Integrative Problem?P264
Date: Nov. 14th
Exchange Rate Behavior
Questions
1. Triangular Arbitrage:
£ = $1.596
A$ = $0.70
Cross exchange rate: £ = A$2.28
Cross interest rate should be: £ = $1.596/$0.70 = A$ 2.28
Triangular arbitrage capitalizes on discrepancies in cross exchange rates.
There are no discrepancies in cross exchange rates. Therefore, triangular arbitrage is not feasible in this situation.
2. Covered Interest Arbitrage:
British pound:
Spot rate: £ = $1.596
Forward rate: £ = $1.58004
U.S interest rate: iU.S. = 8.00%
British interest rate: iBritish =9.09%
(F-S)/S = ($1.58004-$1.596)/ $1.596 = -1%
ih ? if = 8%-9.09% = -1%
We get: (F-S)/S = ih ? if
Covered interest arbitrage capitalizes on discrepancies between the forward rate and the interest rate differential.
(F-S)/S = ih ? if, therefore, covered interest arbitrage is not feasible on British pound.
Australian dollars:
Spot rate: A$ = $0.70
Forward rate: A$ = $0.71
U.S interest rate: iU.S. = 8.00%
Australian interest rate: iAustralian =7.00%
(F-S)/S = ($0.71-$0.70)/ $0.70 = 1.4%
ih ? if = 8%-7.00% = 1%
We get: (F-S)/S ? ih ? if
Therefore, covered interest arbitrage is feasible on Australian dollars.
Conduct:
Suppose we have A$1,000,
Activity Amount
1. Use Australian dollars to purchase U.S. dollars in the spot market, at A$ = $0.70. A$1,000=A$*0.70=$700
2. Engage in a forward contract to sell U.S. dollars forward, at A$ = $0.71. $700(1+8.00%)=$756,
$756/0.71=A$1,065
3. Invest funds from Australia in the United States. Profit=A$1,065-A$1,000=A$65
3. International F ...