Chapter III

INTEREST PARITY

PROBLEMS

Problem 1

The following quotes are available.

Spot : Yen 122 / $

Interest rates ( 3 months ) : $ - 6.0% Yen - 2.0%
Interest rates ( 6 months ) : $ - 7.0% Yen - 2.5%

Calculate the 3 month and 6 month forward rates.

Solution

In this case, since transaction costs are nil, the problem is fairly straight forward. We
assume of course that interest parity holds good.

$1 will fetch returns of $ (1) (1 + .06 / 4) = $ 1. 015 after 3 months.

$1 is equivalent to yen 122 based on the spot rate given.
Yen 122 will fetch returns of yen (122) (1 + .02 / 4) = Yen 122. 61 after 3 months.

Hence, applying interest parity, we get :

3 month forward rate = 122.61 / 1.015 = Yen 120.80 / $

If we invest $ 1 for 6 months, we would get returns of $ (1) (1 + .07/2) = $ 1. 035

$ 1 is equivalent to Yen 122.

Yen 122 will give a return of Yen (122) (1 + .025 / 2) = Yen 123.53 after 6 months.
Applying interest parity condition, we get :
3 month forward rate = 123.53 / 1.035 = Yen 119.35 / $

Problems 2

A customer obtains the following quotes :

Spot Rs / $ : 35.00 / 35.10

6 month $ interest rates : 5% - 5.5 %
6 month Re interest rates : 10% - 11%
What do you think will be the likely six month forward quote ?

Solution

The points to be noted here are that the more adverse rate will be applicable when we try
to sell or buy a currency. Also, when investing, we will get a lower rate of interest and
while borrowing we will have to pay a higher rate of interest.

Assume the customer borrows $ 100 for 6 months.

At the end of six months, he will have to repay the principal with interest. Borrowing is
possible only at the higher rate of 5.5%.

So, interest payable = $ 100 (.055/2) = $ 2.75

Total repayment after 6 months = $ 100 + 2.75 = $ 102.75
If he converts the dollars into rupees, he would obtain Rs (100) (35) = Rs 3500.

Since the loan has to be repaid only after 6 months, he can invest Rs 3500 in the money
markets. When he invests, he will only get the lower interest rate, ie 10%.

Interest earned = Rs 3500 (.10/2) = Rs 175

Total returns after 6 months = Rs 3500 + Rs 175 = Rs 3675

Since the repayment has to be made in dollars, the customer has to convert the rupee
returns into dollars.

If interest parity holds, repayment must equal borrowings.

So, $ 102.75 = Rs 3675
or $1 = 3675 / 102.75 = Rs 35.77

Now assume that the customer borrows Rs 100 for 6 months.

After 6 months, he will have to repay 100 (1+. 11/2) = Rs 105.5 as the interest rate
applicable for borrowing is 11%.

The customer can convert Rs into dollars and invest for 6 months as he has to repay the
loan only after 6 months. The interest earned will be 5%.

Returns earned = $ (100 / 35.1 ) ( 1 + .05 / 2 ) (F) = $ (2.92) (F)

Repayment = Rs 105.5

Equating repayment and borrowing, we get :

F = 105.5 / 2.92 = 36.13
Hence, the forward rates are likely to be
Rs / $ : 35.77 / 36.13

If the customer is smart, he will appreciate that the bank is likely to charge a commission.
Let us say this is 1%.

In that case, the bid rate will be (35.77) ( 1- .01) = 35.41

The offer rate will be (36.13) ( 1 + .01 ) = 36.49

So the quote will be : Rs/$ : 35.41/36.49

The effect of the bank’s commission is to widen the spread.

Problem 3

The following quotes have been obtained :

Spot Rs / $ : 35.10/35.30
3 month forward : Rs / $ : 35.50/35.80
3 month Re interest rates : 16% - 17%
What are the conditions under which arbitrage is ruled out ?
Solution

The points to be noted here are that the more adverse rate will be applicable when we try
to sell or buy a currency. Also, when investing, we will get a lower rate of interest and
while borrowing we will have to pay a higher rate of interest.

Assume a trader borrows Rs 100 for 3 months. After 3 months, he will have to repay 100
( 1 + .17/4 ) = Rs 104.25 since the higher rate of interest has to be paid while borrowing.

Since the trader can utilise the borrowed funds for 3 months, he can convert into dollars,
invest and then sell the proceeds forward.

On converting Rs 100, the trader will receive (100) / (35.30) = $ 2.833

He can invest the dollars so obtained at an interest rate of say, i. In that case, he can hope
to get $ (2.833) (1+i/4) after 3 months. When he converts into rupees, he will obtain
(35.5) (2.833) (1+i/4) = 100.56 (1+i/4)

Arbitrage is ruled out when repayment exceeds the investment returns.

This means, Rs 104.25 > (100.56) (1+i/4) or i < 14.67%

Now assume that the trader borrows $ 100. Let the interest rate applicable be i. In this
case, he has to repay $ (100) (1 + i / 4) after 3 months.

If he converts the dollars borrowed into rupees, invests for 3 months and sells forward the
rupee earnings for dollars, he would get :

(100) (35.10) (1 + .16/4) / ( 35.80 ) = Rs 101.97

To prevent arbitrage, repayment must exceed borrowing. This means that (100) (1 + i/4)
> 101.97 or i > .0786.

Thus, the necessary condition for preventing possibilities of arbitrage is that dollar
interest rate, i should be within the range 7.86% - 14.67%.

Problem 4

The following quotes are available for DM, $ and KD (Kuwaiti Dinar)

Spot (DM/$) : 1.51 /1.52

Spot (KD/$) : .27 / .28

The 3 month interest rates are as follows.

DM - 5. 75 % - 6.00 %
KD - 11.25 % / 11.75 %

Calculate the 3 month forward rates if banks charge a margin of 1%.

Solution

The points to be noted here are that the more adverse rate will be applicable when the
bank tries to sell or buy a currency. Also, when investing, the bank will get a lower rate
of interest and while borrowing it will have to pay a higher rate of interest.

If a bank has to sell Kuwaiti Dinars to the client, it will have to obtain KD by first selling
DM for $ and then $ for KD.

If the bank sells DM 1.52, it will get $1.

If it sells $1, it will obtain KD .27.
Thus, one has to sell DM 1.52 to obtain KD .27
So, the spot offer rate is 1.52 / .27 = 5.63 DM/KD

If the bank purchases KD from the client, it will have to eliminate its exposure by first
selling KD for $ and then selling $ for DM.

If it sells KD . 28, it will get $1.

If it sells $1, it will obtain DM 1.51.
So, the bid exchange rate applicable is 1.51/.28 = 5.39 DM / KD.
Thus, the spot quote is 5.39/5.63.

From the above spot rates, calculation of forward rates using interest parity is a fairly
straightforward process.

Suppose, the bank borrows DM 100.

After 3 months, it will have to repay DM (100) (1 + .06/4) = DM 101.5
If we convert into KD, it gets KD 100 / 5.63

If it invests the KD so obtained, it will get returns of :

100 / 5.63 ( 1 + .1125 / 4) ( F ) = (18.26 ) ( F )

Under interest parity conditions, 18.26 F = 101.5 DM

So, F = 101.5 / 18.26 = DM 5.56 / KD

Assume the bank borrows KD 100

It will have to repay 100 ( 1 + .1175 / 4) = KD 102.94 after 3 months.
If we convert into DM, we get : DM (100) (5.39) = KD 539.
By investing DM, the bank can earn DM 539 (1+ .0575/4) = DM 546.75.
If F is the forward rate and we apply interest parity principle, we get :

102.94 = 546.75/F
or F = 546.75 / 102.94 = 5.31 DM/KD.
Thus, the forward rates are DM/KD : 5.31 / 5.56
If we apply a margin of 1%, we get
Bid rate = ( 5. 31 ) (1 - .01) = 5.26 DM/KD
Offer rate = ( 5.56 ) ( 1 + .01) = 5.62 DM/KD
So, the bank will quote forward rates as given below :
DM/KD : 5.26 / 5.62

Problem 5

An Indian exporter has obtained the following quotes from his bank.
Rs / Spot : 58.35 / 59.51
Three month interest rates : $ : 6.38 - 6.50%
Re : 12.50 - 13.00%
What are the expected spot rates after three months. ?

Solution

We can use the principle of interest parity to work out the spot rates after three months.

Suppose the exporter borrows Rs 100 for three months.

If the exporter converts Rupees into sterlings, he would obtain 100 / 59.51 = £ 1.680.

Since repayment of loan has to be made only after three months, the exporter can invest
sterlings at a rate of 6.38%. In that case, the investment would yield (1.680) (1 + .0638 /
4) = £ 1.707 after three months.

The loan repayment after three months would be (100) (1 + 0.13 /4) = Rs 103.25

If interest parity holds good, £ 1.707 = Rs 103.25

Thus, the three month offer rate for the rupee = 103.25 / 1.707 = Rs 60.49 / £.

Suppose the exporter borrows £100.

If he converts into rupees, he can obtain (100) (58.35) = Rs 5835. This amount can be
invested for three months to fetch (5835) (1+ 0.125/4) = Rs 6017.34 after three months.
Loan repayment = (100) ( 1 + .065/4) = £ 101.625.

If interest parity holds, Rs 6017.34 = £ 101.625.

So, the three month forward bid rate = 6017.34/ 101.625 = Rs 59.12 / £

Hence the expected spot rates after three months will be Rs / £ : 59.21 / 60.49

Problem 6

In April 1997, the following rates were being quoted.

Rs / $ Spot : 35.68 / 36.03
Three month forward : 0.40 / 0.50
Three month interest rates : $-6.0 %, Re-12.0%
Test for interest parity.

Solution

Suppose we borrow Rs 100 for three months.

We have to repay (100) ( 1+0.12/4) = Rs 103 after three months.
If we convert into dollars, we could obtain $ 100/36.03 = $ 2.775
This can be invested for three months to yield (2.775) (1+0.06/4) = $2.817.

Hence if arbitrage is to prevented, $2. 817 = Rs 103.

So, the forward offer rate should be 103/2.817 = Rs 36.56/$.

Suppose we borrow $100 for three months.

We would have to repay (100) (1+ .06/4) = $ 101.5 after three months.

By selling $100, we can obtain (100) (35.68) = Rs 3568.

This can be invested at 12% to get (3568) (1+.12/4) = Rs 3675.04 after three months.

If arbitrage is to be prevented, repayment should equal borrowings.

So, Rs 3675.04 = $ 101.5

Hence, the forward bid rate should be 3675.04 / 101.50 = Rs 36.21 / $

Thus, if interest parity holds, the three month forward rates should be Rs/$ : 36.21/36.56.
But we are given that the forward rates are 36.08/36.53 (obtained by adding the swap
points to the spot rate). Hence, interest parity conditions are violated.
Problem 7

An Indian bank obtains the following quotations :

Rs. / $ Spot : 35.70 / 36.05

3 month Swap : 50/65
6 month Swap : 105/130

The interest rates are as follows:

$ : 3 month LIBOR - 5.5% 6 month LIBOR - 5.75%

Rs : 3 month LIBOR - 11% 6 month LIBOR - 12.00%

The bank can access Rupee or dollar funds. If the bank needs funds immediately for the
next six months where should it borrow if it does not want to have any foreign exchange
exposure ?

Solution

Suppose the bank borrows in $

Repayment for every $ after 6 months = (1) (1 + 0.0575 / 2)
= $1.02875

To obtain $1.02875 after 6 months, it will need to sell (1.02875) (37.35) = Rs. 38.4238

If the bank borrows in rupees, the equivalent of $1 is Rs. 36.05.

Repayment after 6 months = (36.05) (1+ 0.12/12)

= Rs. 38.2130

So, it is cheaper to borrow Rupees.

Problem 8

In the above problem, if the borrower has to be indifferent between 3 month and 6 month
Rupee loans, what should the interest rates be after 3 months for 3 months ?

Solution

Suppose the bank borrows Rs. 1000 for 6 months.

It will have to repay 1000 ( 1 + 0.12/12) = Rs. 1060 after 6 months

If it borrows for 3 months, it will have to repay 1000 ( 1+ 0.11 / 4 ) = Rs. 1027.5 after 3
months.

If 3 month interest rate at that point of time = i, then repayment at the end of six months
= (1027.50) (1 + i/4). If the borrower has to be indifferent between 3 month and 6 month
borrowing, 1060 = (1027.50 (1+i/4) or i = 12.65%

Problem 9

In April, 1997 the following rates were being quoted :

SF/$ : 1.4854 / 1.4900 (Spot)

25 / 15 (3 month forward)

The three month interest rates were :

$ : 5.80/5.90
SF : 1.90/2.00

Explain how a trader could take advantage.

Solution

From the figures, we can see that the interest differential appears to be far more than the
forward premium on SF. This suggest SF borrowing.

Suppose the trader borrows SF 1000 for three months

Repayment after three months = (1000) (1 + 0.0200/4) = 1005

If he converts SF 1000 into $, he would obtain 1000/1.49 = $671.14

This can be invested at 5.80% for three months to fetch (671.14) (1+0.058/4) = $680.87

The forward rates, obtained by subtracting swap points from the spot rates are : 1.4829 /
1.4885

So, SF obtained by selling forward $680.87 = (680.87) (1.4829)

= SF 1009.66

This means a profit of SF 4.66 on SF 1000

Hence, returns = 4.66/1000 x 12/3 x 100 = 1.86%

Problem 10

In April, 1997, the following rates were being quoted.

DM/$ : 1.7385/1.7395 Spot

SF/$ : 1.4850/1.4860 Spot
DM/$ : 1.7395/1.7410 3 months forward
SF/$ : 1.4840/1.4850 3 months forward

The three month interest rates are :

DM : 3.20/3.25%
SF : 1.90/1.95%
Explain how a trader can take advantage of the situation.

Solution

We work out the cross rates.

Suppose we sell DM 100 spot. We get 100/1.7395 = $57.49

If we sell $ 57.49 spot, we get (57.49) (1.4850) = SF 85.37

So, spot rate = 85.37/100 = SF 0.8537/DM

Suppose we sell SF 100 spot. We get 100/1.4860 = $67.29

If we sell $67.29, we get (67.29) (1.7385) = DM 116.98

So, spot rate = SF 100/116.98 = SF 0.8548/DM

So spot cross rates (SF/DM) are 0.8537/0.8548

Similarly, we can work out the forward cross rates as follows:

Sale of DM for SF : 1.4840/1.7410 = SF 0.8524/DM

Sale of SF for DM : 1.4850/1.7395 = SF 0.8537/DM

So the forward cross rates (SF/DM) are 0.8524/0.8537

Suppose we borrow SF 100 for three months

We have to repay 100 (1 + 0.0195/4) = SF 100.49

We can convert SF 100 into DM (100) / (0.8548) = DM 116.98, spot

If we invest DM 116.98 for three months we get (116.98) (1+0.0320/4) = 117.92 DM

We can sell forward at an exchange rate of SF 0.8524/DM to get (117.92) (0.8524) = SF

100.51

So, a marginal arbitraging profit can be made by borrowing in SF and investing in DM.

Problem 11

You have obtained the following information from your banker.

Rs/Can $ Spot : 25.50
Six month forward : 26.00

If free capital flows are allowed and the six month rupee rate of interest is 15%, what
should be the rate of interest on the Canadian $ ?

Solution

Suppose we borrow Rs 100 and convert into Can $.

Can $ obtained = 100/25.50.

If we invest this amount for six months, we can get (100 / 25.50) (1 + i / 2) where i is
the interest rate. This amount however will have to be sold forward at Rs 26.00/Can$ to
get rupees that would enable us to repay the loan which we had taken.

The loan repayment will be 100(1 + 0.15/2) = Rs 107.5

If riskless arbitrage is to be prevented, repayment should equal borrowing.

So, (100 / 25.50) ( 1 + i/2) (26.00) = 107.50

or i = 0.1087 = 10.87%
Problem 12

You have obtained the following information from your banker.

Rs/Can $ Spot : 25.00/26.00
Six month forward : 25.50/26.50
Six month rupee interest rate : 15%

What should be the interest rate on Can $ to eliminate arbitraging possibilities ?

Solution

Suppose we borrow Rs 100.

By converting, we can obtain Can$ 100/26.00

Investing this amount for six months will fetch us Can$ ( 100 / 26 ) ( 1 + i / 2 ) where i
is the investment rate of interest on the Can$.

Since we have to repay the rupee loan, we have to sell this amount forward at Rs 25.50.

The loan repayment will be (100) ( 1 + .15/2) = 107.50

To prevent arbitrage, repayment should exceed borrowing.
So, (100/26) (1+i/2) (25.50) <= 107.50
i <= 19.22%

Suppose we borrow Can$ 100. By converting, we can obtain Rs (100) (25.00). Investing
this amount for six months, we can get (100.00) (25.00) (1 + 0.15/2). If we convert this
amount back to Can$, we would obtain Can$ (100) (25.00) (1 + 0.15/2) / (26.50).

Meanwhile, we have to pay Can$ (100) (1 + i/2) to settle the loan liability where i is the
borrowing rate of interest.

To prevent arbitrage, repayment must exceed the investment returns.

or (100) (1+i/2) >= (100) (25) (1+0.15/2) / 26.50
or i >= .0283
or i >= 2.83%

Thus, we find that when i is between 2.83% and 19.22%, arbitrage is not possible.

Problem 13

If in the previous problem, the bank has quoted the following interest rates, and the spot
and forward exchange rates remain the same, rework the interest rate on Can$ to prevent
arbitrage.

Re interest rates : 14% - 16%

Solution

Suppose we borrow Rs 100.

Converting this amount into Can$ and investing for 6 months will fetch us Rs
(100/26.00) (1 + i/2) (25.50)
Loan repayment = 100 (1 + 0.16/2)

To prevent arbitraging, repayment must exceed the returns obtained from the investment.
or (100) ( 1 + 0.16/2) >= (100/26) ( 1 + i/2) (25.50)
or 0.2023 >= i
or i <= 20.23%

Suppose we borrow Can$ 100.

Converting into rupees and investing for 6 months will fetch us Can$ (100) ( 1 + 0.14 / 2
) / 26.50

Loan repayment = Can$ 100 ( 1 + i/2)

To prevent arbitrage,
100 ( 1 + i/2) >= (100) (25) (1 + 0.14/2) / (26.50)

Thus, we find that when i is between 1.89% and 20.23%, riskless arbitraging profits are
ruled out.

Problem 14

You are given the following information by your banker.

Spot ( Rs / Can$ ) : 25.00 / 26.00

Rupee Interest rate (6 months) : 14.00 / 16.00
Can$ Interest rates (6 months) : 9.00 / 11.00

Determine the six month forward rates.

Solution

Let F be the forward rate (Rs/Can$).

Suppose we borrow Rs 100 for 6 months.

Conversion into Can$ and investment for 6 months yields.

Rs (100 / 26.00) ( 1 + .09/2) (F)

Loan repayment = 100 (1 + 0.16/2)
To prevent arbitrage,
100 ( 1 + 0.16 / 2 ) >= ( 100 / 26.00 ) (1 + 0.9 / 2) ( F )
or 26.87 >= F
or F <= 26.87

Assume we borrow Can$100 for 6 months. conversion into Rs and investment for 6
months will yield :

Can$ (100) (25.00) (1 + 0.14/2) / F

Loan repayment = (100) ( 1 + 0.11 / 2)
To prevent arbitrage,
( 100 ) ( 1 + 0.11 / 2 ) >= ( 100 ) ( 25.00 ) (1 + 0.14 / 2 ) / F
or F >= 25.36

So, the 6 month forward quote will be Rs/Can$ : 25.36 / 26.87

Problem 15

You are given the following information by your banker.

Spot Rs/$ : 35.60 / 36.00

Rs/£ : 57.50 / 58.50
6 month forward Rs/$ : 36.20 / 36.70
Rs/£ : 58.10 / 59.20

6 month $ interest rates : 5.90 / 6.10

Compute the 6 month £ interest rates to prevent arbitrage.

Solution

We first work out the $/£ cross rates.

If we sell $ 1, we get Rs 35.60 spot. If we sell Rs 35.60 spot, we get £ 35.60 / 58.50

So, £ 1 = $ 1.6433

If we sell £ 1 we get Rs 57.50 spot.

If we sell Rs 57.50, we get $ 57.50 / 36.00

So, £ 1 = $ 57.50 / 36.00 = $ 1.5972

Thus, the spot quote is Rs / £ : 1.5972 / 1.6433

Similarly, we can work out the 6 month forward quote as :

$ / £ : 58.10 / 36.70, 59.20 / 36.20

= 1.5831 / 1.6354
Suppose we borrow $ 100.

To prevent arbitrage, the following condition must be satisfied 100 (1+ .061/2) >= [
(100) / (1.6433) ] (1 + i / 2 ) (1.5831) or .1394 >= i
or i <= 13.94%

Thus, we find that the interest rate on £ should be between 1.1% and 13.94% to prevent
arbitrage.

Problem 16

You are given the following exchange rates.

Spot ( Yen / $) : 122

3 month interest rates : DM - 4%; Yen - 3%
3 month forward rate : Yen 80 / DM
German inflation rate : 3%
US inflation rate : 5%
Calculate the 3 month DM / $ rate.

Solution

Let S be the spot rate ( Yen / DM )

Applying interest parity, we get :-

S ( 1 + .03/4) / ( 1 + .04/4) = 80
or S = Yen 80.20 / DM

Let F be the forward rate ( DM / $ )

Spot rate (DM / $ ) = Yen 122 / $ = DM 1.52 / $
Yen 80.20 / DM

Applying Purchasing Power Parity,

F = (1. 52) (1+ 0.03/4) / (1 + 0.05/4) = DM 1.51 / $

(We have of course assumed that PPP holds good even in the short run.)

Problem 17

You are given the following information.

 $ DM
3 month interest rates 6% 5%

6 month interest rates 5.5% 4.5%

3 month forward rate : DM 1.5500 / $

Calculate the 6 month forward rate.

Solution

Let S be the spot rate (DM / $)

Assuming interest parity holds good,

S ( 1 + 0.05 / 4 ) / ( 1 + 0.06 / 4 ) = 1.5500

or S = 1.5538

Let F be the six month forward rate

Applying interest parity,

F = (1.5538) (1+0.045/2) / (1+0.055/2)
= 1.5462

The required forward rate is DM 1.5462/$

Problem 18

You are given the following interest rates.

Re $
3 month 15% 6%
6 month 14.5% 5.5%
9 month 14.0% 5.0%

The 3 month forward rate is Rs. 36/$. Calculate the 3 month forward rate 6 months from
now.

Solution
Let S be the spot rate.

Applying interest parity, (S) (1+0 .15/4) = 36

(1+0.06/4)

=> S = Rs. 35.22 / $

Let F be the six month forward rate now.

Applying interest parity,

F = (35.22) (1+0.145/2) / (1+0.055/2)

= 36.76

We use expectations theory to determine 3 month interest rates 6 months from now. Let i
denote this interest rate.

Rupee interest rate is given by the equation

(1+0.145/2) (1+i/4) = (1+0.14x3/4)

=> i = 0.1212

$ interest rate is given by the equation

(1+0.055/2) (1+i/4) = (1+0.05x3/4)

=> i = 0.0389.

Applying interest parity, 3 month forward rate 6 months from now is given by (36.76) [ (1+0.12121/4) /
(1+0.0389/4) ] = Rs. 37.51 / $ (1+0.1212/4)

Note : In this case because of the absence of transaction costs, interest parity holds in
the strictest sense and the 3 month forward rate after 6 months is equal to the 9 month
forward rate today. Students can verify this for themselves.

Problem 19

An Indian company obtains the following quotes (Rs / $)

Spot : 25.90/36.10
3 month forward : 36.00 / 36.25
6 month forward : 36.10 / 36.40

The company needs $ funds for 6 months. If interest rates are as given below, determine
whether the company should borrow in $ or Rupees.

3 month interest rates : Rs - 12% $ - 6%

6 month interest rates : RS - 11.5% $ - 5.5%

Also determine what should be the 3 month interest rates after 3 months to make the
company indifferent between three month borrowing and six month borrowing in the case
of :-

i) Rupee borrowing
ii) Dollar borrowing

Solution

Suppose the company borrows $ for six months.

Repayment after six months = 100 (1 + 0.55/2) = $102.75

To repay this loan, the company has to sell
forward (102.75) (36.40) = Rs. 3740.10

Suppose the company borrows Rupees and converts into dollars.

In this case, rupees needed to generate $100 = (100) (36.10)

= Rs. 3610

Repayment of loan after 6 months = (3610) (1+.115/2)

= Rs. 3817.58

So, it is cheaper to borrow in $ rather than in rupees.

Suppose the company borrows Rs. 100 for 3 months and rolls over the loan at the rate of
interest prevailing after 3 months, for another 3 months. To make the company indifferent
between three month and six month borrowing, we equate the repayment involved in the
two cases.

100 ( 1 + .12/4) ( 1 + i/4 ) = 100 (1 + .115/2 )

or i = 10. 68%

Suppose the company borrows $100 for 3 months and rolls over the loan at the rate of
interest prevailing after 3 months at the then prevailing rate of interest for another 3
months. To make the company indifferent between three month and six month borrowing,
we equate the repayments involved in the two cases.
 100 ( 1 + 0.055/2) = 100 ( 1 + 0.06/4 ) ( 1 + i/4 )
or i = 4.93%

Problem 20

You have seen the following newspaper quotes.

Rs/$ Spot : 36.00 / 36.50

3 months : Re interest rate - 14% $ interest rate - 6%

The spread is likely to increase at the rate of 10 points per month. Estimate the three
month expected spot rate.

Solution

Currently, the mid rate = (36.00 + 36.50 ) / 2 = 36.25

Using interest parity, the expected three month forward mid rate

( 1 + .14/4 )
= (36.25) ------------------ = Rs. 36.96 / $
( 1 + .06/4 )
At present spread = 50 points

Spread after three months = 50 + (3) (10) = 80 points

So, three month bid rate = 36.96 - .40 = 36.56

three month offer rate = 36.96 + .40 = 37.36

Hence the three month quote is likely to be 36.56 / 37.36

Problem 21

You have collected the following information from the newspaper

Spot (Rs / £) : 61.00 / 61.50

6 month interest rate : £ - 7% Re - 14%

The spread is likely to increase at the rate of 10 points per month. Estimate the spot rate
after 6 months.

Solution

Currently, the mid rate = 61.25

Based on interest parity, the expected mid rate after 6 months can be worked out.

(61.25) (1 + .14 / 2)
Expected mid rate = ----------------------------------- = 63.32
( 1 + .07 / 2 )
Currently, spread = 50 points

After 6 months, spread = 50 + (6) (10) = 110 points

So, bid rate after 6 months = 63.32 - .55 = 62.77

Offer rate after 3 months = 63.32 + .55 = 63.87

Hence, the expected quote after 6 months is 62.77 / 63.87