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. 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.
3. 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 notreflect
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.
4. 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 didnt 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. For further explanation and the exact
formula, please refer to lecture notes or the chapter in the text.
5. 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.
6. 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
