International Finance Exam 2 (Ch. 7)

Arbitrage is defined as
a. Capitalizing on a discrepancy in quoted prices by making a riskless profit
b. Capitalizing on differences in national interest rates through long-term investments
c. Adjusting exchange rate quotations to reflect changes in international trade
d. Speculating on expected currency movements to generate higher returns

A

Which of the following are the correct three types of arbitrage?
a. Forward, futures, and currency options arbitrage
b. Locational, triangular, and covered interest arbitrage
c. Domestic, international, and exchange rate arbitrage
d. Spot market, forward market, and futures market arbitrage

B

This kind of arbitrage is defined as the process of buying a currency where it is cheap, then immediately selling it where it is expensive to make profit.
a. Triangular
b. International
c. Locational
d. Covered

C

This kind of arbitrage is defined as currency transactions in the spot market; intended to capitalize on discrepancies in cross exchange rates.
a. Triangular
b. International
c. Locational
d. Covered

A

This kind of arbitrage is defined as the process of capitalizing on the interest rate differential between two countries, while reducing your exchange rate risk with a forward contract
a. Triangular
b. International
c. Locational
d. Covered

D

Bank A has the following rates for British Pound
- Bid: $1.60/£
- Ask: $1.61/£

Bank B has the following rates for British Pound
- Bid: $1.61/£
- Ask: $1.62/£

Is there a profit opportunity? If so, how much? Assume you start with $10,000.

No

If we buy the cheaper currency (Akron), we buy at $1.61.
Then we’d have to sell at Zyn bank for $1.61. No profit.

When is locational abritrage feasible?
a. When the ask price of a bank exceeds the bid price of another bank for a particular currency
b. When the exchange rates quoted by banks are identical for a particular currency
c. When the bid price of a bank exceeds the ask price of another bank for a particular currency

C

Bank A has the following rates for NZ$
- Bid: $0.635/NZ
- Ask: $0.640/NZ

Bank B has the following rates for NZ$
- Bid: $0.645/NZ
- Ask: $0.650/NZ

is there a profit opportunity? If so, how much? Assume you start with $10,000.

Yes.

1. Buy NZ at $0.64/NZ from Bank A.
$10,000 / $0.64 per NZ = NZ 15,625

2. Sell NZ at $0.645/NZ to Bank B
NZ 15,625 x $0.645 per NZ = $10,078.13; $78.13 profit

A triangular arbitrage occurs when
a. Currency values remain constant across international markets
b. The implied exchange rate differs from the quoted exchange rate
c. Interest rate differentials exist between two countries at a given spot rate
d. Forward exchange rates differ from spot exchange rates

B

What effect does triangular arbitrage have on currency values?

a. It places upward pressure on overvalued currencies and downward pressure on undervalued currencies
b. It increases the volatility of the overvalued currency
c. It places downward pressure on overvalued currencies and upward pressure on undervalued currencies
d. All of the above

C

Regarding covered arbitrage, the size of the premium or discount exhibited by the forward rate should be ____ the differential between the interest rates of the two countries of concern.
a. Greater than
b. Equal to
c. Less than

B

Regarding covered interest arbitrage, the forward rate of the foreign currency will contain a ____ (discount/premium) if it’s interest rate is higher than US interest rate

Discount

Test using the covered interest arbitrage formula:
(1+home interest / 1+foreign interest) - 1
1.05/1.10 - 1 = - 4.5%, a negative number and therefore a discount

What causes a covered interest arbitrage?
a. Cross exchange rate differentials exist between two countries
b. Currency exchange rates allow for profit to be made
c. Forward premium deviates from interest rate differential
d. Spot exchange rates fluctuate between international markets

C

Locational arbitrage ensures ___ are similar across all locations
a. Quoted/Spot exchange rate
b. Cross exchange rate
c. Forward exchange rate
d. None of the above

A

Triangular arbitrage ensures ___ are similar across all locations
a. Quoted/Spot exchange rate
b. Cross exchange rate
c. Forward exchange rate
d. None of the above

B

Covered interest arbitrage ensures ___ are similar across all locations
a. Quoted/Spot exchange rate
b. Cross exchange rate
c. Forward exchange rate
d. None of the above

C

Accorting to Interest Rate Parity, if the forward premium is equal to the interest rate differential, then covered interest arbitrage is ____ (feasible/not feasible)

Not feasible

When is covered interest arbitrage feasible?

a. When interest rates between two countries remain exactly the same
b. When the forward premium differs from the interest rate differential
c. When spot exchange rates are identical across international markets
d. When capital flows between countries are completely unrestricted

B

Interest rate parity states that:

a. Exchange rate changes should match differences in inflation rates between countries
b. The forward premium or discount should equal the interest rate differential between countries
c. Domestic and foreign interest rates must remain identical across financial markets
d. The spot exchange rate should always equal the forward exchange rate

B

If U.S. firms attempt to use covered interest arbitrage to capitalize on the high Argentine peso interest rate, the spot rate of the peso would _____ and the forward rate of the peso would ______.
a. Increase; increase
b. Increase; decrease
c. Decrease; increase
d. Decrease; decrease

B

If home interest rate is greater than foreign interest rate, the forward rate of the foreign currency should exhibit a _____ according to interest rate parity.
a. premium
b. discount

A

If home interest rate is less than foreign interest rate, the forward rate of the foreign currency should exhibit a _____ according to interest rate parity.
a. premium
b. discount

B

Net Profit Per Unit Equations:

Given the following information, fill in the equations for calls and puts

• Strike Price

• Spot Rate

• ± Premium
  

Calls:

1. Buyers:

2. Sellers:

Puts:

1. Buyers:

2. Sellers:

Calls:

1. Spot - Strike - Premium

2. Strike - Spot + Premium

Puts:

1. Strike - Spot - Premium

2. Spot - Strike + Premium

Just remember the equation for buyers of calls. It’s opposite from there.

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 arbitrag

B

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

a. forward realignment arbitrage

b. triangular arbitrage

c. covered interest arbitrage

d. locational arbitrage

C

Assume that the U.S. investors are benefiting from covered interest arbitrage due to higher interest rates on British pounds. Which of the following forces should most likely result from the act of this covered interest arbitrage?

a. downward pressure on the pound’s spot rate.

b. downward pressure on the pound's forward rate.

c. upward pressure on the pound’s spot rate.

d. upward pressure on the pound's forward rate.

B

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

D