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Indicate whether the statement is true or false.
1. Assume locational arbitrage is possible and involves two different banks. The realignment that would occur due to
market forces would increase one bank’s ask rate and would decrease the other bank’s bid rate.
a.
True
b.
False
2. The equilibrium state in which covered interest arbitrage is no longer possible is called interest rate parity (IRP).
a.
True
b.
False
3. If interest rate parity (IRP) exists, then triangular arbitrage will not be possible.
a.
True
b.
False
4. The interest rate in South Africa is 8 percent. The interest rate in the United States is 5 percent. The South African
forward rate should exhibit a premium of about 3 percent.
a.
True
b.
False
5. Triangular arbitrage involves 3 transactions that must be executed at a single bank.
a.
True
b.
False
6. From the U.S. perspective, an example of a cross exchange rate is the exchange rate between a non-U.S. country and
the United States.
a.
True
b.
False
7. If interest rate parity (IRP) exists, then foreign investors will earn the same returns as U.S. investors.
a.
True
b.
False
8. Locational arbitrage involves investing in a foreign country and covering against exchange rate risk by engaging in
forward contracts.
a.
True
b.
False
9. Interest rate parity (IRP) states that the foreign currency’s forward rate premium or discount is roughly equal to the
interest rate differential between the United States and the foreign country.
a.
True
b.
False
10. The yield curve for the United States normally has an upward slope, meaning that the annualized interest rate is higher
for longer terms to maturity.
a.
True
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b.
False
11. Locational arbitrage explains why spot exchange rates among banks at different locations normally will not differ by a
significant amount.
a.
True
b.
False
12. Locational arbitrage is focused on capitalizing on the difference in nominal interest rates in two different locations.
a.
True
b.
False
13. Arbitrage involves capitalizing on a discrepancy in quoted prices in an attempt to make a profit, but it entails
substantial risk.
a.
True
b.
False
14. The larger the degree by which the foreign interest rate exceeds the home interest rate, the larger will be the forward
discount of the foreign currency specified by the interest rate parity (IRP) formula.
a.
True
b.
False
15. Assume that the real interest rate in the United States and in the United Kingdom is 3 percent. The expected annual
inflation in the United States is 3 percent, while in the United Kingdom it is 4 percent. The forward rate on the pound
should exhibit a premium of about 1 percent.
a.
True
b.
False
16. Triangular arbitrage tends to force a relationship between the interest rates of two countries and their forward
exchange rate premium or discount.
a.
True
b.
False
17. Capitalizing on discrepancies in quoted prices involving no risk and no investment of funds is referred to as interest
rate parity.
a.
True
b.
False
18. If interest rate parity (IRP) exists, then the rate of return achieved from covered interest arbitrage should be equal to
the rate available in the foreign country.
a.
True
b.
False
19. If interest rate parity (IRP) does not hold, there is still the possibility that covered interest arbitrage is not worthwhile
because of such factors as transaction costs, currency restrictions, and differential tax laws.
a.
True
b.
False
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20. For locational arbitrage to be possible, one bank’s ask rate must be higher than another bank’s bid rate for a currency.
a.
True
b.
False
21. Interest rate parity suggests that an exchange rate should change over time based on the difference in interest rates
between foreign versus domestic risk-free interest-bearing securities as of today.
a.
True
b.
False
22. The interest rate on euros is 8 percent. The interest rate in the United States is 5 percent. The euro’s forward rate
should exhibit a premium of about 3 percent.
a.
True
b.
False
23. The interest rate on yen is 7 percent. The interest rate in the United States is 9 percent. The yen’s forward rate should
exhibit a premium of about 2 percent.
a.
True
b.
False
24. Realignment in the exchange rates of banks will eliminate locational arbitrage. More specifically, market forces will
increase the ask rate of the bank from which the currency was bought to conduct locational arbitrage and will decrease the
bid rate of the bank to which the currency was sold to conduct locational arbitrage.
a.
True
b.
False
25. The word “covered” in “covered interest arbitrage” refers to the investors hedging their position to protect against the
possibility of default risk.
a.
True
b.
False
26. The interest rate on pounds in the United Kingdom is 8 percent. The interest rate in the United States is 5 percent.
Interest rate parity exists. U.S. investors will earn a lower return domestically than British investors earn domestically.
a.
True
b.
False
27. The yield curve of every country has its own unique shape.
a.
True
b.
False
28. Technology enables more consistent prices among banks and reduces the likelihood of significant discrepancies in
foreign exchange quotations among locations.
a.
True
b.
False
29. To capitalize on high foreign interest rates using covered interest arbitrage, a U.S. investor would convert dollars to
the foreign currency, invest in the foreign country, and simultaneously sell the foreign currency forward.
a.
True
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b.
False
30. For points lying to the left of the interest rate parity (IRP) line, covered interest arbitrage is not possible from a U.S.
investor’s perspective, but is possible from a foreign investor’s perspective.
a.
True
b.
False
31. Forward rates are driven by the government rather than market forces.
a.
True
b.
False
32. If the cross exchange rate of two nondollar currencies implied by their individual spot rates with respect to the dollar
is less than the cross exchange rate quoted by a bank, locational arbitrage is possible.
a.
True
b.
False
Indicate the answer choice that best completes the statement or answers the question.
33. Assume the bid rate of a Swiss franc is $.57 while the ask rate is $.579 at Bank X. Assume the bid rate of the Swiss
franc is $.560 while the ask rate is $.566 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.
$7,067
b.
$8,556
c.
$10,114
d.
$12,238
34. Assume the bid rate of an Australian dollar is $.60 while the ask rate is $.61 at Bank Q. Assume the bid rate of an
Australian dollar is $.62 while the ask rate is $.625 at Bank V. 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.
$10,003
b.
$12,063
c.
$14,441
d.
$16,393
e.
$18,219
35. When using ____, funds are not tied up for any length of time.
a.
covered interest arbitrage
b.
locational arbitrage
c.
triangular arbitrage
d.
locational arbitrage AND triangular arbitrage
36. Which of the following is an example of triangular arbitrage initiation?
a.
buying a currency at one bank’s ask and selling at another bank’s bid, which is higher than the former bank’s
ask
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b.
buying Singapore dollars from a bank (quoted at $.55) that has quoted the South African rand
(SAR)/Singapore dollar (S$) exchange rate at SAR2.50 when the spot rate for the rand is $.20
c.
buying Singapore dollars from a bank (quoted at $.55) that has quoted the South African rand/Singapore dollar
exchange rate at SAR3.00 when the spot rate for the rand is $.20
d.
converting funds to a foreign currency and investing the funds overseas
37. Assume the following information:
You have $400,000 to invest:
Current spot rate of Sudanese dinar (SDD)
=
$.00570
90-day forward rate of the Sudanese dinar
=
$.00569
90-day interest rate in the United States
=
4.0%
90-day interest rate in Sudan
=
4.2%
If you conduct covered interest arbitrage, what amount will you have after 90 days?
a.
$421,213
b.
$419,887
c.
$424,242
d.
$416,068
38. Assume the following information:
U.S. investors have $1,000,000 to invest:
1-year deposit rate offered by U.S. banks
=
10%
1-year deposit rate offered on British pounds
=
13.5%
1-year forward rate of British pound
=
$1.26
Spot rate of British pound
=
$1.30
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.
39. Assume you discovered an opportunity for locational arbitrage involving two banks and have taken advantage of it.
Because of your and other arbitrageurs’ actions, which of the following adjustments must take place?
a.
One bank’s ask price will rise, and the other bank’s bid price will fall.
b.
One bank’s ask price will fall, and the other bank’s bid price will rise.
c.
One bank’s bid/ask spread will widen, and the other bank’s bid/ask spread will fall.
d.
One bank’s ask price will rise, and the other bank’s bid price will fall AND one bank’s bid/ask spread will
widen, and the other bank’s bid/ask spread will fall.
40. 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
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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 ____ percent.
a.
about 11.97
b.
about 9.63
c.
about 11.12
d.
about 11.64
e.
about 10.63
41. Points below the IRP line represent situations where:
a.
covered interest arbitrage is feasible from the perspective of domestic investors and results in the same yield as
investing domestically.
b.
covered interest arbitrage is feasible from the perspective of domestic investors and results in a yield above
what is possible domestically.
c.
covered interest arbitrage is feasible from the perspective of foreign investors and results in a yield above what
is possible in their local markets.
d.
covered interest arbitrage is feasible for neither domestic nor foreign investors.
42. 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 this covered interest arbitrage activity?
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
43. Assume that the euro’s interest rates are higher than U.S. interest rates, and that interest rate parity exists. Which of the
following is true?
a.
Americans using covered interest arbitrage earn the same rate of return as Germans who attempt covered
interest arbitrage.
b.
Americans who invest in the United States earn the same rate of return as Germans who attempt covered
interest arbitrage.
c.
Americans who invest in the United States earn the same rate of return as Germans who invest in Germany.
d.
Americans using covered interest arbitrage earn the same rate of return as Germans who attempt covered
interest arbitrage AND Americans who invest in the United States earn the same rate of return as Germans
who attempt covered interest arbitrage.
e.
None of these are correct.
44. If the interest rate is lower in the United States 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.
U.S. investors could possibly benefit from covered interest arbitrage AND British investors could possibly
benefit from covered interest arbitrage.
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45. Assume that the U.S. interest rate is 10 percent, while the British interest rate is 15 percent. 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 United States.
b.
U.S. investors will earn a higher rate of return when using covered interest arbitrage than what they would
earn in the United States.
c.
U.S. investors will earn 15 percent whether they use covered interest arbitrage or invest in the United States.
d.
U.S. investors will earn 10 percent whether they use covered interest arbitrage or invest in the United States.
46. Bank A quotes a bid rate of $.300 and an ask rate of $.305 for the Malaysian ringgit (MYR). Bank B quotes a bid rate
of $.306 and an ask rate of $.310 for the ringgit. What will be the profit for an investor who has $500,000 available to
conduct locational arbitrage?
a.
$2,041,667
b.
$9,804
c.
$500
d.
$1,639
47. If the interest rate is higher in the United States 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.
U.S. investors could possibly benefit from covered interest arbitrage AND British investors could possibly
benefit from covered interest arbitrage.
Exhibit 7-1
Assume the following information:
You have $300,000 to invest:
The spot bid quote for the euro (€) is $1.08
The spot ask quote for the euro is $1.10
The 180-day forward rate (bid) of the euro is $1.08
The 180-day forward rate (ask) of the euro is $1.10
The 180-day interest rate in the United States is 6%
The 180-day interest rate in Europe is 8%
48. Refer to Exhibit 7-1 above. If you conduct covered interest arbitrage, what amount will you have after 180 days?
a.
$318,109.10
b.
$330,000.00
c.
$312,218.20
d.
$323,888.90
e.
None of these are correct.
49. Assume the following information:
Quoted Bid Price
Quoted Ask Price
Value of an Australian dollar (A$) in $
$0.67
$0.69
Value of Mexican peso in $
$.074
$.077
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Value of an Australian dollar in
Mexican pesos
8.2
8.5
Assume you have $100,000 to conduct triangular arbitrage. What will be your profit from implementing this strategy?
a.
$6,133
b.
$2,368
c.
$6,518
d.
$13,711
50. Assume the following information:
Current spot rate of Australian dollar
=
$.64
Forecasted spot rate of Australian dollar 1 year from now
=
$.59
1-year forward rate of Australian dollar
=
$.62
Annual interest rate for Australian dollar deposit
=
9%
Annual interest rate in the United States
=
6%
Given the information in this question, the return from covered interest arbitrage by U.S. investors with $500,000 to invest
is ____percent.
a.
about 6.60
b.
about 9.00
c.
about 7.33
d.
about 8.14
e.
about 5.59
51. 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
52. Which of the following is not true regarding covered interest arbitrage?
a.
Covered interest arbitrage is a reason for observing interest rate parity (IRP).
b.
If the forward rate is equal to the spot rate, conducting covered interest arbitrage will yield a return that is
exactly equal to the interest rate in the foreign country.
c.
When interest rate parity holds, covered interest arbitrage is not possible.
d.
When interest rate disparity exists, covered interest arbitrage may not be profitable.
e.
All of these are true.
53. Assume that U.S. investors are benefiting from covered interest arbitrage due to high interest rates on euros. Which of
the following forces should result from this covered interest arbitrage activity?
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
54. 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
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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
55. Which of the following is not true regarding interest rate parity (IRP)?
a.
When interest rate parity holds, covered interest arbitrage is not possible.
b.
When the interest rate in the foreign country is higher than that in the home country, the forward rate of that
country’s currency should exhibit a discount.
c.
When the interest rate in the foreign country is lower than that in the home country, the forward rate of that
country’s currency should exhibit a premium.
d.
When covered interest arbitrage is not feasible, interest rate parity must hold.
e.
All of these are true.
56. Which of the following is not true regarding covered interest arbitrage?
a.
Covered interest arbitrage tends to force a relationship between the interest rates of two countries and their
forward exchange rate premium or discount.
b.
Covered interest arbitrage involves investing in a foreign country and covering against exchange rate risk.
c.
Covered interest arbitrage opportunities only exist when the foreign interest rate is higher than the interest rate
in the home country.
d.
If covered interest arbitrage is possible, you can guarantee a return on your funds that exceeds the returns you
could achieve domestically.
e.
All of these are true regarding covered interest arbitrage.
57. Assume that interest rate parity holds. The Mexican interest rate is 50 percent, and the U.S. interest rate is 8 percent.
Subsequently, the U.S. interest rate decreases to 7 percent. According to interest rate parity, the peso’s forward ____ will
____.
a.
premium; increase
b.
discount; decrease
c.
discount; increase
d.
premium; decrease
58. 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
59. Points above the IRP line represent situations where:
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a.
covered interest arbitrage is feasible from the perspective of domestic investors and results in the same yield as
investing domestically.
b.
covered interest arbitrage is feasible from the perspective of domestic investors and results in a yield above
what is possible domestically.
c.
covered interest arbitrage is feasible from the perspective of foreign investors and results in a yield above what
is possible in their local markets.
d.
covered interest arbitrage is feasible for neither domestic nor foreign investors.
60. Assume the following information:
You have $1,000,000 to invest:
Current spot rate of pound
=
$1.60
90-day forward rate of pound
=
$1.57
3-month deposit rate in U.S.
=
3%
3-month deposit rate in U.K.
=
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.
$1,020,500
b.
$1,045,600
c.
$1,073,330
d.
$1,094,230
e.
$1,116,250
61. 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.
62. 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 United States
=
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 these are correct.
63. Assume that British interest rates are higher than U.S. rates, and that the spot rate equals the forward rate. Covered
interest arbitrage puts ____ pressure on the pound’s spot rate and ____ pressure on the pound’s forward rate.
a.
downward; downward
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b.
downward; upward
c.
upward; downward
d.
upward; upward
64. 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
Exhibit 7-1
Assume the following information:
You have $300,000 to invest:
The spot bid quote for the euro (€) is $1.08
The spot ask quote for the euro is $1.10
The 180-day forward rate (bid) of the euro is $1.08
The 180-day forward rate (ask) of the euro is $1.10
The 180-day interest rate in the United States is 6%
The 180-day interest rate in Europe is 8%
65. Refer to Exhibit 7-1 above. If you conduct covered interest arbitrage, what is your percentage return after 180 days? Is
covered interest arbitrage feasible in this situation?
a.
7.96 percent; feasible
b.
6.04 percent; feasible
c.
6.04 percent; not feasible
d.
4.07 percent; not feasible
e.
10.00 percent; feasible
66. Assume that the interest rate in the home country of Currency X is much higher than the U.S. interest rate. According
to interest rate parity, the forward rate of Currency X:
a.
should exhibit a discount
b.
should exhibit a premium
c.
should be zero (i.e., it should equal its spot rate)
d.
should exhibit a premium or should be zero (i.e., it should equal its spot rate)
67. When using ____, funds are typically tied up for a significant period of time.
a.
covered interest arbitrage
b.
locational arbitrage
c.
triangular arbitrage
d.
locational arbitrage AND triangular arbitrage
68. National Bank quotes the following for the British pound and the New Zealand dollar: