FM W7 Flashcards
What are the three types of international arbitrage
- Locational - when a bank’s buying price (bid) is greater than another bank’s selling price (ask) for the same currency.
- Triangular - when a cross exchange rate quote differs from the rate calculated from spot rate quotes.
- Interest - the transfer of short-term liquid funds abroad to earn a higher rate of return.
What is the difference between covered and uncovered interest arbitrage
Uncovered = when the transfer abroad entails foreign exchange risk due to depreciation.
Covered = spot purchase of foreign currency and the forward sale of foreign currency to cover foreign exchange risk.
What is Interest Rate Parity (IRP)
The difference in interest rates between two countries should equal the expected change in the exchange rate between their currencies.
What would happen if the forward rate equalled the spot rate, but different interest rates.
Borrow currency with the lower rate. Convert cash at spot rate. Enter forward contract. Invest money at higher rate. Convert back through the higher rate. Repay principal and interest, the interest will be lower than the interest received.
What are the implications of IRP
If domestic interest rates are lower than foreign interest rates, invest in foreign currency at higher IRs. Domestic investors benefit by investing in foreign market.
Forward Premium (p) equation:
p = (1 + home interest rate) / (1 + foreign interest rate) - 1
What are 2 considerations you should make when assessing IRP
- Political risk - government could restrict any exchange of the local currency for other currencies.
- Differential tax laws - if tax laws vary, after-tax returns should be considered instead of before-tax returns.
What is an efficient foreign exchange market
If the forward rates accurately predict future spot rates.
What is Eurocurrency and why is it important
Commercial bank deposits outside the country of issue. Useful because IRs on short-term deposits are often higher abroad than domestic rates. It is also convenient for international corporations to hold balances abroad.
What are the 3 types of exposure
- Transaction - future cash transactions affected by exchange rate fluctuations. Measured by estimating net cash inflows and outflows in each currency, then measuring the impact of exposure to these currencies.
- Economic - firm’s present value of the future cash flows can be influenced by exchange rate fluctuations. Measured by assessing the sensitivity of the firm’s earnings to exchange rates.
- Translation - exposure of an MNC’s consolidated financial statements to exchange rate fluctuations.
What is Absolute PPP
It suggests that the exchange rate between two currencies should reflect the relative price levels of identical goods in each country.
S = P/P*.
What is Relative PPP
It suggests that the percentage change in the exchange rate between two currencies should approximately equal the difference in the inflation rates of the two countries.
ef = (1 + inflh / 1 + inflf) - 1
What is the law of one price
A good should have the same price in both countries when expressed in terms of the same currency.
Why doesn’t PPP occur consistently
- Confounding effects.
- Lack of substitutes for some traded goods.
What is the International Fisher Effect and formula
Countries with higher inflation have higher interest rates.
IFE = PPP + FE.
rh - rf = (e1 - e0) / e0
