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# 1. Assume the current U.S. dollar-British spot rate is 0.6993/\$.

I the current
nominal one-!ear interest rate in the U.S. is "# and the compara\$le rate in Britain
is 6#% &hat is the appro'imate or&ard e'chan(e rate or 360 da!s)
A* 1.+,/\$
B* 1.+3/\$
-* 0.6993/\$
.* 0./060/\$
0* 0.69,//\$
Ans&er1 .
,1 2ou are (i3en the ollo&in( e'chan(e rate 4uotes in S!dne!1
US./AU. 0."366
AU./0U5 1.6+,6
US./0U5 0.6/6,
-alculate the US dollar proit% i an!% on a three-point ar\$itra(e.
A71 US.0.0036 or e3er! 1 US. in3ested
B1 US.0.,3,0 or e3er! 1 US. in3ested
-1 US.1.00+3 or e3er! 1 US. in3ested
.1 8il
0. US.0.016/3 or e3er! 1 US. in3ested
3. I the (ross domestic return is hi(her than the (ross co3ered orei(n return then1
A1 the interest parit! or&ard rate is lo&er than the actual or&ard rate.
B1 the interest rate dierential is lo&er than the or&ard spread.
-71 the interest parit! or&ard rate is hi(her than the actual or&ard rate.
.1 the or&ard discount is hi(her than the interest rate dierential in a3or o the
domestic currenc! assets.
01 none o the a\$o3e.
+. I the net orei(n return is lo&er than the domestic interest rate then1
A1 the interest parit! or&ard rate is lo&er than the actual or&ard rate.
B71 the interest parit! or&ard rate is hi(her than the actual or&ard rate.
-1 the interest rate dierential is lo&er than the or&ard spread.
.1 the or&ard discount is hi(her than the interest dierential in a3or o the home
currenc! assets.
01 none o the a\$o3e.
". I the interest rate dierential is three per cent &hile the or&ard spread is one per cent
then1
A1 there is a 4ualitati3e 3iolation o -I9.
B71 there is a 4uantitati3e 3iolation o -I9.
-1 there are \$oth a 4ualitati3e and 4uantitati3e 3iolation o -I9.
.1 nothin( deinite can \$e stated \$ased on this inormation onl!.
01 none o the a\$o3e
6. I the interest rate dierential and the or&ard spread are positi3e and e4ual then1
A1 the orei(n currenc! should oer a hi(her interest rate and sell at a or&ard
discount.
B1 the orei(n currenc! should oer a hi(her interest rate and sell at a or&ard
-1 the domestic currenc! should oer a hi(her interest rate and sell at a or&ard
.71 the domestic currenc! should oer a hi(her interest rate and sell at a or&ard
discount.
01 A and -.
/. I the interest rate dierential and the or&ard spread are ne(ati3e and e4ual then1
A1 the orei(n currenc! should oer a hi(her interest rate and sell at a or&ard
B1 the domestic currenc! should oer a hi(her interest rate and sell at a or&ard
-1 the domestic currenc! should oer a hi(her interest rate and sell at a or&ard
discount.
.1 none o the a\$o3e
071 the orei(n currenc! should oer a hi(her interest rate and sell at a or&ard
discount.
6. I the interest rate dierential and the or&ard spread are positi3e \$ut the ormer is lo&er
than the latter1
A1 the orei(n currenc! should oer a hi(her interest rate and sell at a or&ard
discount.
B1 the orei(n currenc! should oer a hi(her interest rate and sell at a or&ard
-1 the domestic currenc! should oer a hi(her interest rate and sell at a or&ard
.71 the domestic currenc! should oer a hi(her interest rate and sell at a or&ard
discount.
01 A and -.
9. Under &hich o the ollo&in( conditions &ill out&ard ar\$itra(e \$e tri((ered)
A1 :he interest rate dierential and or&ard spread are positi3e and the dierential
B1 :he interest rate dierential and or&ard spread are ne(ati3e and the a\$solute
3alue o the interest dierential is lo&er than the a\$solute 3alue o the spread.
-71 :he interest rate dierential and or&ard spread are positi3e and the interest
dierential is lo&er than the spread.
.1 :he interest rate dierential is positi3e &hile the spread is ne(ati3e.
01 B and -.
10. Under &hich o the ollo&in( conditions &ill in&ard ar\$itra(e \$e tri((ered)
A1 :he interest rate dierential and or&ard spread are positi3e and the dierential
B71 :he interest rate dierential and or&ard spread are ne(ati3e and the a\$solute
3alue o the interest dierential is lo&er than the a\$solute 3alue o the spread.
-1 :he interest rate dierential and or&ard spread are ne(ati3e and the a\$solute
3alue o the interest dierential is (reater than the a\$solute 3alue o the spread.
.1 :he interest rate dierential is ne(ati3e &hile the spread is positi3e.
01 none o the a\$o3e.
11. ;ut&ard co3ered ar\$itra(e does not cause1
A1 a rise in the domestic interest rate.
B1 a all in the orei(n interest rate.
-1 a all in the or&ard e'chan(e rate.
.71 a all in the spot e'chan(e rate.
01 - and ..
1,1 In&ard co3ered ar\$itra(e does not cause1
A1 a all in the domestic interest rate.
B1 a rise in the orei(n interest rate.
-71 a rise in the spot e'chan(e rate.
.1 a rise in the or&ard e'chan(e rate.
01 . and -.
13. <hich o the ollo&in( statements is true &ith respect to the -I9 h!pothesis)
A1 :he -I9 h!pothesis descri\$es the e4uili\$rium relationship \$et&een the spot
e'chan(e rate% the or&ard e'chan(e rate% domestic interest rates and orei(n
interest rates.
B1 :he -I9 h!pothesis descri\$es the e4uili\$rium relationship \$et&een the actual and
the interest parit! or&ard rate.
-1 :he -I9 h!pothesis &as ori(inall! de3eloped \$! =e!nes in the 19,0s.
.1 :he -I9 h!pothesis descri\$es the e4uili\$rium relationship \$et&een the or&ard
discount >premium* on the home >orei(n* currenc! and the (ross real interest
rate dierentials.
01 All o the a\$o3e are true e'cept ..
?or 4uestions 1"-16% !ou are (i3en the ollo&in( inormation1
Spot e'chan(e rate >AU./US.* 1./66,
Australian three-month interest rate +.6"# pa
U.S. three-month interest rate 1.+1# pa
1+. I -I9 holds% &hat &ill \$e the three-month or&ard e'chan(e rate >AU./US.*% accordin(
to the precise -I9 ormula)
A1 AU./US. 1.6,61
B1 AU./US. 1./063
-1 AU./US. 1./61+
.71 AU./US. 1./613
01 AU./US. 1.6,66
1". I -I9 holds% &hat &ill \$e the interest dierential on domestic and orei(n assets%
accordin( to the precise -I9 ormula)
A71 0.006"/
B1 0.00660
-1 0.01,13
.1 0.003"3
01 0.00,90
16. I -I9 holds% &hat &ill \$e the (ross interest dierential on domestic and orei(n assets%
accordin( to the precise -I9 ormula)
A1 1.01,13
B1 1.003"3
-71 1.006"/
.1 1.001,3
01 none o the a\$o3e.
1/1 I -I9 holds% &hat should \$e the AU./US. three-month or&ard e'chan(e rate%
accordin( to the appro'imate -I9 ormula)
A1 AU./US. 1.6,61
B1 AU./US. 1./063
-71 AU./US. 1./61+
.1 AU./US. 1./613
01 AU./US. 1.6,66
16. I the positi3e interest rate dierential in a3or o the domestic currenc! is hi(her than the
A71 the in3estors around the &orld are moti3ated to mo3e their capital unds rom the
orei(n inancial mar@ets to&ards the domestic inancial mar@ets.
B1 the in3estors around the &orld are moti3ated to mo3e their capital unds rom the
domestic inancial mar@ets to&ards the orei(n inancial mar@ets.
-1 the in3estors are around the &orld are not moti3ated to mo3e their unds in either
direction.
.1 All the a\$o3e are incorrect.
01 A and B.
19. I the positi3e interest rate dierential in a3or o the orei(n currenc! is lo&er than the
A1 the in3estors around the &orld are moti3ated to mo3e their capital unds rom the
domestic inancial mar@ets to&ards the orei(n inancial mar@ets.
B1 the in3estors are around the &orld are not moti3ated to mo3e their unds in either
direction.
-71 the in3estors around the &orld are moti3ated to mo3e their capital unds rom the
orei(n inancial mar@ets to&ards the domestic inancial mar@ets.
.1 All the a\$o3e are incorrect.
01 B and -.
,0. I the domestic interest rate is lo&er than the orei(n interest rate% then
A1 capital unds &ill al&a!s tend to mo3e out o the home countr!.
B71 capital unds &ill tend to mo3e out o the home countr! i the home currenc!
sells at a discount.
-1 capital unds &ill not tend to mo3e in either direction.
.1 All the a\$o3e are the correct.
01 capital unds &ill tend to mo3e out o the home countr! i the home currenc!
,1. I the domestic interest rate is lo&er than the orei(n interest rate% then
A1 capital unds &ill al&a!s tend to mo3e out o the home countr!.
B71 capital unds &ill not tend to mo3e out o the home countr! unless the interest
dierential in a3or o the orei(n currenc! is much \$i((er than the premium on
the domestic currenc!.
-1 capital unds &ill not tend to mo3e in either direction.
.1 All the a\$o3e are the correct.
01 A and B.
-hica(o Ban@ e'pects the e'chan(e rate the 8e& Aealand dollar to appreciate rom
its present le3el \$0."0 to \$0.", in 30 da!s. :he \$an@ is a\$le to \$orro& \$,0 million or
8A\$+0 million on a short-term \$asis rom other \$an@. Because \$ro@ers sometimes
ser3e as intermediaries \$et&een \$an@s% the lendin( rate diers rom the \$orro&in(
rate. Short-term interest rates >annualiBed* in the inter\$an@ mar@et at &hich -hica(o
\$an@ can lend or \$orro& are as ollo&s1
-urrenc! Cendin( 5ate Borro&in( 5ate
US dollars 6./,# /.,0#
8e& Aealand dollars 6.+6# 6.96#
Suppose -hica(o \$an@ \$orro&s \$,0 million or 30 da!s% con3ert the \$,0 million to
8e& Aealand dollar to lend in the 8e& Aealand dollar or 30 da!s and con3ert the
proceeds rom the 8e& Aealand dollar loan repa!ment at the e'pected spot e'chan(e
rate to repa! the dollars \$orro&ed to close out its positions on .a! 30.
A* -alculate the total US dollar amount necessar! to repa! the loan.
B* -alculate the total 8e& Aealand dollar proceeds that the \$an@ &ill recei3e on
.a! 30.
-* .etermine &hether the \$an@ &ould ma@e speculati3e proit or loss.
A. Borro& \$,0 million at /.,# or a month
\$,0>1D0.0/,/1,* E \$,0%1,0%000
This is the loan with interest payments to be paid back to a US bank one month
later.
B. -on3ert the unds \$orro&ed >\$,0* into 8e& Aealand dollar at the spot rate o 1/S to
o\$tain
\$,0/0." E 8A\$+0 million
In3est 8A\$+0 million in 8e& Aealand at monthl! interest rate o 6.+6# to o\$tain
8A\$+0>1D0.06+6/1,* E 8\$+0% ,16%000
C. Sell the proceeds rom in3estment denominated in the 8e& Aealand dollar or the US
dollar at the 1-month uture spot rate o \$0.", to o\$tain \$,0% 91,% 3,0.
9roit E \$,0% 91,% 3,0 - \$,0%1,0%000 E \$/9,%3,0
(ii) <hat happens i the -hica(o Ban@ e'pects the e'chan(e rate o the 8e& Aealand dollar
to depreciate rom its present le3el o \$0."0 to \$0.+6 in 30 da!s)
:here is a loss1 \$19% 303% 660 - \$,0%1,0%000 E -\$616% 3,0
,,. 2ou are (i3en the ollo&in( inormation1
Spot e'chan(e rate >AU./0U5* 1.60
;ne-!ear or&ard rate >AU./0U5* 1.6,
;ne-!ear interest rate on the Australian dollar 6."#
;ne-!ear interest rate on the euro 6."#
>a* Is there an! 3iolation o -I9)
>\$* -alculate the co3ered mar(in >(oin( short on the AU.*.
>c* -alculate the interest parit! or&ard rate and compare it &ith the actual or&ard
rate.
>d* -alculate the or&ard spread and compare it &ith the interest dierential.
>e* <hat &ould ar\$itra(ers do)
>* I ar\$itra(e is initiated% su((est some 3alues or the interest and e'chan(e rates
ater it has stopped and e4uili\$rium has \$een reached.
Solution
>a* Since the or&ard e'chan(e rate is hi(her than the spot rate% the 0U5 is sellin( at a
premium. Because it oers a lo&er interest rate% there is no F4ualitati3eG 3iolation o -I9%
in the sense that the lo& interest currenc! sells at a premium% not at a discount. <hether
or not there is a F4uantitati3eG 3iolation o -I9 can onl! \$e @no&n \$! ans&erin( the
ollo&in( parts o the pro\$lem.
>\$* :he co3ered mar(in >(oin( short on the AU.* is calculated as
006/ . 0 * 06" . 0 1 > * 06" . 0 1 >
60 . 1
6, . 1
= + +
Since the co3ered mar(in is not e4ual to Bero% there is a 3iolation o -I9.
>c* :he interest parit! or&ard rate is calculated as
6301 . 1
06" . 1
06" . 1
60 . 1
1
1
7
= =

+
+
=
i
i
S F
&hich is hi(her than the actual or&ard rate% impl!in( de3iations rom -I9.
>d* :he or&ard spread and the interest rate dierential are calculated as
# ," . 1 01," . 0
60 . 1
60 . 1 6, . 1
= =

=
S
S F
f
0, . 0 06" . 0 06" . 0
7
= = i i E ,#
:he or&ard spread and interest rate dierential are une4ual \$ut ha3e the same si(n%
impl!in( a 4uantitati3e 3iolation o -I9.
>e* Ar\$itra(ers &ill \$orro& the euro% con3ert it into Australian dollars and in3est the
proceeds at 6." per cent or one !ear. Upon the maturit! o the in3estment% the proceeds
&ill \$e con3erted \$ac@ into the euro at the or&ard rate. :he co3ered mar(in in this case
is 0./" percenta(e points >, H 1.,"*.
>* Ar\$itra(e &ill come to an end &hen 6, . 1 = F . I interest rates are unchan(ed% then
the spot rate must all to 1."6/6. At this rate the co3ered mar(in is Bero either &a! >!ou
ma! &ant to conirm this or !oursel*.