Download Exercise Ch5

Exercise Ch5
1.
a)
Interest Rate Parity (IRP) is best defined as:
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
Answer: c
2.
When Interest Rate Parity (IRP) holds between two different countries X
and Y, your decision to invest your money will:
a)
be indifferent between country X and country Y
b)
involve a forward hedging
c)
depend on which country initiated the IRP
d)
a and b
Answer: d
3.
When Interest Rate Parity (IRP) does not hold
a)
there is a high degree of inflation
b)
the financial markets are in equilibrium
c)
there are opportunities for covered interest arbitrage
d)
b and c
Answer: c
4.
Purchasing Power Parity (PPP) theory states that:
a)
The exchange rate between currencies of two countries should be equal to the
ratio of the countries’ price levels.
b)
As the purchasing power of a currency sharply declines (due to hyperinflation)
that currency will depreciate against stable currencies.
c)
The prices of standard commodity baskets in two countries are not related.
a)
a and b
Answer: d
5.
The main approaches to forecasting exchange rates are:
a)
Efficient market, Fundamental, and Technical approaches
b)
Efficient market and Technical approaches
c)
Efficient market and Fundamental approaches
d)
Fundamental and Technical approaches
Answer: a
6.
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 or
€892,857 (which is the equivalent of $1,000,000 at the spot exchange
rate of $1.12/€). What is the net cash flow in one year?
(1) According to IRP, the arbitrage opportunity exist.
1+5%<(1.16/1.12)(1+3.5%)=1.0720
(2) The arbitrager should sell €924,107 for 1 year forward and borrow
$1,000,000. Sell them for €892,857 with the spot rate. (1,000,000/1.12)
(3) Invest €892,857 for 1year, the arbitrager will get €924,107. (892,857×
(1+3.5%))
(4) Sell them for $1,071,964 with the forward rate 1.16. (924,107×1.16) After
repaying $1,050,000, the arbitrage profit is $21,964.