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HW - Spring 2020

This document contains a homework assignment for an international financial management course. It includes 5 problems related to foreign exchange rates, purchasing power parity, and arbitrage opportunities. Students are asked to calculate exchange rates, analyze data to assess whether purchasing power parity holds, and identify arbitrage profits by taking advantage of temporary differences in currency prices. The homework is due on February 17, 2020 and students should show their work to receive full credit.

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Lam
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185 views

HW - Spring 2020

This document contains a homework assignment for an international financial management course. It includes 5 problems related to foreign exchange rates, purchasing power parity, and arbitrage opportunities. Students are asked to calculate exchange rates, analyze data to assess whether purchasing power parity holds, and identify arbitrage profits by taking advantage of temporary differences in currency prices. The homework is due on February 17, 2020 and students should show their work to receive full credit.

Uploaded by

Lam
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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IBUS 401 – INTERNATIONAL FINANCIAL MANAGEMENT

Homework
Two students per group
(It is important that you show all the steps for a full grade; Due at the beginning of
class on February 17, 2020)

Problem 1 (10 points)


Assume that the domestic volatility (standard deviation in yen) of the Japanese stock market is
18%. The volatility of the yen against the U.S. dollar is 6%.
1. What would the dollar volatility of the Japanese stock market be for a U.S. investor if the
correlation between the Japanese stock market returns and exchange rate movements were
zero? (5 points)
2. Suppose the dollar volatility of the Japanese stock market is 18.4%, what can you conclude
about the correlation between the Japanese stock market movements and exchange rate
movements? (5 points)

Problem 2 (20 points)


1. The euro is quoted as $/€ = 1.1420–1.1425, and the Canadian dollar is quoted as C$/US$
= 1.3540–1.3545. What is the direct quotation for the euro in Canada? Explain the
rationale behind the formula used. Explain your answer. (10 points)

2. How large would transactions costs (in percentage) have to be to make triangular arbitrage
between the exchange rates S$/£ = $1.5422/£, S$/€ = $0.9251/€, and S€/£ = €1.6650/£
profitable? (5 points)

3. The U.S. and the country of Rueland have the same real interest rate of 3%. The expected
inflation over the next year is 6 percent in the U.S. versus 21% in Rueland. Interest rate
parity exists. The one-year currency futures contract on Rueland’s currency (called the ru)
is priced at $.40 per ru. What is the spot rate of the ru? (5 points)

Problem 3 (10 points)


Between 1980 and 1995, the ¥/$ exchange rate moved from ¥226.63/$ to ¥93.96/$. During the same
15-year period, the consumer price index (CPI) in Japan rose from 91.0 to 119.2 and the U.S. CPI
rose from 82.4 to 152.4.
1. If PPP has held over this period, what would the ¥/$ exchange rate have been in 1995? (5
points)
2. What happened to the real value of the yen in term of dollars during this period? Provide
calculations that substantiate your answer. (5 points)

1
Problem 4 (25 points)
You are assigned to check whether the relative version of the purchasing power parity holds. Using
data provided to you for the period 1973-2015 (see Excel file), prepare a brief report on the
following question: Does the purchasing power parity hold for the British pound—US dollar
exchange rate? Among other things you need to do the following:
1. Plot past exchange rate changes against differential inflation rates between Britain and the
United states. (7 points)
2. Using Excel, regress the percentage exchange rate changes on the inflation rate differential
to estimate the intercept and the slope coefficient. Provide an interpretation of the
regression results. What do you conclude? Why? Explain your answer. (18 points)

Problem 5: Blades, Inc. Case (Madura, Chapter 7, 13th edition, pages 254-255) (35 points)
1. The first arbitrage opportunity relates to locational arbitrage. Holt has obtained spot rate
quotations from two banks in Thailand, Minzu Bank and Sobat Bank, both located in Bangkok.
The bid and ask prices of Thai baht for each bank are displayed in the table below:
Minzu Bank Sobat Bank
Bid $0.0224 $0.0228
Ask $0.0227 $0.0229

Determine whether the foreign exchange quotations are appropriate. If they are not appropriate,
determine the profit you could generate by withdrawing $100,000 from Blades’ checking
account and engaging in arbitrage before the rates are adjusted. (7 points)

2. Besides the bid and ask quotes for the Thai baht provided in the previous question, Minzu Bank
has provided the following quotations for the U.S. dollar and the Japanese yen:
Quoted Bid Price Quoted Ask Price
Value of a Japanese yen in U.S. dollars $0.0085 $0.0086
Value of a Thai baht in Japanese yen ¥2.69 ¥2.70

Determine whether the cross exchange rate between the Thai baht and Japanese yen is
appropriate. If it is not appropriate, determine the profit you could generate for Blades Inc, by
withdrawing $100,000 from Blades’ checking account and engaging in triangular arbitrage
before the rates are adjusted. (10 points)

3. Ben Holt has obtained several forward contract quotations for the Thai baht to determine
whether covered interest arbitrage may be possible. He was quoted a forward rate of $0.0225
per Thai baht for a 90-day forward contract. The current spot rate is $0.0227. Ninety-day
interest rates available to Blades in the U.S. are 2 percent, while 90-day interest rates in
Thailand are 3.75 percent (these rates are not annualized). Holt is aware that covered interest
arbitrage, unlike locational and triangular arbitrage, requires an investment of funds. Thus, he
would like to be able to estimate the dollar profit resulting from arbitrage over and above the
dollar amount available on a 90-day U.S. deposit.

Determine whether the forward rate is priced appropriately. If it is not priced appropriately,
determine the profit you could generate for Blades by withdrawing $100,000 from Blades’
checking account and engaging in covered interest arbitrage. Measure the profit as the excess
amount above what you could generate by investing in the U.S. money market. (12 points)

4. Why are arbitrage opportunities likely to disappear soon after they have been discovered? To
illustrate your answer, assume that covered interest arbitrage involving the immediate purchase
and forward sale of baht is possible. Discuss how the baht’s spot and forward rates would adjust
until covered interest arbitrage is no longer possible. What is the resulting equilibrium state
called? (6 points)
2

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