HOME ASSIGNMENT 2 IFTM

International Finance and Treasury Management Home Assignment 2 Submission date: 19 March 2012 Mode: Mail File Name (Most important): H2 last three digits of your Roll Number 01. 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. 02. 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 No.1 In New York Market, the two different spot exchange rates are: DM= $0.60 FF= $0.15 In Paris Market, the prevailing spot exchange rate is: DM= FF4 Computation of $/DM in Paris: $/DM = $ value of FF/ DM value of FF Where $ value of FF = $/FF Therefore, $/FF = 0.15

And, DM value of FF = DM/FF DM = FF4 1FF = DM = DM0.25/FF Therefore, DM/FF = 0.25 Hence, $/DM = 0.15/0.25 = $0.60DM Computation of FF/DM in New York: FF/DM = FF value of $/DM value of $ Where FF value of $ = FF/$ $0.15/FF 1 FF= 0.15$ 1$= 1/0.15FF = FF6.667/$ And, DM value of $ = DM/$ $0.60/DM 1DM= 0.60$ 1$ = 1/0.60DM = 1.6667DM/$ Hence, FF/DM = FF6.667/$ / DM1.6667/$ = FF4/DM CONCLUSION: 1. The DM in terms of $ is at parity in both the markets of New York and Paris. 2. The $ and FF are at parity in both the markets of New York and Paris. 3. The DM in terms of FF is at parity in both the markets of New York and Paris. Therefore, the possibility of Arbitration does not exist. Solution No.2 Test the inequality for foreign market (British market) to be an investment market. [(1+r$)/ (1+rGBP)]< (F/S) Where, r$= US Interest Rate and rGBP = British Interest Rate [(1+0.003/2)/ (1+0.04/2)] < (1.56/1.60) (1.015/1.02)<0.975 0.99509<0.975

Which is not true and therefore the British market (Foreign market) is not an investment market, instead domestic market (US) is an investment market. Therefore, the covered interest arbitrage route is: 1. Borrow GBP at 4% creating a future liability of = GBP100 (1+0.04/2) = GBP102 2. Convert GBP into $ at spot, 100GBP* 1.60 = $160 3. Invest $ into the domestic market at 3% and create an asset worth = 160[1+0.03/2] = $162.4 4. Sell forward the realization from investment in dollars = $162.4/ $1.56/GBP = 104.1025GBP 5. Repay the borrowed liability i.e. 102GBP and realize the Net Profits. Net Profits = 104.1025GBP 102GBP = 2.1025 GBP CONCLUSION: Thus we see that for every 100 GBP borrowings we can have a profit of 2.1025GBP. Thus, covered interest rate arbitrage is feasible.