When one country offers a higher interest rate then another country, it is tempting to borrow...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
When one country offers a higher interest rate then another country, it is tempting to borrow money in the lower interest rate country currency and invest in the higher interest rate country currency. But interest rate parity theory suggests that a person would not make a profit with that scheme because the difference in interest rates between two countries will be negated by the relative change in the foreign exchange rate between the two currencies over the same period. However, and this is where things get interesting, currency exchange markets are not constantly in interest rate parity. When markets are not in equilibrium, there is the potential for making a profit through interest rate arbitrage. An investor needs to take into account both the current difference in interest rates and potential future change in exchange rates. Let's look at hypothetical case. Jack is a foreign exchange trader for a bank in New York. He has $1 million (or Swiss franc equivalent) available to borrow and will then invest it in a short term money market investment. He is wondering whether he can make a covered interest rate arbitrage (CIA) profit and/or an uncovered interest rate arbitrage (UIA) profit by borrowing in either the U.S. dollar or Swiss franc, and then investing in the other currency. He has the following data: arbitrage funds available spot exchange rate 3-month forward rate forward premium on the Swiss franc expected spot rate in 90 days U.S. dollar 3-month interest rate Swiss franc 3-month interest rate $1,000,000 (or Swiss franc equivalent) SFr1.2810/$ SFr1.2740/$ 2.198% (spot forward)/forward x 360/90 SFr1.2700/$ 4.8% annually 3.2% annually 1. Assess whether CIA profit is possible. (a) Is there a CIA profit potential? Show how you arrived at this answer. (b) Which currency should Jack borrow in and which should he invest in? Why? Hint: CIA is only possible if the cost of hedging the exchange risk is less than the additional return generated by investing in the other currency. To make this determination, compare the forward premium on the franc to how much more the dollar interest rate pays than the franc interest rate. 2. Given your conclusions for question 1, show how Jack can make a profit (i.e. show how and what numbers you get for how much he would owe on borrowing in the one currency and how much he would make in investing in the other currency). 3. What is the exchange rate risk that Jack is taking by engaging in CIA: risky or not risky? When one country offers a higher interest rate then another country, it is tempting to borrow money in the lower interest rate country currency and invest in the higher interest rate country currency. But interest rate parity theory suggests that a person would not make a profit with that scheme because the difference in interest rates between two countries will be negated by the relative change in the foreign exchange rate between the two currencies over the same period. However, and this is where things get interesting, currency exchange markets are not constantly in interest rate parity. When markets are not in equilibrium, there is the potential for making a profit through interest rate arbitrage. An investor needs to take into account both the current difference in interest rates and potential future change in exchange rates. Let's look at hypothetical case. Jack is a foreign exchange trader for a bank in New York. He has $1 million (or Swiss franc equivalent) available to borrow and will then invest it in a short term money market investment. He is wondering whether he can make a covered interest rate arbitrage (CIA) profit and/or an uncovered interest rate arbitrage (UIA) profit by borrowing in either the U.S. dollar or Swiss franc, and then investing in the other currency. He has the following data: arbitrage funds available spot exchange rate 3-month forward rate forward premium on the Swiss franc expected spot rate in 90 days U.S. dollar 3-month interest rate Swiss franc 3-month interest rate $1,000,000 (or Swiss franc equivalent) SFr1.2810/$ SFr1.2740/$ 2.198% (spot forward)/forward x 360/90 SFr1.2700/$ 4.8% annually 3.2% annually 1. Assess whether CIA profit is possible. (a) Is there a CIA profit potential? Show how you arrived at this answer. (b) Which currency should Jack borrow in and which should he invest in? Why? Hint: CIA is only possible if the cost of hedging the exchange risk is less than the additional return generated by investing in the other currency. To make this determination, compare the forward premium on the franc to how much more the dollar interest rate pays than the franc interest rate. 2. Given your conclusions for question 1, show how Jack can make a profit (i.e. show how and what numbers you get for how much he would owe on borrowing in the one currency and how much he would make in investing in the other currency). 3. What is the exchange rate risk that Jack is taking by engaging in CIA: risky or not risky?
Expert Answer:
Related Book For
Microeconomics
ISBN: 978-0321866349
14th canadian Edition
Authors: Christopher T.S. Ragan, Richard G Lipsey
Posted Date:
Students also viewed these finance questions
-
During an ice show, a 60.0-kg skater leaps into the air and is caught by an initially stationary 75.0-kg skater. (a) What is their final velocity assuming negligible friction and that the 60.0-kg...
-
Planning is one of the most important management functions in any business. A front office managers first step in planning should involve determine the departments goals. Planning also includes...
-
The Crazy Eddie fraud may appear smaller and gentler than the massive billion-dollar frauds exposed in recent times, such as Bernie Madoffs Ponzi scheme, frauds in the subprime mortgage market, the...
-
Explain why a safety net can save the life of a circus performer.
-
Handbook values for the latent heats of vaporization in J g-1 arc given in the table for several pure liquids at 0(C. ________________________(H at 0(C Chloroform............................270.9...
-
Polska Corporation, in preparation of its December 31, 2015, financial statements, is attempting to determine the proper accounting treatment for each of the following situations. 1. As a result of...
-
\(\sim(\sim r \vee \sim s)\) Given: \(p\) : Frodo is a hobbit, \(q\) : Gandalf is a wizard, \(r\) : Frodo and Samwise will take the ring to Mordor, and \(s\) : Gollum will help Frodo get into Mordor....
-
AirQual Test Corporation provides on-site air quality testing services. The company has provided the following data concerning its operations: The company uses the number of jobs as its measure of...
-
Smug Ltd produces and sells two versions of fruit juicers: Deluxe and Premium. The juicers produced by Smug Ltd use a patented technology to extract maximum possible juice from most fruits. The...
-
Cp = kYp is to Friedman Consumption hypothesis while C = aWR + cY, is to Ando and Modigliani Consumption hypothesis. Compare and Contrast. [8 Marks].
-
An independent auditor has completed substantive tests of balance sheet and income statement accounts, and now plans to begin procedures designed to determine whether there are any loss contingencies...
-
You were engaged to audit the financial statements of Ronlyn Corporation for the year ended June 30, 1999. On May 1, 1999, the corporation borrowed $500,000 from Second National Bank to finance plant...
-
In testing prepaid insurance, how does an auditor address rights and obligations?
-
What sources does an auditor use to test for overstated accounts payable, and how are those sources used?
-
The following covenants are extracted from the indenture of a bond issue. Although the bond due date is 2016, failure to comply with any covenant automatically advances the due date of the loan to...
-
2. Adam's class has 14 students. Their scores on the midterm are shown in the table. Answer the following questions. 50 50 71 65 54 84 69 82 67 52 52 86 85 94 72 272 a) Calculate the mean and the...
-
In your audit of Garza Company, you find that a physical inventory on December 31, 2012, showed merchandise with a cost of $441,000 was on hand at that date. You also discover the following items...
-
The federal government has imposed many regulations aimed at reducing the pollution that is generated by driving. The more familiar regulations are direct-catalytic converters, fuel-efficiency...
-
Suppose the relationship between the government's tax revenue (T) and national income (Y) is represented by the following equation: T= 10 + 0.25 Y. Plot this relationship on a scale diagram, with Y...
-
Consider the market for lumber, which we assume h to be perfectly competitive. a. Suppose that for each unit of lumber produced, the firms also generate $10 of damage to the environment. Draw the...
-
J Owens year ended on 30 June 19X8. Write up the ledger accounts, showing the transfers to the final accounts and the balances carried down to the next year for the following: (a) Stationery: Paid...
-
The two accounts below were taken from the books of a retailer at the end of his financial year, 31 December 19X7. Required: Answers to the following questions. Insurance Account Dr 19X7 19X7 Jan 1...
-
On 1 January 19X6 the following balances, among others, stood in the books of T Thomas: (a) Lighting and heating, (Dr) 277. (b) Insurance, (Dr) 307. During the year ended 31 December 19X6 the...
Study smarter with the SolutionInn App