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Chapter 07—International Arbitrage and Interest Rate Parity

1. Due to ____, market forces should realign the relationship between the interest rate differential of two currencies and
the forward premium (or discount) on the forward exchange rate between the two currencies.
a. forward realignment arbitrage b. triangular arbitrage
c. covered interest arbitrage d. locational arbitrage
ANSWER::
ANSWER c

2. Due to ____, market forces should realign the spot rate of a currency among banks.
a. forward realignment arbitrage b. triangular arbitrage
c. covered interest arbitrage d. locational arbitrage
ANSWER::
ANSWER d

3. Due to ____, market forces should realign the cross exchange rate between two foreign currencies based on the spot
exchange rates of the two currencies against the U.S. dollar.
a. forward realignment arbitrage b. triangular arbitrage
c. covered interest arbitrage d. locational arbitrage
ANSWER::
ANSWER b

4. If interest rate parity exists, then ____ is not feasible.

a. forward realignment arbitrage b. triangular arbitrage

c. covered interest arbitrage d. locational arbitrage
ANSWER::
ANSWER c

5. In which case will locational arbitrage most likely be feasible?

a. One bank's ask price for a currency is greater than another bank's bid price for the currency.
b. One bank's bid price for a currency is greater
greater than another bank's ask pri
price
ce for the currency.
c. One bank's ask price for a currency is less than another bank's ask price for the currency.
d. One bank's bid price for a currency is less than another bank's bid price for the currency.
ANSWER::
ANSWER b

6. When using ____, funds are not tied up for any length of time.

a. covered interest arbitrage b. locational arbitrage

c. triangular arbitrage d. B and C
ANSWER::
ANSWER d

7. When using ____, funds are typically tied up for a significant period of time.
a. covered interest arbitrage b. locational arbitrage
c. triangular arbitrage d. B and C
ANSWER::
ANSWER a

8. Assume that the interest rate in the home country of Currency X is a much higher interest rate than the UK interest rate.
According to interest rate parity, the forward rate of Currency X:
a. should exhibit a discount.

b. should exhibit a premium.

premium.
c. should be zero (i.e., it should equal its spot rate).
d. B or C
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Chapter 07—International Arbitrage and Interest Rate Parity

ANSWER::
ANSWER a

9. If the interest rate is higher in the U.S. than in the United Kingdom, and if the forward rate of the British pound (in U.S.
dollars) is the same as the pound's spot rate, then:
a. U.S. investors could possibly benefit from covered interest arbitr
arbitrage.
age.
b. British investors could
could possibly benefit fro
from
m covered interest arbitrage.
c. neither U.S. nor British investors could benefit from covered interest arbitrage.
d. A and B
ANSWER::
ANSWER b

10. If the interest rate is lower in the U.S. than in the United Kingdom, and if the forward rate of the British pound is the
same as its spot rate:
a. U.S. investors could possibly benefit from covered interest arbitr
arbitrage.
age.
b. British investors could
could possibly benefit fro
from
m covered interest arbitrage.
c. neither U.S. nor British investors could benefit from covered interest arbitrage.
d. A and B
ANSWER::
ANSWER a

11. Assume that the UK investors are benefiting from covered interest arbitrage due to high interest rates on euros. Which
of the following forces should result from the act of this covered interest arbitrage?
a. downward pressure on the euro's spot rate.
b. downward pressure on the euro's
euro's forward rate.
c. downward pressure on the UK interest rate.
d. upward pressure on the euro's interest rate.
ANSWER::
ANSWER b

12. Assume that Swiss investors are benefiting from covered interest arbitrage due to a high UK interest rate. Which of
the following forces results from the act of this covered interest arbitrage?
a. upward pressure on the Swiss franc's spot rate.
b. upward pressure on the UK interest
interest rate.
c. downward pressure on the Swiss interest rate.
d. upward pressure on the Swiss franc's forward rate.
ANSWER::
ANSWER d

13. Assume that a UK firm can invest funds for one year in the UK at 12% or invest funds in Mexico at 14%. The spot
rate of the peso is £0.06 while the one-year forward rate of the peso is £0.06. If UK firms attempt to use covered interest
arbitrage, what forces should occur?
a. spot rate of peso increases; forward rate of peso decreases.
b. spot rate of peso decreases; forward
forward rate of peso increases.
c. spot rate of peso decreases; forward rate of peso decreases.
d. spot rate of peso increases; forward rate of peso increases.
ANSWER::
ANSWER a

14. Assume the bid rate of a New Zealand dollar is £0.183 while the ask rate is £0.185 at Bank X. Assume the bid rate of
the New Zealand dollar is £0.179 while the ask rate is £0.182 at Bank Y. Given this information, what would be your gain
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Chapter 07—International Arbitrage and Interest Rate Parity

if you use £1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the
£1,000,000 you started with?
a. -£16,484. b. £21,978.
c. £16,484. d. £5,494.
ANSWER::
ANSWER a

15. Based on interest rate parity, the larger the degree by which the foreign interest rate exceeds the UK interest rate, the:
a. larger will be the forward discount of the foreign currency.
b. larger will be the forward premium
premium of the foreign currency.
c. smaller will be the forward premium of the foreign currency.
d. smaller will be the forward discount of the foreign currency.
ANSWER::
ANSWER a

16. Assume that the U.S. interest rate is 10%, while the British interest rate is 15%. If interest rrate
ate parity exists, then:
a. British investors who invest in the United Kingdom will achieve the same return as U.S. investors who invest
in the U.S.
b. U.S. investors will earn a higher
higher rate of return when using covered in
interest
terest arbitrage than what th
they
ey would
earn in the U.S.

c. U.S. investors will earn 15% whether they use covered interest arbitrage or invest in the U.S.
d. U.S. investors will earn 10% whether they use covered interest arbitrage or invest in the U.S.
ANSWER::
ANSWER d

17. Assume the following information:

UK investors have £1,000,000 to invest

1-year deposit rate offered on pounds = 12%

1-year deposit rate offered on Singapore dollars = 10%
1-year forward rate of Singapore dollars = £0.23
Spot rate of Singapore dollar = £0.22

Given this information:

a. interest rate parity exists and covered interest arbitrage by UK investors results in the same yield as investing
domestically.
b. interest rate parity doesn't
doesn't exist and covered interest ar
arbitrage
bitrage by UK investors res
results
ults in a yield above what
what is
possible domestically.
domestically.
c. interest rate parity exists and covered interest arbitrage by UK investo
investors
rs results in a yield above what is
possible domestically.
domestically.
d. interest rate parity doesn't exist and covered interest arbitrage by UK investors results in a yield below what is
possible domestically.
domestically.
ANSWER::
ANSWER b

18. Assume the following information:

Current spot rate of New Zealand dollar = £0.230

Forecasted spot rate of New Zealand dollar 1 year from now = £0.240
One-year forward rate of the New Zealand dollar = £0.235
Annual interest rate on New Zealand dollars = 8%
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Chapter 07—International Arbitrage and Interest Rate Parity

Annual interest rate on £’s = 9%

Given the information in this question, the return from covered interest arbitrage by UK investors with £100 to invest is
____%.
a. about 3.04
b. about 3.39

c. about 1.89
d. about 1.35
e. about 1.65
ANSWER::
ANSWER d

19. Assume the following bid and ask rates of the pound for two banks as shown below:

Bid Ask
Bank A $1.41 $1.42
Bank B $1.39 $1.40

As locational arbitrage occurs:

a. the bid rate for pounds at Bank A will increase; the ask rate for pounds at Bank B will increase.
b. the bid rate for pounds at Bank A will
will increase; the ask rate for poun
pounds
ds at Bank B will decrease.
c. the bid rate for pounds at Bank A will decrease; the ask rate for pounds at Bank B will decrease.
d. the bid rate for pounds at Bank A will decrease; the ask rate for pounds at Bank B will increase.
ANSWER::
ANSWER d

20. Assume the bid rate of a Singapore dollar is £0.20 while the ask rate is £0.21 at Bank X. Assume the bid rate of a
Singapore dollar is £0.22 while the ask rate is £0.23 at Bank Z. Given this information, what would be your gain if you
use £1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the £1,000,000
you started with?
a. £11,764.
b. £47,619.
c. £36,585.
d. £48,710.
e. £18,219.
ANSWER::
ANSWER d

21. Based on interest rate parity, the larger the degree by which the UK interest rate exceeds the foreign interest rate, the:
a. larger will be the forward discount of the foreign currency.
b. larger will be the forward premium
premium of the foreign currency.
c. smaller will be the forward premium of the foreign currency.
d. smaller will be the forward discount of the foreign currency.
ANSWER::
ANSWER b

22. Assume the following exchange rates: £1 = NZ $3, NZ $1 = MXP2, and £1 = MXP5. Given this information, as you
and others perform triangular arbitrage, the exchange rate of the New Zealand dollar (NZ) with respect to the pound
should ____? and/or the exchange rate of the Mexican peso (MXP) with respect to the pound should ____.
a. appreciate; depreciate
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Chapter 07—International Arbitrage and Interest Rate Parity

b. depreciate; appreciate
c. depreciate; depreciate
d. appreciate; appreciate
e. remain stable; appreciate
ANSWER::
ANSWER a

23. Assume the following information:

Spot rate today of Swiss franc = £0.25

1-year forward rate as of today for Swiss franc = £0.26
Expected spot rate 1 year from now = £0.27
Rate on 1-year deposits denominated in Swiss francs = 7%
Rate on 1-year deposits denominated in UK pounds = 9%

From the perspective of UK investors with £1,000,000, covered interest arbitrage would yield a rate of return of ____%.
a. 5.00
b. 11.28
c. 15.50
d. 15.13
e. 12.22
ANSWER::
ANSWER b

24. Assume the following information for a bank quoting on spot exchange rates:

Exchange rate of Singapore dollar in euros = 0.50 euros

Exchange rate of pound in euros = 1.4 euros
Exchange rate of pound in Singapore dollars = S$3.00

Based on the information given, as you and others perform triangular arbitrage, what should logically happen to the spot
exchange rates?
a. The Singapore dollar value in £'s should appreciate, the pound value in euros should appreciate.

b. The Singapore dollar value

value in £'s should depreciate, th
thee pound value in euros sho
should
uld appreciate.
c. The Singapore dollar value in £'s should depreciate, the pound value in euros should appreciate.
d. The Singapore dollar value in £'s should appreciate, the pound value in euros should depreciate.
ANSWER::
ANSWER a

25. Assume the U.S. dollar is worth £0.82, and the Canadian dollar is worth £0.61. What is the value of the Canadian
dollar in U.S. dollars to the nearest cent?
a. 1.34.
b. 0.50.
c. 0.15
d. 0.74
e. 1.17

ANSWER::
ANSWER d

26. Assume that the euro's interest rates are higher than U.S. interest rates, and that interest rate parity exists. Which of the
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Chapter 07—International Arbitrage and Interest Rate Parity

following is true?
a. Americans using covered interest arbitrage earn the same rate of return as Germans who attempt covered
interest arbitrage.
b. Americans who invest in the
the U.S. earn the same rate of return as Germans who attempt covered
covered interest
arbitrage.
c. Americans who invest in the U.S. earn the same rate of return as Germans who invest in Germany.
d. A and B
e. None of the above
ANSWER::
ANSWER e

27. Assume the UK interest rate is 2% higher than the Swiss rate, and the forward rate of the Swiss franc has a 4%
premium. Given this information:
information:
a. Swiss investors who attempt covered interest arbitrage
arbitrage earn the same rate of return
r eturn as if they invested in
Switzerland.
b. UK investors who attempt
attempt covered interest arbitrage earn a higher
higher rate of return than if they invested in the
UK
c. A and B
d. none of the above
ANSWER::
ANSWER b

28. Assume that British interest rates are higher than U.S. rates, and that the spot rate equals the forward rate. Covered
interest arbitrage puts ____ pressure on the pound's spot rate, and ____ pressure on the pound's forward rate.
a. downward; downward b. downward; upward
c. upward; downward d. upward; upward
ANSWER::
ANSWER c

29. Assume that interest rate parity holds, and the euro's interest rate is 9% while the U.S. interest rate is 12%. Then the
euro's interest rate increases to 11% while the U.S. interest rate remains the same. As a result of the increase in the interest
rate on euros, the euro's forward ____ will ____ in order to maintain interest rate parity.
a. discount; increase b. discount; decrease
c. premium; increase d. premium; decrease
ANSWER::
ANSWER d

30. Assume the bid rate of a Swiss franc is £0.42 while the ask rate is £0.45 at Bank X. Assume the bid rate of the Swiss
franc is £0.40 while the ask rate is £0.41 at Bank Y. Given this information, what would be your gain if you use
£1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the £1,000,000 you
started with?
a. £24,340. b. £125,000.
c. £150,000. d. £12,550.
ANSWER::
ANSWER a

31. Assume the following information:

You have £1,000,000 to invest

Current spot rate of dollar = £0.54
90-day forward rate of dollar = £0.53
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Chapter 07—International Arbitrage and Interest Rate Parity

1 year deposit rate in U.S. = 4%
1 year deposit rate in U.K. = 3%

If you use covered interest arbitrage for a 1 year investment, what will be the amount of pounds you will have after 1
year?
a. £1,020,740.

b. £1,045,600.
c. £1,073,330.
d. £1,094,230.
e. £1,116,250.
ANSWER::
ANSWER a

32. Assume the following information:

UK investors have £1,000,000 to invest

1-year deposit rate offered by UK banks = 12%

1-year deposit rate offered on Swiss francs = 10%
1-year forward rate of Swiss francs = £0.42
Spot rate of Swiss franc = £0.41
Given this information:
a. interest rate parity exists and covered interest arbitrage by UK investors results in the same yield as investing
domestically.
b. interest rate parity doesn't
doesn't exist and covered interest ar
arbitrage
bitrage by UK investors res
results
ults in a yield above what
what is
possible domestically.
domestically.
c. interest rate parity exists and covered interest arbitrage by UK investo
investors
rs results in a yield above what is
possible domestically.
domestically.
d. interest rate parity doesn't exist and covered interest arbitrage by UK investors results in a yield below what is
possible domestically.
domestically.
ANSWER::
ANSWER b

33. Assume the following information:

Current spot rate of Australian dollar = £0.40

Forecasted spot rate of Australian dollar 1 year from now = £0.37
1-year forward rate of Australian dollar = £0.38
Annual interest rate for Australian dollar deposit = 9%
Annual interest rate in the UK = 6%

Given the information in this question, the return from covered interest arbitrage by UK investors is ????%.
a. 3.00
b. 4.15
c. 2.33
d. 1.14
e. 3.55
ANSWER::
ANSWER e

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Chapter 07—International Arbitrage and Interest Rate Parity

34. Assume the following bid and ask rates of the pound for two banks as shown below:

Bid Ask
Bank C $1.61 $1.63
Bank D $1.58 $1.60

As locational arbitrage occurs:

a. the bid rate for pounds at Bank C will increase; the ask rate for pounds at Bank D will increase.
b. the bid rate for pounds at Bank C will
will increase; the ask rate for pounds at Bank D will decrease.
c. the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will decrease.
d. the bid rate for pounds at Bank C will decrease; the ask rate for pounds at Bank D will increase.
ANSWER::
ANSWER d

35. Assume the bid rate of an Australian dollar is £0.40 while the ask rate is £0.42 at Bank Q. Assume the bid rate of an
Australian dollar is £0.415 while the ask rate is £0.419 at Bank V. Given this information, what would be your gain if you
use £1,000,000 and execute locational arbitrage? That is, how much will you end up with over and above the £1,000,000
you started with?
a. £10,003.
b. £12,063.
c. £14,441.
d. £0.
e. £18,219.
ANSWER::
ANSWER d

36. Bank A quotes a bid rate of £0.125 and an ask rate of £0.155 for the Malaysian ringgit (MYR). Bank B quotes a bid
rate of £0.162 and an ask rate of £0.171 for the ringgit. What will be the profit for an investor who has £500,000 available
to conduct locational arbitrage?
a. £184,000. b. £22,581.
c. £148,000. d. £31,639.
ANSWER::
ANSWER b

37. You just received a gift from a friend

f riend consisting of 1,000 Thai baht, which you would like to exchange for Australian
dollars (A$). You observe that exchange rate quotes for the baht are currently £0.0115, while quotes for the Australian
dollar are £0.288. How many Australian dollars should you expect to receive for your baht?
a. A$399. b. A$2,504.
c. A$553. d. none of the above
ANSWER::
ANSWER a

38. National Bank quotes the following for the British pound and the New Zealand dollar:

Quoted
Bid Price Quoted
Ask Price
Value of a US dollar in £’s £0.620 £0.625
Value of a New Zealand dollar (NZ$) in £’s £0.310 £0.315
Value of a US dollar in New Zealand dollars NZ $2.20 NZ $2.25

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Chapter 07—International Arbitrage and Interest Rate Parity

Assume you have £10,000 to conduct triangular arbitrage. What is your profit from implementing this strategy?
a. £1,340. b. £1,250.
c. £1,253. d. £1,160.
ANSWER::
ANSWER d

39. Assume the following information:

You have £900,000 to invest

Current spot rate of Australian dollar (A$) = £0.35

180-day forward rate of the Australian dollar = £0.36
180-day interest rate in the U.S. = 3.5%
180-day interest rate in Australia = 3.0%

If you conduct covered interest arbitrage, what is the nearest pound profit you will have realized after 180 days?
a. £1,250. b. £53,490.
c. £58,114. d. none of the above.
ANSWER::
ANSWER b

40. Assume the following information:

You have £400,000 to invest

Current spot rate of Sudanese

S udanese dinar (SDD) = £0.00317
1 year forward rate of the dinar = £0.00311
1 year interest rate in the UK = 4.0%
1 year interest rate in Sudan = 4.2%

If you conduct covered interest arbitrage, what amount will you have after 1 year to the nearest £?
a. £416,000.
b. £424,841.
c. £424,242.

d. £408,911.
e. none of the above
ANSWER::
ANSWER d

41. Assume the following information:

You have £300,000 to invest

The spot bid rate for the euro (€) is £0.67
The spot ask quote for the euro is £0.68
The 1 year forward rate (bid) of the euro is £0.67
The 1 year forward rate (ask) of the euro is £0.68
The 1 year interest rate in the UK is 6%
The 1 year interest rate in Europe is 8%

If you conduct covered interest arbitrage, what amount will you have after 1 year to the nearest pound?
a. £319,235.
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Chapter 07—International Arbitrage and Interest Rate Parity

b. £313,323.
c. £312,218.
d. £328,836.
e. none of the above
ANSWER::
ANSWER a

42. According to interest rate parity (IRP):

a. the forward rate differs from the spot rate by a sufficient amount to offset the inflation differential between
two currencies.
b. the future spot rate differs from the current
current spot rate by a sufficient amou
amount
nt to offset the interest ra
rate
te
differential between two currencies.
c. the future spot rate differs from the current spot rate by a sufficient amount to offset the inflation differential
between two currencies.
d. the forward rate differs from the spot rate by a sufficient amount to offset the interest rate differential between
two currencies.
ANSWER::
ANSWER d

43. Assume that interest rate parity holds. The Nigerian interest rate is 50%, and the UK interest rate is 8%. Subsequently,
the UK interest rate decreases to 7%. According to interest rate parity, the peso's forward ____ will ____.
a. premium; increase b. discount; decrease
c. discount; increase d. premium; decrease
ANSWER::
ANSWER c

44. If the cross exchange rate of two noneuro currencies implied by their individual spot rates with respect to the euro is
less than the cross exchange rate quoted by a bank, locational arbitrage is possible.
a. true. b. false.
ANSWER::
ANSWER b

45. For locational arbitrage to be possible, one bank's ask rate must be higher than another bank's bid rate for a currency.
a. true. b. false.
ANSWER::
ANSWER
b
46. Assume locational arbitrage is possible and involves two different banks. The realignment that would occur due to
market forces would increase one bank's ask rate and would decrease the other bank's bid rate.
a. true. b. false.
ANSWER::
ANSWER a

47. Triangular arbitrage tends to force a relationship between the interest rates of two countries and their forward
exchange rate premium or discount.
a. true. b. false.
ANSWER::
ANSWER b

48. The interest rate on euros is 8%. The interest rate in the UK is 5%. The euro's forward rate should exhibit a premium
of about 3%.
a. true. b. false.
ANSWER:: b
ANSWER
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Test Bank for International Financial Management, 4th Edition Jeff Madura Roland Fox

Name: Class: Date:

Chapter 07—International Arbitrage and Interest Rate Parity

49. Capitalizing on discrepancies in quoted prices involving no risk and no investment of funds is referred to as interest
rate parity.
a. true. b. false.
ANSWER::
ANSWER b

50. Realignment in the exchange rates of banks will eliminate locational arbitrage. More specifically, market forces will
increase the ask rate of the bank from which the currency was bought to conduct locational arbitrage and will decrease the
bid rate of the bank to which
which the currency was sold to cond
conduct
uct locational arbitrage.
arbitrage.
a. true. b. false.
ANSWER::
ANSWER a

51. Locational arbitrage involves investing in a foreign country and covering against exchange rate risk by engaging in
forward contracts.
a. true. b. false.
ANSWER::
ANSWER b

52. To capitalize on high foreign interest rates using covered interest arbitrage, a UK investor would convert pounds to the
foreign currency, invest in the foreign country, and simultaneously sell the foreign currency forward.
a. true. b. false.
ANSWER::
ANSWER a

53. If interest rate parity (IRP) exists, then the rate of return achieved from covered interest arbitrage should be equal to
the rate available in the foreign country.
a. true. b. false.
ANSWER::
ANSWER b

54. If interest rate parity (IRP) exists, then triangular arbitrage will not be possible.
a. true. b. false.
ANSWER::
ANSWER b

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