Int Finance – Chapter 4 – Instructor: Bimesh Man Pati

1. Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for six
months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in Germany.
Currently, the spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate
is DM1.56 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where
should he/she invest to maximize the return?

2. While you were visiting London, you purchased a Jaguar for £35,000, payable in three months.
You have enough cash at your bank in New York City, which pays 0.35% interest per month,
compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£ and the
three-month forward exchange rate is $1.40/£. In London, the money market interest rate is 2.0%
for a three-month investment. There are two alternative ways of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so
that the maturity value becomes equal to £35,000. Evaluate each payment method. Which method
would you prefer? Why?

3. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is
$1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the
U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.
a. Determine whether the interest rate parity is currently holding.
b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the
steps and determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of covered arbitrage activities.

4. Suppose that the current spot exchange rate is FF6.25/$ and the three-month forward exchange
rate is FF6.28/$. The three-month interest rate is 5.6% per annum in the U.S. and 8.8% per annum
in France. Assume that you can borrow up to $1,000,000 or FF6,250,000.
a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to
realize profit in terms of U.S. dollars. Also determine the magnitude of arbitrage profit.
b. Assume that you want to realize profit in terms of French francs. Show the covered arbitrage
process and determine the arbitrage profit in French francs.

5. In the issue of October 23, 1999, the Economist reports that the interest rate per annum is 5.93%
in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in
Turkey? Based on the reported interest rates, how would you predict the change of the exchange
rate between the U.S. dollar and the Turkish lira?

6. As of November 1, 2014, the exchange rate between the Brazilian real and U.S. dollar is
R$1.95/$. The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period
is 2.6% and 20.0%, respectively. How would you forecast the exchange rate to be at around
November1,2015?

7. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250
million payable in three months. Currently, the spot exchange rate is ¥105/$ and the three-
month forward rate is ¥100/$. The three-month money market interest rate is 8 percent per
annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use
 Int Finance – Chapter 4 – Instructor: Bimesh Man Pati

the money market hedge to deal with this yen account payable.(a) Explain the process of a
money market hedge and compute the dollar cost of meeting the yen obligation. (b) Conduct
the cash flow analysis of the money market hedge.

8. McDonnell Douglas just signed a contract to sell a DC 10 aircraft to Air France. Air France will
be billed FF50 million which is payable in one year. The current spot exchange rate is $0.20/FF
and the oneyear forward rate is $0.19/FF. The annual interest rate is 6.0% in the U.S. and 9.5% in
France. McDonnell Douglas is concerned with the volatile exchange rate between the dollar and
the franc and would like to hedge exchange exposure. (a) It is considering two hedging
alternatives: sell the franc proceeds from the sale forward or borrow francs from the Credit
Lyonnaise against the franc receivable. Which alternative would you recommend? Why? (b)
Other things being equal, at what forward exchange rate would McDonnell Douglas be indifferent
between the two hedging methods?

9. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes
Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per
dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan
and 8% in the U.S.PCC can also buy a one-year call option on yen at the strike price of $.0081
per yen for a premium of .014 cents per yen.(a) Compute the future dollar costs of meeting this
obligation using the money market hedge and the forward hedges. (b) Assuming that the forward
exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost
of meeting this obligation when the option hedge is used.

10. In early 1996, the short-term interest rate in France was 3.7%, and forecast French inflation was 1.8%. At
the same time, the short-term German interest rate was 2.6% and forecast German inflation was 1.6%.
a. Based on these figures, what were the real interest rates in France and Germany?

11. If expected inflation is 100% and the real required return is 5%, what will the nominal interest
rate be according to the Fisher effect?
12. if inflation in USA is 5% and inflation in UK is 10%. What will happen to the value of GBP against
USD?
13. Assume the change in price level in Nepal is 50% and is 5% in USA. Calculate the change in spot
exchange rates according to exact and approximately dynamic for of PP condition and interpret the
result.
14. assume that the exchange rate of NPR and USD in 1983 was Rs. 25 per USD and in 2008 the rate was
quoted at Rs 64 Per USD. However price levels too change in both the currencies between 1983 and
2008. The price in Nepal in 2008 stood 4 times that of 1983. Price in USA double during the same
period.
a. what is the depreciation of the rupee over the last 25 years?
b. how much is the real depreciation?

15. Omni Advisors, an international pension fund manager, uses the concepts of
purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates.

Omni gathers the financial information as follows:

Base price level 100

Current U.S. price level 105
Current South African price level 111
Base rand spot exchange rate $0.175
Current rand spot exchange rate $0.158
Expected annual U.S. inflation 7%
 Int Finance – Chapter 4 – Instructor: Bimesh Man Pati

Expected annual South African inflation 5%

Expected U.S. one-year interest rate 10%
Expected South African one-year interest rate 8%

Calculate the following exchange rates (ZAR and USD refer to the South African and U.S. dollar,
respectively).
a. The current ZAR spot rate in USD that would have been forecast by PPP.
b. Using the IFE, the expected ZAR spot rate in USD one year from now.
c. Using PPP, the expected ZAR spot rate in USD four years from now

16. Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate is
€1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most
€1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot exchange rate.
a. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a
euro-based investor. Also determine the size of the arbitrage profit.
b. Discuss how the interest rate parity may be restored as a result of the above
transactions.
c. Suppose you are a pound-based investor. Show the covered arbitrage process and
determine the pound profit amount.

17. Due to the integrated nature of their capital markets, investors in both the U.S. and U.K. require
the same real interest rate, 2.5%, on their lending. There is a consensus in capital markets that
the annual inflation rate is likely to be 3.5% in the U.S. and 1.5% in the U.K. for the next three
years. The spot exchange rate is currently $1.50/£. a. Compute the nominal interest rate per
annum in both the U.S. and U.K., assuming that the Fisher effect holds. b. What is your expected
future spot dollar-pound exchange rate in three years from now? c. Can you infer the forward
dollar-pound exchange rate for one-year maturity?

18. Jason Smith is a foreign exchange trader with Citibank. He notices the following quotes.
Spot exchange rate SFr1.6627/$
Six-month forward exchange rate SFr1.6558/$
Six-month $ interest rate 3.5% per year
Six-month SFr interest rate 3.0% per year
a. Ignoring transaction costs, is the interest rate parity holding?
b. Is there an arbitrage possibility? If yes, what steps would be needed to make an arbitrage
profit? Assuming that Jason Smith is authorized to work with $1,000,000 for this purpose, how
much would the arbitrage profit be in dollars?
 Int Finance – Chapter 4 – Instructor: Bimesh Man Pati

Ans1 : in us final wealth = usd 1040000, in germany final wealth = usd 1056410.

Ans 2: Option a:
When you buy £35,000 forward, you will need $49,000 in three months to fulfill the forward
contract. The present value of $49,000 is computed as follows:
$49,000/(1.0035)3 = $48,489.
Thus, the cost of Jaguar as of today is $48,489.
Option b:
The present value of £35,000 is £34,314 = £35,000/(1.02). To buy £34,314 today, it will cost
$49,755 = 34,314x1.45. Thus the cost of Jaguar as of today is $49,755.
You should definitely choose to use “option a”, and save $1,266, which is the difference between
$49,755 and $48489.

Ans 3: Let’s summarize the given data first:

S = $1.5/£; F = $1.52/£; I$ = 2.0%; I£ = 1.45%
Credit = $1,500,000 or £1,000,000.
a. (1+I$) = 1.02
(1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280
Thus, IRP is not holding exactly.
b. (1) Borrow $1,500,000; repayment will be $1,530,000.
(2) Buy £1,000,000 spot using $1,500,000.
(3) Invest £1,000,000 at the pound interest rate of maturity value will be £1,014,500.
(4) Sell £1,014,500 forward for $1,542,040
Arbitrage profit will be $12,040
c. Following the arbitrage transactions described above,
The dollar interest rate will rise;
The pound interest rate will fall;
The spot exchange rate will rise;
The forward exchange rate will fall.

These adjustments will continue until IRP holds.

Ans 4. S = FF6.25/$ = $0.16/FF;

F = FF6.28/$ = $0.1592/FF;
I$ = 1.40%; iFF = 2.20%
(1+I$) = 1.014 < (1+iFF)(F/S) = (1.022)(.1592/.16) = 1.0169
a. (1) Borrow $1,000,000; repayment will be $1,014,000.
(2) Buy FF6,250,000 spot for $1,000,000.
(3) Invest in France; maturity value will be FF6,387,500.
(4) Sell FF6,387,500 forward for $1,017,118.
Arbitrage profit will be $3,118 = $1,017,118 - $1,014,000.
b. (1) Borrow $1,000,000; repayment will be $1,014,000.
(2) Buy FF6,250,000 spot for $1,000,000.
(3) Invest in France; maturity value will be FF6,387,500.
(4) Buy $1,014,000 forward for FF6,367,920.
Arbitrage profit will be FF19,580 = FF6,387,500-FF6,367,920. Note that only step (4) is different.
 Int Finance – Chapter 4 – Instructor: Bimesh Man Pati

Ans 5. A high Turkish interest rate must reflect a high expected inflation in Turkey. According to
international Fisher effect (IFE), we have
E(e) = i$ - iLira
= 5.93% - 70.0% = -64.07%

The Turkish lira thus is expected to depreciate against the U.S. dollar by about 64%.

Ans 6: Since the inflation rate is quite high in Brazil, we may use the purchasing power parity to forecast
the exchange rate.
E(e) = E(π$) - E(πR$)
= 2.6% - 20.0%
= -17.4%
E(ST) = So(1 + E(e))
= (R$1.95/$) (1 + 0.174)

= R$2.29/$
Ans 7: Let’s first compute the PV of ¥250 million, i.e.,
250m/1.0175 = ¥245,700,245.7
So if the above yen amount is invested today at the Japanese interest rate for three months, the maturity
value will be exactly equal to ¥25 million which is the amount of payable.
To buy the above yen amount today, it will cost:
$2,340,002.34 = ¥250,000,000/105.
The dollar cost of meeting this yen obligation is $2,340,002.34 as of today.
(b)
___________________________________________________________________
Transaction CF0 CF1
____________________________________________________________________
1. Buy yens spot -$2,340,002.34
with dollars ¥245,700,245.70
2. Invest in Japan - ¥245,700,245.70 ¥250,000,000
3. Pay yens - ¥250,000,000
Net cash flow - $2,340,002.34

Ans 8: (a) In the case of forward hedge, the future dollar proceeds will be (50,000,000)(0.19) =
$9,500,000.
In the case of money market hedge (MMH), the firm has to first borrow the PV of its franc receivable,
i.e.,
$ Cost
Options hedge
Forward hedge
$3,453.75
$3,150
0 0.579 0.64
(strike price)
$/SF
$253.75
 Int Finance – Chapter 4 – Instructor: Bimesh Man Pati

5
50,000,000/1.095 =FF45,662,100. Then the firm should exchange this franc amount into dollars at the
current spot rate to receive: (FF45,662,100)(0.20) = $9,132,420, which can be invested at the dollar
interest rate for one year to yield:
$9,132,420(1.06) = $9,680,365.
Clearly, the firm can receive $180,365 more by using MMH.
(b) According to IRP, F = S(1+i$)/(1+iF). Thus the “indifferent” forward rate will be:

F = 0.20(1.06)/1.095 = $0.1936/FF.

Ans 9: In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In the case of
money market hedge, the future dollar cost will be: 500,000,000(1.08)/(1.05)(124)
= $4,147,465.
(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000(1.08) =
$75,600.
At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC will
exercise its call option and buy ¥500,000,000 for $4,050,000 (=500,000,000x.0081).
The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.
(c) When the option hedge is used, PCC will spend “at most” $4,125,000. On the other hand, when the
forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This
means that
the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between

forward and options hedges.

Ans 10: The French real interest rate was 1.037/1.018 - 1 = 1.87%. The corresponding real rate in
Germany was 1.026/1.016 - 1 = 0.98%.

Ans 11: According to the Fisher effect, the relationship between the nominal interest rate, r, the real
interest rate a, and the expected inflation rate, i, is 1 + r = (1 + a)(1 + i). Substituting in the numbers in
the problem yields 1 + r = 1.05 x 2 = 2.1, or r = 110%.

Ans 15: ZAR spot rate under PPP = [1.05/1.11](0.175) = $0.1655/rand. b. Expected ZAR spot rate =
[1.10/1.08] (0.158) = $0.1609/rand. c. Expected ZAR under PPP = [(1.07)4/(1.05)4] (0.158) =
$0.1704/rand.
 Int Finance – Chapter 4 – Instructor: Bimesh Man Pati

Ans no: 16 First, note that (1+i €) = 1.054 is less than (F/S)(1+i €) = (1.60/1.50)(1.052) = 1.1221.
You should thus borrow in euros and lend in pounds. 1) Borrow €1,000,000 and promise to
repay €1,054,000 in one year. 2) Buy ₤666,667 spot for €1,000,000. 3) Invest ₤666,667 at the
pound interest rate of 5.2%; the maturity value will be ₤701,334. 4) To hedge exchange risk,
sell the maturity value ₤701,334 forward in exchange for €1,122,134. The arbitrage profit will
be the difference between €1,122,134 and €1,054,000, i.e., €68,134. b. As a result of the above
arbitrage transactions, the euro interest rate will rise, the pound interest rate will fall. In
addition, the spot exchange rate (euros per pound) will rise and the forward rate will fall.
These adjustments will continue until the interest rate parity is restored. c. The pound-based
investor will carry out the same transactions 1), 2), and 3) in a. But to hedge, he/she will buy
€1,054,000 forward in exchange for ₤658,750. The arbitrage profit will then be ₤42,584 =
₤701,334 - ₤658,750.

Ans 17: Nominal rate in US = (1+ρ) (1+E(π$)) – 1 = (1.025)(1.035) – 1 = 0.0609 or 6.09%.

Nominal rate in UK= (1+ρ) (1+E(π₤)) – 1 = (1.025)(1.015) – 1 = 0.0404 or 4.04%. b. E(ST) =
[(1.0609)3/(1.0404)3] (1.50) = $1.5904/₤. c. F = [1.0609/1.0404](1.50) = $1.5296/₤.
 Int Finance – Chapter 4 – Instructor: Bimesh Man Pati

Ans 18: