International Finance: Arbitrage & Parity Conditions

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Questions and Answers

Explain how transaction costs can eliminate potential profits from locational arbitrage opportunities, even when bid-ask spreads between banks initially suggest a profitable scenario.

Transaction costs, such as fees charged by banks for currency exchange, reduce the overall profit margin. If these costs exceed the difference between the bid and ask prices at different banks, the arbitrage opportunity becomes unprofitable.

Describe a scenario where covered interest arbitrage might fail to achieve its intended profit, even if the forward rate differs from the interest rate parity forward rate.

If the amount of capital that can be deployed is limited, or if the arbitrageur faces significant borrowing costs in either currency, the potential profit might be outweighed by these constraints, making the arbitrage less attractive or even unprofitable.

How does relative Purchasing Power Parity (PPP) account for market imperfections and what are some specific examples of these imperfections that cause deviations from absolute PPP?

Relative PPP acknowledges that market imperfections, such as transportation costs, tariffs, quotas, and other trade barriers, prevent prices of identical goods from being equal across countries when measured in a common currency. These costs create deviations from absolute PPP.

Explain how significant capital controls imposed by a government could disrupt the effectiveness of covered interest arbitrage, even when interest rate differentials and forward exchange rates suggest a profitable opportunity.

Capital controls restrict the flow of funds across borders, limiting the ability of arbitrageurs to move capital to exploit interest rate differentials. These restrictions can prevent the necessary currency transactions, thus nullifying the arbitrage opportunity. Signup and view all the answers

Discuss how changes in expectations regarding future inflation rates can impact the relationship between spot exchange rates and relative purchasing power parity (PPP) in the short term.

If expectations of future inflation rise in one country relative to another, investors might anticipate a depreciation of the first country's currency. This expectation can lead to immediate adjustments in the spot exchange rate that deviate from the predictions of relative PPP, as currency values react to anticipated rather than current inflation differentials. Signup and view all the answers

Describe how the 'quantamental' approach integrates different forecasting methods and explain why it is particularly useful for short-term financing decisions in Forex trading?

The quantamental approach integrates quantitative analysis with fundamental analysis and technical analysis. It helps Forex traders capture the dynamic variation in currency prices. It's useful for short-term financing because it allows for quick adjustments based on a comprehensive view of market factors. Signup and view all the answers

Explain Absolute Forecast Error (AFE) and discuss its significance in evaluating the effectiveness of a forecasting technique. In your explanation, include the formula for AFE and how it's used in performance monitoring.

Absolute Forecast Error (AFE) measures the percentage difference between the forecasted value and the actual realized value. The formula is AFE = |(forecasted value - realized value) / realized value|. AFE is crucial for monitoring forecast performance and assessing whether a forecasting technique is reliable. Signup and view all the answers

Describe how a Z-score is utilized to understand deviations from expected values in financial analysis, and explain its relevance in predicting potential reversals in asset prices based on historical time series data.

A Z-score indicates how many standard deviations a data point is from its mean, helping to gauge its unusualness. By analyzing historical time series, a Z-score helps identify when an asset's price deviates significantly from its norm, signaling potential overbought or oversold conditions and possible reversals. Signup and view all the answers

Explain the concept of transaction exposure for multinational corporations (MNCs) and describe how it can be measured. Then, discuss how Value at Risk (VaR) method is applied to manage this exposure.

Transaction exposure assesses how exchange rate fluctuations impact future cash transactions. It's measured by estimating net cash inflows/outflows in foreign currencies and assessing the potential impact of currency movements. VaR is used to determine the potential maximum one-period loss on MNCs positions, using volatility and correlation. Signup and view all the answers

Given an initial excess return $(e(t))$ of 4% at time $t$, and assuming a reversal factor of 70%, calculate the expected excess return $e(t+1)$ at time $t+1$ using the provided model. Explain the implications of this calculation for short-term trading strategies.

Given $e(t) = 4%$ and a reversal factor of 70%, then $e(t+1) = e(t) * -0.70$. So, $e(t+1) = 4% * -0.70 = -2.8%$. This suggests a likely price correction, implying that short-term trading strategies might consider selling to capitalize on the expected downward movement. Signup and view all the answers

Explain how the International Fisher Effect combines Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) to predict exchange rate movements. What are the key assumptions underlying this theory?

The International Fisher Effect combines PPP and IRP by suggesting that nominal interest rate differences between two countries reflect expected inflation differences. It assumes that real interest rates are equal across countries for similar risk levels, implying that the only reason for differing interest rates is differences in expected inflation. Signup and view all the answers

Describe the key differences between currency forward markets and currency futures markets. What are the advantages and disadvantages of using each for hedging exchange rate risk?

Currency forward markets are agreements between firms and banks, customizable in amount and date, while futures markets are standardized and traded through brokers. Forwards offer flexibility but may have counterparty risk; futures are more liquid and transparent but less customizable. Signup and view all the answers

Explain how a non-deliverable forward contract (NDF) works and why it is used. How does the settlement process differ from a standard forward contract?

An NDF is a forward contract where there is no actual exchange of currencies. Instead, one party makes a net payment to the other based on the spot exchange rate on the settlement date. It is used when currency exchange is restricted. The settlement avoids currency delivery, relying on cash payment. Signup and view all the answers

Differentiate between a currency call option and a currency put option. Under what circumstances would a company choose to buy a call option versus a put option on a foreign currency?

A call option gives the right to buy a currency at a strike price; a put option gives the right to sell. A company buys a call option when it expects the currency to appreciate, needing to buy it in the future. It buys a put option when expecting depreciation, needing to sell it. Signup and view all the answers

A U.S. company has a large payable denominated in Euros (€) due in 90 days. Discuss three different hedging strategies the company could use to mitigate the risk of the Euro appreciating against the U.S. Dollar ($).

The company could 1) buy Euro forward contracts to lock in an exchange rate, 2) buy Euro futures, or 3) buy Euro call options to hedge against a Euro appreciation, limiting losses. Signup and view all the answers

Explain how a sterilized intervention diﬀers from a non-sterilized intervention and discuss the implications of each on the domestic money supply and exchange rates.

A sterilized intervention involves oﬀsetting the impact of the central bank's foreign exchange intervention on the domestic money supply, typically through open market operations. A non-sterilized intervention does not include such oﬀsetting actions. Sterilized interventions have a limited eﬀect on exchange rates because they don't alter the money supply, while non-sterilized interventions directly aﬀect the money supply, leading to potentially larger exchange rate movements. Signup and view all the answers

Describe how the International Fisher Eﬀect (IFE) relates to Purchasing Power Parity (PPP) and outline a method to empirically test for the validity of PPP.

The IFE suggests that diﬀerences in nominal interest rates between two countries are an unbiased predictor of future changes in exchange rates. PPP states that exchange rates should adjust to equalize the purchasing power of currencies. Both theories are related, as deviations from PPP may create opportunities for interest rate diﬀerentials, which the IFE then suggests will be oﬀset by exchange rate changes. PPP can be tested by comparing relative price levels across countries and examining whether exchange rates adjust accordingly over time. Regression analysis can determine the statistical relationship and the speed of adjustment. Signup and view all the answers

Critically analyze how agency costs for multinational corporations (MNCs) diﬀer from those of domestic ﬁrms, and propose a comprehensive strategy to mitigate these elevated agency costs.

Agency costs tend to be higher for MNCs due to geographical dispersion, cultural diﬀerences, monitoring diﬃculties, and conﬂicting goals between parent and subsidiary managers. A comprehensive strategy would encompass enhanced monitoring systems, aligning managerial incentives with shareholder value across all subsidiaries, promoting a strong corporate culture, and implementing robust internal controls. Signup and view all the answers

Explain how changes in government regulations can aﬀect Foreign Direct Investment (FDI) flows, using specific examples to illustrate your points.

Government regulations significantly influence FDI. For instance, stricter environmental regulations may discourage investment from industries with high pollution potential, while tax incentives or subsidies can attract FDI. Furthermore, changes in regulations regarding intellectual property rights can impact technology-intensive investments, and relaxed labor laws might attract industries seeking lower labor costs. Signup and view all the answers

A U.S.-based MNC is considering establishing a new manufacturing facility in either Brazil or India. Identify and justify the key variable inputs required for a robust capital budgeting analysis of this international project, taking into account unique risks and opportunities in each country.

Key variable inputs include initial investment, projected revenues, operating costs (including labor, materials, and energy), tax rates, depreciation schedules, terminal value, the cost of capital, and exchange rates. When comparing Brazil and India, you should use diﬀerent values for the same input due to diﬀerences in inflation, political stability, regulatory environment, and market characteristics. India's labor costs might be lower, however energy may be more expansive due to scarcity. Brazil may have more market saturation than India due to it's smaller population to consumer base ratio, additionally the infrastructure of Brazil is likely more predictable. Signup and view all the answers

Flashcards

International Fisher Effect

Theory stating that nominal interest rate is approximately the sum of the real interest rate and inflation rate.

Currency Forward Market

Agreement between a firm and a commercial bank for a specific exchange rate, amount, and future date.

Forward Swap

A spot transaction paired with a forward transaction that reverses the spot transaction.

NDF (Non-Deliverable Forward)

Forward contract where there is no physical exchange of currencies; settlement is based on the difference between the agreed rate and the spot rate at settlement.