finance arbitrage homework

Week 8 Chapter 7 and 8: Case Study 4

1. Beal Bank Yardley Bank

Bid price of Swiss Franc $.201 $.198

Ask price of Swiss Franc $.204 $.200

Given this information, is locational arbitrage possible? Explain why.

2. Beal Bank Yardley Bank

Bid price of Malaysian Ringitt $.705 $.709

Ask price of Malaysian Ringitt $.706 $.710

Given this information, is locational arbitrage possible? Explain Why. What is the profit made on this

transaction if you have $10,000 U.S. dollars and purchase and sell Ringitt using locational arbitrage?

3. Triangular Arbitrage. Assume the following information:

Quoted Price

Value of Canadian dollar in U.S. dollars $1.20

Value of Mexican Peso in U.S. dollars $.30

Value of Canadian dollar in Mexican pesos MX$4.02

Given this information, is triangular arbitrage possible? Explain why. What is the profit earned if you have

$10,000 U.S. dollars and purchase and sell MX dollars using triangular arbitrage?

4. Covered Interest Arbitrage. Assume the following information about a possible investment in Germany

using Euros:

Quoted Price

Spot rate of the Euro $.84

90day forward rate of Euro $.83

90day Euro interest rate 5%

90day U.S. interest rate 3.5%

Given this information, what would be the yield (in dollars) to a U.S. investor who used covered interest

arbitrage? (Assume the investor invests $1,000,000)

5. (a) Using the information from question 4, calculate the Interest Rate Parity using the formula below:













1

1

1

where

forward premium

home interest rate

foreign interest rate

h

f

h

f

i

p

i

p

i

i

What was the result? What does it mean, explain in detail using the terms in learn in chapter 7.

(b) Use the information from question 4, calculate the forward premium or discount.















where

forward premium (or discount)

forward rate in dollars

spot rate in dollars

home interest rate

foreign interest rate

hf

h

f

FS

pii

S

p

F

S

i

i

Compare it to the Interest Rate Parity. Is this a profitable covered interest arbitrage? Why or Why not?

(c) Using the information from question 4, calculate if a profit can be made if the forward rate was $.81.

Calculate the Forward premium discount. What have you learned when you compare it to the previous IRP and

Forward Premium (discount). Explain in detail.

In chapter 8 we learn about Purchasing Power Parity and International Fisher Effect. Define each concept in

detail and then use these concepts to forecast the movements of the following spot rates:

6. Estimating Depreciation Due to PPP. Assume that the spot exchange rate of the British

pound is $1.73. How will this spot rate adjust according to PPP if the United Kingdom

experiences an inflation rate of 7 percent while the United States experiences an inflation rate of

2 percent?

7. Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate of the Singapore

dollar is $.70. The oneyear interest rate is 11 percent in the United States and 7 percent in Singapore. What

will the spot rate be in one year according to the IFE? Which force causes the spot rate to change according to

the IFE?

8. Capital Budgeting: Two managers of Marshall, Inc. want to explore an opportunity to establish a subsidiary

in Jamaica. They have a new technology they currently own, a patent that expires in 3 years, the conversion

process of recycled plastic and rubber materials to rubber socks. The rubber socks can be used when walking

and doing water activities on beaches and water parks. Jamaica has a lucrative tourism market with millions of

local and international beach goers in need of rubber socks. Marshall, Inc. has marketed these socks as Aqua

socks and want to start a business in Jamaica called Aqua Socks Limited. The patented technology includes a

machine that converts the recycled materials to the final product at a low cost per unit. One of the managers,

Frank, has researched the costs and estimated the demand shown below in Jamaican dollars and believes, high

demand and a high salvage rate of JM$24,000, will result in maximizing shareholder wealth. The other

manager, Serena, is however concerned about the implications of the exchange rate of Jamaican dollars to US

dollars and would rather invest in a country with an equal exchange that also has a lucrative tourism market.

Revenue

Initial investment: US$ 34,000

Price and consumer demand:

Year 1: 13,250 units @ JM$400.00/unit

Year 2: 14,750 units @ JM$400.00/unit

Year 3: 25,500 units @ JM$400.00/unit

Costs

Variable costs: JM$0.20/unit year 1, JM$0.30/unit year 2, and JM$0.50/unit year 3

Annual Fixed costs: JM$1,000 per year

Other Annual Fixed costs: JM$100

Depreciation: JM$200.00

Tax laws: 2% corporate income tax

Remitted funds: 1% withholding tax on remitted funds

Exchange rates: Spot exchange rate of $0.0067 for Jamaican dollar

Salvage values: JM$24,000 thousand

Required rate of return: 12%

1. Using the information provided above and the table below, calculate the cumulative net present value (NPV)

of the project over 3 years in Jamaica.

(a) Will the project add to shareholder wealth or should they pursue the project in another host country?