Wk7

Question 1

What is international arbitrage

Answer 1

-Making a riskless profit off of discrepancies in quoted price
- doesn’t require funds to be tied up for a long period of time
- causes price to realign so that there is no futher risk free profit can be made - mechanism

Question 2

What are the different types of international arbitrage (3)

Answer 2

• locational
• triangular
• covered interest arbitrage

Question 3

What is locational arbitrage

Answer 3

• When a banks buying price (bid price ) is higher than another banks selling price (ask price) for the same currency
• buying a currency where it’s cheaper and then immédiatetés sell where the price is higher

Question 4

What is triangular arbitrage

Answer 4

• when you exploit discrepancies in the quoted exchange rate between three diffrent currencies to make a profit - buy low sell high

Question 5

What interest arbitrage

Answer 5

The transfer of short term liquid funds abroad to earn a higher interest rate
Capitalising on the interest rate differences in another country
- uncovered interest arbitrage has the risk of possible depreciation of the foreign currency during the investment period

Question 6

What is carry trade

Answer 6

Borrowing of low yielding currencies and lending in high yield inf currencies

Question 7

What is covered interest arbitrage

Answer 7

• You are covered for the exchange rate risk
• force a relationship between forward rate premiums and interest rate differentials

Question 8

How does covered arbitrage work

Answer 8

• spot rate = 90 day = $1.60
• US 90 day IR = 2%
• UK 90 day IR = 4%

Borrow $ at 3% or use the existing funds which are earning interest at 2%
Conger the dollar to pounds and engage in a 90 day forward contract to sell £ to $1.60/£ lend £ at 4%
- will not make profits instantaneously

Question 9

What happens when you trigger arbitrage

Answer 9

Capitalising on the discrepancy will eliminate it and the forgiven exchange market will become orderly

Question 10

What is interest rate parity

Answer 10

An equilibrium state is achieved when interest arbitrage is no longer feasible
- The difference between interest rates in any two countries is the same as the difference between the forward, and the sport rates of their respective currencies
-Plays in a central role in the foreign exchange market

Question 11

What does interest rate parity cover

Answer 11

• A currency is worth, what it can earn
• The return on a currency is the interest rate on that currency, plus the expected rate of appreciation over a given period of
• When they return onto currencies, equal interest rate, parity prevails
  -This does not mean that the interest rates are now the same just the returns on them

Question 12

Explanation of the interest rate parity - 2 options

Answer 12

• invest in foreign currency locally at the risk free rate for a specific period of time that the proceeds into your domestic currency at maturity
• Or invest the same dollars in your domestic market for the same period of time, and where no arbitrage opportunities exist cash flows from both are equal

Question 13

Violation of IRP

Answer 13

arbitrage opportunities exist
E.g . If the sport rate equals the forward rate, but interest rates were different:
– Investors would borrow in the currency with a lower rate
– Convert the cash at spot rates
-Enter into a Food contract, convert the cash, plus the expected interest rate at the same rate
-Invest the money at a higher rate
-Convert back through forward contract
- Repay the principle and the interest, knowing the latter will be less than the interest received

Question 14

What are the implications of IRP

Answer 14

• If domestic IR are less than foreign you would invest in a foreign country at a higher interest rate and domestic investors can benefit by investing in the foreign market.
• If domestic rates are more than for an interest rate, you will invest in domestic market at higher interest rates, and for investors can benefit by investing in the domestic market

Question 15

Look at derivation

Answer 15

Xxxxxx

Question 16

What is PPP based

Answer 16

Based on trade and the exchange rate will adjust to offset inflation differences and holds for large differences

Question 17

What is the IFE based on

Answer 17

Based on investment - investing in countries with higher interest rates is known as the carry trade x suggests that the exchange rate will change to offset any gains

Question 18

Look at summary of emoercical evidence of parity conditions

Question 19

Why is PPP and IRP important

Answer 19

Provide the markets best guess under the assumption of no expected profit given current prices
- these are assumptions for arbitrage instruments
Eliminated need to pay for pro analysis - few outperform market expectations
- simple framework to determine financial linkages between countries which affects capital markets

Question 20

Why is country risk analysis important

Answer 20

Represents the potentially adverse impact of country Environment on forex returns
- countries risks are binary gov allowed or denies

Question 21

Why may country risk analysis be used

Answer 21

To devise a risk management strategy appropriate to a country
– As a screening advice to avoid conducting business in countries with excessive risk
– To revise its investment of financing decisions, considering recent events

Question 22

What do you need to consider when you look at a country risk?

Answer 22

• The attitudes of consumers in the host country
  Some may be loyal to the locally manufactured products

– And the actions of the host government
They may want to impose special requirements or taxes, restrict fund transfers and subsidies local firms
Investors can also be hurt by a lack of restrictions, such as failure to enforce copyright laws

Question 23

What other political risk factors are there to country risk

Answer 23

• blockage of fund transfer
• currency in convertibility
  Foreign currency cannot be changed into other currencies. Therefore, the parent company may need to exchange earnings for goods.
• war
• burecracy
• corruption

Question 24

What are financial risk factors

Answer 24

• • recession can reduce demand
    -interest rates / exchange rates b inflation - country dependent on several financial factors

Question 25

What are the types of country risk assessments

Answer 25

A macro assessment of country risk is An overall risk assessment of a country without considering the individual business
- A micro assessment of country risk is the risk assessment of a country with respect to the countries individual type of business

Question 26

What are the techniques of assessing country risk

Answer 26

• The checklist approach
• the Delphi technique
• quantitive analysis
• inspection visit
• use a variety of techniques

Question 27

What does the checklist approach entail in measuring risk

Answer 27

-Assigning, values and weights to political and financial risk factors
– Multiplying the factor values with their weights, and summing up to give the political and financial risk ratings
 assign weights to the risk ratings 

Question 28

How do you get the total risk rating?

Answer 28

Multiply the rated, assign to the factor, which ranges between 1-5 the weight assigned by the company to the factor according to the importance 

Question 29

How do you quantify countries risk?

Answer 29

It will vary with the assessor, the country being assessed, as well as the type of operations being planned
– Firms use country risk ratings when screening potential projects and monitoring existing projects

Question 30

What is foreign investment risk matrix?

Answer 30

It is one approach to comparing political and financial ratings among countries
The matrix displays, financial and political risk by intervals, ranging from poor to good
- each country can be positioned on the matrix based on its political and financial ratings
E.g. actual country risk ratings

Question 31

How can country risk be incorporated into capital budgeting

Answer 31

Adjusting the discount rate or by adjusting the estimated cash flows
The higher the risk the higher the discount rate that should be applied to the projects cash flow