1. At the time Argentina launched its new exchange rate scheme, the euro was trading at $0.85.

Exporters and importers would be able to convert between dollars and pesos at an exchange
rate that was an average of the dollar and the euro exchange rates, that is, P1 = $0.50 ± 0.50.

a. How many pesos would an exporter receive for one dollar under the new system?

ANSWER. Under the new system, P1 = $0.50 + _0.50 = $0.50 + $0.85/2 = $0.925. The peso value
of a dollar is thus 1/0.925, or $1 = P1.081. This exchange rate is equivalent to dollar appreciation
of 8.1% against the peso.

b. How many dollars would an importer receive for one peso under the new system?

ANSWER. As shown in the answer to Part a, P1 = $0.925. This exchange rate is equivalent to
peso devaluation against the dollar of 7.5%.

2. In the second half of 1997,the Indonesian rupiah devalued by 84% against the US Dollar By
how much has the dollar appreciated against the rupiah

INR Devalued 84% retained 16% of its value while USD still 100%
USD/INR appreciates=1/0,16 x
100%-100%=525%

3. Suppose the Russian ruble devalues by 75% against the dollar. What is the
percentageappreciation of the dollar against the ruble?
ANSWER.The ruble is now worth 25% of its previous dollar value; that is, the dollar is now
worth 4 timesits previous ruble value. The ruble value of the dollar has, therefore, increased by
300% (the first 100% isits previous value).

4. Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile,
the expected inflation rate in France is 12%, and the English interest rate is 14%. To the
nearest whole number, what is the best estimate of the one-year forward exchange premium
(discount) at which the pound will be selling relative to the French franc?

ANSWER. Based on the numbers, Japan's real interest rate is about 5% (8% - 3%). From that, we
can calculate France's nominal interest rate as about 17% (12% + 5%), assuming that arbitrage
will equate real interest rates across countries and currencies. Since England's nominal interest
rate is 14%, for interest rate parity to hold, the pound should sell at around a 3% forward
premium relative to the French franc.

5. Assume the interest rate is 16% on pounds sterling and 7% on the Euro. At the same time,
inflation is running at an annual rate of 3% in Germany and 9% in England.

a. If the Euro is selling at a one-year forward premium of 10% against the pound, is there an
arbitrage opportunity? Explain.
ANSWER. According to interest rate parity, with a Euro rate of 7% and a 10% forward premium
on the Euro against the pound, the equilibrium pound interest rate should be

1.07 x 1.10 - 1 = 17.7%

Since the pound interest rate is only 16%, there is an arbitrage opportunity. It involves
borrowing pounds at 16%, converting them into Euro, investing them at 7%, and then selling
the proceeds forward, locking in a pound return of 17.7%.

b. What is the real interest rate in Germany? in England?

ANSWER. The real interest rate in Germany is 1.07/1.03 -1 = 3.88%. The real interest rate in
England is 1.16/1.09 -1 = 6.42%.

c. Suppose that during the year the exchange rate changes from Euro2.7/£1 to Euro2.65/£1.
What are the real costs to a German company of borrowing pounds? Contrast this cost to its
real cost of borrowing Euro.

ANSWER. At the end of one year, the German company must repay 1.16 for every pound
borrowed. However, since the pound has devalued against the Euro by 1.85% (2.65/2.70 - 1 = -
1.85%), the effective cost in Euro is 1.16 x (1 - 0.0185) - 1 = 13.85%. In real terms, given the
3% rate of German inflation, the cost of the pound loan is found as 1.1385/1.03 -1 = 10.54%.

As shown above, the real cost of borrowing Euro equals 3.88%, which is significantly lower
than the real cost of borrowing pounds. What happened is that the pound loan factored in an
expected devaluation of about 9% (16% - 7%), whereas the pound only devalued by about 2%.
The difference between the expected and actual pound devaluation accounts for the
approximately 7% higher real cost of borrowing pounds.

d. What are the real costs to a British firm of borrowing Euro? Contrast this cost to its real cost
of borrowing pounds.

ANSWER. During the year, the Euro appreciated by 1.89% (2.70/2.65 - 1) against the pound.
Hence, a Euro loan at 7% will cost 9.02% in pounds (1.07 x 1.0189 - 1). In real pound terms,
given a 9% rate of inflation in England, this loan will cost the British firm 0.02% (1.0902/1.09 -
1) or essentially zero. As shown above, the real interest on borrowing pounds is 6.42%.

6. Suppose the Eurosterling rate is 15 percent, and the Eurodollar rate is 11.5 percent. What is
the forward premium on the dollar? Explain.

ANSWER. According to interest rate parity, if P is the forward premium on the dollar, then
(1.115)(1 + P) = 1.15, or P = 3.14%.
7. Here are some prices in the international money markets:
Spot rate = $1.46/€
Forward rate (one year) = $1.49/€
Interest rate (€) = 7% per year
Interest rate ($) = 9% per year

a. Assuming no transaction costs or taxes exist, do covered arbitrage profits exist in the above
situation? Describe the flows.

ANSWER. The annual dollar return on dollars invested in Germany is (1.07 x 1.49)/1.46 - 1 =
9.20%. This return exceeds the 9% return on dollars invested in the United States by 0.25% per
annum. Hence arbitrage profits can be earned by borrowing dollars or selling dollar assets,
buying euros in the spot market, investing the euros at 7%, and simultaneously selling the euro
interest and principal forward for one year for dollars.

8. As a foreign exchange trader at Sumitomo Bank, one of your customers would like a yen quote on Australian
dollars. Current market rates are:

Spot 30-day
¥101.37-85/U.S.$1 15-13
A$1.2924-44/U.S.$1 20-26

a. What bid and ask yen cross rates would you quote on spot Australian dollars?

ANSWER. By means of triangular arbitrage, we can calculate the market quotes for the Australian dollar in terms of
yen as

¥78.31-81/A$1

These prices can be found as follows. For the yen bid price for the Australian dollar, we need to first sell Australian
dollars for U.S. dollars and then sell the U.S. dollars for yen. It costs a$1.2944 to buy U.S. $1. With U.S. $1 we can
buy ¥101.37. Hence, A$1.2944 = ¥101.37, or A$1 = ¥78.31. This is the yen bid price for the Australian dollar.

The yen ask price for the Australian dollar can be found by first selling yen for U.S. dollars and then using the U.S.
dollars to buy Australian dollars. Given the quotes above, it costs ¥101.85 to buy U.S. $1, which can be sold for
a$1.2924. Hence, A$1.2924 = ¥101.85, or A$1 = ¥78.81. This is the yen ask price for the Australian dollar.

As a foreign exchange trader, you would try to buy Australian dollars at slightly less than ¥78.31 and sell them at
slightly more than ¥78.81. Buying and selling Australian dollars at the market price will leave you with no profit.
How much better than the market prices you can do depends on the degree of competition you face from other
traders and the extent to which your customers are willing to shop around to get better quotes.

b. What outright yen cross rates would you quote on 30-day forward Australian dollars?

ANSWER. Given the swap rates, we can compute the outright forward direct quotes for the yen and Australian dollar
by adding or subtracting the forward points as follows

Spot 30-day 30-day outright forward rates

¥78.04-58/A$1

These prices can be found as follows. For the yen bid price for the forward Australian dollar, we need to first sell
Australian dollars forward for U.S. dollars and then sell the U.S. dollars forward for yen. It costs a$1.2970 to buy
U.S. $1 forward. With U.S. $1 we can buy ¥101.22. Hence, A$1.2970 = ¥101.22, or A$1 = ¥78.04. This is the yen
bid price for the forward Australian dollar.

The yen ask price for the Australian dollar can be found by first selling yen forward for U.S. dollars and then using
the U.S. dollars to buy forward Australian dollars. Given the quotes above, it costs ¥101.72 to buy U.S. $1, which
can be sold for a$1.2944. Hence, A$1.2944 = ¥101.71, or A$1 = ¥78.58. This is the yen ask price for the forward
Australian dollar.

c. What is the forward premium or discount on buying 30-day Australian dollars against yen delivery?

ANSWER. As shown in parts a and b, the ask rate for 30-day forward Australian dollars is ¥78.58 and the spot ask
rate is ¥78.81. Thus, the Australian dollar is selling at a forward discount to the yen. The annualized discount equals
-3.43%, computed as follows:
Forward premium Forward rate Spot rate 360 78.58 - 78.81 360
= x = x = - 3.43%
or discount Spot rate Forward contract 78.81 30
number of days

9. Suppose Air France receives the following indirect quotes in New York: €0.92 - 3 and £0.63
- 4. Given these quotes, what range of £/ € bid and ask quotes in Paris will permit arbitrage?

ANSWER. Triangular arbitrage can take place in either of two ways: (1) Convert from euros to
dollars (at the ask rate), then from dollars to pounds (at the bid rate), or (2) convert from pounds
to dollars (at the ask rate), then from dollars to euros (at the bid rate). The first quote will give us
the bid price for the euro in terms of the pound and the second quote will yield the ask price.
Using the given rates, Air France would end up with the following amounts:

(1) Euros to pounds= €/$ (ask) x $/£ (bid)

(2) Pounds to euros= £/$ (ask) x $/ € (bid)

The import of the figures in method (1) is that Air France can buy pounds in New York for
€1.4762/£, which is the equivalent of selling euros at a rate of £0.6774/ €. So, if Air France can
buy euros in Paris for less than £0.6774/ € (which is the equivalent of selling pounds for more
than €0.6774/£), it can earn an arbitrage profit. Similarly, the figures in method (2) tell us that
Air France can buy euros in New York at a cost of £0.6957/ €. Given this exchange rate, Air
France can earn an arbitrage profit if it can sell these euros for more than £0.6957/FF in Paris.
Thus, Air France can profitably arbitrage between New York and Paris if the bid rate for the euro
in Paris is greater than £0.6957/ € or the ask rate is less than £0.6774/ €.

10. On checking the Telerate screen, you see the following exchange rate and interest rate
quotes:

Currency 90-day interest rates Spot rates 90-day forward rates

a. Can you find an arbitrage opportunity?

ANSWER. Yes. There are two possibilities: Borrow dollars and lend in Swiss francs or borrow
Swiss francs and lend in dollars. The profitable arbitrage opportunity lies in the former: Lend
Swiss francs financed by borrowing U.S. dollars.

b. What steps must you take to capitalize on it?

ANSWER. Borrow dollars at 1.2575% for 90 days (5.03%/4), convert these dollars into francs at
the ask rate of $0.722, lend the francs at 0.785% for 90 days (3.14%/4), and immediately sell the
francs forward for dollars at the buy rate of $0.726.

c. What is the profit per $1,000,000 arbitraged?

ANSWER. The profit is $1,000,000 x [(1.00785/0.722) x 0.726 - 1.012575] = $858.66.