FINA3326 APPLIED FINANCIAL MANAGEMENT
TUTORIAL QUESTIONS 04
Prepare for Week 05 Discussion

For the tutorial prepare questions 1 to 8.
Chapters 4, 5 and 7 questions are for revision.


1. One year interest rates on Euros are at 4.23% and Swiss Francs are at 2.89%. The CHF is selling at
a one-year forward premium of 1.6%. Show whether or not there is an investment opportunity?
What types of transaction costs would likely affect this?

2. Quoted six-month nominal interest rates in Europe are 4.54% In the U.S. they currently sit at 5.33%.
The current spot price of the EUR is EUR / USD 1.3405. Assuming interest rate parity is holding,
what will the 6-month forward rate be on the EUR?

3. Suppose that three month interest rates in Australia are 7.66% for borrowing and 5.66% for lending
and in New Zealand they are 8.63% for borrowing and 6.63% for lending. If the current spot rate
is 1.1578 / 1.1601 AUD / NZD and the current three-month forward rate is 1.020 / 1.046 AUD /
NZD.

a) Would investors in either Australia or New Zealand be likely to invest overseas?
b) As an arbitrageur where would you borrow?
c) Assuming no additional transaction costs, what percentage arbitrage profit could be generated
(Calculate as a percentage of your initial borrowings)?

4. On August 16, the spot quotation on the pound was GBP / USD 1.9833 with the September futures
contract closing at 1.9843. Yet on the 1st August the pound was valued at around GBP / USD 2.04.
What do you think has happened to the price of the September pound futures contract over the
month of August? Why?

5. The 3-month forward bid price on August 20 for the EUR is 1.4622, at the same time the price of
IMM Euro futures for delivery on December 7th is 1.4403. How could a speculator or arbitrageur
profit from this situation? What will be the profit per futures contract (size is €125,000)? In
attempting to exploit this, what issues must be addressed?

6. Imagine you find the following two quotes available to you from two retail currency dealers, one
in Zurich, one in London:
• GBP / CHF 1.7275 / 1.7990
• CHF / GBP 0.5565 / 0.5798
Assuming no additional transaction costs, is there an arbitrage opportunity, and if so what
percentage return can you generate?







7. Using the following quotations in the interbank market, calculate any triangular arbitrage profit
opportunities. If so, what percentage return can you generate?

EUR / GBP 0.8622 / 0.8624
EUR / USD 1.4150 / 1.4152
GBP / USD 1.6456 / 1.6459

8. Would you be more likely to find triangular arbitrage opportunities in either retail or interbank
markets? What barriers would exist that would prevent triangular arbitrage opportunities? Can
triangular arbitrage exist in an efficient market?


REVISION QUESTIONS
Chapter 4

20. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot
rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist:

Lending Rate Borrowing Rate
U.S. dollar 8.0% 8.3%
Mexican peso 8.5% 8.7%

Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peos in the
interbank market, depending on which currency it wants to borrow.

a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited
funds? Estimate the profits that could be generated from this strategy.

b. Assume all the preceding information with this exception: Blue Demon Bank expects the peso to
appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on its
expectations without using deposited funds? Estimate the profits that could be generated from this strategy.

21. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the dollar from its spot rate
of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist:
Lending Rate Borrowing Rate
U.S. dollar 7.0% 7.2%
Singapore dollar 22.0% 24.0%

Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds
in dollars for 60 days. Estimate the profits (or losses) that could be earned from this strategy. Should Diamond
Bank pursue this strategy?







Chapter 5


27. Currency Straddles. Reska, Inc., has constructed a long euro straddle. A call option on euros with an exercise
price of $1.10 has a premium of $.025 per unit. A euro put option has a premium of $.017 per unit. Some
possible euro values at option expiration are shown in the following table. (See Appendix B in this chapter.)

Value of Euro at Option Expiration
$.90 $1.05 $1.50 $2.00
Call
Put
Net

a. Complete the worksheet and determine the net profit per unit to Reska Inc. for each possible future spot
rate.
b. Determine the break-even point(s) of the long straddle. What are the break-even points of a short straddle
using these options?

28. Currency Straddles. Refer to the previous question, but assume that the call and put option premiums are $.02
per unit and $.015 per unit, respectively. (See Appendix B in this chapter.)

a. Construct a contingency graph for a long euro straddle.
b. Construct a contingency graph for a short euro straddle.



Chapter 7

2. Locational Arbitrage. Assume the following information:
Beal Bank Yardley Bank
Bid price of New Zealand dollar $.401 $.398
Ask price of New Zealand dollar $.404 $.400

Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage,
and compute the profit from this arbitrage if you had $1,000,000 to use. What market forces would occur to
eliminate any further possibilities of locational arbitrage?

4. Triangular Arbitrage. Assume the following information:
Quoted Price
Value of Canadian dollar in U.S. dollars $.90
Value of New Zealand dollar in U.S. dollars $.30
Value of Canadian dollar in New Zealand dollars NZ$3.02
Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect triangular
arbitrage, and compute the profit from this strategy if you had $1,000,000 to use. What market forces would
occur to eliminate any further possibilities of triangular arbitrage?








6. Covered Interest Arbitrage. Assume the following information:

Quoted Price
Spot rate of Canadian dollar $.80
90-day forward rate of Canadian dollar $.79
90-day Canadian interest rate 4%
90-day U.S. interest rate 2.5%

Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest
arbitrage? (Assume the investor invests $1,000,000.) What market forces would occur to eliminate any further
possibilities of covered interest arbitrage?

9. Interest Rate Parity. Explain the concept of interest rate parity. Provide the rationale for its possible existence.

21. Deriving the Forward Rate. Assume that annual interest rates in the U.S. are 4 percent, while interest rates in
France are 6 percent.

a. According to IRP, what should the forward rate premium or discount of the euro be?
b. If the euro’s spot rate is $1.10, what should the one-year forward rate of the euro be?

30. Testing IRP. The one-year interest rate in Singapore is 11 percent. The one-year interest rate in the U.S. is 6
percent. The spot rate of the Singapore dollar (S$) is $.50 and the forward rate of the S$ is $.46. Assume zero
transactions costs.

a. Does interest rate parity exist?

b. Can a U.S. firm benefit from investing funds in Singapore using covered interest arbitrage?

32. Triangular Arbitrage. You go to a bank and are given these quotes:

You can buy a euro for 14 pesos.
The bank will pay you 13 pesos for a euro.

You can buy a U.S. dollar for .9 euros.
The bank will pay you .8 Euros for a U.S. dollar.

You can buy a U.S. dollar for 10 pesos.
The bank will pay you 9 pesos for a U.S. dollar.

You have $1,000. Can you use triangular arbitrage to generate a profit? If so, explain the order of the
transactions that you would execute, and the profit that you would earn. If you can not earn a profit from
triangular arbitrage, explain why.

40. Interpreting Forward Rate Information. Assume that interest rate parity exists. The 6-month
forward rate of the Swiss franc has a premium while the 12-month forward rate of the Swiss franc has a
discount. What does this tell you about the relative level of Swiss interest rates versus U.S. interest rates?

42. Profit from Covered Interest Arbitrage. Today, the one-year U.S. interest rate is 4%,
while the one-year interest rate in Argentina is 17%. The spot rate of the Argentine peso (AP) is $.44.
The one-year forward rate of the AP exhibits a 14% discount. Determine the yield (percentage return on
investment) to an investor from Argentina who engages in covered interest arbitrage.