Finance Arbitrage Principles

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Questions and Answers

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/£?

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?

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?

$1.00625 Signup and view all the answers

How much profit would be pocketed from the arbitrage opportunity described?

$0.03728 Signup and view all the answers

What was one significant finding of the research conducted by Akram, Rime, and Sarno in 2008 regarding covered interest rate parity (CIRP)?

CIRP violations are short-lived but economically significant. Signup and view all the answers

Since the global financial crisis (GFC), what has been noted about covered interest rate parity?

CIRP has displayed unprecedented violations and inconsistencies. Signup and view all the answers

Mark Taylor's research in 1987 primarily supported which hypothesis in relation to covered interest parity?

Market efficiency hypothesis. Signup and view all the answers

What aspect of covered interest rate parity was highlighted as a reason for previously undetected violations according to Akram, Rime, and Sarno?

The low duration of arbitrage opportunities. Signup and view all the answers

Which period marked the beginning of the era of 'freely' floating exchange rates?

The collapse of the Bretton Woods System. Signup and view all the answers

What assumption must hold for two portfolios with identical payoffs and equal risk to have the same price?

The market is perfect, with no frictions. Signup and view all the answers

What outcome is suggested by the no-arbitrage principle?

Buy the low-priced portfolio and sell the high-priced one. Signup and view all the answers

In the context of covered interest rate parity, what is a key insight regarding the risks for both strategies when starting with $1?

There is zero risk for both strategies and they have the same price. Signup and view all the answers

What does St represent in the context of the two strategies described?

The spot exchange rate between US dollars and foreign currency. Signup and view all the answers

In the strategies outlined, what is assumed regarding the interest rates for both domestic and foreign currencies?

They are risk-free and guaranteed. Signup and view all the answers

What is implied when all prices (interest rates, spot rates, and forward rates) are agreed upon today?

The concept of covered interest rate parity is valid. Signup and view all the answers

Which of the following statements is true regarding lending $1 for k-periods at the domestic interest rate it,k?

The payoff becomes $1(1 + it,k). Signup and view all the answers

What does the no-arbitrage price assume about the market when comparing both lending strategies?

The market is completed without taxes or transaction costs. Signup and view all the answers

What does Uncovered Interest Rate Parity (UIRP) state about expected returns when investing in risk-free rates overseas?

Investors should only expect to receive a domestic risk-free rate. Signup and view all the answers

Under what conditions does the currency excess return (CER) equal zero according to UIRP?

When St + k equals Ft →t + k. Signup and view all the answers

Which assumption is NOT part of the criteria for UIRP to hold true?

Investors have irrational expectations. Signup and view all the answers

What happens if the forward exchange rate is not an unbiased predictor, according to the Unbiasedness Hypothesis?

CER will not equal zero. Signup and view all the answers

What is characterized by the condition that investors do not require extra compensation for uncertainty?

Risk neutrality Signup and view all the answers

What would cause some investors to expect negative returns on a forward contract?

Differences in available information among investors. Signup and view all the answers

What does the currency excess return (CER) represent in international finance?

The return an investor earns from currency lending. Signup and view all the answers

Which factor does NOT affect the currency excess return (CER)?

The level of investor risk aversion. Signup and view all the answers

What major regulatory factor has constrained banks from exploiting arbitrage opportunities post-GFC?

Bank leverage constraints Signup and view all the answers

Which strategy can be used to hedge foreign currency transaction risk?

Entering a currency forward contract Signup and view all the answers

What is an example of a money-market hedge in foreign currency transaction risk management?

Buying the present value (PV) of euros today Signup and view all the answers

What will happen if an investor does not hedge the exchange rate while investing abroad?

They may face unpredictable currency risks. Signup and view all the answers

In the provided example, what is the total cost of entering a forward contract to buy euros in 90 days?

$4,320,000 Signup and view all the answers

What does the term 'riskless' imply in the context of interbank lending/borrowing?

It is free from credit risk Signup and view all the answers

What is implicit in the concept of uncovered interest rate parity (CIRP)?

Investors should be indifferent between domestic and foreign lending Signup and view all the answers

What does the abbreviation 'PV' stand for in the context of financial transactions?

Present Value Signup and view all the answers

What is a common impediment to banks acting on arbitrage opportunities after the GFC?

Regulatory constraints on leverage Signup and view all the answers

In the provided scenario, what is the annualized interest rate for euros used in the calculations?

13.519% Signup and view all the answers

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.