Chapter 7
International Arbitrage and Interest Rate Parity
Lecture Outline
International Arbitrage
Locational Arbitrage
Triangular Arbitrage
Covered Interest Arbitrage
Comparison of Arbitrage Effects
Interest Rate Parity
Derivation of Interest Rate Parity
Determining the Forward Premium
Graphic Analysis of Interest Rate Parity
How to Test Whether Interest Rate Parity Exists
Interpretation of Interest Rate Parity
Does Interest Rate Parity Hold?
Considerations When Assessing Interest Rate Parity
Variation in Forward Rate Premiums
Forward Premiums Across Maturities
Changes in Forward Premiums Over Time
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2  International Arbitrage and Interest Rate Parity
Chapter Theme
This chapter illustrates how three types of arbitrage (locational, triangular, and covered interest) are
executed. Emphasize that the key to arbitrage from an MNC's perspective is not the potential profits, but
the relationships that should exist due to arbitrage. The linkage between covered interest arbitrage and
interest rate parity is critical.
Topics to Stimulate Class Discussion
1. Why are quoted spot rates very similar across all banks?
2. Why don't arbitrage opportunities exist for long periods of time?
3. Present a scenario and ask whether any type of international arbitrage is possible. If so, how would it
be executed and how would market forces be affected?
4. Provide current interest rates of two countries and ask students to determine the forward rate that
would be expected according to interest rate parity.
POINT/COUNTER-POINT:
Does Arbitrage Destabilize Foreign Exchange Markets?
POINT: Yes. Large financial institutions have the technology to recognize when one participant in the
foreign exchange market is trying to sell a currency for a higher price than another participant. They also
recognize when the forward rate does not properly reflect the interest rate differential. They use arbitrage
to capitalize on these situations, which results in large foreign exchange transactions. In some cases, their
arbitrage involves taking large positions in a currency, and then reversing their positions a few minutes
later. This jumping in and out of currencies can cause abrupt price adjustments of currencies and may
create more volatility in the foreign exchange market. Regulations should be created that would force
financial institutions to maintain their currency positions for at least one month. This would result in a
more stable foreign exchange market.
COUNTER-POINT: No. When financial institutions engage in arbitrage, they create pressure on the
price of a currency that will remove any pricing discrepancy. If arbitrage did not occur, pricing
discrepancies would become more pronounced. Consequently, firms and individuals who use the foreign
exchange market would have to spend more time searching for the best exchange rate when trading a
currency. The market would become fragmented, and prices could differ substantially among banks in a
region, or among regions. If the discrepancies became large enough, firms and individuals might even
attempt to conduct arbitrage themselves. The arbitrage conducted by banks allows for a more integrated
foreign exchange market, which ensures that foreign exchange prices quoted by any institution are in line
with the market.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
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International Arbitrage and Interest Rate Parity  3
ANSWER: The counter-point is correct. The type of arbitrage mentioned in this chapter is necessary to
have consistent foreign exchange quotations among the financial institutions that serve as dealers in the
foreign exchange market. Arbitrage does not destabilize the foreign exchange market.
Answers to End of Chapter Questions
1. Locational Arbitrage. Explain the concept of locational arbitrage and the scenario necessary for it
to be plausible.
ANSWER: Locational arbitrage can occur when the spot rate of a given currency varies among
locations. Specifically, the ask rate at one location must be lower than the bid rate at another
location. The disparity in rates can occur since information is not always immediately available to
all banks. If a disparity does exist, locational arbitrage is possible; as it occurs, the spot rates among
locations should become realigned.
2. Locational Arbitrage. Assume the following information:
Bid price of New Zealand dollar
Ask price of New Zealand dollar
Beal Bank Yardley Bank
$.401
$.398
$.404
$.400
Given this information, is locational arbitrage possible? If so, explain the steps involved in
locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. What
market forces would occur to eliminate any further possibilities of locational arbitrage?
ANSWER: Yes! One could purchase New Zealand dollars at Yardley Bank for $.40 and sell them to
Beal Bank for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased
at Yardley Bank. These New Zealand dollars could then be sold to Beal Bank for $1,002,500,
thereby generating a profit of $2,500.
The large demand for New Zealand dollars at Yardley Bank will force this bank's ask price on New
Zealand dollars to increase. The large sales of New Zealand dollars to Beal Bank will force its bid
price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank,
locational arbitrage will no longer be beneficial.
3. Triangular Arbitrage. Explain the concept of triangular arbitrage and the scenario necessary for it
to be plausible.
ANSWER: Triangular arbitrage is possible when the actual cross exchange rate between two
currencies differs from what it should be. The appropriate cross rate can be determined given the
values of the two currencies with respect to some other currency.
4. Triangular Arbitrage. Assume the following information:
Value of Canadian dollar in U.S. dollars
Value of New Zealand dollar in U.S. dollars
Value of Canadian dollar in New Zealand dollars
Quoted Price
$.90
$.30
NZ$3.02
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4  International Arbitrage and Interest Rate Parity
Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect
triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use. What
market forces would occur to eliminate any further possibilities of triangular arbitrage?
ANSWER: Yes. The appropriate cross exchange rate should be 1 Canadian dollar = 3 New Zealand
dollars. Thus, the actual value of the Canadian dollars in terms of New Zealand dollars is more than
what it should be. One could obtain Canadian dollars with U.S. dollars, sell the Canadian dollars for
New Zealand dollars and then exchange New Zealand dollars for U.S. dollars. With $1,000,000, this
strategy would generate $1,006,667 thereby representing a profit of $6,667.
[$1,000,000/$.90 = C$1,111,111 × 3.02 = NZ$3,355,556 × $.30 = $1,006,667]
The value of the Canadian dollar with respect to the U.S. dollar would rise. The value of the
Canadian dollar with respect to the New Zealand dollar would decline. The value of the New
Zealand dollar with respect to the U.S. dollar would fall.
5. Covered Interest Arbitrage. Explain the concept of covered interest arbitrage and the scenario
necessary for it to be plausible.
ANSWER: Covered interest arbitrage involves the short-term investment in a foreign currency that
is covered by a forward contract to sell that currency when the investment matures. Covered interest
arbitrage is plausible when the forward premium does not reflect the interest rate differential between
two countries specified by the interest rate parity formula. If transactions costs or other
considerations are involved, the excess profit from covered interest arbitrage must more than offset
these other considerations for covered interest arbitrage to be plausible.
6. Covered Interest Arbitrage. Assume the following information:
Spot rate of Canadian dollar
90-day forward rate of Canadian dollar
90-day Canadian interest rate
90-day U.S. interest rate
Quoted Price
$.80
$.79
4%
2.5%
Given this information, what would be the yield (percentage return) to a U.S. investor who used
covered interest arbitrage? (Assume the investor invests $1,000,000.) What market forces would
occur to eliminate any further possibilities of covered interest arbitrage?
ANSWER:
$1,000,000/$.80 = C$1,250,000 × (1.04)
= C$1,300,000 × $.79
= $1,027,000
Yield = ($1,027,000 – $1,000,000)/$1,000,000 = 2.7%, which exceeds the yield in the U.S. over the
90-day period.
The Canadian dollar's spot rate should rise, and its forward rate should fall; in addition, the Canadian
interest rate may fall and the U.S. interest rate may rise.
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International Arbitrage and Interest Rate Parity  5
7. Covered Interest Arbitrage. Assume the following information:
Spot rate of Mexican peso
180-day forward rate of Mexican peso
180-day Mexican interest rate
180-day U.S. interest rate
= $.100
= $.098
= 6%
= 5%
Given this information, is covered interest arbitrage worthwhile for Mexican investors who have
pesos to invest? Explain your answer.
ANSWER: To answer this question, begin with an assumed amount of pesos and determine the yield
to Mexican investors who attempt covered interest arbitrage. Using MXP1,000,000 as the initial
investment:
MXP1,000,000 × $.100 = $100,000 × (1.05) = $105,000/$.098 = MXP1,071,429
Mexican investors would generate a yield of about 7.1% ([MXP1,071,429 –
MXP1,000,000]/MXP1,000,000), which exceeds their domestic yield. Thus, it is worthwhile for
them.
8. Effects of September 11. The terrorist attack on the U.S. on September 11, 2001 caused
expectations of a weaker U.S. economy. Explain how such expectations could have affected U.S.
interest rates, and therefore have affected the forward rate premium (or discount) on various foreign
currencies.
ANSWER: The expectations of a weaker U.S. economy resulted in a decline of short-term interest
rates (in fact, the Fed expedited the movement by increasing liquidity in the banking system). The
U.S. interest rate was reduced while foreign interest rates were not. Therefore, the forward premium
on foreign currencies decreased, or the forward discount became more pronounced.
9. Interest Rate Parity. Explain the concept of interest rate parity. Provide the rationale for its
possible existence.
ANSWER: Interest rate parity states that the forward rate premium (or discount) of a currency
should reflect the differential in interest rates between the two countries. If interest rate parity didn't
exist, covered interest arbitrage could occur (in the absence of transactions costs, and foreign risk),
which should cause market forces to move back toward conditions which reflect interest rate parity.
The exact formula is provided in the chapter.
10. Inflation Effects on the Forward Rate. Why do you think currencies of countries with high
inflation rates tend to have forward discounts?
ANSWER: These currencies have high interest rates, which cause forward rates to have discounts as
a result of interest rate parity.
11. Covered Interest Arbitrage in Both Directions. Assume that the existing U.S. one-year interest
rate is 10 percent and the Canadian one-year interest rate is 11 percent. Also assume that interest rate
parity exists. Should the forward rate of the Canadian dollar exhibit a discount or a premium? If
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6  International Arbitrage and Interest Rate Parity
U.S. investors attempt covered interest arbitrage, what will be their return? If Canadian investors
attempt covered interest arbitrage, what will be their return?
ANSWER: The Canadian dollar's forward rate should exhibit a discount because its interest rate
exceeds the U.S. interest rate.
U.S. investors would earn a return of 10 percent using covered interest arbitrage, the same as what
they would earn in the U.S.
Canadian investors would earn a return of 11 percent using covered interest arbitrage, the same as
they would earn in Canada.
12. Interest Rate Parity. Why would U.S. investors consider covered interest arbitrage in France when
the interest rate on euros in France is lower than the U.S. interest rate?
ANSWER: If the forward premium on euros more than offsets the lower interest rate, investors
could use covered interest arbitrage by investing in euros and achieve higher returns than in the U.S.
13. Interest Rate Parity. Consider investors who invest in either U.S. or British one-year Treasury
bills. Assume zero transaction costs and no taxes.
a. If interest rate parity exists, then the return for U.S. investors who use covered interest arbitrage
will be the same as the return for U.S. investors who invest in U.S. Treasury bills. Is this
statement true or false? If false, correct the statement.
ANSWER: True
b. If interest rate parity exists, then the return for British investors who use covered interest
arbitrage will be the same as the return for British investors who invest in British Treasury bills.
Is this statement true or false? If false, correct the statement.
ANSWER: True
14. Changes in Forward Premiums. Assume that the Japanese yen’s forward rate currently exhibits a
premium of 6 percent and that interest rate parity exists. If U.S. interest rates decrease, how must
this premium change to maintain interest rate parity? Why might we expect the premium to change?
ANSWER: The premium will decrease in order to maintain IRP, because the difference between the
interest rates is reduced. We would expect the premium to change because as U.S. interest rates
decrease, U.S. investors could benefit from covered interest arbitrage if the forward premium stays
the same. The return earned by U.S. investors who use covered interest arbitrage would not be any
higher than before, but the return would now exceed the interest rate earned in the U.S. Thus, there
is downward pressure on the forward premium.
15. Changes in Forward Premiums. Assume that the forward rate premium of the euro was higher last
month than it is today. What does this imply about interest rate differentials between the United
States and Europe today compared to those last month?
ANSWER: The interest rate differential is smaller now than it was last month.
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International Arbitrage and Interest Rate Parity  7
16. Interest Rate Parity. If the relationship that is specified by interest rate parity does not exist at any
period but does exist on average, then covered interest arbitrage should not be considered by U.S.
firms. Do you agree or disagree with this statement? Explain.
ANSWER: Disagree. If at any point in time, interest rate parity does not exist, covered interest
arbitrage could earn excess returns (unless transactions costs, tax differences, etc., offset the excess
returns).
17. Covered Interest Arbitrage in Both Directions. The one-year interest rate in New Zealand is 6
percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar
(NZ$) is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage
feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why
covered interest arbitrage is or is not feasible.
ANSWER:
To determine the yield from covered interest arbitrage by U.S. investors, start with an assumed initial
investment, such as $1,000,000.
$1,000,000/$.50 = NZ$2,000,000 × (1.06)
= NZ$2,120,000 × $.54 = $1,144,800
Yield = ($1,144,800 – $1,000,000)/$1,000,000 = 14.48%
Thus, U.S. investors can benefit from covered interest arbitrage because this yield exceeds the U.S.
interest rate of 10 percent.
To determine the yield from covered interest arbitrage by New Zealand investors, start with an
assumed initial investment, such as NZ$1,000,000:
NZ$1,000,000 × $.50 = $500,000 × (1.10)
= $550,000/$.54 = NZ$1,018,519
Yield = (NZ$1,018,519 – NZ$1,000,000)/NZ$1,000,000 = 1.85%
Thus, New Zealand investors would not benefit from covered interest arbitrage since the yield of
1.85% is less than the 6% that they could receive from investing their funds in New Zealand.
18. Limitations of Covered Interest Arbitrage. Assume that the one-year U.S. interest rate is 11
percent, while the one-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is
willing to purchase the currency of that country from you one year from now at a discount of 13
percent. Would covered interest arbitrage be worth considering? Is there any reason why you should
not attempt covered interest arbitrage in this situation? (Ignore tax effects.)
ANSWER: Covered interest arbitrage would be worth considering since the return would be 21.8
percent, which is much higher than the U.S. interest rate. Assuming a $1,000,000 initial investment,
$1,000,000 × (1.40) × .87 = $1,218,000
Yield = ($1,218,000 – $1,000,000)/$1,000,000 = 21.8%
However, the funds would be invested in Malaysia, which could cause some concern about default
risk or government restrictions on convertibility of the currency back to dollars.
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8  International Arbitrage and Interest Rate Parity
19. Covered Interest Arbitrage in Both Directions. Assume that the annual U.S. interest rate is
currently 8 percent and Germany’s annual interest rate is currently 9 percent. The euro’s one-year
forward rate currently exhibits a discount of 2 percent.
a. Does interest rate parity exist?
ANSWER: No, because the discount is larger than the interest rate differential.
b. Can a U.S. firm benefit from investing funds in Germany using covered interest arbitrage?
ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of
investing in Germany.
c. Can a German subsidiary of a U.S. firm benefit by investing funds in the United States through
covered interest arbitrage?
ANSWER: Yes, because even though it would earn 1 percent less interest over the year by investing
in U.S. dollars, it would be able to sell dollars for 2 percent more than it paid for them (it would be
buying euros forward at a discount of 2 percent).
20. Covered Interest Arbitrage. The South African rand has a one-year forward premium of 2 percent.
One-year interest rates in the U.S. are 3 percentage points higher than in South Africa. Based on this
information, is covered interest arbitrage possible for a U.S. investor if interest rate parity holds?
ANSWER:
No, covered interest arbitrage is not possible for a U.S. investor. Although the investor can lock in
the higher exchange rate in one year, interest rates are 3 percent lower in South Africa.
21. Deriving the Forward Rate. Assume that annual interest rates in the U.S. are 4 percent, while
interest rates in France are 6 percent.
a. According to IRP, what should the forward rate premium or discount of the euro be?
b. If the euro’s spot rate is $1.10, what should the one-year forward rate of the euro be?
ANSWER:
a. p 
(1.04)
 1  .0189  1.89%
(1.06)
b. F  $1.10(1  .0189)  $1.079
22. Covered Interest Arbitrage in Both Directions. The following information is available:





You have $500,000 to invest
The current spot rate of the Moroccan dirham is $.110.
The 60-day forward rate of the Moroccan dirham is $.108.
The 60-day interest rate in the U.S. is 1 percent.
The 60-day interest rate in Morocco is 2 percent.
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International Arbitrage and Interest Rate Parity  9
a. What is the yield to a U.S. investor who conducts covered interest arbitrage? Did covered
interest arbitrage work for the investor in this case?
b. Would covered interest arbitrage be possible for a Moroccan investor in this case?
ANSWER:
a.
Covered interest arbitrage would involve the following steps:
1. Convert dollars to Moroccan dirham: $500,000/$.11 = MD4,545,454.55
2. Deposit the dirham in a Moroccan bank for 60 days. You will have MD4,545,454.55 ×
(1.02) = MD4,636,363.64 in 60 days.
3. In 60 days, convert the dirham back to dollars at the forward rate and receive
MD4,636,363.64 × $.108 = $500,727.27
The yield to the U.S. investor is $500,727.27/$500,000 – 1 = .15%. Covered interest arbitrage
did not work for the investor in this case. The lower Moroccan forward rate more than offsets
the higher interest rate in Morocco.
b. Yes, covered interest arbitrage would be possible for a Moroccan investor. The investor would
convert dirham to dollars, invest the dollars at a 1 percent interest rate in the U.S., and sell the
dollars forward 60 days. Even though the Moroccan investor would earn an interest rate that is
1 percent lower in the U.S., the forward rate discount of the dirham more than offsets that
differential.
Advanced Questions
23. Economic Effects on the Forward Rate. Assume that Mexico’s economy has expanded
significantly, causing a high demand for loanable funds there by local firms. How might these
conditions affect the forward discount of the Mexican peso?
ANSWER: Expansion in Mexico creates a demand for loanable funds, which places upward
pressure on Mexican interest rates, which increases the forward discount on the Mexican peso (or
reduces the premium).
24. Differences among Forward Rates. Assume that the 30-day forward premium of the euro is -1
percent, while the 90-day forward premium of the euro is 2 percent. Explain the likely interest rate
conditions that would cause these premiums. Does this ensure that covered interest arbitrage is
worthwhile?
ANSWER: These premiums could occur when the euro’s 30-day interest rate is above the U.S. 30day interest rate, but the euro’s 90-day interest rate is below the U.S. 90-day interest rate. Covered
interest arbitrage is not necessarily worthwhile, since interest rate parity may still hold.
25. Testing Interest Rate Parity. Describe a method for testing whether interest rate parity exists. Why
are transactions costs, currency restrictions, and differential tax laws important when evaluating
whether covered interest arbitrage can be beneficial?
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10  International Arbitrage and Interest Rate Parity
ANSWER: At any point in time, identify the interest rates of the U.S. versus some foreign country.
Then determine the forward rate premium (or discount) that should exist according to interest rate
parity. Then determine whether this computed forward rate premium (or discount) is different from
the actual premium (or discount).
Even if interest rate parity does not hold, covered interest arbitrage could be of no benefit if
transactions costs or tax laws offset any excess gain. In addition, currency restrictions enforced by a
foreign government may disrupt the act of covered interest arbitrage.
26. Deriving the Forward Rate. Before the Asian crisis began, Asian central banks were maintaining a
somewhat stable value for their respective currencies. Nevertheless, the forward rate of Southeast
Asian currencies exhibited a discount. Explain.
ANSWER: The forward rate for the Asian currencies exhibited a discount to reflect that differential
between the Asian country's interest rate and the U.S. interest rate, in accordance with interest rate
parity (IRP). If the forward rate had not exhibited a discount, a U.S. investor could have conducted
covered interest arbitrage by converting dollars to the foreign currency, investing in the foreign
country, and simultaneously selling the foreign currency forward.
27. Interpreting Changes in the Forward Premium. Assume that interest rate parity holds. At the
beginning of the month, the spot rate of the Canadian dollar is $.70, while the one-year forward rate
is $.68. Assume that U.S. interest rates increase steadily over the month. At the end of the month, the
one-year forward rate is higher than it was at the beginning of the month. Yet, the one-year forward
discount is larger (the one-year premium is more negative) at the end of the month than it was at the
beginning of the month. Explain how the relationship between the U.S. interest rate and the
Canadian interest rate changed from the beginning of the month until the end of the month.
ANSWER: The forward discount at the beginning of the month implies that the U.S. interest rate is
lower than the Canadian interest rate. During the month, the Canadian interest rate must have
increased by a greater degree than the U.S. interest rate. At the end of the month, the gap between the
Canadian dollar and the U.S. dollar is greater than it was at the beginning of the month. This results
in a more pronounced forward discount.
28. Interpreting a Large Forward Discount. The interest rate in Indonesia is commonly higher than the
interest rate in the U.S., which reflects a higher expected rate of inflation there. Why should Nike
consider hedging its future remittances from Indonesia to the U.S. parent even when the forward
discount on the currency (rupiah) is so large?
ANSWER: Nike may still consider hedging under these conditions because the alternative is to be
exposed to the risk that the rupiah may depreciate over the six-month period by an amount that
exceeds the degree of the discount. A large forward discount implies that the nominal interest rate in
Indonesia is much higher than in the U.S., which may suggest a higher rate of expected inflation.
Thus, there may be severe downward pressure on the rupiah’s spot rate over time.
29. Change in the Forward Premium. At the end of this month, you (owner of a U.S. firm) are meeting
with a Japanese firm to which you will try to sell supplies. If you receive an order from that firm,
you will obtain a forward contract to hedge the future receivables in yen. As of this morning, the
forward rate of the yen and spot rate are the same. You believe that interest rate parity holds.
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International Arbitrage and Interest Rate Parity  11
This afternoon, news occurs that makes you believe that the U.S. interest rates will increase
substantially by the end of this month, and that the Japanese interest rate will not change. However,
your expectations of the spot rate of the Japanese yen are not affected at all in the future. How will
your expected dollar amount of receivables from the Japanese transaction be affected (if at all) by the
news that occurred this afternoon? Explain.
ANSWER: If U.S. interest rates increase, then the forward rate of the yen will exhibit a premium.
Therefore, if you hedge your receivables at the end of this month, the dollar amount to be received
would be higher.
30. Testing IRP. The one-year interest rate in Singapore is 11 percent. The one-year interest rate in the
U.S. is 6 percent. The spot rate of the Singapore dollar (S$) is $.50 and the forward rate of the S$ is
$.46. Assume zero transactions costs.
a.
Does interest rate parity exist?
ANSWER: No, because the discount is larger than the interest rate differential.
b. Can a U.S. firm benefit from investing funds in Singapore using covered interest arbitrage?
ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of
investing in Singapore.
31. Implications of IRP. Assume that interest rate parity exists. You expect that the one-year nominal
interest rate in the U.S. is 7%, while the one-year nominal interest rate in Australia is 11%. The spot
rate of the Australian dollar is $.60. You will need 10 million Australian dollars in one year. Today,
you purchase a one-year forward contract in Australian dollars. How many U.S. dollars will you need
in one year to fulfill your forward contract?
ANSWER:
[(1.07)/(1.11)] – 1 = -3.60%. So the one-year forward rate is $.60 x [1 + (-.036)] = $.5784. You will
need 10,000,000 x $.5784 = $5,784,000.
32. Triangular Arbitrage. You go to a bank and are given these quotes:
You can buy a euro for 14 pesos.
The bank will pay you 13 pesos for a euro.
You can buy a U.S. dollar for .9 euros.
The bank will pay you .8 Euros for a U.S. dollar.
You can buy a U.S. dollar for 10 pesos.
The bank will pay you 9 pesos for a U.S. dollar.
You have $1,000. Can you use triangular arbitrage to generate a profit? If so, explain the order of the
transactions that you would execute, and the profit that you would earn. If you can not earn a profit
from triangular arbitrage, explain why.
ANSWER: Yes, you can generate a profit by converting dollars to euros, and then euros to pesos,
and then pesos to dollars.
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12  International Arbitrage and Interest Rate Parity
First convert the information to direct quotes:
Euro in $
Pesos in $
Euro in pesos
Bid
1.11
$.10
13
Ask
1.25
$.11
14
Use $1,000 to purchase euros: $1,000/1.25=800 euros.
Convert 800 euros to buy pesos: 800 euros x 13= 10,400 pesos.
Convert the 10,400 pesos to U.S. dollars: 10,400 x $.10 = 1,040. There is profit of $40 on a $1,000
investment.
The alternative strategy that you could attempt is to first buy pesos:
Use $1,000 to purchase pesos: $1,000/$.11 = 9,090.9 pesos.
Convert 9,090 pesos to euros: 9,090.9/14 = 649.35 euros.
Convert 649.35 euros to dollars: 649.35 euros x 1.11 = $720.78.
This strategy results in a loss.
33. Triangular Arbitrage. You are given these quotes by the bank:
You can sell Canadian dollars (C$) to the bank for $.70.
You can buy Canadian dollars from the bank for $.73.
The bank is willing to buy dollars for 0.9 euros per dollar.
The bank is willing to sell dollars for 0.94 euros per dollar. .
The bank is willing to buy Canadian dollars for 0.64 euros per C$.
The bank is willing to sell Canadian dollars for 0.68 euros per C$.
You have $100,000. Estimate your profit or loss if you would attempt triangular arbitrage by
converting your dollars to euros, and then convert euros to Canadian dollars and then convert
Canadian dollars to U.S. dollars.
ANSWER:
$100,000 x .90 = 90,000 euros
90,000/.68 = C$132,353
C$132,353 x $.70 = $92,647
Profit = $92,647 - $100,000 = -$7,353 [loss]
34. Movement in Cross Exchange Rates. Assume that cross exchange rates are always proper such
that triangular arbitrage is not feasible. While at the Miami airport today, you notice that a U.S.
dollar can be exchanged for 125 Japanese yen, or 4 Argentine pesos at the foreign exchange booth.
Last year, the Japanese yen was valued at $0.01, and the Argentine peso was valued at $.30. Based
on this information, the Argentine peso has changed by what percent against the Japanese yen over
the last year?
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International Arbitrage and Interest Rate Parity  13
ANSWER:
Convert peso to direct exchange rate:
Peso = ¼ of $1 = $.25
Convert yen to direct exchange rate.
Yen = 1/125 = $.008
Cross-rate now:
Peso =.$25/$.008 = 31.25 yen
Cross rate last year:
Peso = $.30/$.01 = 30 yen
Change = (31.25 - 30) / 30 = +4.17%
35. Impact of Arbitrage on the Forward Rate. Assume that the annual U.S. interest rate is currently
6 percent and Germany’s annual interest rate is currently 8 percent. The spot rate of the euro is $1.10
and the one-year forward rate of the euro is $1.10. Assume that as covered interest arbitrage occurs,
the interest rates are not affected, and the spot rate is not affected. Explain how the one-year forward
rate of the euro will change in order to restore interest rate parity, and why it will change Your
explanation should specify which type of investor (German or U.S.) would be engaging in covered
interest arbitrage, whether they are buying or selling euros forward, and how that affects the forward
rate of the euro.
ANSWER:
U.S. investors will engage in covered interest arbitrage, which involves forward sales of euros, and
will place downward pressure on the one-year forward rate.
36. IRP and Changes in the Forward Rate. Assume that interest rate parity exists. As of this
morning, the 1-month interest rate in Canada was lower than the 1-month interest rate in the
U.S.. Assume that as a result of the Fed’s monetary policy this afternoon, the one-month
interest rate in the U.S. declined this afternoon, but was still higher than the Canadian onemonth interest rate. The one-month interest rate in Canada remained unchanged. Based on the
information, the forward rate of the Canadian dollar exhibited a ________ [discount or
premium] this morning that _________[increased or decreased] this afternoon. Explain.
ANSWER: The premium decreased. For all situations in which the foreign interest is less than
the US, the forward rate should exhibit a premium that is the same as the difference in interest
rates. The interest rate differential based on IRP would result in a forward rate premium. The
interest rate differential is reduced in the afternoon, but still in the same direction so a
premium still exists.
37. Deriving the Forward Rate Premium. Assume that the spot rate of the Brazilian real is $.30
today. Assume that interest rate parity exists. Obtain the interest rate data you need from
Bloomberg.com to derive the one-year forward rate premium (or discount), and then determine the
one-year forward rate of the Brazilian real.
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14  International Arbitrage and Interest Rate Parity
ANSWER: Obtain the one-year U.S. interest rate and one-year Brazilian interest rate. Plug the
interest rate into the forward rate premium formula:
Forward rate (FR) Premium = [(1 + U.S. interest rate)/(1 + Brazilian interest rate)]-1
Derive the FR as $.30 x (1 + FR Premium).
38. Change in the Forward Premium Over Time. Assume that interest rate parity exists and
will continue to exist. As of today, the one-year interest rate of Singapore is 4% versus 7% in
the U.S. The Singapore central bank is expected to decrease interest rates in the future so that
as of December 1, you expect that the one-year interest rate in Singapore will be 2%. The U.S.
interest rate is not expected to change over time. Based on the information, explain how the
forward premium (or discount) is expected to change by December 1.
ANSWER: The forward premium will become larger. For all situations in which the foreign
interest is less than the US, the forward rate should exhibit a premium that is the same as the
difference in interest rates. The differential is expected to increase over time, so the premium
will become larger.
39. Forward Rates for Different Time Horizons. Assume that interest rate parity (IRP) exists.
Assume this information provided by today’s Wall Street Journal.
Spot rate of British pound = $1.80
6-month forward rate of pound=$1.82
12-month forward rate of pound=$1.78
a. Is the annualized 6-month U.S. risk-free interest rate above, below, or equal to the British risk-free
interest rate?
b. Is the 12-month U.S. risk-free interest rate above, below, or equal to the British risk-free interest
rate?
ANSWER:
a. The 6-month U.S. risk-free interest rate must be above the 6-month British risk-free interest rate,
since the forward rate of the pound has a premium.
b. The 12-month U.S. risk-free interest rate must be below the 12-month British risk-free interest
rate, since the forward rate of the pound has a discount.
40. Interpreting Forward Rate Information. Assume that interest rate parity exists. The 6-month
forward rate of the Swiss franc has a premium while the 12-month forward rate of the Swiss franc
has a discount. What does this tell you about the relative level of Swiss interest rates versus U.S.
interest rates?
ANSWER: The 6-month Swiss interest rate must be lower than the 6-month U.S. interest rate. The
12-month Swiss interest rate must be higher than the 12-month U.S. interest rate.
41. IRP and Speculation in Currency Futures. Assume that interest rate parity exists. The spot rate
of the Argentine peso is $.40. The one-year interest rate in the U.S. is 7% versus 12% in Argentina.
Assume the futures price is equal to the forward rate. An investor purchased futures contracts on
Argentine pesos, representing a total of 1,000,000 pesos. Determine the total dollar amount of profit
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International Arbitrage and Interest Rate Parity  15
or loss from this futures contract based on the expectation that the Argentine peso will be worth $.42
in one year.
ANSWER:
Forward premium = (1 + .07)/ (1 + .12) -1 = -.04464
Forward rate = $.40 x (1 - .044640) = $.38214
Profit = ($.42 - $.38214) x 1,000,000 = $37,860
42. Profit from Covered Interest Arbitrage. Today, the one-year U.S. interest rate is 4%,
while the one-year interest rate in Argentina is 17%. The spot rate of the Argentine peso (AP)
is $.44. The one-year forward rate of the AP exhibits a 14% discount. Determine the yield
(percentage retrun on investment) to an investor from Argentina who engages in covered
interest arbitrage.
ANSWER:
Forward rate of Argentine peso = $.44 x (1 - .14) = $.3784.
Assume Argentine investors invest AP100,000. [You can start with any assumed amount.]
AP100,000 euros x $.44 = $44,000
Invest in U.S.: $44,000 x (1.04) =$45,760
Convert back to AP: $45,760/.3784 = AP120,930.
Yield = (AP120,930 - AP100,000)/AP100,000 = 20.930%.
43. Assessing Whether IRP Exists. Assume zero transactions costs. As of now, the Japanese one-year
interest rate is 3 percent, and the U.S. one-year interest rate is 9 percent. The spot rate of the
Japanese yen is $.0090 and the one-year forward rate of the Japanese yen is $.0097.
a. Determine whether interest rate parity exists, or whether the quoted forward rate is quoted too
high or too low.
b. Based on the information provided in (a), is covered interest arbitrage feasible for U.S. investors,
for Japanese investors, for both types of investors, or for neither type of investor?
ANSWER:
a. (1 + .09)/(1 + .03) -1 = ..05825 if IRP exists.
If IRP exists, the forward rate should be [1 + (.05825)] x $.009 = $.00952
The quoted forward rate is too high. IRP does not exist.
b. U.S. investors could engage in covered interest arbitrage by exchanging dollars for yen today and
then selling yen forward.
44. Change in Forward Rate Due to Arbitrage. Earlier this morning, the annual U.S. interest rate
was 6 percent and Mexico’s annual interest rate was 8 percent. The spot rate of the Mexican peso
was $.16. The one-year forward rate of the peso was $.15. Assume that as covered interest arbitrage
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16  International Arbitrage and Interest Rate Parity
occurred this morning, the interest rates were not affected, and the spot rate was not affected, but the
forward rate was affected, and consequently interest rate parity now exists. Explain which type of
investor (Mexican or U.S.) engaged in covered interest arbitrage, whether they were buying or selling
pesos forward, and how that affected the forward rate of the peso.
ANSWER:
Forward rate premium should = (1 + .06)/(1 + .08) -1 = -.01852 if IRP existed.
If IRP exists, the forward rate should be [1 + (-.01852)] x $.16 = $.1570.
The quoted forward rate is too low. So Mexican investors engaged in covered interest arbitrage by
exchanging pesos for dollars today and then buying pesos forward.
45. IRP Relationship. Assume that interest rate parity (IRP) exists. Assume this information is
provided by today’s Wall Street Journal.
Spot rate of Swiss franc = $.80
6-month forward rate of Swiss franc = $.78
12-month forward rate of Swiss franc = $.81
Assume that the annualized U.S. interest rate is 7% for a six-month maturity and a 12-month
maturity. Do you think the Swiss interest rate for a 6-month maturity is greater than, equal to, or less
than the U.S. interest rate for a 6-month maturity? Explain.
ANSWER: Since the 6-month forward rate contains a discount, the Swiss 6-month interest rate must
be higher than the U.S. 6-month interest rate.
46. Impact of Arbitrage on Forward Rate. Assume that the annual U.S. interest rate is currently
8 percent and Japan’s annual interest rate is currently 7 percent. The spot rate of the Japanese yen is
$.01. The one-year forward rate of the Japanese yen is $.01. Assume that as covered interest arbitrage
occurs, the interest rates are not affected, and the spot rate is not affected. Explain how the one-year
forward rate of the yen will change in order to restore interest rate parity, and why it will change
[your explanation should specify which type of investor (Japanese or U.S.) would be engaging in
covered interest arbitrage and whether these investors are buying or selling yen forward, and how
that affects the forward rate of the yen.]
ANSWER: Japanese investors will be able to engage in covered interest rate arbitrage and take
advantage of higher interest rates that exist in US. They will exchange yen for dollars in the spot
market, and invest dollars at 8%. They will also buy one-year yen forward contracts. Due to Japanese
investors taking advantage of interest rate arbitrage, a large number of yen forward contracts will be
bought. This will cause an upward pressure on the one-year forward yen rate.
47. Profit from Triangular Arbitrage. The bank is willing to buy dollars for 0.9 euros per dollar.
It is willing to sell dollars for .91 euros per dollar.
You can sell Australian dollars (A$) to the bank for $.72.
You can buy Australian dollars from the bank for $.74.
The bank is willing to buy Australian dollars (A$) for 0.68 euros per A$.
The bank is willing to sell Australian dollars (A$) for 0.70 euros per A$.
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International Arbitrage and Interest Rate Parity  17
You have $100,000. Estimate your profit or loss if you were to attempt triangular arbitrage by
converting your dollars to Australian dollars, and then convertubg Australian dollars to euros, and
then converting euros to U.S. dollars.
ANSWER:
$100,000/$.74=A$135,135
A$135,135 x .68 = 91,892 euros.
91,892 euros/.91 = $100,980
Gain = $100,980 - $100,000 = $980
48. Profit from Triangular Arbitrage. Alabama Bank is willing to buy or sell British pounds for $1.98.
The bank is willing to buy or sell Mexican pesos at an exchange rate of 10 pesos per dollar. The bank is
willing to purchase British pounds at an exchange rate of 1 peso = .05 British pounds. Show how you can
make a profit from triangular arbitrage and what your profit would be if you had $100,000.
ANSWER: 1 pound = 20 pesos
$100,000/1.98 = 50,505 pounds
50,505 pounds x 20 = 1,010,100 pesos = $101,010
Profit is $1,010
49. Cross-rate and Forward Rate. Biscayne Co. will be receiving Mexican pesos and today and will
need to convert them into Australian dollars. Today, a U.S. dollar can be exchanged for 10 Mexican
pesos. Also, an Australian dollar is worth one-half of a U.S. dollar.
a. What is the spot rate of a Mexican peso in Australian dollars?
b. Assume that interest rate parity exists and that the annual risk-free interest rate in the U.S., Australia,
and Mexico is 7 percent. What is the one-year forward rate of a Mexican peso in Australian dollars?
ANSWER
a. peso = $.10
A$ = %.50
peso/A$ = $.10/$.50 = A$0.20
b. Since interest rates are the same, the forward rate is the same as the prevailing spot rate for all three
currencies. Thus, the peso's one-year forward rate is A$0.20.
50. Changes in the Forward Rate. Assume that interest rate parity exists and will continue to exist. As
of this morning, the 1-month interest rate in the U.S. was higer than the 1-month interest rate in the
eurozone. Assume that as a result of the European Central Bank’s monetary policy this afternoon, the
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18  International Arbitrage and Interest Rate Parity
one-month interest rate of the euro increased, and is now higher than the U.S. one-month interest rate.
The one-month interest rate in the U.S. remained unchanged. a. a. Based on the information, do you think
the one-month forward rate of the euro exhibited a discount or premium this morning?
b. How did the forward premium change this afternoon?
ANSWER
a. Under conditions of interest rate parity, the forward rate exhibited a premium in the morning
because the foreign interest rate was higher than the US interest rate.
b. In the afternoon, the foreign interest rate is below the US interest rate, so the forward rate
should exhibit a discount.
51. Forces of Triangular Arbitrage. You obtain the following quotes from different banks. One bank is
willing to buy or sell Japanese yen at an exchange rate of 110 yen per dollar. A second bank is willing to
buy or sell the Argentine peso at an exchange rate of $.37 per peso. A third bank is willing to exchange
Japanese yen at an exchange rate of 1 Argentine peso = 40 yen.
a. Show how you can make a profit from triangular arbitrage and what your profit would be if you had
$1,000,000.
b. As investors engage in triangular arbitrage, explain the effect on each of the exchange rates until
triangular arbitrage would no longer be possible.
ANSWER:
a Direct rate of peso =$.37
Direct rate of yen = 1/110 = .0091
Cross rate of peso should be 42.857 yen
But the actual peso cross rate is lower than it should be. So obtain yen and convert to pesos, and then
convert to dollars.
$1,000,000 x 110 = 110,000,000 yen /40 = 2,750,000 pesos x .37 = $1,072,500.
Profit is $17,500
b. As dollars are converted to yen, the yen's value should appreciate against the dollar. As yen are
converted into pesos, the yen's value should depreciate against the peso. As pesos are converted into
dollars, the peso's value should depreciate against the dollar.
52. Return Due to Covered Interest Arbitrage. Interest rate parity exists between the U.S. and
Poland (its currency is the zloty). The one-year risk-free CD (deposit) rate in the U.S. is 7%. The
one-year risk-free CD rate in Poland is 5% and denominated in zloty. Assume that there is zero
probability of any financial or political problem in either country such as a bank default or
government restrictions on bank deposits or currencies. Myron is from Poland and plans to invest in
the U.S. What is Myron’s return if he invests in the U.S. and covers the risk of his investment with a
forward contract?
ANSWER: His return is 5%. The forward premium on the zloty will be about 2%. He will earn 7% on
the U.S. investment but will pay about 2% more when he buys zloty forward to close out his position
than what he exchanged zloty for to obtain dollars when initiating the investment.
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International Arbitrage and Interest Rate Parity  19
53. Forces of Covered Interest Arbitrage. As of now, the nominal interest rate is 6% in the U.S. and
6% in Australia. The spot rate of the Australian dollar is $.58, while the one-year forward rate of the
Australian dollar exhibits a discount of 2%. Assume that as covered interest arbitrage occurred this
morning, the interest rates were not affected, and the spot rate of the Australian dollar was not
affected, but the forward rate of the Australian dollar was affected, and consequently interest rate
parity now exists. Explain the forces that caused the forward rate of the Australian dollar to change
by completing this sentence: The ___________ [Australian or U.S.?] investors could benefit from
engaging in covered interest arbitrage; their arbitrage would involve ___________ [buying or
selling?] Australia dollars forward, which would cause the forward rate of the Australian dollar to
____________ [increase or decrease?].]
ANSWER: If IRP exists, the forward rate should be the same as the spot rate, since interest rates are
equal. The quoted forward rate has a discount and therefore is too low. So Australian investors could
engage in covered interest arbitrage by exchanging Australian dollars for U.S. dollars today and then
buying Australian dollars forward at a discount. This would place upward pressure on the forward
rate of the Australian dollar.
Solution to Continuing Case Problem: Blades, Inc.
1. The first arbitrage opportunity relates to locational arbitrage. Holt has obtained spot rate quotations
from two banks in Thailand, Minzu Bank and Sobat Bank, both located in Bangkok. The bid and ask
prices of Thai baht for each bank are displayed in the table below:
Bid
Ask
Minzu Bank
$0.0224
$0.0227
Sobat Bank
$0.0228
$0.0229
Determine whether the foreign exchange quotations are appropriate. If they are not appropriate,
determine the profit you could generate by withdrawing $100,000 from Blades’ checking account
and engaging in arbitrage before the rates are adjusted.
ANSWER: Locational arbitrage is possible:
Locational Arbitrage
1. Buy Thai baht from Minzu Bank ($100,000/$0.0227)
4,405,286.34
2. Sell Thai baht to Sobat Bank (THB4,405,286.34 × $0.0228)
100,440.53
3. Dollar profit ($100,440.53 – $100,000)
440.53
2. Besides the bid and ask quotes for the Thai baht provided in the previous question, Minzu Bank has
provided the following quotations for the U.S. dollar and the Japanese yen:
Value of a Japanese yen in U.S. dollars
Quoted Bid Price
$0.0085
Quoted Ask Price
$0.0086
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20  International Arbitrage and Interest Rate Parity
Value of a Thai baht in Japanese yen
¥2.69
¥2.70
Determine whether the cross exchange rate between the Thai baht and Japanese yen is appropriate. If
it is not appropriate, determine the profit you could generate for Blades Inc, by withdrawing
$100,000 from Blades’ checking account and engaging in triangular arbitrage before the rates are
adjusted.
ANSWER: Triangular arbitrage is possible.
Triangular Arbitrage
1. Exchange dollars for Thai baht ($100,000/$0.0227)
4,405,286.34
2. Convert the Thai baht into Japanese yen (THB4,405,286.34 × ¥2.69)
11,850,220.25
3. Convert the Japanese yen into dollars (¥11,850,220.26 × $0.0085)
100,726.87
4. Dollar profit ($100,726.87 – $100,000)
726.87
3. Ben Holt has obtained several forward contract quotations for the Thai baht to determine whether
covered interest arbitrage may be possible. He was quoted a forward rate of $0.0225 per Thai baht
for a 90-day forward contract. The current spot rate is $0.0227. Ninety-day interest rates available to
Blades in the U.S. are 2 percent, while 90-day interest rates in Thailand are 3.75 percent (these rates
are not annualized). Holt is aware that covered interest arbitrage, unlike locational and triangular
arbitrage, requires an investment of funds. Thus, he would like to be able to estimate the dollar profit
resulting from arbitrage over and above the dollar amount available on a 90-day U.S. deposit.
Determine whether the forward rate is priced appropriately. If it is not priced appropriately,
determine the profit you could generate for Blades by withdrawing $100,000 from Blades’ checking
account and engaging in covered interest arbitrage. Measure the profit as the excess amount above
what you could generate by investing in the U.S. money market.
ANSWER: Covered interest arbitrage is possible.
Covered Interest Arbitrage
1. On Day 1, convert U.S. dollars to Thai baht and set up a 90-day deposit
account at a Thai bank ($100,000/$0.0227)
4,405,286.34
2. In 90 days, the Thai deposit will mature to THB4,405,286.34 × 1.0375,
which is the amount to be sold forward
4,570,484.58
3. In 90 days, convert the Thai baht into U.S. dollars at the agreed-upon rate
(THB4,570,484.58 × $0.0225)
102,835.90
4. Dollar amount available on a 90-day U.S. deposit ($100,000 × 1.02)
102,000.00
5. Dollar profit over and above the dollar amount available on a 90-day U.S.
deposit ($102,835.90 – $100,000)
2,835.90
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International Arbitrage and Interest Rate Parity  21
4. Why are arbitrage opportunities likely to disappear soon after they have been discovered? To
illustrate your answer, assume that covered interest arbitrage involving the immediate purchase and
forward sale of baht is possible. Discuss how the baht’s spot and forward rates would adjust until
covered interest arbitrage is no longer possible. What is the resulting equilibrium state called?
ANSWER: Arbitrage opportunities are likely to disappear soon after they have been discovered
because of market forces. Due to the actions taken by arbitrageurs, supply and demand for the foreign
currency adjust until the mispricing disappears. For example, covered interest arbitrage involving the
immediate purchase and subsequent sale of Thai baht would place upward pressure on the spot rate
of the Thai baht and downward pressure on the Thai baht forward rate until covered interest arbitrage
is no longer possible. At that point, interest rate parity exists, and the interest rate differential
between the two countries is exactly offset by the forward premium or discount.
Solution to Supplemental Case: Zuber, Inc.
a. The expected value of the yield on investing funds in this country would be 14 percent, versus only 9
percent in the U.S. However, there is much uncertainty about the foreign yield. If the currency
depreciates by a large amount, it will wipe out some of the principal invested. Given that Zuber did
not want to target these funds for a speculative purpose, it would not be wise to invest these funds in
the country without covering.
b. Covered interest arbitrage would involve exchanging dollars for the currency today, investing the
currency in the country’s Treasury securities, and negotiating a forward contract to sell the currency
in one year in exchange for dollars.
Given that $10 million is available, this amount would be converted into 25 million units of the
foreign currency, which would accumulate to 28.5 million units (at 14 percent) by the end of the
year, and be converted into $11,115,000 at the time (based on a forward rate of $.39). This reflects a
return of 11.15 percent.
c. The risks of covered interest arbitrage are as follows:

The Treasury of the country could default on its securities issued.

The bank may not fulfill its obligation on the forward contract (the bank was just recently
privatized and does not have a track record as a privatized institution).

The government could restrict funds from being converted into dollars. (Since the country has
only allowed foreign investments recently, it does not have a track record. There is some
uncertainty about its future laws on international finance.)
d. While covered interest arbitrage would be expected to achieve a yield of 11.15 percent (versus only 9
percent in the U.S.), the risks are significant, especially considering that the country is still
experimenting with cross-border transactions. Since some students will probably suggest going for
the higher returns, this question may allow for an interesting class discussion.
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22  International Arbitrage and Interest Rate Parity
Small Business Dilemma
Assessment of Prevailing Spot and Forward Rates by the Sports Exports Company
1. Do you think Jim will be able to find a bank that provides him with a more favorable spot rate than
his local bank? Explain.
ANSWER: The quoted spot rate for British pounds will typically be similar among banks at a given
point in time, because locational arbitrage might be possible if there were significant differences. It
is possible that some banks that rarely provide the foreign exchange services quote a less favorable
exchange rate, and locational arbitrage will not necessarily correct this if these banks have a large
spread between the bid and the ask quotes. Therefore, it may be worthwhile for Jim to call other
banks to obtain quotes, but Jim will likely find that he cannot obtain a much better rate than what his
local bank provides.
2. Do you think that Jim’s bank is likely to provide more reasonable quotations for the spot rate of the
British pound if it is the only bank in town that provides foreign exchange services? Explain.
ANSWER: The bank is likely to provide more reasonable quotations for the spot rate of the British
pound if there are many banks in town that provide foreign exchange services. In this case, there is
more competition, and a local bank is more likely to lose business if its quotations are not reasonable.
3. Jim is considering using a forward contract to hedge the anticipated receivables in pounds next
month. His local bank quoted him a spot rate of $1.65 and a one-month forward rate of $1.6435.
Before Jim decides to sell pounds one month forward, he wants to be sure that the forward rate is
reasonable, given the prevailing spot rate. A one-month Treasury security in the United States
currently offers a yield (not annualized) of 1 percent, while a one-month Treasury security in the
United Kingdom offers a yield of 1.4 percent. Do you believe that the one-month forward rate is
reasonable given the spot rate of $1.65?
ANSWER: Yes. According to interest rate parity, the forward rate premium should be based on the
differential between interest rates:
p = [(1 + .01)/(1 + .014)] – 1
= [.996055] – 1
= –.0039448
The actual premium is:
p = (F – S)/S
= ($1.6435 – $1.65)/$1.65
= –.003939
The actual premium is very close to what the premium should be according to interest rate parity.
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