CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS AND FORECASTING FOREIGN

EXCHANGE RATES
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Give a full definition of arbitrage.
2. Discuss the implications of the interest rate parity for the exchange rate determination.
3. Explain the conditions under which the forward exchange rate will be an unbiased predictor
of the future spot exchange rate.
5. Discuss the implications of the deviations from the purchasing power parity for countries
competitive positions in the world market.
6. Explain and derive the international Fisher effect.

7.

Researchers found that it is very difficult to forecast the future exchange rates more

accurately than the forward exchange rate or the current spot exchange rate. How would you
interpret this finding?

10. Explain the following three concepts of purchasing power parity (PPP):
a. The law of one price.
b

b. Absolute PPP.
c. Relative PPP.

PROBLEMS
1. Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for
six months. The six-month interest rate is 8 percent per annum in the United States and 7

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percent per annum in Germany. Currently, the spot exchange rate is 1.01 per dollar and the
six-month forward exchange rate is 0.99 per dollar. The treasurer of IBM does not wish to bear
any exchange risk. Where should he/she invest to maximize the return?

Online problem format original question:

What will the value of the investment be in six months if invested in US$?
a. $100,000,000 x 1.04 = $104,000,000
b. $100,000,000 x 1.035 = $103,500,000
c. $100,000,000 x (1.04 -1.035) = $100,500,000
d. None of the above

What will the value of the investment in Euros be if invested in Germany for 6 months?
a. $100,000,000 x 1.04 = $104,000,000 x 0.99 = 102,960,000
b. $100,000,000 x 1.01 x 1.04 = 105,040,000
c. $100,000,000 x 1.01 x 1.035 = 104,535,000
d. $100,000,000 x 0.99 x 1.035 = 102,465,000
If he considers to do an investment in Euros then what forward position will he take with
preference to the currency that he will exchange his investment to after 6 months?
a. Long in
b. Short in
c. Long in $
d. Short in $
What will the $ value of the investment in Germany be after 6 months?
a. 102,960,000 / 0.99 = $104,000,000.00
b. 105,040,000 x 0.99 =$103,989.00
c. 104,535,000 / 0.99 = $105,590,909.09
d. 102,465,000 x 0.99 = $101,440,350.00
e. 102,960,000 / 1.01 = $101,940,594.06

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f. 105,040,000 x 1.01 = $106,090,400.00

g. 104,535,000 / 1.01 = $103,500,000.00
h. 102,465,000 x 1.01 = $103,489,650.00

2. While you were visiting London, you purchased a Jaguar for 35,000, payable in three
months. You have enough cash at your bank in New York City, which pays 0.35% interest per
month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/
and the three-month forward exchange rate is $1.40/. In London, the money market interest
rate is 2.0% for a three-month investment. There are two alternative ways of paying for your
Jaguar.
(a) Keep the funds at your bank in the U.S. and buy 35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months
so that the maturity value becomes equal to 35,000.
Evaluate each payment method. Which method would you prefer? Why?

Online problem format original question:

While you were visiting London, you purchased a Jaguar for 35,000, payable in three months.
You have enough cash at your bank in New York City, which pays 0.35% interest per month,
compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/ and the
three-month forward exchange rate is $1.40/. In London, the money market interest rate is
2.0% for a three-month investment. There are two alternative ways of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy 35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months
so that the maturity value becomes equal to 35,000.
Evaluate each payment method. Which method would you prefer? Why?
In what currency and for what amount should the forward contract be entered into if you keep
the funds in your US account?
a. Long in pound = 35,000
b. Long In dollar = 35,000 x $1.40/ = $49,000
c Short in pound = 35,000

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d. Short In dollar = 35,000 x $1.40/ = $49,000

What will be the cost of the Jaguar as of today in $ if you enter into the forward contract and
keep the funds in your US account?
a. PV =(35,000/(1.02) x 1.40 = $48,039.22
b. PV = $49,000/(1.0035)3) = $48,489.08
What amount in pound will you purchase today to invest in the UK if you apply option b?
a. PV = $49,000/(1.0035)3) / 1.40 = 34,635.06
b. PV = 35000/(1.02) = 34,313.73
Which method is the best and why?
a. Alternative A because cheaper
b. Alternative B because cheaper
3. Currently, the spot exchange rate is $1.50/ and the three-month forward exchange rate is
$1.52/. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in
the U.K. Assume that you can borrow as much as $1,500,000 or 1,000,000.
a. Determine whether the interest rate parity is currently holding.
b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the
steps and determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of covered arbitrage activities.

Online problem format original Question:

Currently, the spot exchange rate is $1.50/ and the three-month forward exchange rate is
$1.52/. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in
the U.K. Assume that you can borrow as much as $1,500,000 or 1,000,000.
a. Determine whether the interest rate parity is currently holding.
b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the
steps and determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of covered arbitrage activities.

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Calculate the forward rate, based on IRP ($(1+i $)/(1+i)), to determine whether the interest rate
parity is currently holding What rate do you find?
a. $1.53/
b. $1.52/
c. $1.51/
Does interest rate parity hold or not?
a. Yes
b. No
What currency will you borrow?
a. $
b.
c. Will not borrow
What is the interest rate at which you will borrow?
a. 2% for three months
b. 1.45% for three months
c. Not applicable
What is the total end-of-period borrowed amount?
a. $1,521,750
b. 1,014,500
c. $1,530,000
d. 1,020,000
e. Not applicable
In what currency will you invest?
a. $
b.
c. Not applicable
Will you go short or long in a forward contract?
a. Short $1,521,750

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b. Long $1,521,750
c. Short 1,014,500
d. Long 1,014,500
e. Short $1,530,000
f. Long $1,530,000
g. Short 1,020,000
h. Long 1,020,000
i. Not applicable
How much arbitrage profit will you make in $?
a. $22,185
b. 22,185
c. $12,040
d. 12,040
e. No profit due to no arbitrage opportunity
Indicate which of the following situations may occur to restore the IRP as a result of covered
arbitrage activities:
a. The dollar interest rate will rise
b. The pound interest rate will fall
c. The spot exchange rate will rise
d.The forward exchange rate will fall
e. a and b
f. c and d
g. a, b, c and d

7. (CFA question) Omni Advisors, an international pension fund manager, uses the concepts of
purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot
exchange rates. Omni gathers the financial information as follows:
Base price level
Current U.S. $ price level
Current South African price level
Base rand spot exchange rate
Current rand spot exchange rate
Expected annual U.S. inflation

100
105
111
$0.175
$0.158
7%

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Expected annual South African inflation

Expected U.S. one-year interest rate
Expected South African one-year interest rate

5%
10%
8%

Calculate the following exchange rates (ZAR and USD refer to the South African rand and U.S.
dollar, respectively).
a. The current ZAR spot rate in USD that would have been forecast by PPP.
b. Using the IFE, the expected ZAR spot rate in USD one year from now.
c. Using PPP, the expected ZAR spot rate in USD four years from now.

IMPORTANT NOTE: IFE suggests that the nominal interest rate difference reflects the
expected change in exchange rates p.158 in textbook.

Online problem format original question:

Formulas to be applied:
The absolute version of purchasing power parity (PPP):
S = P$/P.
The relative version is: e = $ - .
The international Fisher effect: E(e) = i$ - i.
You are provided with the following solutions to the questions in this problem:
i. [1.10/1.08] (0.158) = $0.1609/rand.
ii. [(1.07)4/(1.05)4] (0.158) = $0.1704/rand.
iii. [1.05/1.11](0.175) = $0.1655/rand.
Which one of the solutions calculates the ZAR spot rate under PPP?
a. i.
b. ii.
c. iii.
Which one of the solutions calculates the expected ZAR spot rate one year from now with IFE?
a. i.

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b. ii.
c. iii.
Which one of the solutions calculates the expected ZAR spot rate in USD four years from now
under PPP?
a. i.
b. ii.
c. iii.

11. James Clark is a foreign exchange trader with Citibank. He notices the following quotes.
Spot exchange rate

SFr1.2051/$

Six-month forward exchange rate

SFr1.1922/$

Six-month $ interest rate

2.5% per year

Six-month SFr interest rate

2.0% per year

a. Is the interest rate parity holding? You may ignore transaction costs.
b. Is there an arbitrage opportunity? If yes, show what steps need to be taken to make
arbitrage profit. Assuming that James Clark is authorized to work with $1,000,000, compute
the arbitrage profit in dollars.

ONLINE QUESTION FORMAT ORIGINAL QUESTION

Calculate the forward rate, based on IRP (SFr(1+i SFr)/$(1+i$)), to determine whether the interest
rate parity is currently holding What rate do you find?
a. SFr1.2021$
b. SFr1.0210/$
c. SFr1.2102/$
Does interest rate parity hold or not?
a. Yes
b. No

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What currency will you borrow?

a. $
b. SFr
c. Will not borrow
What is the interest rate at which you will borrow?
a. 1% for six months
b. 1.25% for six months
c. Not applicable
What is the total end-of-period borrowed amount?
a. $1,012,500
b. SFr 1,217,151
c. $1,010,000
d. SFr1, 220,164
e. Not applicable
In what currency will you invest?
a. $
b. SFr
c. Not applicable
Will you go short or long in a forward contract?
a. Short $1,012,500
b. Long $1,012,500
c. Short SFr 1,217,151
d. Long SFr 1,217,151
e. Short $1,010,000
f. Long $1,010,000
g. Short SFr1, 220,164
h. Long SFr1, 220,164
i. Not applicable

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How much arbitrage profit will you make in $?

a. $8,428.54
b. SFr 8,932.88
c. $ 8,932.88
d. SFr8,428.54
e. No profit due to no arbitrage opportunity

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