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a. How many dollars might Theresa expect to need one year hence to pay for her 30-day vacation?
b. By what percent has the dollar cost gone up? Why?
Assumptions
Charge for suite plus meals in Malaysian ringgit (RM) per day
Spot exchange rate (RM/$)
US$ cost today for a 30 day stay
Malaysian ringgit inflation rate expected to be
U.S. dollar inflation rate expected to be
Value
1,045.00
3.1350
$10,000.00
2.750%
1.250%
a. How many dollars might you expecte to need one year hence for your 30-day vacation?
Spot exchange rate (ringgit per US$)
Malaysian ringgit inflation rate expected to be
U.S. dollar inflation rate expected to be
3.1350
2.750%
1.250%
3.181444
32,212.13
$10,125.00
$10,125.00
$10,000.00
1.250%
The dollar cost has risen by the US dollar inflation rate. This is a result of Theresa's estimation of the future suite
costs and the exchange rate changing in proportion to inflation (relative purchasing power parity).
per day
Value
1.0000
3.2000
2.20%
20.00%
a. What should have been the exchange rate in January 2003 if PPP held?
Beginning spot rate (Ps/$)
Argentine inflation
US inflation
PPP exchange rate
1.00
20.00%
2.20%
1.17
3.20
1.17
-63.307%
Value
850.00
930.00
1.0941
1.15%
3.13%
850.00
930.00
1.0941
b. What should be the price of the luggage set in A$ in 1-year if PPP holds?
Beginning spot rate (A$/$)
Australian inflation
US inflation
PPP exchange rate
Price of 3-Piece Luggage set in US$
PPP exchange rate
Price of 3-piece luggage set in Sydney (A$)
However, purchasing power parity is not always an accurate predictor of exchange rate
movements, particularly in the short-term.
1.0941
3.13%
1.15%
1.1155
850.00
1.1155
948.19
Value
5.6288
25.70
2.65
4.57
9.70
112.408%
Value
87.60
2,150,000
2.200%
0.000%
75.000%
a. What was the export price for the Corolla at the beginning of the year?
Year-beginning price of an Corolla ()
Spot exchange rate (/$)
Year-beginning price of a Corolla ($)
2,150,000
87.60
24,543.38
b. What is the expected spot rate at the end of the year assuming PPP?
Initial spot rate (/$)
Expected US$ inflation
Expected Japanese yen inflation
Expected spot rate at end of year assuming PPP (/$)
c. Assuming complete pass through, what will the price be in US$ in one year?
Price of Corolla at beginning of year ()
Japanese yen inflation over the year
Price of Corolla at end of year ()
Expected spot rate one year from now assuming PPP (/$)
Price of Corolla at end of year in ($)
d. Assuming partial pass through, what will the price be in US$ in one year?
Price of Corolla at end of year ()
Amount of expected exchange rate change, in percent (from PPP)
Proportion of exchange rate change passed through by Toyota
Proportional percentage change
Effective exchange rate used by Toyota to price in US$ for end of year
Price of Toyota at end of year ($)
87.60
2.20%
0.00%
85.71
2,150,000
0.000%
2,150,000
85.71
25,083.33
2,150,000
2.200%
75.000%
1.6500%
86.178
24,948.34
-2.2%
-1.61%
86.19
Value
$5,000,000
6.1720
6.1980
3.000%
5.000%
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or
expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest
rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
Difference in interest rates (ikr - i$)
Forward discount on the krone
CIA profit potential
2.000%
-1.678%
0.322%
This tells Heidi Hi Jensen that he should borrow dollars and invest in the higher yielding currency the Danish
kroner, for CIA profit.
START
$
5,000,000.00
Spot (kr/$)
6.1720
kr 30,860,000.00
1.0075
END
1.0125
5,037,500.00
5,041,263.31
$
3,763.31
Forward-90 (kr/$)
6.1980
kr 31,245,750.00
5.000%
Danish kroner interest (3-month)
Heidi Hi 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.
Value
$5,000,000
6.1720
6.1980
4.000%
5.000%
kr Equivalent
kr 30,860,000
a)
a)
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or
expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest
rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
Difference in interest rates (ikr - i$)
Forward discount on the krone
CIA profit potential
1.000%
-1.678%
-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.
5,000,000.00
Spot (kr/$)
6.1720
kr 30,860,000.00
START
1.0100
1.0125
5.000%
Danish kroner interest (3-month)
5,050,000.00
F-90 (kr/$)
6.1980
kr 31,299,900.00
kr 31,245,750.00
kr 54,150.00
END
a) Heidi Hi 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.
Value
$1,000,000
1.2810
1.2740
4.800%
3.200%
SFr. Equivalent
SFr. 1,281,000
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 ( i SFr. - i $)
Forward premium on the Swiss franc
CIA profit potential
-1.600%
2.198%
0.598%
This tells Casper Landsten he should borrow U.S. dollars and invest in the LOWER yielding currency, the Swiss
franc, in order to earn covered interest arbitrage (CIA) profits.
START
$
1,000,000.00
Spot (SFr./$)
1.2810
SFr. 1,281,000.00
1.0120
END
1.0080
1,012,000.00
1,013,538.46
$
1,538.46
Forward-90 (SFr./$)
1.2740
SFr. 1,291,248.00
3.200%
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:
0.62%
Value
$1,000,000
1.3392
1.3286
4.750%
3.625%
SFr. Equivalent
SFr. 1,339,200
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 SFr. - i $)
Forward premium on the Swiss france
CIA profit
-1.125%
3.191%
2.066%
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.
START
$1,000,000
Spot (SFr./$)
1.3392
SFr. 1,339,200.00
1.011875
END
1.0090625
1,011,875.00
1,017,113.13
$
5,238.13
F-90 (SFr./$)
1.3286
SFr. 1,351,336.50
3.625%
Swiss franc interest rate (3-month)
Yes, Casper should undertake the covered interest arbitrage transaction, as it would yield a risk-less profit (exchange
rate risk is eliminated with the forward contract, but counterparty risk still exists if one of his counterparties failed to
actually make good on their contractual commitments to deliver the forward or pay the interest) of $5,238.13 on
each $1 million invested.
Value
$3,000,000
6.0312
6.0186
5.000%
4.450%
Krone Equivalent
18,093,600
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 $)
Forward premium on the krone
CIA profit
-0.550%
0.835%
0.285%
This tells Ari Karlsen he should borrow U.S. dollars and invest in the lower yielding currency, the Norwegian
krone, selling the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.
18,093,600.00
Spot (Nok/$)
6.0312
3,000,000.00
Borrow US$
START
1.0111250
1.01250000
5.000%
U.S. dollar interest rate (3-month)
18,294,891.30
Forward-90 (Nok/$)
6.0186
$
3,039,710.25
$
3,037,500.00
$
2,210.25
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%