Podcast
Questions and Answers
What is the computed 90-day forward exchange rate based on the provided calculations?
What is the computed 90-day forward exchange rate based on the provided calculations?
- $1.45/£
- $1.50/£
- $1.5400/£
- $1.4464/£ (correct)
What would be the outcome if the quoted forward exchange rate is $1.50/£?
What would be the outcome if the quoted forward exchange rate is $1.50/£?
- A profit is guaranteed by purchasing British pounds in the forward market.
- The forward rate indicates a strong expectation for pound depreciation.
- No action would be necessary as it reflects the true market value.
- An arbitrage opportunity would exist due to F90 being too high. (correct)
Which step is involved in the arbitrage strategy when F90 is too high?
Which step is involved in the arbitrage strategy when F90 is too high?
- Borrow British pounds at the forward rate.
- Convert pounds back to dollars immediately after borrowing.
- Sell dollars in the spot market to avoid losses.
- Convert dollars to pounds and lend at the interest rate. (correct)
What total amount in dollars would need to be repaid after borrowing $1 at the rate indicated after 90 days?
What total amount in dollars would need to be repaid after borrowing $1 at the rate indicated after 90 days?
How much profit would be pocketed from the arbitrage opportunity described?
How much profit would be pocketed from the arbitrage opportunity described?
What was one significant finding of the research conducted by Akram, Rime, and Sarno in 2008 regarding covered interest rate parity (CIRP)?
What was one significant finding of the research conducted by Akram, Rime, and Sarno in 2008 regarding covered interest rate parity (CIRP)?
Since the global financial crisis (GFC), what has been noted about covered interest rate parity?
Since the global financial crisis (GFC), what has been noted about covered interest rate parity?
Mark Taylor's research in 1987 primarily supported which hypothesis in relation to covered interest parity?
Mark Taylor's research in 1987 primarily supported which hypothesis in relation to covered interest parity?
What aspect of covered interest rate parity was highlighted as a reason for previously undetected violations according to Akram, Rime, and Sarno?
What aspect of covered interest rate parity was highlighted as a reason for previously undetected violations according to Akram, Rime, and Sarno?
Which period marked the beginning of the era of 'freely' floating exchange rates?
Which period marked the beginning of the era of 'freely' floating exchange rates?
What assumption must hold for two portfolios with identical payoffs and equal risk to have the same price?
What assumption must hold for two portfolios with identical payoffs and equal risk to have the same price?
What outcome is suggested by the no-arbitrage principle?
What outcome is suggested by the no-arbitrage principle?
In the context of covered interest rate parity, what is a key insight regarding the risks for both strategies when starting with $1?
In the context of covered interest rate parity, what is a key insight regarding the risks for both strategies when starting with $1?
What does St represent in the context of the two strategies described?
What does St represent in the context of the two strategies described?
In the strategies outlined, what is assumed regarding the interest rates for both domestic and foreign currencies?
In the strategies outlined, what is assumed regarding the interest rates for both domestic and foreign currencies?
What is implied when all prices (interest rates, spot rates, and forward rates) are agreed upon today?
What is implied when all prices (interest rates, spot rates, and forward rates) are agreed upon today?
Which of the following statements is true regarding lending $1 for k-periods at the domestic interest rate it,k?
Which of the following statements is true regarding lending $1 for k-periods at the domestic interest rate it,k?
What does the no-arbitrage price assume about the market when comparing both lending strategies?
What does the no-arbitrage price assume about the market when comparing both lending strategies?
What does Uncovered Interest Rate Parity (UIRP) state about expected returns when investing in risk-free rates overseas?
What does Uncovered Interest Rate Parity (UIRP) state about expected returns when investing in risk-free rates overseas?
Under what conditions does the currency excess return (CER) equal zero according to UIRP?
Under what conditions does the currency excess return (CER) equal zero according to UIRP?
Which assumption is NOT part of the criteria for UIRP to hold true?
Which assumption is NOT part of the criteria for UIRP to hold true?
What happens if the forward exchange rate is not an unbiased predictor, according to the Unbiasedness Hypothesis?
What happens if the forward exchange rate is not an unbiased predictor, according to the Unbiasedness Hypothesis?
What is characterized by the condition that investors do not require extra compensation for uncertainty?
What is characterized by the condition that investors do not require extra compensation for uncertainty?
What would cause some investors to expect negative returns on a forward contract?
What would cause some investors to expect negative returns on a forward contract?
What does the currency excess return (CER) represent in international finance?
What does the currency excess return (CER) represent in international finance?
Which factor does NOT affect the currency excess return (CER)?
Which factor does NOT affect the currency excess return (CER)?
What major regulatory factor has constrained banks from exploiting arbitrage opportunities post-GFC?
What major regulatory factor has constrained banks from exploiting arbitrage opportunities post-GFC?
Which strategy can be used to hedge foreign currency transaction risk?
Which strategy can be used to hedge foreign currency transaction risk?
What is an example of a money-market hedge in foreign currency transaction risk management?
What is an example of a money-market hedge in foreign currency transaction risk management?
What will happen if an investor does not hedge the exchange rate while investing abroad?
What will happen if an investor does not hedge the exchange rate while investing abroad?
In the provided example, what is the total cost of entering a forward contract to buy euros in 90 days?
In the provided example, what is the total cost of entering a forward contract to buy euros in 90 days?
What does the term 'riskless' imply in the context of interbank lending/borrowing?
What does the term 'riskless' imply in the context of interbank lending/borrowing?
What is implicit in the concept of uncovered interest rate parity (CIRP)?
What is implicit in the concept of uncovered interest rate parity (CIRP)?
What does the abbreviation 'PV' stand for in the context of financial transactions?
What does the abbreviation 'PV' stand for in the context of financial transactions?
What is a common impediment to banks acting on arbitrage opportunities after the GFC?
What is a common impediment to banks acting on arbitrage opportunities after the GFC?
In the provided scenario, what is the annualized interest rate for euros used in the calculations?
In the provided scenario, what is the annualized interest rate for euros used in the calculations?
Study Notes
No Arbitrage and Pricing
- Two portfolios with the same payoff and equal risk should have the same price.
- If there is a difference, one could buy the cheaper portfolio and sell the more expensive one, earning risk-free profit.
- This assumes frictionless markets, meaning there are no taxes or costs.
Covered Interest Rate Parity (CIRP)
- Two different strategies for investing: Lend domestically at the domestic risk-free rate or convert to foreign currency and lend at the foreign risk-free rate.
- In a no-arbitrage world, the return must be the same.
- This leads to CIRP: The forward exchange rate should reflect the difference in interest rates between the two countries.
- For example, if the domestic interest rate is higher than the foreign interest rate, the forward exchange rate should be stronger for the domestic currency, reflecting the higher return on the domestic investment.
Exploiting Arbitrage Opportunities
- If CIRP doesn't hold, there are potential profit opportunities for investors.
- For example, if the actual 90-day forward exchange rate is higher than predicted by CIRP, an investor could borrow in the domestic currency, convert to foreign currency and lend at the foreign rate, then convert back to domestic currency at the 90-day forward rate, realizing a profit.
Evidence on CIRP
- Research has shown CIRP holds relatively well, especially in the pre-Global Financial Crisis (GFC) era.
- However, after the GFC, significant deviations from CIRP have become common.
Explanations for CIRP Deviations
- Proposed explanations include:
- Regulatory constraints on banks (e.g., leverage limits)
- Interbank lending/borrowing being riskier than assumed.
Hedging Transaction Risk
- Businesses with foreign currency exposure (e.g., importers or exporters) face transaction risk.
- Two hedging methods: Currency forward contracts or money market hedges.
Liability Hedging: An Example
- A US importer of French wine can hedge their €4 million payment due in 90 days by:
- Entering a forward contract at the current 90-day forward rate.
- Entering a money-market hedge: buying the present value of €4 million at the spot rate and lending in the domestic currency.
Speculating in the Foreign Exchange Market
- CIRP implies that investors should be indifferent between lending at the domestic risk-free rate or lending at the foreign risk-free rate and hedging the exchange rate exposure.
- The key is to lock in the implied rate from CIRP.
Currency Excess Returns
- If an investor does not use a forward contract to hedge, they are exposed to exchange rate risk.
- The Currency Excess Return (CER) measures the difference between the returns of lending in foreign currency and lending in domestic currency.
Uncovered Interest Rate Parity (UIRP)
- UIRP states that investors should not expect to earn a higher return from lending in a foreign currency than in the domestic currency, even without hedging.
- UIRP assumes risk neutrality and rational expectations, which are used to explain the convergence of expected spot and forward rates.
- UIRP is also often used to explain a market efficiency concept.
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Description
Explore the key concepts of no-arbitrage pricing and covered interest rate parity. This quiz examines how these principles ensure equilibrium in financial markets and the implications of arbitrage opportunities. Test your understanding of risk-free profit strategies and currency investment returns.
