Question 4

(a)The ISO currency code for the Indonesian Rupiah is IDR, and the code for the Malaysian Ringgit is MYR. Suppose that a basket of goods costs MYR110.00 in Malaysia, and the same basket of goods costs IDR362,760.70 in Indonesia.

(i)Compute the equilibrium or arbitrage-free MYR/IDR spot exchange rate.

(ii)Suppose that the actual MYR/IDR spot exchange rate is 3,292.37. Does an opportunity to engage in a commodity arbitrage exist? If your answer is `yes,' describe the commodity arbitrage process. Describe in which country the arbitrageur would buy one basket of goods and sell in which country at what price. Also, explain the amount of profit in MYR. Use a single basket of goods in your discussion. Assume that there is no restriction on movements of goods across the two countries and also assume no transportation or any other costs.

(b)Suppose that the 6-month nominal risk-free rate in Indonesia is 6.5 percent, and the 6-month nominal risk-free interest rate in Malaysia is 5.5 percent. Compute the 6-month forward MYR/IDR exchange rate. Use the spot MYR/IDR exchange rate from part (a.ii) above, which is equal to 3,292.37.