Week 3

ANALYTICAL APPLICATION 1

The value of each Latin American currency relative to the dollar is dictated by supply and demand conditions between that currency and the dollar. The values of Latin American currencies have generally declined substantially against the dollar over time. Most of these countries have high inflation rates and high interest rates. The data on inflation rates, economic growth, and other economic indicators are subject to error, because limited resources are used to compile the data.

a. If the forward rate is used as a market-based forecast, will this rate result in a forecast of appreciation, depreciation, or no change in any particular Latin American currency? Explain.

b. If technical forecasting is used, will this result in a forecast of appreciation, depreciation, or no change in the value of a specific Latin American currency? Explain.

c. Do you think that U.S. firms can accurately forecast the future values of Latin American currencies? Explain.

ANALYTICAL APPLICATION 2

Blades, a U.S. manufacturer of roller blades, has chosen Thailand as its primary export target for Speedos, Blades' primary product. Moreover, Blades' primary customer in Thailand, Entertainment Products, has committed itself to purchase 180,000 Speedos annually for the next 3 years at a fixed price denominated in baht, Thailand's currency. Because of quality and cost considerations, Blades also imports some of the rubber and plastic components needed to manufacture Speedos from Thailand.

Lately, Thailand has experienced weak economic growth and political uncertainty. As investors lost confidence in the Thai baht as a result of the political uncertainty, they withdrew their funds from the country. This resulted in an excess supply of baht for sale over the demand for baht in the foreign exchange market, which put downward pressure on the baht's value. As foreign investors continued to withdraw their funds from Thailand, the baht's value continued to deteriorate. Because Blades has net cash flows in baht resulting from its exports to Thailand, a deterioration in the baht's value will affect the company negatively.

Ben Holt, Blades' CFO, would like to ensure that the spot and forward rates Blades' bank has quoted are reasonable. If the exchange rate quotes are reasonable, then arbitrage will not be possible. If the quotations are not appropriate, however, arbitrage may be possible. Under these conditions, Holt would like Blades to use some form of arbitrage to take advantage of possible mispricing in the foreign exchange market. Although Blades is not an arbitrageur, Holt believes that arbitrage opportunities could offset the negative impact resulting from the baht's depreciation, which would otherwise seriously affect Blades' profit margins.

Ben Holt has identified three arbitrage opportunities as profitable and would like to know which one of them is the most profitable. Thus, he has asked you, Blades' financial analyst, to analysis of the arbitrage opportunities he has identified. This would allow Holt to assess the profitability of arbitrage opportunities very quickly.

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 $.0224 $.0228

Ask $.0227 $.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.

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.

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 United States are 2%, whereas 90-day interest rates in Thailand are 3.75% (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 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.

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?