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HW 3

1. The Argentine peso depreciated from Ps1.0/$ in the 1990s to Ps3.20/$ in January 2003, an annual inflation rate of 20%. Based on PPP, the expected exchange rate should have been Ps1.17/$. 2. Takeshi Kamada can profit from covered interest arbitrage between USD and JPY by borrowing yen and investing dollars, as the USD interest rate is higher than JPY by more than the forward premium on the yen. 3. Casper Landsten can profit from covered interest arbitrage between USD and CHF by borrowing dollars and investing francs, as the CHF interest rate is higher than USD by more than the forward premium

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HW 3

1. The Argentine peso depreciated from Ps1.0/$ in the 1990s to Ps3.20/$ in January 2003, an annual inflation rate of 20%. Based on PPP, the expected exchange rate should have been Ps1.17/$. 2. Takeshi Kamada can profit from covered interest arbitrage between USD and JPY by borrowing yen and investing dollars, as the USD interest rate is higher than JPY by more than the forward premium on the yen. 3. Casper Landsten can profit from covered interest arbitrage between USD and CHF by borrowing dollars and investing francs, as the CHF interest rate is higher than USD by more than the forward premium

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chocolatedoggy12
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Courtney Gilliam

2.11.2017
FIN 435
UIN: 00981224
CRN: 27697
Chapter 6 Homework (#2a, 7, 12, and 16)
2a. Argentine Tears. The Argentine peso was fixed through a currency board at
Ps1.0/$ 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,
Argentinas 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?

Beginning spot rate 1.00


Argentine inflation 20%
US inflation 2.20%
PPP exchange rate 1.00*(1+20%) / (1+2.20%) = 1.17

7. Takeshi KamadaCIA 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. Is CIA profit possible? If so, how?

Arbitrage funds available $5,000,000


Spot rate (/$) 118.60
180-day forward rate (/$) 117.80
180-day U.S. dollar interest 4.800%
rate
180-day Japanese yen 3.4000%
interest rate

Yen Equivalent = 5,000,000 * 118.60 = 593,000,000


Difference in interest rates = 3.4- 4.8 = -1.4%
Forward premium on the yen = (118.60-117.80) /117.80 * (360/180) * 100 =
1.3582%
CIA profit potential = -1.4% + 1.3582% = .0418%

He should borrow yen and invest in the U.S. dollar.


Courtney Gilliam
2.11.2017
FIN 435
UIN: 00981224
CRN: 27697

12. Casper LandstenCIA (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 three months or make a CIA investment in the Swiss franc. He faces the
following quotes:

Arbitrage funds available $1,000,000


Spot exchange rate (SFr/$) 1.2810
3-month forward rate (SFr/$) 1.2740
U.S. dollar 3-month interest 4.800%
rate
Swiss franc 3-month interest 3.2000%
rate

Difference in interest rates = 3.2 4.8 = -1.6%


Forward premium on the Swiss franc = (1.2810 1.2740) / 1.2740 * (360/90) * 100
= 2.1978%
CIA profit potential = -1.6% + 2.1978% = 0.5978%

He should borrow US dollars and invest in the Swiss franc.

16. Separated by the Atlantic. Separated by more than 3,000 nautical miles and
fie time zones, money and foreign exchange markets I 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
1-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?
100 + 3.900% = 103.9% ; 100+ 4.5% = 104.5% ; 100 + 1.250% = 101.250%
(104.5% / 101.250%) * 100 = 103.210%
103.210 100 = 3.210%
The expected rate of inflation in Europe is: ((103.900/103.210) -1) * 100 = .669%

b. Estimate todays 1-year forward exchange rate between the dollar and the
euro?
Courtney Gilliam
2.11.2017
FIN 435
UIN: 00981224
CRN: 27697
Spot exchange rate ($/) 1.3264
US dollar one-year Treasury bill rate 4.500%
European euro one-year Treasury bill 3.900%
rate
One year forward rate ($/) 1.3264 * (1+4.500%) / (1 + 3.900%) =
1.3341

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