QuestionQuestion

Aswer the following questions:

Question 1:
Assume the following information:
a.      Spot Rate of Pounds = $1.60
b.      180 day forward rate of Pounds = $1.56
c.      180 day British interest rate = 4%
d.      180 day U.S. interest rate = 3%

Based on the above information, is covered interest arbitrage by the U. S. investor feasible?
Please show your work/calculations and explain your answer.

Question 2:
Assume the spot exchange rate of the Singapore dollar is $.70. The one-year interest rate is 11% in the U.S. and 7% in Singapore. What will the spot rate be in one year according to the International Fischer Effect (IFE), You may use the approximate formula to answer this question.

Question 3:
Thompson Corporation has recently initiated a market-based forecast system using the forward rate as an estimator of the future spot rate on the Japanese yen and the Australian dollar. Below are the forecasted and realized values for the last period:

CURRENCY             FORCASTED VALUE             REALIZED VALUE
Australian dollar                      $0.60                                    $0.55
Japanese yen                         $0.0067                               $0.0069

According to the information provided above and using the absolute forecast error as percentage of the realized value, which currency has Thompson forecasted more accurately and by what percentage? Explain.

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Solution:
If covered arbitrage is possible, then the exchange rate would not be at parity.
Using the interest rates given in the question,
Forward rate of pounds should be = Spot rate of pounds * (1 + US rate)/(1 + British rate)
= 1.60 * (1 + 3%)/(1 + 4%) = $1.585 per pound.
Since the forward rate is $1.56, it is clear that pound is underpriced in the forward market. Therefore, long position should be taken in pound in forward market. It should be sold short now.
If we start with 100 pounds today, it can be converted into $1.60 * 100 = $160 US dollars today.
This would be invested at 3% to earn 160 * 1.03 = $164.80
The dollars would be sold short in the forward market at $1.56 per pound to obtain 164.80/1.56 = 105.64 pounds...
$51.75 for this solution

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