Please refer to sent images for solutions of Q # 3, Q # 4 and Q # 10
Q8 Solution. 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.a.
What is the yield to a U.S. investor who conducts covered interest arbitrage? Did coveredinterest
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:
Step 1
Convert dollars to Moroccan dirham: $500,000/$.11 = MD4,545,454.552.
Step 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.
Step 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 is1 percent
lower in the U.S., the forward rate discount of the dirham more than offsets that differential.
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Q 9 Part A
Foreign Exchange. You just came back from Canada, where the Canadian
dollar was worth $.70.You still have C$200 from your trip and could exchange
them for dollars at the airport, but the airport foreign exchange desk will only
buy them for $.60. Next week, you will be going to Mexico and will need
pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso.
You met a tourist at the airport who is from Mexico and is on his way to
Canada. He is willing to buy your C$200 for1,300 pesos. Should you accept the
offer or cash the Canadian dollars in at the airport? Explain.
ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the
foreign exchange desk, the cross-rate is $.60/$.10 = 6. Thus, the C$200 would
be exchanged for 1,200 pesos (computed as 200 × 6). If you exchange
Canadian dollars for pesos with the tourist, you will receive 1,300 pesos
Q 9 (Part B)
Assume you have $1,000 and plan to travel from the United States to the
United Kingdom. Assume further that the bank’s bid rate for the British pound
is $1.52 and its asked rate is $1.60. Before leaving on your trip, you go to this
bank to exchanged dollars for pounds. Now suppose that because of an
emergency you cannot take the trip, and reconvert the pounds back to U.S.
dollars, if the exchange rate has not changed what number of dollars you will
lose?
Answer:
Convert Dollars to British Pound @ Ask Rate: 1000 / 1.60= 625 British Pounds
because of an emergency you as cannot take the trip, to reconvert the pounds
back to U.S. dollars assuming exchange rates are unchanged
Convert Pounds to US Dollars @ Bid Rate: 625 x 1.52 = 950 US Dollars
Difference/Lost Dollars = 1000$ - 950$ = 50 US Dollars
So you will lose 50 US Dollars due to prevailing spread.
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