IFTM HOME ASSIGNMENT- 2

SUBMITTED TO: Prof. Pushpendra Singh SUBMITTED BY: Nupur Jain(FT-FS-11-333)

Q1. Assume that the following spot exchange rates exist today; DM = $ .60 FF = $ .15 DM = FF 4 Assume no transaction costs. Based on these exchange rates, can triangular arbitrage be used to earn profit? Explain.

SOLUTION DM

PARIS(FF)

NEW YORK($)

NEW YORK($) FF/DM=? DM=$0.60(Given) FF=$0.15 (Given) 1$= 1/0.60 DM = 1.666 DM 1$= 1/0.15 FF = 6.666 FF

FF/DM = 6.666/1.666 = 3.999 Therefore, DM= 3.999 FF

PARIS(FF) $/DM=? 1FF = 0.15$ 1DM= 4FF 1FF= 1/4DM 1FF=0.25DM $/DM= 0.15/0.25 = 0.6 Therefore, DM=0.6$

CONCLUSION 1.DM in terms of FF is cheaper in NEW YORK. 2.DM in terms of $ is cheaper in PARIS. 3.$ and DM are at parity in both the markets. ARBITRATION 1.Buy DM against FF from NEW YORK. 2.Sell DM against $ in PARIS. 3.Convert FF into $ in any of the markets. 1FF=0.15$ 3.999FF= 0.15*3.999$ .5998$=1DM(3.999FF)

Q2.Assume the following information: Spot rate of GBP = $ 1.60 180 day forward rate of GBP = $ 1.56 180 day British interest rate = 4% 180 day US interest rate = 3% Based on the above information, is covered interest arbitrage by US investors feasible? Explain. SOLUTION To test route of arbitrage, we test the inequality for foreign market to be an investment market.

(1+r $ ) / (1+rGBP)

<

1.60(spot)/1.56(fwd)

(1+0.03/2) / (1+0.04/2) < 1.025 (1+0.015) / (1+0.02) < 1.025 (1.015)/(1.02) < 1.025 1.015/1.02 < 1.025 0.995 < 1.025 Hence, this is true.

Therefore, foreign market is investment market and domestic market is not an investment market.

Conclusion
Buy $ @ 3% from US and convert $ in GBP at spot rate and sell GBP into London. Invest GBP in foreign market @ 4%.