This question requires reading of the following paper:

Frenkel J.A., Levich R.M., 1975. Covered interest arbitrage: Unexploited profits. Journalof Political Economy 83, 325-338.

The covered interest parity relationship that we studied in class ignores transaction costs. In practice, transaction costs are paid both for forward and spot transaction in the FX markets and also for borrowing and lending in foreign and domestic currencies (in the Libor market for example).

1)

Following the convention in Frenkel and Levich (1975), we model transaction costs as a percentage of wealth that is ?burned? and denoting the transaction costs as t, t^*, t_S,t_F respectively in domestic deposit securities, foreign deposit securities, the spot FX market and the forward FX market. Using arguments similar to what we studied in class (using the four dots diagrams), show that to preclude covered interest arbitrage, formula (8) of Frenkel and Levich (1975) must hold. Use a direct approach rather than the equilibrium arguments in page 327 of the paper Frenkel and Levich (1975).

2)

Alternatively, if transaction costs are modeled as bid-ask price/rate for the four markets (domestic and foreign security deposit and spot and forward FX), provide the covered interest parity no arbitrage conditions in term of the bid-ask prices/rates.

3)

Explain intuitively how Frenkel and Levich (1975) indirectly estimated the level of total transaction costs that arbitrageurs must pay (respectively in the spot and 90 days forward markets) to implement triangular arbitrage involving a triplet of currencies (Section II). What are the estimates of these transaction costs for the spot and the forward markets for the three triplets of currencies considered in Frenkel and Levich (1975)?

4-1)

Verify if the following prices are consistent with the absence of CIP arbitrage

	Bid	Ask
Spot (Yen per dollars)	82.67	82.71
Forward (Yen per dollars)	82.32	82.37
Dollar interest rates	0.91	1.11
Yen interest rates	0.46	0.58

4-2)

Verify additionally that these prices are consistent with the two conditions that you gave in question b).

5)

What are the estimates of the total transaction costs for implementing a covered interest parity arbitrage (the variable is denoted by ? in Frenkel and Levich (1975)).

6)

During the Lehman Failure (September 2008) we have seen substantial deviations from the CIP conditions whereby the difference between (1+i_UK)F/S and (1+i_US) reached a level a high as 2 to 3% in the US$ versus British Pounds market. Discuss why these deviations may not necessarily translate into profit opportunities during the crisis period.