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Chapter 7—International Arbitrage and Interest Rate Parity

1. Due to ____, market forces should realign the relationship between the interest rate

differential of two currencies and the forward premium (or discount) on the forward exchange rate

between the two currencies.

a. forward realignment arbitrage

b. triangular arbitrage

c. covered interest arbitrage

d. locational arbitrage

ANS: C PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Comprehension

2. Due to ____, market forces should realign the spot rate of a currency among banks.

a. forward realignment arbitrage

b. triangular arbitrage

c. covered interest arbitrage

d. locational arbitrage

ANS: D PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Knowledge

3. 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 arbitrage

ANS: B PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Knowledge

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

a. forward realignment arbitrage

b. triangular arbitrage

c. covered interest arbitrage

d. locational arbitrage

ANS: C PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Knowledge

5. In which case will locational arbitrage most likely be feasible?

a. One bank’s ask price for a currency is greater than another bank’s bid price for the currency.

b. One bank’s bid price for a currency is greater than another bank’s ask price for the currency.

c. One bank’s ask price for a currency is less than another bank’s ask price for the currency.

d. One bank’s bid price for a currency is less than another bank’s bid price for the currency.

ANS: B PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Comprehension

6. When using ____, funds are not tied up for any length of time.

a. covered interest arbitrage

b. locational arbitrage

c. triangular arbitrage

d. B and C

ANS: D PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Knowledge

7. When using ____, funds are typically tied up for a significant period of time.

a. covered interest arbitrage

b. locational arbitrage

c. triangular arbitrage

d. B and C

ANS: A PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Knowledge

8. Assume that the interest rate in the home country of Currency X is a much higher

interest rate than the U.S. interest rate. According to interest rate parity, the forward rate of Currency

a. should exhibit a discount.

b. should exhibit a premium.

c. should be zero (i.e., it should equal its spot rate).

d. B or C

ANS: A PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.02

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Comprehension

9. If the interest rate is higher in the U.S. than in the United Kingdom, and if the forward

rate of the British pound (in U.S. dollars) is the same as the pound’s spot rate, then:

a. U.S. investors could possibly benefit from covered interest arbitrage.

b. British investors could possibly benefit from covered interest arbitrage.

c. neither U.S. nor British investors could benefit from covered interest arbitrage.

d. A and B

ANS: B PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Application

10. If the interest rate is lower in the U.S. than in the United Kingdom, and if the forward

rate of the British pound is the same as its spot rate:

a. U.S. investors could possibly benefit from covered interest arbitrage.

b. British investors could possibly benefit from covered interest arbitrage.

c. neither U.S. nor British investors could benefit from covered interest arbitrage.

d. A and B

ANS: A PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Comprehension

11. Assume that the U.S. investors are benefiting from covered interest arbitrage due to

high interest rates on euros. Which of the following forces should result from the act of this covered

interest arbitrage?

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

b. downward pressure on the euro’s forward rate.

c. downward pressure on the U.S. interest rate.

d. upward pressure on the euro’s interest rate.

ANS: B PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Comprehension

12. Assume that Swiss investors are benefiting from covered interest arbitrage due to a

high U.S. interest rate. Which of the following forces results from the act of this covered interest

arbitrage?

a. upward pressure on the Swiss franc’s spot rate.

b. upward pressure on the U.S. interest rate.

c. downward pressure on the Swiss interest rate.

d. upward pressure on the Swiss franc’s forward rate.

ANS: D PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Comprehension

13. Assume that a U.S. firm can invest funds for one year in the U.S. at 12% or invest

funds in Mexico at 14%. The spot rate of the peso is $.10 while the one-year forward rate of the peso is

$.10. If U.S. firms attempt to use covered interest arbitrage, what forces should occur?

a. spot rate of peso increases; forward rate of peso decreases.

b. spot rate of peso decreases; forward rate of peso increases.

c. spot rate of peso decreases; forward rate of peso decreases.

d. spot rate of peso increases; forward rate of peso increases.

ANS: A PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Application

14. Assume the bid rate of a New Zealand dollar is $.33 while the ask rate is $.335 at

Bank X. Assume the bid rate of the New Zealand dollar is $.32 while the ask rate is $.325 at Bank Y.

Given this information, what would be your gain if you use $1,000,000 and execute locational

arbitrage? That is, how much will you end up with over and above the $1,000,000 you started with?

a. $15,385.

b. $15,625.

c. $22,136.

d. $31,250.

ANS: A

SOLUTION: $1,000,000/$.325 = NZ$3,076,923 × $.33 = $1,015,385. Thus, the profit is

$15,385.

PTS: 1 DIF: Challenging OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Application

15. Based on interest rate parity, the larger the degree by which the foreign interest rate

exceeds the U.S. interest rate, the:

a. larger will be the forward discount of the foreign currency.

b. larger will be the forward premium of the foreign currency.

c. smaller will be the forward premium of the foreign currency.

d. smaller will be the forward discount of the foreign currency.

ANS: A PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.02

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Comprehension

16. Assume the following information:

You have $1,000,000 to invest:

Current spot rate of pound = $1.30

90-day forward rate of pound = $1.28

3-month deposit rate in U.S. = 3%

3-month deposit rate in Great Britain = 4%

If you use covered interest arbitrage for a 90-day investment, what will be the amount of U.S. dollars

you will have after 90 days?

a. $1,024,000.

b. $1,030,000.

c. $1,040,000.

d. $1,034,000.

e. none of the above

ANS: A

SOLUTION: $1,000,000/$1.30 = 769,231 pounds × (1.04) = 800,000 pounds × 1.28 =

$1,024,000

PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Application

17. Assume that the U.S. interest rate is 10%, while the British interest rate is 15%. If

interest rate parity exists, then:

a. British investors who invest in the United Kingdom will achieve the same return as U.S.

investors who invest in the U.S.

b. U.S. investors will earn a higher rate of return when using covered interest arbitrage than

what they would earn in the U.S.

c. U.S. investors will earn 15% whether they use covered interest arbitrage or invest in the

U.S.

d. U.S. investors will earn 10% whether they use covered interest arbitrage or invest in the

U.S.

ANS: D PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.02

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Application

18. Assume the following information:

U.S. investors have $1,000,000 to invest:

1-year deposit rate offered on U.S. dollars = 12%

1-year deposit rate offered on Singapore dollars = 10%

1-year forward rate of Singapore dollars = $.412

Spot rate of Singapore dollar = $.400

Given this information:

a. interest rate parity exists and covered interest arbitrage by U.S. investors results in the same

yield as investing domestically.

b. interest rate parity doesn’t exist and covered interest arbitrage by U.S. investors results in a

yield above what is possible domestically.

c. interest rate parity exists and covered interest arbitrage by U.S. investors results in a yield

above what is possible domestically.

d. interest rate parity doesn’t exist and covered interest arbitrage by U.S. investors results in a

yield below what is possible domestically.

ANS: B

SOLUTION: $1,000,000/$.400 = S$2,500,000 × (1.1)

= S$2,750,000 × $.412 = $1,133,000

Yield = ($1,133,000 − $1,000,000)/$1,000,000 = 13.3%

This yield exceeds what is possible domestically.

PTS: 1 DIF: Challenging OBJ: INFM.MADU.15.07.02

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Analysis

19. Assume the following information:

Current spot rate of New Zealand dollar = $.41

Forecasted spot rate of New Zealand dollar 1 year from now = $.43

One-year forward rate of the New Zealand dollar = $.42

Annual interest rate on New Zealand dollars = 8%

Annual interest rate on U.S. dollars = 9%

Given the information in this question, the return from covered interest arbitrage by U.S. investors

with $500,000 to invest is ____%.

a. about 11.97

b. about 9.63

c. about 11.12

d. about 11.64

e. about 10.63

ANS: E

SOLUTION: $500,000/$.41 = NZ$1,219,512 × (1.08)

= NZ$1,317,073 × .42 = $553,171

Yield = ($553,171 − $500,000)/$500,000 = 10.63%

PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.02

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Application

20. Assume the following bid and ask rates of the pound for two banks as shown below:

Bid Ask

Bank A $1.41 $1.42

Bank B $1.39 $1.40

As locational arbitrage occurs:

a. the bid rate for pounds at Bank A will increase; the ask rate for pounds at Bank B will

increase.

b. the bid rate for pounds at Bank A will increase; the ask rate for pounds at Bank B will

decrease.

c. the bid rate for pounds at Bank A will decrease; the ask rate for pounds at Bank B will

decrease.

d. the bid rate for pounds at Bank A will decrease; the ask rate for pounds at Bank B will

increase.

ANS: D PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.02

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Analysis

21. Assume the bid rate of a Singapore dollar is $.40 while the ask rate is $.41 at Bank X.

Assume the bid rate of a Singapore dollar is $.42 while the ask rate is $.425 at Bank Z. Given this

information, what would be your gain if you use $1,000,000 and execute locational arbitrage? That is,

how much will you end up with over and above the $1,000,000 you started with?

a. $11,764.

b. −$11,964.

c. $36,585.

d. $24,390.

e. $18,219.

ANS: D

SOLUTION: $1,000,000/$.41 = S2,439,024 × $.42 = $1,024,390

PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Application

22. Based on interest rate parity, the larger the degree by which the U.S. interest rate

exceeds the foreign interest rate, the:

a. larger will be the forward discount of the foreign currency.

b. larger will be the forward premium of the foreign currency.

c. smaller will be the forward premium of the foreign currency.

d. smaller will be the forward discount of the foreign currency.

ANS: B PTS: 1 DIF: Easy OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Comprehension

23. Assume the following exchange rates: $1 = NZ$3, NZ$1 = MXP2, and $1 = MXP5.

Given this information, as you and others perform triangular arbitrage, the exchange rate of the New

Zealand dollar (NZ) with respect to the U.S. dollar should ____, and the exchange rate of the Mexican

peso (MXP) with respect to the U.S. dollar should ____.

a. appreciate; depreciate

b. depreciate; appreciate

c. depreciate; depreciate

d. appreciate; appreciate

e. remain stable; appreciate

ANS: A PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Analysis

24. Assume the following information:

Spot rate today of Swiss franc = $.60

1-year forward rate as of today for Swiss franc = $.63

Expected spot rate 1 year from now = $.64

Rate on 1-year deposits denominated in Swiss francs = 7%

Rate on 1-year deposits denominated in U.S. dollars = 9%

From the perspective of U.S. investors with $1,000,000, covered interest arbitrage would yield a rate

of return of ____%.

a. 5.00

b. 12.35

c. 15.50

d. 14.13

e. 11.22

ANS: B

SOLUTION: $1,000,000/$.60 = SF1,666,667 × (1.07)

= SF1,783,333 × $.63 = $1,123,500

Yield = ($1,123,500 − $1,000,000)/$1,000,000 = 12.35%

PTS: 1 DIF: Moderate OBJ: INFM.MADU.15.07.01

NAT: BUSPROG.INFM.MADU.15.03 STA: DISC.INFM.MADU.15.02

KEY: Bloom’s: Application

25. Assume the following information for a bank quoting on spot exchange rates: