓ ↑
↓ Malaysian ringgit versus US dollars ↑
Spot (M$/$) ---------------> 180 days ----------------> Expected Spot (M$/$)
3.1384 3.1384
↓ ↑
↓ ↑
↓ ↑
4,964,948.80 → → 1.0445 → → 5,185,889.02
Malaysian ringgit Ringgit proceeds
8.900%
Malaysian ringgit deposit rate (180 days)

If Clayton Moore invests in the Malaysian ringgit deposit, and accepts the uncovered risk associated with the RM/$
exchange rate (managed by the government), and sells the dollar proceeds forward, he should expect a return of
6.188% on his 180-day pound investment. This is better than the 4.200% he can earn in the euro-pound market.

Interestingly, if Clayton chose to NOT sell the dollars forward, and accepted the uncovered risk of the $/£ exchange
rate as well, he may or may not do better than 6.188%. For example, if the spot rate remained unchanged at $1.5820/£,
Clayton's return would only be 4.450%. This demonstrates that much of the added return Clayton is earning is arising
from the forward rate itself, and not purely from the nominal interest differentials.
Problem 6.21 The Beer Standard

In 1999 the Economist magazine reported the creation of an index or standard for the evaluation of African currency values using the local prices of beer. Beer
was chosen as the product for comparison because McDonald's had not peneterated the African continent beyond South Africa, and beer met most of the same
product and market characteristics required for the construction of a proper currency index. Investec, a South African investment banking firm, has replicated
the process of creating a measure of purchasing power parity (PPP) like that of the Big Mac Index of the Economist, for Africa.

The index compares the cost of a 375 milliliter bottle of clear lager beer across sub-Sahara Africa. As a measure of PPP the beer needs to be relatively
homogeneous in quality across countries, needs to possess substantial elements of local manufacturing, inputs, distribution, and service, in order to actually
provide a measure of relative purchasing power. The beers are first priced in local currency (purchased in the taverns of the local man, and not in the high-
priced tourist centers), then converted to South African rand. The prices of the beers in rand are then compared to form one measure of whether the local
currencies are undervalued (-%) or overvalued (+%) versus the South African rand. Use the data in the exhibit and complete the calculation of whether the
individual currencies are under- or over-valued.

Beer Prices Spot Under or


Local Local In Implied rate overvalued
Country Beer currency currency rand PPP rate (3/15/99) to rand (%)
South Africa Castle Rand 2.30 ---- ---- ---- ----
Botswana Castle Pula 2.20 2.94 0.96 0.75 27.9%
Ghana Star Cedi 1,200.00 3.17 521.74 379.10 37.6%
Kenya Tusker Shilling 41.25 4.02 17.93 10.27 74.6%
Malawi Carlsberg Kwacha 18.50 2.66 8.04 6.96 15.6%
Mauritius Phoenix Rupee 15.00 3.72 6.52 4.03 61.8%
Namibia Windhoek N$ 2.50 2.50 1.09 1.00 8.7%
Zambia Castle Kwacha 1,200.00 3.52 521.74 340.68 53.1%
Zimbabwe Castle Z$ 9.00 1.46 3.91 6.15 -36.4%

Notes:
1. Beer price in South African rand = Price in local currency / spot rate on 3/15/99.
2. Implied PPP exchange rate = Price in local currency / 2.30.
3. Under or overvalued to rand = Implied PPP rate / spot rate on 3/15/99.
Problem 6.22 Grupo Bimbo (Mexico)

Grupo Bimbo, headquartered in Mexico City, is one of the largest bakery companies in the world. On January 1st, when the
spot exchange rate is Ps10.80/$, the company borrows $25.0 million from a New York bank for one year at 6.80% interest
(Mexican banks had quoted 9.60% for an equivalent loan in pesos). During the year, U.S. inflation is 2% and Mexican
inflation is 4%. At the end of the year the firm repays the dollar loan.

a. If Bimbo expected the spot rate at the end of one year to be that equal to purchasing power parity, what would be the cost
to Bimbo of its dollar loan in peso-denominated interest?

b. What is the real interest cost (adjusted for inflation) to Bimbo, in peso-denominated terms, of borrowing the dollars for
one year, again assuming purchasing power parity ?

c. If the actual spot rate at the end of the year turned out to be Ps9.60/$, what was the actual peso-denominated interest cost
of the loan?

Borrowing principal $ 25,000,000


Current spot rate, pesos/dollar (Ps/$) 10.800
Mexican inflation (actual) 4.00%
US dollar inflation (actual) 2.00%
PPP forecast of spot rate (Ps/$) 11.01 Spot (PPP) = S * (1 + πPs) / (1 + π$ )
Actual spot rate end of year (Ps/$) 9.60
Actual spot rate end of year (Ps/$) 9.60

U.S. dollar borrowing rate (one year)


6.800%

$ 25,000,000 → → 1.0680 → → $ 26,700,000


↓ ↓
↓ ↓
↓ ↓
↓ ↓
↓ ↓
Spot (Ps/$) ---------------> 360 days ----------------> EOY Spot (Ps/$)
10.80 11.01
↓ ↓
↓ ↓

270,000,000 294,014,118
Mexican pesos Pesos needed to repay
U.S. dollar loan
9.600%
Quoted Mexico peso borrowing rate (one year)

Implied cost = (Repaid/Initial proceeds) - 1 8.894%

a. If the ending spot rate was Ps11.01/$ as PPP would predict, the actual peso-based interest cost would be 8.894%.

b. The real peso-denominated interest cost (corrected for inflation) would be:

The calculation shown at right is the precise or Nominal interest 8.8940%


exact answer. The approximate form, found Actual inflation 4.0000%
simply by subtracting inflation from nominal Real peso-interest 4.7058%
interest, would be 4.894%.

b. If the actual end of year spot rate was Ps9.60/$ (just plug it into the spreadsheet for the EOY Spot rate), the actual peso-
denominated interest cost would be -5.067%. (Yes, a negative interest rate.)
Problem 6.23 AvtoVAZ of Russia's Kalina Export Pricing Analysis

AvtoVAZ OAO, a leading auto manufacturer in Russia, was launching a new automobile model in 2001, and is in the midst of completing a complete pricing
analysis of the car for sales in Russia and export. The new car, the Kalina, would be initially priced at Rubles 260,000 in Russia, and if exported, $8,666.67 in
U.S. dollars at the current spot rate of Rubles 30 = $1.00. AvtoVAZ intends to raise the price domestically with the rate of Russian inflation over time, but is
worried about how that compares to the export price given U.S. dollar inflation and the future exchange rate. Use the following data table to answer the pricing
analysis questions.

Calendar year 2001 2002 2003 2004 2005 2006


Kalina Price (rubles) 260,000
Russian inflation (forecast) 14.0% 12.0% 11.0% 8.0% 8.0%
U.S. inflation (forecast) 2.5% 3.0% 3.0% 3.0% 3.0%
Exchange rate (rubles = USD 1.00) 30.00

a. If the domestic price of the Kalina increases with the rate of inflation, what would its price be over the 2002-2006 period?

b. Assuming that the forecasts of US and Russian inflation prove accurate, what would the value of the ruble be over the coming years if its value versus the
dollar followed purchasing power parity?

c. If the export price of the Kalina were set using the purchasing power parity forecast of the ruble-dollar exchange rate, what would the export price be over
the 2002-2006 period?

d. How would the Kalina's export price evolve over time if it followed Russian inflation and the exchange rate of the ruble versus the dollar remained relatively
constant over this period of time?

e. Vlad, one of the newly hired pricing strategists, believes that prices of automobiles in both domestic and export markets will both increase with the rate of
inflation, and that the ruble/dollar exchange rate will remain fixed. What would this imply or forecast for the future export price of the Kalina?

f. If you were AvtoVAZ, what would you hope would happen to the ruble's value versus the dollar over time given your desire to export the Kalina? Now if you
combined that 'hope' with some assumptions about the competition -- other automobile sales prices in dollar markets over time -- how might your strategy
evolve?

g. So what did the Russian ruble end up doing over the 2001-2006 period?

Calendar year 2001 2002 2003 2004 2005 2006

a. Kalina Price with Russian inflation (rubles) 260,000 296,400 331,968 368,484 397,963 429,800

b. Exchange rate (rubles=$1.00) if purchasing 30.00 33.37 36.28 39.10 41.00 42.99
power parity (PPP) holds

c. Export price if using PPP (dollars) $ 8,666.67 $ 8,883.33 $ 9,149.83 $ 9,424.33 $ 9,707.06 $ 9,998.27

d. Export price at fixed exchange rate (dollars) $ 8,666.67 $ 9,880.00 $ 11,065.60 $ 12,282.82 $ 13,265.44 $ 14,326.68

An added note is to recognize that if this was the case, PPP is definitely not 'holding' in the academic sense.

e. Vlad is actually not saying anything different than what questions c) and d) addressed. If the export price is based on the initial dollar price of $8,667.67 then
rising with dollar inflation, it reaches $9,998.27 in 2006 (same as part c)). Alternatively, if the pricing follows the price in the domestic market, in rubles, rising
with Russian inflation, it reaches Rubles 429,800 in 2006, and when converted to U.S. dollars at an assumed fixed rate of exchange of Rubles 30 = $1.00, the
same $14,326.68 as in part d).

If export price rises at dollar inflation $ 8,666.67 $ 8,883.33 $ 9,149.83 $ 9,424.33 $ 9,707.06 $ 9,998.27

299,948

f. Exporters generally would prefer that their own currency weakens over time versus the currency of the customer -- making their product offering increasingly
affordable (cheaper), and hopefully increasing sales volume. Since AvtoVAZ's costs are all in Russian rubles, earning a hard currency like the dollar which
would be slowly strengthenging against the ruble might increase profit margins (depending on what happens to costs over time from other factors).

If most of the competition in the target dollar markets were dollar-based manufacturers, their costs and prices might be rising with dollar inflation. The answers
to parts c) and d) provide some ideas or possible boundaries on what you might consider. At fixed exchange rates, the dollar price would rise quite high by
2006 (to $14,326.68), whereas if rate of exchange had remained fixed the export price would be much lower in 2006 ($9,998.27). Of course pricing strategies
can and should be changed over time with changing market conditions, but the general consensus of analysts would be to expect to increase the at a rate
somewhere inbetween c) and d) forecasts.