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School of Business

University of Alberta

Masa Watanabe
Winter 2015

INTERNATIONAL FINANCIAL MARKETS

FIN 442

FOREIGN EXCHANGE RATES,


INTERNATIONAL PARITY CONDITIONS I
FX Market Characteristics .............................................................................. 4
The Domestic Fisher Equation ..................................................................... 10
The Law of One Price (LOP) = Purchasing Power Parity (PPP) ................. 11
Locational Arbitrage ..................................................................................... 12
Cross Rates and Triangular Arbitrage .......................................................... 13
Interest Rate Parity (IRP) .............................................................................. 14
Forward Parity and Unbiased Expectations Hypothesis (UEH)................... 18
Practice Problems with Solutions: Butler 5th ed. Chs. 3 & 4 ........................ 21
So much of barbarism, however still remains in the
transactions of most civilized nations, that almost all
independent countries choose to assert their nationality by
having, to their own inconvenience and that of their
neighbors, a peculiar currency of their own.
~ John Stuart Mill

Day

Night

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INTL PARITY CONDITIONS I


Notation used in this note

Nominal interest rate. For example, i denotes the nominal interest rate for the
British pound.

Inflation rate (Butler uses p for this)

Real interest rate

St

Spot exchange rate at time t. For example, S0$/ denotes the value of the euro in
dollars at time 0.

Ft,T

Forward exchange rate, quoted at time t for delivery at time T > t. For example,
F0,1/$ denotes the value of the dollar in yen for delivery at time 1, quoted at time 0.

St

Change in the spot rate. St = St St-1.

st

Percentage change in the spot rate. st = St / St-1 1.

FPt,T

Forward premium. FPt,T = Ft,T / St 1.

Change in the value of your position. For example, V$/ may denote the change in
the value per pound of your receipt from an export to UK.

Price of a good. For example, P may denote the price of gold in British pound.

Et[]

Expectation operator. For example, Et[ST] is the market participants expectation


about the future time T spot rate formed at time t.

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The FX Market

8 hours
(covers NYC & London)

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FX MARKET CHARACTERISTICS
Average Daily Turnover - US$ Equivalent
(Trillions)
2.0

1.5

1.0

0.5

0.0
1970s

1980s

1990s

2000s

Source: BIS, Triennial Central Bank Survey

The FX market is the worlds largest financial market. It operates 24 hours a day.
Volume: $5 trillion per day (April 2013, Triennial Central Bank Survey by the Bank
for International Settlements). 75% is in the interbank market.
London is the worlds largest foreign exchange center with over 30% of all activity.
Londons advantages include its:
history (going back to the days when the pound was the predominant world
currency),
geography (can trade with Tokyo and Hong Kong in the morning and New York in
the afternoon), and
the right regulatory environment.
Commercial banks are the market makers. Their clients are corporations (typically
hedgers) and fund managers (sometimes speculators). SWIFT and CHIPS are the
operational backbone of the interbank market.
Spot transactions make up about 40% of all FX trading activity.
Around half of all FX transactions involve the US$.
Liquidity is the ease of capturing an assets value. The interbank foreign exchange
market for large transactions is the worlds most liquid market.

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INTL PARITY CONDITIONS I

Currency is just like any other commodity: it has a price.


Spot Rate
The spot rate, SA/B, is the value of currency B in A. For example, S$/ = 1.30$/
means that the price of the euro is $1.30.
Forward Rate
A forward contract is an agreement to buy or sell a currency at a future time for a
pre-determined price. This pre-determined price is called the forward rate, denoted
by FA/B.
Note that these are the prices of Currency B, the currency in the denominator.
Rule
Always buy or sell the currency in the denominator of a foreign exchange quote.

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INTL PARITY CONDITIONS I


Exchange-rate Quotations
National Post, 2014/12/31, Page FP7.

Wall Street Journal Asia, 2015/1/2, Page 25.


Any interesting observations?

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INTL PARITY CONDITIONS I


FX Market Quotes with Bid-Ask Spread
Bid

: the price at which a market maker is willing to buy a currency.

Ask (offer): the price at which a market maker is willing to sell a currency.
Bid-ask spread: ask price bid price.
Spreads in the most active markets are less than 5bp (0.05%). For less liquid
currencies they can be much larger.
The spread size depends on the markets liquidity and volatility and on the size of
the transaction.
Note that the quotation on the previous page shows no spreads. The rates are the
average of the quote-midpoint over banks, and therefore do not represent tradable
exchange rates.
Example of a tradable quote from Reuters:

The bid rate is $1.2078/. This is the price at which Citibank is willing to buy .
The ask rate is $1.2081/. This is the price at which Citibank is willing to sell .
Aside: these rates are quoted at 01:01a.m. Central Standard Time (the time
zone is not shown, but the quote was taken in Houston), 8/25/2004 by Citibank
Hong Kong. Although everybody is asleep in North America, Asian markets are
wide open (see the FX Market map above)! Literally, the Citi never sleeps
The market maker keeps the spread. The implicit transaction fee on a single trade is
half of the spread.
Buy 1 from Citi and simultaneously sell 1 to it. You will lose 1.2081 1.2078
= $0.0003 or 3/100 round-trip. Your one-way cost is half of it: 1.5/100.

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The ask rate must be greater than the bid for the market maker to be willing to make
a market.
If not, the quote refers to the prices of the currency in the numerator. For
example, the above quote is equivalent with:
Bid $1.2081/ > Ask $1.2078/ for $.
Citi will buy the dollar at $1.2081/ and sell it at $1.2078/ (also see Method 2 in
the next example).
Example. If a Citibank currency trader quotes a spread of 1.2078 USD 1.2081 USD
against the euro (see the Reuters indication above), how many euros would it take to
buy one dollar? How many euros would be received in exchange for one dollar?
(Note that we are buying or selling the currency in the numerator.)
Solution: Method 1. Do it intuitively.
It is either 1/1.2078 or 1/1.2081.
You always lose (unfortunately) against the market maker, so you have to pay the
larger of the two, 1/1.2078 = 0.8280 euros to buy $1.
Contrarily, you will only receive 1/1.2081=0.8277 euros when you sell $1.
Note: As the number of currencies involved increases, you can easily get confused with
this intuitive method. Try to see this yourself by applying it to the Triangular Arbitrage
later in this note.

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INTL PARITY CONDITIONS I


Method 2. More systematically, apply the Rule.
If necessary, invert the rates so that the currency in question (the dollar) appears in
the denominator. Also rearrange them so that ask > bid.
Bid 1.2078

1.2081 Ask

($/euro = bid & ask for the euro)

Bid 1/1.2081

1/1.2078 Ask (euro/$ = bid & ask for the dollar)

Note that upon inverting, the bid quote for becomes the ask for $ and the ask quote
for becomes the bid for $.
Buy or sell the currency in the denominator.
To buy $1, you have to buy at the ask for the dollar, paying 1/1.2078 = 0.8280
euros.
To sell $1, you receive the bid rate for the dollar, 1/1.2081=0.8277 euros.

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THE DOMESTIC FISHER EQUATION
1 + i = (1 + )(1 + e )
i

e

=
=
=

nominal interest rate


inflation rate
real interest rate

Approximation when both and e are small:


i + e
That is, the real interest rate approximately equals the nominal interest rate less
(expected) inflation.
Intuition: You have $1. The price of an apple is $1. You can either buy an apple
today, or deposit the dollar in your bank account. Your bank account pays a 5%
interest. So, you will receive $1.05 in 1 year. But if the apple price has doubled, you
can buy only about half an apple. That is, your dollar has lost its real purchasing
power by about a half. The real interest rate will tell you exactly how much.
Example: What is the real interest rate in the above setting according to the exact
formula? What if you use the approximate formula?

Example: The nominal euro interest rate on a one-year deposit is 6%. Expected
inflation is 4%. What is the expected real interest rate?

The real interest rate can be negative. See Buttonwood: The real deal, The
Economist, 10/29/2012.
Recently, in some currencies even nominal interest rates have become negative.

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THE LAW OF ONE PRICE (LOP) = PURCHASING POWER PARITY (PPP)
Equivalent assets sell for the same price.
Various parity conditions are derived from LOP.
Cant be used when assets vary in quality.
Seldom holds for non-traded assets.
May not hold precisely when there are market frictions.
Example. Suppose the price of gold is P = 250/oz in London, and P = 400/oz in
Berlin. What is the exchange rate that PPP implies?
Answer. The law of one price requires
P = P S/
400 = 250 S/
S/ = 400/250 = 1.6000/
If this relation does not hold, then there is an opportunity to lock in a riskless arbitrage
profit (in a costless world).
Riskless arbitrage is a profitable position obtained with
no net investment
no risk

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LOCATIONAL ARBITRAGE
In the real world, there is a bid-ask spread.
No Arbitrage Condition in the Presence of Cost
Equivalent assets sell for the same price within the bounds of transactions cost.
Locational arbitrage exists when somebodys ask price is lower (i.e., you can buy low)
than anothers bid (i.e., you can sell high).
Q1. Bank X quotes 125.26/ bid, 125.32/ ask.
Bank Y quotes 125.28/ bid, 125.34/ ask.
Can you make money? How do you know? How much?
125.34
125.32
125.28
125.26

Bank X

Bank Y

Q2. Bank X quotes 125.26/ bid, 125.32/ ask.


Bank Z quotes 125.33/ bid, 125.37/ ask.

125.37

Can you make money? How do you know? How much?


125.33
125.32

125.26

Bank X

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Bank Z

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CROSS RATES AND TRIANGULAR ARBITRAGE
Replace gold with another currency Triangular arbitrage
A cross exchange rate is an exchange rate that does not involve the domestic
currency.
Example. The following spot exchange rates are observed in the market: $1.0779/,
125.29/, 116.19/$. Can you make any money? How much? Specify each transaction.
(We are ignoring spread.)
Solution.
First, eliminate one currency. To do so, compute a synthetic exchange rate implied by
any two rates (say the first two):
/
/$
/$
/$
125.29 1/1.0779 = 116.235 (synthetic) > 116.19 (market)
Thus, it is cheaper to buy the dollar at the market rate of 116.19. We wish to sell the
dollar effectively at the synthetic rate, which actually involves two transactions.
Specifically:
1. Sell $1.0779 and receive 1,
Selling $ against at the synthetic rate
2. Sell 1 and get 125.29, and
3. Sell 125.29 at 116.19/$ and receive 125.29/116.19 = $1.0783.
Profit of $0.0004 for every euro bought and sold.
Graphical Representation

Buy 1
Sell $1.0779

Arbitrage profit of
$0.0004 per every 1
bought and sold.
No investment
No risk

Sell 125.29
Buy $(125.29/116.19)
= $1.0783

Sell 1
Buy 125.29

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INTEREST RATE PARITY (IRP)
d/f
t ,T

d/f
t

1 id
1 if

d/f
d
f
or FPt ,T i i ,

d/f
d/f
d/f
where FPt ,T Ft ,T / St 1 is the forward premium.

A currency is selling at a forward premium when the price in the forward market is
higher than the price in the spot market (FPt,T > 0).
A currency is selling at a forward discount when the price in the forward market is
lower than the price in the spot market (FPt,T < 0).
Implication: The forward premium is determined by the interest rate differential.
A high interest-rate currency must be in forward discount.
This is a parity condition that you can trust, because:
All numbers are competitively determined in liquid markets (spot and forward FX
markets, Eurocurrency markets) in which arbitrage works.
Involves no human expectation (compared to other parity conditions to be
introduced).
Note that id and if are interest rates for the period between t and T. So, if you are given
annual interest rates and if T t > 1 year, you must compound them. Similarly, if T t
< 1 year, you must prorate them (on a 360-day basis). That is, for a 6-month forward
rate (T t = years), the IRP becomes
d/f
t ,T

1 id / 2
S
.
1 if / 2
d/f
t

Note that Butler 5th ed. applies his general formula, Eq. (4.4) on p.80, to all occasions
including cases in which the time to maturity is less than 1 year, using a 365-day basis
(see, e.g., p.123-124 & Figure 5.6). But in real markets, Eurocurrency interest rates are
usually quoted as simple interest rates on a 360-day basis, which produces the above
formula. In class, we will follow the latter convention.
Q3. Does IRP tell us anything about what the future spot rate (St+1) will be?
Q4. Does IRP tell us anything about what the future forward rate (Ft+1,T+1) will be?

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Interest Rate Parity (IRP) Take 1
Rewrite IRP as
1 i$

Ft $/f
,T
S

$/f
t

(1 i f )

A fundamental idea in Finance: If there are multiple ways to achieve the same cash
flows and the alternatives have the same risk, they will also have the same return.
Example. Consider two nearly risk-free investment alternatives for $100,000.
Alternative #1:

Deposit $100,000 in a Eurodollar CD at i$ for 1 year.

Alternative #2:

Exchange $100,000 for x euros at the current spot rate, S$/.


Deposit the x euros in a euro CD at i for 1 year (yields y).
Enter into a forward contract to sell the y euros at F$/ in 1 year for $z.

Are these two paths to the same end? Suppose all of these transactions can be done with a
single creditworthy bank, so that the two alternatives have the same risk.
Alternative #1
$100,000(1 + i$)

Deposit $100,000 in a 1
year Eurodollar CD at i$.

Withdraw
$100,000(1 + i$)

IRP

Alternative #2
Exchange $100,000 for
euros at S$/.

Receive
$100,000(F/S)(1 + i)

($100,000/ S$/ )(1 + i) F$/


= $z

($100,000 / S$/) = x

Deposit x euros in a 1year Euroeuro (Euribor)


CD at i.

($100,000/ S$/ )(1 + i) = y

15

Sell y euros forward in 1


year at F$/ for $z

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Covered Interest Arbitrage
Covered interest arbitrage enforces IRP. How?
If
d/f
t ,T

d/f
t

1 id
1 if

then
d/f
t ,T

So

may be too high.

d/f
Sell f forward at Ft ,T .

Std/f

may be too low.


may be too low.
may be too high.

Buy f at St .
Borrow at id.
Lend at if.

id
if

d/f

Similarly for the other direction. Lets apply this.


Interest Rate Parity (IRP) Take 2
Example. Suppose the current spot rate is 1.47 $/, the 1-year Europound rate is 4.55%,
and the 1-year Eurodollar rate is 2.66%. What is the implied 1-year forward rate? If the
quoted 1-year forward rate is 1.46 $/, can you make money? How?
Answer. By IRP,
Fimp = S$/ (1 + i$) / (1 + i)
= 1.47 1.0266 / 1.0455
= 1.4434 $/
< Fmarket = 1.46$/
This is the same relation as above. So:
Borrow $1.47 at 2.66%
for 1 year
Sell $1.47 spot @$1.47/
for 1

$1.471.0266

Riskless profit
of $0.0173

Deposit 1 pound in a 1year Europound CD at


4.55%

Repay the dollar loan in


1 year:
$1.471.0266 = $1.5091

11.0455

16

Sell 1.0455 forward in


1 year at 1.46$/ for
$1.5264

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1. Exercise: IRP and Covered Interest Arbitrage. Citibank quotes:
Yen spot rate:

110/$

Yen interest rate:

0%

Dollar interest rate:

4%

a) Is the following statement true, false, or uncertain? Explain.


Since the yen interest rate is zero, a strategy to exploit an arbitrage opportunity,
if any, will involve borrowing in yen.
Annualized 1-month T-bill rate
0.2
0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02

b) Compute the 6-month forward rate.

c) If Chase quotes a 6-month forward rate at 106/$, can you make money? How?

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Jul-01

Jul-96

Jul-91

Jul-86

Jul-81

Jul-76

Jul-71

Jul-66

Jul-61

Jul-56

Jul-51

Jul-46

Jul-41

Jul-36

Jul-31

0
-0.02

Jul-26

Aside: Japans near-zero interest rate is


no longer a rare occurrence. As of
January 2015, short rates on major
currencies are close to zero, and in
fact, was negative for the Swiss franc
in early 2014. Around 1940, the
annualized U.S. short rate actually
hit zero. It was below 0.1% for 35
out of 48 months from 1938 through
1941.

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Less Reliable Parity Conditions
All of the conditions below involve market participants expectations (hence less
reliable).
FORWARD PARITY AND UNBIASED EXPECTATIONS HYPOTHESIS (UEH)
Forward Parity
Ft,T = Et[ST]
Forward parity says that the forward rate is an unbiased predictor of the future spot
rate.
That is, our best guess today of what the spot rate will be in 3 months for example is
todays 3-month forward rate.
The Forward Rate as an Unbiased Predictor of the Future Spot Rate

Exchange Rate

Spot
Probability
distribution
of actual
exchange rate
Forward
Actual

Today

In three months
Time

This is the Unbiased Expectations Hypothesis applied to the FX market.


The counterpart for the interest rate market is the hypothesis that the implied
forward interest rate is the best guess of the future spot interest rate.
The idea is that speculators (not arbitrageurs) will force this relation to hold on
average. How does this work?

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Testing the UEH
Divide both sides of the Forward Parity relation by St and subtract 1. Then,
FPt,T = Et[st,T],
where FPt,T = Ft,T / St 1 is the forward premium and st,T = ST / St 1 is the currency
return (the percentage spot rate change) from time t to T.
This form of the Forward Parity says that the forward premium is an unbiased predictor
of the currency return.
To test this, run a regression
st,T = + FPt,T + t.
What is the hypothesis to be tested?
H0:
Note: one observation tells us nothing. That is, if todays 3 month forward rate is
$1.30/, and if the spot rate turns out to be $1.30/ in 3 months, this by itself does not
validate the UEH. Think in this way: can you run a regression with only one
observation?
Froot and Thaler find that, on average, = -0.88 (!). This is called the forward
premium anomaly. What slope do you see in the following plot if you fit a line?

The one-month /$ forward rate


as a predictor of the future spot rate
15%

Actual change in the spot rate


(S1/$/S0/$)-1

10%
5%

Forward premium
(F1/$/S0/$)-1

0%
-5%
-10%
-15%
-1%

0%

1%

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The evidence indicates that for short horizonsdailythe current spot rate is the best
guess for tomorrows spot rate (This price pattern is called a martingale).
The evidence is mixed and controversial but at longer intervals the performance of the
forward rate as predictor of a future spot rate improves.
Nevertheless, there is no solid evidence in favor of a better predictor.

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PRACTICE PROBLEMS WITH SOLUTIONS: BUTLER 5TH ED. CHS. 3 & 4
Solve the following end-of-chapter problems from Butler:
3.1 a-b, 3.2, 3.6, 3.7, 4.5b (Locational arbitrage), 4.7 (IRP, Forward Parity. Interpret
the prime rates as interbank Eurocurrency rates), 4.11 (Covered Interest Arbitrage)
Suggested Solutions to Practice Problems: Butler Chs. 3 & 4
3.1

a. The bid rate is less than the offer rate, so Citicorp is quoting the currency in the
denominator. Citicorp is buying dollars at the DKK5.62/$ bid rate and selling
dollars at the DKK5.87/$ offer rate.
b. In American terms, the bid price is $0.1704/DKK and the ask price is
$0.1779/DKK. Citicorp is buying and selling the kroner at these quotes
respectively.

3.2

The ask price is higher than the bid, so these are the rates at which the bank is
willing to buy or sell dollars (in the denominator). Youre selling dollars, so youll
get the banks dollar bid price. You need to pay SKr10,000,000/(SKr7.5050/$) =
$1,332,445.04.

3.6

a. (PZ5,000,000) / (PZ4.0200/$) = $1,243,781. Warsaws bid price for PZ is their


ask price for dollars. So, PZ4.0200/$ is equivalent to $0.2488/PZ.
b. (PZ20,000,000) / (PZ3.9690/$) = $5,039,053
PZ3.9690/$ is equivalent to $0.2520/PZ
Payment is made on (the second business day after) the three-month expiration
date.

3.7

You initially receive 104,000,000 / (104/$) = $1 million. When you buy back the
yen, you must pay 104,000,000 / (100/$) = $1.04 million. Your dollar loss is
$40,000.

4.5

b. The Mexican banks yen quote can be converted into a quote for the Mexican
peso as follows:
/MXN
= 1/(MXN0.03416/) 29.27/MXN bid on the yen and ask on the peso.
S
S/MXN = 1/(MXN0.03420/) 29.24/MXN ask on the yen and bid on the peso.
So MXN0.03416/ BID and MXN0.03420/ ASK on the yen is equivalent to
29.24/MXN BID and 29.27/MXN ASK on the Mexican peso.
The winning strategy is to buy pesos (and sell yen) from the Tokyo bank at the
28.77/MXN ask price for pesos and sell pesos (and buy yen) to the Mexican bank
at the 29.24/MXN bid price for pesos. Buying pesos in Tokyo yields
(1,000,000)/(28.77/MXN) = MXN34,758. Selling pesos in Mexico City yields

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(MXN34,758)(29.24/MXN) = 1,016,336. Your arbitrage profit is 16,336 yen, or
about MXN559 at the Mexican banks 29.24/MXN bid price for pesos.
4.7

a. From interest rate parity, (210/$)/(190/$) = (1+i)/(1.15) i = 27.11%.


b. Because the forward rate of 210/$ is greater than the spot rate of 190/$, the dollar
is at a forward premium. If forward rates are unbiased predictors of future spot
rates, the dollar is likely to appreciate against the yen by (210/$)/(190/$)-1 =
10.526%.

4.11 a. FtBt/$/S0Bt/$ = (1 + iBt)/(1 + i$) (Bt 25.64/$)/(Bt 24.96/$) = (1 + iBt)/(1.06125)


1.02724 = (1 + iBt)/1.06125 iBtimp = 9.02%
b. The 10% market rate is higher than the implied 9.02% rate from Part a. So,
borrow at i$ and deposit at iBt. To do so, make the following four transactions:
Buy Bt24,960,000 (= $1MBt24.96/$) spot at Bt24.96/$, paying $1M.
Bt24,960,000

Convert to baht at the spot exchange rate

$1,000,000
Deposit Bt24,960,000 at 10% and receive Bt27,456,000 (= 24,960,000 1.1) in
1 year.
Invest at the 10% baht interest rate

Bt27,456,000

Bt24,960,000

Borrow $1M at 6.125% and repay $1,061,250 (=1,000,0001.06125) in 1 year.

+$1,000,000

Borrow at the 6.125% dollar interest rate

$1,061,250
Sell Bt27,456,000 forward in 1 year at Bt25.64/$ for a receipt of $1,070,827 (=
27,456,000/25.64) then.
Cover baht forward

$1,070,827
Bt27,456,000

This leaves a net gain at time 1 of $1,070,827 - $1,061,250 = $9,577, which is


worth $9,577/1.06125 = $9,024 in present value.

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