Locational Arbitrage.

Assume the following information:

Beal Bank  Yardley Bank

Bid price of New Zealand dollar $.401 $.398
Ask price of New Zealand dollar $.404 $.400

Given this information, is locational arbitrage possible?  If so, explain

the steps involved in locational arbitrage, and compute the profit from
this arbitrage if you had $1,000,000 to use. What market forces would
occur to eliminate any further possibilities of locational arbitrage?

ANSWER: Yes!  One could purchase New Zealand dollars at Yardley

Bank for $.40 and sell them to Beal Bank for $.401.  With $1 million
available, 2.5 million New Zealand dollars could be purchased at
Yardley Bank.  These New Zealand dollars could then be sold to Beal
Bank for $1,002,500, thereby generating a profit of $2,500.

The large demand for New Zealand dollars at Yardley Bank will force
this bank's ask price on New Zealand dollars to increase.  The large
sales of New Zealand dollars to Beal Bank will force its bid price
down.  Once the ask price of Yardley Bank is no longer less than the
bid price of Beal Bank, locational arbitrage will no longer be
beneficial.

Triangular Arbitrage. Assume the following information:

Quoted Price
Value of Canadian dollar in U.S. dollars $.90
Value of New Zealand dollar in U.S. dollars $.30
Value of Canadian dollar in New Zealand dollars NZ$3.02

Given this information, is triangular arbitrage possible?  If so, explain

the steps that would reflect triangular arbitrage, and compute the profit
from this strategy if you had $1,000,000 to use. What market forces
would occur to eliminate any further possibilities of triangular
arbitrage?

ANSWER: Yes.  The appropriate cross exchange rate should be 1

Canadian dollar = 3 New Zealand dollars.  Thus, the actual value of
the Canadian dollars in terms of New Zealand dollars is more than
what it should be.  One could obtain Canadian dollars with U.S.
dollars, sell the Canadian dollars for New Zealand dollars and then
 exchange New Zealand dollars for U.S. dollars.  With $1,000,000, this
strategy would generate $1,006,667 thereby representing a profit of
$6,667.

[$1,000,000/$.90 = C$1,111,111 × 3.02 = NZ$3,355,556 × $.30 =

$1,006,667]

The value of the Canadian dollar with respect to the U.S. dollar would
rise.  The value of the Canadian dollar with respect to the New
Zealand dollar would decline.  The value of the New Zealand dollar
with respect to the U.S. dollar would fall.

Covered Interest Arbitrage. Assume the following information:

Quoted Price
Spot rate of Canadian dollar $.80
90-day forward rate of Canadian dollar $.79
90-day Canadian interest rate 4%
90-day U.S. interest rate 2.5%

Given this information, what would be the yield (percentage return) to

a U.S. investor who used covered interest arbitrage?  (Assume the
investor invests $1,000,000.) What market forces would occur to
eliminate any further possibilities of covered interest arbitrage?

ANSWER:

$1,000,000/$.80 = C$1,250,000 × (1.04)

= C$1,300,000 × $.79
= $1,027,000

Yield = ($1,027,000 – $1,000,000)/$1,000,000 = 2.7%, which exceeds

the yield in the U.S. over the 90-day period. 

The Canadian dollar's spot rate should rise, and its forward rate

should fall; in addition, the Canadian interest rate may fall and the U.S.

interest rate may rise.

7. Covered Interest Arbitrage. Assume the following information:

Spot rate of Mexican peso = $.100

180-day forward rate of Mexican peso = $.098
180-day Mexican interest rate = 6%
180-day U.S. interest rate = 5%

Given this information, is covered interest arbitrage worthwhile for

Mexican investors who have pesos to invest?  Explain your answer.

ANSWER: To answer this question, begin with an assumed amount

of pesos and determine the yield to Mexican investors who attempt
covered interest arbitrage.  Using MXP1,000,000 as the initial
investment:

MXP1,000,000 × $.100 = $100,000 × (1.05) = $105,000/$.098 =

MXP1,071,429

Mexican investors would generate a yield of about 7.1%

([MXP1,071,429 – MXP1,000,000]/MXP1,000,000), which exceeds
their domestic yield.  Thus, it is worthwhile for them.

17.Covered Interest Arbitrage in Both Directions. The one-year

interest rate in New Zealand is 6 percent.  The one-year U.S. interest
rate is 10 percent.  The spot rate of the New Zealand dollar (NZ$) is
$.50.  The forward rate of the New Zealand dollar is $.54.  Is covered
interest arbitrage feasible for U.S. investors?  Is it feasible for New
Zealand investors?  In each case, explain why covered interest
arbitrage is or is not feasible.

ANSWER:
To determine the yield from covered interest arbitrage by U.S.
investors, start with an assumed initial investment, such as
$1,000,000.

$1,000,000/$.50 = NZ$2,000,000 × (1.06)

= NZ$2,120,000 × $.54 = $1,144,800
Yield = ($1,144,800 – $1,000,000)/$1,000,000 = 14.48%
 Thus, U.S. investors can benefit from covered interest arbitrage
because this yield exceeds the U.S. interest rate of 10 percent.
To determine the yield from covered interest arbitrage by New
Zealand investors, start with an assumed initial investment,
such as NZ$1,000,000:

NZ$1,000,000 × $.50 = $500,000 × (1.10)

= $550,000/$.54 = NZ$1,018,519
Yield = (NZ$1,018,519 – NZ$1,000,000)/NZ$1,000,000 = 1.85%

Thus, New Zealand investors would not benefit from covered interest
arbitrage since the yield of 1.85% is less than the 6% that they could
receive from investing their funds in New Zealand. 

Limitations of Covered Interest Arbitrage. Assume that the one-

year U.S. interest rate is 11 percent, while the one-year interest rate in
Malaysia is 40 percent. Assume that a U.S. bank is willing to
purchase the currency of that country from you one year from now at a
discount of 13 percent. Would covered interest arbitrage be worth
considering? Is there any reason why you should not attempt covered
interest arbitrage in this situation? (Ignore tax effects.)

ANSWER: Covered interest arbitrage would be worth considering

since the return would be 21.8 percent, which is much higher than the
U.S. interest rate. Assuming a $1,000,000 initial investment,
$1,000,000 × (1.40) × .87 = $1,218,000
Yield = ($1,218,000 – $1,000,000)/$1,000,000 = 21.8%

However, the funds would be invested in Malaysia, which could cause

some concern about default risk or government restrictions on
convertibility of the currency back to dollars.

Deriving the Forward Rate. Assume that annual interest rates in the
U.S. are 4 percent, while interest rates in France are 6 percent.

a. According to IRP, what should the forward rate premium or

discount of the euro be?
b. If the euro’s spot rate is $1.10, what should the one-year forward
rate of the euro be?

ANSWER:
 (1 .04 )
p= −1=−. 0189=−1 . 89 %
a. (1 . 06)

b. F=$ 1 . 10(1−. 0189)=$ 1 . 079

Covered Interest Arbitrage in Both Directions. The following

information is available:

 You have $500,000 to invest

 The current spot rate of the Moroccan dirham is $.110.
 The 60-day forward rate of the Moroccan dirham is $.108.
 The 60-day interest rate in the U.S. is 1 percent.
 The 60-day interest rate in Morocco is 2 percent.

a. What is the yield to a U.S. investor who conducts covered

interest arbitrage? Did covered interest arbitrage work for the
investor in this case?
b. Would covered interest arbitrage be possible for a Moroccan
investor in this case?

ANSWER:

a. Covered interest arbitrage would involve the following steps:

1. Convert dollars to Moroccan dirham: $500,000/$.11 =

MD4,545,454.55
2. Deposit the dirham in a Moroccan bank for 60 days. You
will have MD4,545,454.55 × (1.02) = MD4,636,363.64 in 60
days.
3. In 60 days, convert the dirham back to dollars at the forward
rate and receive MD4,636,363.64 × $.108 = $500,727.27

The yield to the U.S. investor is $500,727.27/$500,000 – 1 = .

15%. Covered interest arbitrage did not work for the investor in
this case. The lower Moroccan forward rate more than offsets the
higher interest rate in Morocco.

b. Yes, covered interest arbitrage would be possible for a Moroccan

investor. The investor would convert dirham to dollars, invest the
dollars at a 1 percent interest rate in the U.S., and sell the dollars
forward 60 days. Even though the Moroccan investor would earn
 an interest rate that is 1 percent lower in the U.S., the forward
rate discount of the dirham more than offsets that differential.

Testing IRP. The one-year interest rate in Singapore is 11 percent. The

one-year interest rate in the U.S. is 6 percent. The spot rate of the
Singapore dollar (S$) is $.50 and the forward rate of the S$ is $.46.
Assume zero transactions costs.

a. Does interest rate parity exist?

ANSWER: No, because the discount is larger than the interest rate
differential.

b. Can a U.S. firm benefit from investing funds in Singapore using

covered interest arbitrage?

ANSWER: No, because the discount on a forward sale exceeds the

interest rate advantage of investing in Singapore.

Solution to Continuing Case Problem: Blades, Inc.

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 Sobat
Bank 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.

ANSWER: Locational arbitrage is possible:

 Locational Arbitrage

1. Buy Thai baht from Minzu Bank ($100,000/$0.0227) 4,405,286.34

2. Sell Thai baht to Sobat Bank (THB4,405,286.34 × 100,440.53

$0.0228)

3. Dollar profit ($100,440.53 – $100,000) 440.53

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 Quoted Ask

Price Price
Value of a Japanese yen in U.S. $0.0085 $0.0086
dollars
Value of a Thai baht in Japanese ¥2.69 ¥2.70
yen

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.

ANSWER: Triangular arbitrage is possible.

Triangular Arbitrage

1. Exchange dollars for Thai baht ($100,000/$0.0227) 4,405,286.3

4

2. Convert the Thai baht into Japanese yen (THB4,405,286.34 11,850,220.

× ¥2.69) 25

3. Convert the Japanese yen into dollars (¥11,850,220.26 × 100,726.87

$0.0085)

4. Dollar profit ($100,726.87 – $100,000) 726.87

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.

ANSWER: Covered interest arbitrage is possible.

Covered Interest Arbitrage

1. On Day 1, convert U.S. dollars to Thai baht and set up a 90-

day deposit
account at a Thai bank ($100,000/$0.0227) 4,405,286.
34

2. In 90 days, the Thai deposit will mature to THB4,405,286.34

× 1.0375,
which is the amount to be sold forward 4,570,484.
58

3. In 90 days, convert the Thai baht into U.S. dollars at the

agreed-upon rate
(THB4,570,484.58 × $0.0225) 102,835.9
0

4. Dollar amount available on a 90-day U.S. deposit ($100,000 102,000.0

× 1.02) 0
 5. Dollar profit over and above the dollar amount available on a 2,835.90
90-day U.S.
deposit ($102,835.90 – $100,000)

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?

ANSWER: Arbitrage opportunities are likely to disappear soon after

they have been discovered because of market forces. Due to the
actions taken by arbitrageurs, supply and demand for the foreign
currency adjust until the mispricing disappears. For example, covered
interest arbitrage involving the immediate purchase and subsequent
sale of Thai baht would place upward pressure on the spot rate of the
Thai baht and downward pressure on the Thai baht forward rate until
covered interest arbitrage is no longer possible. At that point, interest
rate parity exists, and the interest rate differential between the two
countries is exactly offset by the forward premium or discount.

Solution to Supplemental Case: Zuber, Inc.

a. The expected value of the yield on investing funds in this country

would be 14 percent, versus only 9 percent in the U.S.  However, there
is much uncertainty about the foreign yield.  If the currency
depreciates by a large amount, it will wipe out some of the principal
invested.  Given that Zuber did not want to target these funds for a
speculative purpose, it would not be wise to invest these funds in the
country without covering.

b. Covered interest arbitrage would involve exchanging dollars for the

currency today, investing the currency in the country’s Treasury
securities, and negotiating a forward contract to sell the currency in
one year in exchange for dollars.

Given that $10 million is available, this amount would be converted

into 25 million units of the foreign currency, which would accumulate
to 28.5 million units (at 14 percent) by the end of the year, and be
 converted into $11,115,000 at the time (based on a forward rate of
$.39).  This reflects a return of 11.15 percent.

c. The risks of covered interest arbitrage are as follows:

· The Treasury of the country could default on its securities issued.

· The bank may not fulfill its obligation on the forward contract (the
bank was just recently privatized and does not have a track record
as a privatized institution).

· The government could restrict funds from being converted into

dollars.  (Since the country has only allowed foreign investments
recently, it does not have a track record.  There is some uncertainty
about its future laws on international finance.)

d. While covered interest arbitrage would be expected to achieve a yield

of 11.15 percent (versus only 9 percent in the U.S.), the risks are
significant, especially considering that the country is still
experimenting with cross-border transactions.  Since some students
will probably suggest going for the higher returns, this question may
allow for an interesting class discussion.

Small Business Dilemma

Assessment of Prevailing Spot and Forward Rates by the Sports

Exports Company

1. Do you think Jim will be able to find a bank that provides him with a
more favorable spot rate than his local bank? Explain.

ANSWER: The quoted spot rate for British pounds will typically be
similar among banks at a given point in time, because locational
arbitrage might be possible if there were significant differences. It is
possible that some banks that rarely provide the foreign exchange
services quote a less favorable exchange rate, and locational arbitrage
will not necessarily correct this if these banks have a large spread
between the bid and the ask quotes. Therefore, it may be worthwhile
for Jim to call other banks to obtain quotes, but Jim will likely find
 that he cannot obtain a much better rate than what his local bank
provides.

2. Do you think that Jim’s bank is likely to provide more reasonable

quotations for the spot rate of the British pound if it is the only bank in
town that provides foreign exchange services? Explain.

ANSWER: The bank is likely to provide more reasonable quotations

for the spot rate of the British pound if there are many banks in town
that provide foreign exchange services. In this case, there is more
competition, and a local bank is more likely to lose business if its
quotations are not reasonable.

3. Jim is considering using a forward contract to hedge the anticipated

receivables in pounds next month. His local bank quoted him a spot
rate of $1.65 and a one-month forward rate of $1.6435. Before Jim
decides to sell pounds one month forward, he wants to be sure that the
forward rate is reasonable, given the prevailing spot rate. A one-
month Treasury security in the United States currently offers a yield
(not annualized) of 1 percent, while a one-month Treasury security in
the United Kingdom offers a yield of 1.4 percent. Do you believe that
the one-month forward rate is reasonable given the spot rate of $1.65?

ANSWER: Yes. According to interest rate parity, the forward rate

premium should be based on the differential between interest rates:

p = [(1 + .01)/(1 + .014)] – 1

= [.996055] – 1
= –.0039448

The actual premium is:

p = (F – S)/S
= ($1.6435 – $1.65)/$1.65
= –.003939

The actual premium is very close to what the premium should be

according to interest rate parity.