Professional Documents
Culture Documents
Fund 4e Chap07 Pbms
Fund 4e Chap07 Pbms
Fund 4e Chap07 Pbms
1 Starbucks in Croatia
Starbucks opened its first store in Zagreb, Croatia in October 2010. The price of a tall vanilla latte
in Zagreb is 25.70kn. In New York City, the price of a tall vanilla latte is $2.65. The exchange
rate bewteen Croatian kunas (kn) and U.S. dollars is kn5.6288/$. According to purchasing power
parity, is the Croatian kuna overvalued or undervalued?
Assumptions
Spot exchange rate (Kn/$)
Price of vanilla latter in Zagreb (kn)
Price of vanilla latter in NYC ($)
Value
5.6288
25.70
2.65
4.57
9.70
112.408%
Value
1.0000
3.2000
2.20%
20.00%
a. What should have been the exchange rate in January 2003 if PPP held?
Beginning spot rate (Ps/$)
Argentine inflation
US inflation
PPP exchange rate
1.00
20.00%
2.20%
1.17
3.20
1.17
-63.307%
Value
850.00
930.00
1.0941
1.15%
3.13%
850.00
930.00
1.0941
a. What should be the price of the luggage set in A$ in 1-year if PPP holds?
Beginning spot rate (A$/$)
Australian inflation
US inflation
PPP exchange rate
Price of 3-Piece Luggage set in US$
PPP exchange rate
Price of 3-piece luggage set in Sydney (A$)
However, purchasing power parity is not always an accurate predictor of exchange rate
movements, particularly in the short-term.
1.0941
3.13%
1.15%
1.1155
850.00
1.1155
948.19
Value
$5,000,000
118.60
117.80
4.800%
3.400%
Yen Equivalent
593,000,000
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
Difference in interest rates ( i - i $)
Forward premium on the yen
CIA profit potential
-1.400%
1.358%
-0.042%
This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to
lock-in a covered interest arbitrage (CIA) profit.
5,000,000
Spot (/$)
118.60
593,000,000.00
Japanese yen
START
1.0240
1.0170
3.400%
Japanese yen interest rate (180 days)
5,120,000
Forward-180 (/$)
117.80
603,136,000
603,081,000
55,000
END
Takeshi Kamada generates a CIA profit by investing in the higher interest rate currency, the dollar, and simultaneously
selling the dollar proceeds forward into yen at a forward premium which does not completely negate the interest
differential.
Value
$5,000,000
118.60
117.80
118.00
4.800%
3.400%
Yen Equivalent
593,000,000
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
Difference in interest rates ( i - i $)
Expected gain (loss) on the spot rate
UIA profit potential
-1.400%
1.017%
-0.383%
This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to
potentially gain on an uncovered basis (UIA).
Spot (/$)
118.60
593,000,000.00
Japanese yen
START
1.0240
1.0170
3.400%
Japanese yen interest rate (180 days)
$5,120,000
604,160,000
603,081,000
1,079,000
END
a) Takeshi Kamada generates an uncovered interest arbitrage (UIA) profit of 1,079,000 if his expectations about the
future spot rate, the one in effect in 180 days, prove correct.
b) The risk Takeshi is taking is that the actual spot rate at the end of the period can theoretically be anything, better or
worse for his speculative position. He in fact has very little "wiggle room," as they say. A small movement will cost
him a lot of money. If the spot rate ends up any stronger than about 117.79/$ (a smaller number), he will lose money.
(Verify by inputting 117.70/$ in the expected spot rate cell under assumptions.)
Value
1.100%
5.900%
4.700%
9.500%
89.00
84.90
a.
Approximate Form
Forward rate as
an unbaised
predictor (E)
International
Fisher Effect (C)
Forward premium
on foreign currency
4.8%
(Japanese yen at a premium)
Interest rate
parity (D)
Forecast change in
spot exchange rate
4.8%
(Dollar expected to weaken)
Difference in nominal
interest rates
-4.8%
(higher in United States)
Purchasing
power
parity (A)
Forecast difference
in rates of inflation
-4.8%
(US higher than Japan)
Fisher
effect (B)
As is the always the case with parity conditions, the future spot rate is implicitly forecast to be equal to the forward rate, the implied rate
from the international Fisher effect, and the rate implied by purchasing power parity. According to Yazzie's calculations, the markets are
indeed in equilibrium -- parity.
b.
89.00
84.90
4.8%
Value
87.60
2,150,000
3.400%
0.000%
75.000%
a. What was the export price for the Corolla at the beginning of the year?
Year-beginning price of an Corolla ()
Spot exchange rate (/$)
Year-beginning price of a Corolla ($)
2,150,000
87.60
24,543.38
b. What is the expected spot rate at the end of the year assuming PPP?
Initial spot rate (/$)
Expected US$ inflation
Expected Japanese yen inflation
Expected spot rate at end of year assuming PPP (/$)
c. Assuming complete pass through, what will the price be in US$ in one year?
Price of Corolla at beginning of year ()
Japanese yen inflation over the year
Price of Corolla at end of year ()
Expected spot rate one year from now assuming PPP (/$)
Price of Corolla at end of year in ($)
d. Assuming partial pass through, what will the price be in US$ in one year?
Price of Corolla at end of year ()
Amount of expected exchange rate change, in percent (from PPP)
Proportion of exchange rate change passed through by Toyota
Proportional percentage change
Effective exchange rate used by Toyota to price in US$ for end of year
Price of Toyota at end of year ($)
87.60
3.40%
0.00%
84.72
2,150,000
0.000%
2,150,000
84.72
25,377.85
2,150,000
3.400%
75.000%
2.550%
85.422
25,169.24
Value
$5,000,000
6.1720
6.1980
3.000%
5.000%
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
Difference in interest rates (ikr - i$)
Forward discount on the krone
CIA profit potential
2.000%
-1.678%
0.322%
This tells Heidi Hi Jensen that he should borrow dollars and invest in the higher yielding currency the Danish kroner,
for CIA profit.
START
$
5,000,000.00
Spot (kr/$)
6.1720
kr 30,860,000.00
1.0075
END
1.0125
5,037,500.00
5,041,263.31
$
3,763.31
Forward-90 (kr/$)
6.1980
kr 31,245,750.00
5.000%
Danish kroner interest (3-month)
Heidi Hi Jensen generates a covered interest arbitrage (CIA) profit because she is able to generate an even higher
interest return in Danish kroner than she "gives up" by selling the proceeds forward at the forward rate.
Value
$5,000,000
6.1720
6.1980
4.000%
5.000%
kr Equivalent
kr 30,860,000
a)
a)
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
Difference in interest rates (ikr - i$)
Forward discount on the krone
CIA profit potential
1.000%
-1.678%
-0.678%
This tells Heidi that she should borrow Danish kroner and invest in the LOWER interest rate currency, the dollar,
gaining on the re-exchange of dollars for kroner at the end of the period.
5,000,000.00
Spot (kr/$)
6.1720
kr 30,860,000.00
START
1.0100
1.0125
5.000%
Danish kroner interest (3-month)
5,050,000.00
F-90 (kr/$)
6.1980
kr 31,299,900.00
kr 31,245,750.00
kr 54,150.00
END
a) Heidi Hi Jensen generates a covered interest arbitrage profit of kr54,150 because, although U.S. dollar interest
rates are lower, the U.S. dollar is selling forward at a premium against the Danish krone.
Value
$5,000,000
6.1720
6.1980
3.000%
6.000%
kr Equivalent
kr 30,860,000
b)
b)
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
Difference in interest rates (ikr - i$)
Forward discount on the krone
CIA profit potential
3.000%
-1.678%
1.322%
This tells Heidi Hi Jensen that she should borrow US dollars and invest in the HIGHER interest rate currency, the
kroner, gaining on the re-exchange of kroner for dollars at the end of the period.
Spot (kr/$)
6.1720
kr 30,860,000.00
1.0075
1.0150
$
$
$
END
5,037,500.00
5,053,710.87
16,210.87
F-90 (kr/$)
6.1980
kr 31,322,900.00
6.000%
Danish kroner interest (3-month)
b) If the Danish kroner interest rate increases to 6.00%, while the U.S. dollar interest rate stays at 3.00% and spot and
forward rates remain the same, Heidi Hi Jensen's CIA profit is $16,210.87.
Value
$1,000,000
1.2810
1.2740
4.800%
3.200%
SFr. Equivalent
SFr. 1,281,000
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
Difference in interest rates ( i SFr. - i $)
Forward premium on the Swiss franc
CIA profit potential
-1.600%
2.198%
0.598%
This tells Casper Landsten he should borrow U.S. dollars and invest in the LOWER yielding currency, the Swiss
franc, in order to earn covered interest arbitrage (CIA) profits.
START
$
1,000,000.00
Spot (SFr./$)
1.2810
SFr. 1,281,000.00
1.0120
END
1.0080
1,012,000.00
1,013,538.46
$
1,538.46
Forward-90 (SFr./$)
1.2740
SFr. 1,291,248.00
3.200%
Swiss franc interest rate (3-month)
a) Casper Landsten makes a net profit, a covered interest arbitrage profit, of $1,538.46 on each million he invests in
the Swiss franc market (by going around the box). He should therefore take advantage of it and perform covered
interest arbitrage.
b) Assuming a $1 million investment for the 90-day period, the annual rate of return on
this near risk-less investment is:
0.62%
Value
$1,000,000
1.2810
1.2740
1.2700
4.800%
3.200%
SFr. Equivalent
SFr. 1,281,000
Since Casper is in the US market (starting point), if he were to undertake uncovered interest arbitrage he would be
first exchange dollars for Swiss francs, investing the Swiss francs for 90 days, and then exchanging the Swiss franc
proceeds (principle and interest) back into US dollars at whatever the spot rate of exchange is at that time. In this case
Casper will have to -- at least in his mind -- make some assumption as to what the exchange rate will be at the end of
the 90 day period.
START
1,000,000
Spot (SFr/$)
1.2810
SFr. 1,281,000
1.0120
END
1,012,000.00
1,012,029.16
29.16
SFr. 1,291,248
1.0080
$
$
$
3.200%
Swiss franc interest rate (3-month)
If Casper assumed the spot rate at the end of 90 days were the same as the current spot rate (SFr1.2810/$), the UIA
transaction would not make much sense. The lower Swiss franc interest rate would yield final dollar proceeds of only
$1,008,000, a full $4,000 less than simply investing in the US (straight across the top of the box).
For an UIA transaction to result in higher dollar proceeds at the end of the 90 day period, the ending spot rate of
exchange would have to be SF1.2759/$ or less (a stronger and stronger Swiss franc resulting in more and more US
dollars when exchanged).
Should Casper do it? Well, depends on his bank's policies on uncovered transactions, and his beliefs on the future
spot exchange rate. But, given that he is invested in a foreign currency with a lower interest rate, not a higher one, so
he is placing all of his 'bets' on the exchange rate, it is not a speculation for the weak of heart.
Value
$1,000,000
1.3392
1.3286
4.750%
3.625%
SFr. Equivalent
SFr. 1,339,200
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less
than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
Difference in interest rates ( i SFr. - i $)
Forward premium on the Swiss france
CIA profit
-1.125%
3.191%
2.066%
This tells Casper Landsten he should borrow U.S. dollars and invest in the lower yielding currency, the Swiss franc,
and then sell the Swiss franc principal and interest forward three months locking in a CIA profit.
START
$1,000,000
Spot (SFr./$)
1.3392
SFr. 1,339,200.00
1.011875
END
1.0090625
1,011,875.00
1,017,113.13
$
5,238.13
F-90 (SFr./$)
1.3286
SFr. 1,351,336.50
3.625%
Swiss franc interest rate (3-month)
Yes, Casper should undertake the covered interest arbitrage transaction, as it would yield a risk-less profit (exchange
rate risk is eliminated with the forward contract, but counterparty risk still exists if one of his counterparties failed to
actually make good on their contractual commitments to deliver the forward or pay the interest) of $5,238.13 on each
$1 million invested.
a. How many dollars might Theresa expect to need one year hence to pay for her 30-day vacation?
b. By what percent has the dollar cost gone up? Why?
Assumptions
Charge for suite plus meals in Malaysian ringgit (RM)
Spot exchange rate (RM/$)
US$ cost today for a 30 day stay
Malaysian ringgit inflation rate expected to be
U.S. dollar inflation rate expected to be
Value
1,045.00
3.1350
$10,000.00
2.750%
1.250%
a. How many dollars might you expecte to need one year hence for your 30-day vacation?
Spot exchange rate (ringgit per US$)
Malaysian ringgit inflation rate expected to be
U.S. dollar inflation rate expected to be
3.1350
2.750%
1.250%
3.181444
32,212.13
$10,125.00
$10,125.00
$10,000.00
1.250%
The dollar cost has risen by the US dollar inflation rate. This is a result of Theresa's estimation of the future suite
costs and the exchange rate changing in proportion to inflation (relative purchasing power parity).