Chapter 7

Question 1

Locational Arbitrage

Answer 1

FX quotations differ among banks

the act of LA should force the FX quotations of banks to become realigned, and make arbitrage disappear

Question 2

Triangular Arbitrage

Answer 2

related to cross exchange rates
CER between 2 currencies is determined by the values of these 2 currencies with respect to a 3rd one
if actual CER of these 2 differs from the rate that should exist –> we have TA
the act of TA should force cross exchange ates to become realigned, at which time TA would disappear

Question 3

CIA

Answer 3

based on the RS between fwd premium & interest rat differential
the size of the p/d of the fwd rate of the currency should be = interest rate differential
if the fwd p/d deviates substantially from IR differentials –> CIA would appeared
In this type of arbitrage, foreign short-term investment in foreign currency is covered by a fwd sale of that foreign currency

Question 4

IRP

Interest Rate Parity

Answer 4

theory stating that the size of the fwd p/d = to interest rate differential between 2 countries
when IRP exists, CIA is NOT feasible since IR advantage in the foreign country will be offset by the discount on fwd rate
Thus act of COIA would generate a return that is no higher than what would be generated by a domestic investment

Question 5

describe transaction cost effects on IRP and CIA

Answer 5

TC further the distance away from IRP for CIA to be worthwhile

Question 6

Describe Political Risk of IRP and CIA

Answer 6

investing overseas is subject to political risk
there is no guarantee that the foreign country will reconvert funds to domestic currency
crisis may force foreign governments to restrict currency conversion
there is a possibility foreign government will default on their debt

Question 7

Describe tax laws effect on IRP and CIA

Answer 7

taxes must be considered

CIA may be feasible before taxes are considered but not after

Question 8

Describe how different maturity dates affect forward premiums

Answer 8

The forward premium or discount will depend on the interest rate at different maturity dates - the relationship between yield curve of different countries is relevant. The amount of money needed to hedge the investment will change with this potential discount or premium

Question 9

Factors which influence Forward Rate

Answer 9

same factors which influence spot rate - inflation and interest rate differentials.

Question 10

CIA

Meaning

Answer 10

“interest arbitrage” –> process of capitalising on the IR differential between two currencies
“covered” –> hedging position against ER Risk (fwd contract - lock fwd rate)

Question 11

Graphs:

Answer 11

IRP - fwd p/d and IR D
above graph - invest at home
below - invest abroad (CIA)

Question 12

Does IRP always hold?

Answer 12

when IRP doesn´t hold –> engage in CIA ?
CIA still may not be worthhil due to other factors of foreign investment (transaction costs, political risk, diff. tax laws)