56. Explaining Movellen Assume that interest rate parity holds anu w to hold in the future. At the beginning of the month, the spot rate of the British pound is $1.60, while the one-year forward rate is $1.50. Assume that U.S. annual interest rate remains steady over the month. At the end of the month, the one-year forward rate of the BLADES, Inc. CASE Assessment of Potential Arbitrage Opportu Recall that 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 con- fidence in the Thai baht as a result of the political uncertainty, they withdrew their funds from the coun- try. This resulted in an excess supply of baht for sale over the demand for baht in the foreign exchange mar- ket, which put downward pressure on the baht's value. cerguson (instructors and search using ISBN 9781133947837 rtunities As foreign investors continued to withdraw their funds from Thailand, the baht's value continued to deterio- rate. Since 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 of spot and forward rates Blades' bank has quoted Es reasonable. If the exchange rate quotes are rea then arbitrage will not be possible. If the quot not appropriate, however, arbitrage may be po hic Under these conditions, Holt would like Blades to on- arbitrage to take advantage of possil may be possible 4 like Blades to use sale some form of arbitrage to take advanta mispricing in the foreign exchange mark Blades is not an arbitrageur. Holt believes that opportunities could offset the negative in from the baht's depreciation, which seriously affect Blades' profit margins. nar- ange market. Although believes that arbitrage gative impact resulting Would otherwise alue. Holt has identi profitable and the most profitab financial analyst. opportunities has identified three arbitrage opportunities as ble and would like to know which one of them is profitable. Thus, he has asked you, Blades cial analyst, to prepare an analysis of the arbitrage tunities he has identified. This would allow Holt assess the profitability of arbitrage opportunities very quickly. The first arbitrage opportunity relates to locational bitrage. 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: SOBAT BANK MINZU BANK $.0224 $.0227 Bid Ask $.0228 $.0229 Determine wheth the Thai baht and not appropriate, erate for Blades checking accoun before the rates 3. Ben Holt has quotations for th covered interest quoted a forward 90-day forward $.0227. Ninety- the United State rates in Thailan annualized). Ho trage, unlike loc requires an inve be able to estin arbitrage over on a 90-day U. Determine appropriately. mine the profi withdrawing $ and engaging i profit as the e generate by in 4. Why are a soon after the answer, assun ing the imme possible. Disc would adjust longer possib called? 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 $.0085 $.0086 Value of a Japanese yen in U.S. dollars Value of a Thai baht in Japanese yen 42.69 12.70 ities as hem is Blades bitrage w Holt inities cross exchange rate between yen is appropriate. If it is e the profit you could gen- awing $100,000 from Blades' Determine whether the cross excha the Thai baht and Japanese yen is appro not appropriate, determine the profit you o erate for Blades by withdrawing $100,000 from ecking 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 $.0225 per Thai baht for a 90-day forward contract. The current spot rate is $.0227. Ninety-day interest rates available to Blades in the United States are 2 percent, while 90-day interest tional from Bank, of e VK ns mine 0,000 rates in Thailand are 3.75 percent (these rates are not annualized). Holt is aware that covered interest arbi- trage, 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, deter- mine 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 ht soon after they have been discovered? To illustrate your answer, assume that covered interest arbitrage involv- ing 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? 56. Explaining Movellen Assume that interest rate parity holds anu w to hold in the future. At the beginning of the month, the spot rate of the British pound is $1.60, while the one-year forward rate is $1.50. Assume that U.S. annual interest rate remains steady over the month. At the end of the month, the one-year forward rate of the BLADES, Inc. CASE Assessment of Potential Arbitrage Opportu Recall that 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 con- fidence in the Thai baht as a result of the political uncertainty, they withdrew their funds from the coun- try. This resulted in an excess supply of baht for sale over the demand for baht in the foreign exchange mar- ket, which put downward pressure on the baht's value. cerguson (instructors and search using ISBN 9781133947837 rtunities As foreign investors continued to withdraw their funds from Thailand, the baht's value continued to deterio- rate. Since 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 of spot and forward rates Blades' bank has quoted Es reasonable. If the exchange rate quotes are rea then arbitrage will not be possible. If the quot not appropriate, however, arbitrage may be po hic Under these conditions, Holt would like Blades to on- arbitrage to take advantage of possil may be possible 4 like Blades to use sale some form of arbitrage to take advanta mispricing in the foreign exchange mark Blades is not an arbitrageur. Holt believes that opportunities could offset the negative in from the baht's depreciation, which seriously affect Blades' profit margins. nar- ange market. Although believes that arbitrage gative impact resulting Would otherwise alue. Holt has identi profitable and the most profitab financial analyst. opportunities has identified three arbitrage opportunities as ble and would like to know which one of them is profitable. Thus, he has asked you, Blades cial analyst, to prepare an analysis of the arbitrage tunities he has identified. This would allow Holt assess the profitability of arbitrage opportunities very quickly. The first arbitrage opportunity relates to locational bitrage. 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: SOBAT BANK MINZU BANK $.0224 $.0227 Bid Ask $.0228 $.0229 Determine wheth the Thai baht and not appropriate, erate for Blades checking accoun before the rates 3. Ben Holt has quotations for th covered interest quoted a forward 90-day forward $.0227. Ninety- the United State rates in Thailan annualized). Ho trage, unlike loc requires an inve be able to estin arbitrage over on a 90-day U. Determine appropriately. mine the profi withdrawing $ and engaging i profit as the e generate by in 4. Why are a soon after the answer, assun ing the imme possible. Disc would adjust longer possib called? 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 $.0085 $.0086 Value of a Japanese yen in U.S. dollars Value of a Thai baht in Japanese yen 42.69 12.70 ities as hem is Blades bitrage w Holt inities cross exchange rate between yen is appropriate. If it is e the profit you could gen- awing $100,000 from Blades' Determine whether the cross excha the Thai baht and Japanese yen is appro not appropriate, determine the profit you o erate for Blades by withdrawing $100,000 from ecking 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 $.0225 per Thai baht for a 90-day forward contract. The current spot rate is $.0227. Ninety-day interest rates available to Blades in the United States are 2 percent, while 90-day interest tional from Bank, of e VK ns mine 0,000 rates in Thailand are 3.75 percent (these rates are not annualized). Holt is aware that covered interest arbi- trage, 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, deter- mine 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 ht soon after they have been discovered? To illustrate your answer, assume that covered interest arbitrage involv- ing 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