Chapter 06 International Parity Relationships and Forecasting Foreign Exchange Rates Key
1.
An arbitrage is best defined as
A. a legal condition imposed by the CFTC.
B.the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making reasonable profits.
C.the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making guaranteed profits.
D.None of the above
Eun – Chapter 06 #1 Topic: Interest Rate Parity
2.Interest Rate Parity (IRP) is best defined as
A. when a government brings its domestic interest rate in line with other major financial markets.
B.when the central bank of a country brings its domestic interest rate in line with its major trading partners.
C.an arbitrage condition that must hold when international financial markets are in equilibrium.
D.None of the above
Eun – Chapter 06 #2 Topic: Interest Rate Parity
3.When Interest Rate Parity (IRP) does not hold
A.there is usually a high degree of inflation in at least one country.
B.the financial markets are in equilibrium.
C.there are opportunities for covered interest arbitrage.
D.both b and c
Eun – Chapter 06 #3 Topic: Interest Rate Parity
4.Suppose you observe a spot exchange rate of $1.50/€. If interest rates are 5% APR in the U.S. and 3% APR in the euro zone, what is the no-arbitrage 1-year forward rate?
A.€1.5291/$
B.$1.5291/€
C.€1.4714/$
D.$1.4714/€
Eun – Chapter 06 #4 Topic: Interest Rate Parity
5.Suppose you observe a spot exchange rate of $1.50/€. If interest rates are 3% APR in the U.S. and 5% APR in the euro zone, what is the no-arbitrage 1-year forward rate?
A.€1.5291/$
B.$1.5291/€
C.€1.4714/$
D.$1.4714/€
Eun – Chapter 06 #5 Topic: Interest Rate Parity
6.Suppose you observe a spot exchange rate of $2.00/£. If interest rates are 5% APR in the U.S. and 2% APR in the U.K., what is the no-arbitrage 1-year forward rate?
A.£2.0588/$
B.$2.0588/£
C.£1.9429/$
D.$1.9429/£
Eun – Chapter 06 #6 Topic: Interest Rate Parity
7.A formal statement of IRP is
A.
Eun – Chapter 06 #7 Topic: Interest Rate Parity
8.Suppose that the one-year interest rate is 5.0 percent in the United States; the spot exchange rate is $1.20/€; and the one-year forward exchange rate is $1.16/€. What must one-year interest rate be in the euro zone to avoid arbitrage?
A.
5.0%
B.
6.09%
C.
8.62%
D.
None of the above
Eun – Chapter 06 #8 Topic: Covered Interest Arbitrage
9.
Suppose that the one-year interest rate is 3.0 percent in the Italy, the spot exchange rate is $1.20/€, and the one-year forward exchange rate is $1.18/€. What must one-year interest rate be in the United States?
A.
1.2833%
B.
1.0128%
C.
4.75%
D.
None of the above
Eun – Chapter 06 #9 Topic: Covered Interest Arbitrage
10.
Suppose that the one-year interest rate is 4.0 percent in the Italy, the spot exchange rate is $1.60/€, and the one-year forward exchange rate is $1.58/€. What must one-year interest rate be in the United States?
A.
2%
B.
2.7%
C.
5.32%
D.
None of the above
Eun – Chapter 06 #10 Topic: Covered Interest Arbitrage
11.
Covered Interest Arbitrage (CIA) activities will result in
A.
an unstable international financial markets.
B.
restoring equilibrium prices quickly.
C.
a disintermediation.
D.
no effect on the market.
Eun – Chapter 06 #11 Topic: Covered Interest Arbitrage
12.
Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and that the spot exchange rate is $1.12/€ and the one-year forward exchange rate, is $1.16/€. Assume that an arbitrageur can borrow up to $1,000,000.
A.
This is an example where interest rate parity holds.
B.
This is an example of an arbitrage opportunity; interest rate parity does NOT hold.
C.
This is an example of a Purchasing Power Parity violation and an arbitrage opportunity.
D.
None of the above
Eun – Chapter 06 #12 Topic: Covered Interest Arbitrage
13.
Suppose that you are the treasurer of IBM with an extra U.S. $1,000,000 to invest for six months. You are considering the purchase of U.S. T-bills that yield 1.810% (that’s a six month rate, not an annual rate by the way) and have a maturity of 26 weeks. The spot exchange rate is $1.00 = ¥100, and the six month forward rate is $1.00 = ¥110. The interest rate in Japan (on an investment of comparable risk) is 13 percent. What is your strategy?
A.
Take $1m, invest in U.S. T-bills.
B.
Take $1m, translate into yen at the spot, invest in Japan, and repatriate your yen earnings back into dollars at the spot rate prevailing in six months.
C.
Take $1m, translate into yen at the spot, invest in Japan, hedge with a short position in the forward contract.
D.
Take $1m, translate into yen at the forward rate, invest in Japan, hedge with a short position in the spot contract.
Eun – Chapter 06 #13 Topic: Covered Interest Arbitrage
14.
Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in Germany, and that the spot exchange rate is $1.60/€ and the forward exchange rate, with one-year maturity, is $1.58/€. Assume that an arbitrager can borrow up to $1,000,000 or €625,000. If an astute trader finds an arbitrage, what is the net cash flow in one year?
A.
$238.65
B.
$14,000
C.
$46,207
D.
$7,000
Eun – Chapter 06 #14 Topic: Covered Interest Arbitrage
15.
A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how to realize a certain profit via covered interest arbitrage.
A.
Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B.
Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit $2,400.
C.
Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit €2,000.
D.
Both c and b
Eun – Chapter 06 #15 Topic: Covered Interest Arbitrage
16.
Suppose that the annual interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and that the spot exchange rate is $1.12/€ and the forward exchange rate, with one-year maturity, is $1.16/€. Assume that an arbitrager can borrow up to $1,000,000. If an astute trader finds an arbitrage, what is the net cash flow in one year?
A.
$10,690
B.
$15,000
C.
$46,207
D.
$21,964.29
Eun – Chapter 06 #16 Topic: Covered Interest Arbitrage
17.
A U.S.-based currency dealer has good credit and can borrow $1,000,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how to realize a certain dollar profit via covered interest arbitrage.
A.
Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B.
Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit $2,400.
C.
Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit €2,000.
D.
Both c and b
Eun – Chapter 06 #17 Topic: Covered Interest Arbitrage
18.
An Italian currency dealer has good credit and can borrow €800,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.20 = €1.00. Show how to realize a certain euro-denominated profit via covered interest arbitrage.
A.
Borrow $1,000,000 at 2%. Trade $1,000,000 for €800,000; invest at i€ = 6%; translate proceeds back at forward rate of $1.20 = €1.00, gross proceeds = $1,017,600.
B.
Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €848,000 back into euro at the forward rate of $1.20 = €1.00. Net profit $2,400.
C.
Borrow €800,000 at i€ = 6%; translate to dollars at the spot, invest in the U.S. at i$ = 2% for one year; translate €850,000 back into euro at the forward rate of $1.20 = €1.00. Net profit €2,000.
D.
Both c and b
Eun – Chapter 06 #18 Topic: Covered Interest Arbitrage
19.
Suppose that you are the treasurer of IBM with an extra U.S. $1,000,000 to invest for six months. You are considering the purchase of U.S. T-bills that yield 1.810% (that’s a six month rate, not an annual rate by the way) and have a maturity of 26 weeks. The spot exchange rate is $1.00 = ¥100, and the six month forward rate is $1.00 = ¥110. What must the interest rate in Japan (on an investment of comparable risk) be before you are willing to consider investing there for six months?
A.
11.991%
B.
1.12%
C.
7.45%
D.
-7.45%
Eun – Chapter 06 #19 Topic: Covered Interest Arbitrage
20.
How high does the lending rate in the euro zone have to be before an arbitrageur would NOT consider borrowing dollars, trading for euro at the spot, investing in the euro zone and hedging with a short position in the forward contract?
A.
The bid-ask spreads are too wide for any profitable arbitrage when i€ > 0
B.
3.48%
C.
-2.09%
D.
None of the above
Eun – Chapter 06 #20 Topic: Covered Interest Arbitrage
21.
Suppose that the one-year interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and the one-year forward exchange rate is $1.16/€. What must the spot exchange rate be?
A.
$1.1768/€
B.
$1.1434/€
C.
$1.12/€
D.
None of the above
Eun – Chapter 06 #21 Topic: Interest Rate Parity and Exchange Rate Determination
22.
A higher U.S. interest rate (i$ ↑) will result in
A.
a stronger dollar.
B.
a lower spot exchange rate (expressed as foreign currency per U.S. dollar).
C.
both a and b
D.
none of the above
Eun – Chapter 06 #22 Topic: Interest Rate Parity and Exchange Rate Determination
23.
If the interest rate in the U.S. is i$ = 5 percent for the next year and interest rate in the U.K. is i£ = 8 percent for the next year, uncovered IRP suggests that
A.
the pound is expected to depreciate against the dollar by about 3 percent.
B.
the pound is expected to appreciate against the dollar by about 3 percent.
C.
the dollar is expected to appreciate against the pound by about 3 percent.
D.
both a and c
Eun – Chapter 06 #23 Topic: Interest Rate Parity and Exchange Rate Determination
24.
A currency dealer has good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$ = 2% and in the euro zone the one-year interest rate is i€ = 6%. The one-year forward exchange rate is $1.20 = €1.00; what must the spot rate be to eliminate arbitrage opportunities?
A.
$1.2471 = €1.00
B.
$1.20 = €1.00
C.
$1.1547 = €1.00
D.
none of the above
Eun – Chapter 06 #24 Topic: Interest Rate Parity and Exchange Rate Determination
25.
Will an arbitrageur facing the following prices be able to make money?
A.
Yes, borrow $1,000 at 5%; Trade for € at the ask spot rate $1.01 = €1.00; Invest €990.10 at 5.5%; Hedge this with a forward contract on €1,044.55 at $0.99 = €1.00; Receive $1.034.11.
B.
Yes, borrow €1,000 at 6%; Trade for $ at the bid spot rate $1.00 = €1.00; Invest $1,000 at 4.5%; Hedge this with a forward contract on €1,045 at $1.00 = €1.00.
C.
No; the transactions costs are too high.
D.
None of the above
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