Chapter 7
International Arbitrage and Interest Rate Parity
1. Due to _______, market forces should realign the relationship between the
interest rate differential of two currencies and the forward premium (or discount)
on the forward exchange rate between the two currencies.
A) forward realignment arbitrage
B) triangular arbitrage
C) covered interest arbitrage
D) locational arbitrage
ANSWER: C
2. Due to _______, market forces should realign the spot rate of a currency among
banks.
A) forward realignment arbitrage
B) triangular arbitrage
C) covered interest arbitrage
D) locational arbitrage
ANSWER: D
3. Due to _______, market forces should realign the cross exchange rate between
two foreign currencies based on the spot exchange rates of the two currencies
against the U.S. dollar.
A) forward realignment arbitrage
B) triangular arbitrage
C) covered interest arbitrage
D) locational arbitrage
ANSWER: B
4. If interest rate parity exists, then _______ is not feasible.
A) forward realignment arbitrage
B) triangular arbitrage
C) covered interest arbitrage
D) locational arbitrage
ANSWER: C
5. In which case will locational arbitrage most likely be feasible?
A) One bank’s ask price for a currency is greater than another bank’s bid price for
the currency.
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, B) One bank’s bid price for a currency is greater than another bank’s ask price for
the currency.
C) One bank’s ask price for a currency is less than another bank’s ask price for
the currency.
D) One bank’s bid price for a currency is less than another bank’s bid price for the
currency.
ANSWER: B
6. When using _______, funds are not tied up for any length of time.
A) covered interest arbitrage
B) locational arbitrage
C) triangular arbitrage
D) locational arbitrage or triangular arbitrage
ANSWER: D
7. When using _______, funds are typically tied up for a significant period of time.
A) covered interest arbitrage
B) locational arbitrage
C) triangular arbitrage
D) locational arbitrage or triangular arbitrage
ANSWER: A
8. Assume that the interest rate in the home country of Currency X is a much higher
interest rate than the U.S. interest rate. According to interest rate parity, the
forward rate of Currency X:
A) should exhibit a discount.
B) should exhibit a premium.
C) should be zero (i.e., it should equal its spot rate).
D) should exhibit a premium or should be zero.
ANSWER: A
9. If the interest rate is higher in the U.S. than in the United Kingdom, and if the
forward rate of the British pound (in U.S. dollars) is the same as the pound’s spot
rate, then:
A) U.S. investors could possibly benefit from covered interest arbitrage.
B) British investors could possibly benefit from covered interest arbitrage.
C) neither U.S. nor British investors could benefit from covered interest arbitrage.
D) U.S. and British investors could possibly benefit from covered interest
arbitrage.
ANSWER: B
,10. If the interest rate is lower in the U.S. than in the United Kingdom, and if the
forward rate of the British pound is the same as its spot rate:
A) U.S. investors could possibly benefit from covered interest arbitrage.
B) British investors could possibly benefit from covered interest arbitrage.
C) neither U.S. nor British investors could benefit from covered interest arbitrage.
D) U.S. and British investors could possibly benefit from covered interest
arbitrage.
ANSWER: A
11. Assume that the U.S. investors are benefiting from covered interest arbitrage due
to high interest rates on euros. Which of the following forces should result from
the act of this covered interest arbitrage?
A) downward pressure on the euro’s spot rate.
B) downward pressure on the euro’s forward rate.
C) downward pressure on the U.S. interest rate.
D) upward pressure on the euro’s interest rate.
ANSWER: B
12. Assume that Swiss investors are benefiting from covered interest arbitrage due to
a high U.S. interest rate. Which of the following forces results from the act of this
covered interest arbitrage?
A) upward pressure on the Swiss franc’s spot rate.
B) upward pressure on the U.S. interest rate.
C) downward pressure on the Swiss interest rate.
D) upward pressure on the Swiss franc’s forward rate.
ANSWER: D
13. Assume that a U.S. firm can invest funds for one year in the U.S. at 12% or invest
funds in Mexico at 14%. The spot rate of the peso is $.10 while the one-year
forward rate of the peso is $.10. If U.S. firms attempt to use covered interest
arbitrage, what forces should occur?
A) spot rate of peso increases; forward rate of peso decreases.
B) spot rate of peso decreases; forward rate of peso increases.
C) spot rate of peso decreases; forward rate of peso decreases.
D) spot rate of peso increases; forward rate of peso increases.
ANSWER: A
14. Assume the bid rate of a New Zealand dollar is $.33 while the ask rate is $.335 at
Bank X. Assume the bid rate of the New Zealand dollar is $.32 while the ask rate
is $.325 at Bank Y. Given this information, what would be your gain if you use
$1,000,000 and execute locational arbitrage? That is, how much will you end up
with over and above the $1,000,000 you started with?
, A) $15,385.
B) $15,625.
C) $22,136.
D) $31,250.
ANSWER: A
SOLUTION: $1,000,000/$.325 = NZ$3,076,923 × $.33 = $1,015,385. Thus, the
profit is $15,385.
15. Based on interest rate parity, the larger the degree by which the foreign interest
rate exceeds the U.S. interest rate, the:
A) larger will be the forward discount of the foreign currency.
B) larger will be the forward premium of the foreign currency.
C) smaller will be the forward premium of the foreign currency.
D) smaller will be the forward discount of the foreign currency.
ANSWER: A
16. Assume the following information:
You have $1,000,000 to invest
Current spot rate of pound = $1.30
90-day forward rate of pound = $1.28
3-month deposit rate in U.S. = 3%
3-month deposit rate in Great Britain = 4%
If you use covered interest arbitrage for a 90-day investment, what will be the
amount of U.S. dollars you will have after 90 days?
A) $1,024,000.
B) $1,030,000.
C) $1,040,000.
D) $1,034,000.
E) none of these.
ANSWER: A
SOLUTION: $1,000,000/$1.30 = 769,231 pounds × (1.04) = 800,000 pounds ×
1.28 = $1,024,000
17. Assume that the U.S. interest rate is 10%, while the British interest rate is 15%. If
interest rate parity exists, then:
A) British investors who invest in the United Kingdom will achieve the same
return as U.S. investors who invest in the U.S.
B) U.S. investors will earn a higher rate of return when using covered interest
arbitrage than what they would earn in the U.S.
International Arbitrage and Interest Rate Parity
1. Due to _______, market forces should realign the relationship between the
interest rate differential of two currencies and the forward premium (or discount)
on the forward exchange rate between the two currencies.
A) forward realignment arbitrage
B) triangular arbitrage
C) covered interest arbitrage
D) locational arbitrage
ANSWER: C
2. Due to _______, market forces should realign the spot rate of a currency among
banks.
A) forward realignment arbitrage
B) triangular arbitrage
C) covered interest arbitrage
D) locational arbitrage
ANSWER: D
3. Due to _______, market forces should realign the cross exchange rate between
two foreign currencies based on the spot exchange rates of the two currencies
against the U.S. dollar.
A) forward realignment arbitrage
B) triangular arbitrage
C) covered interest arbitrage
D) locational arbitrage
ANSWER: B
4. If interest rate parity exists, then _______ is not feasible.
A) forward realignment arbitrage
B) triangular arbitrage
C) covered interest arbitrage
D) locational arbitrage
ANSWER: C
5. In which case will locational arbitrage most likely be feasible?
A) One bank’s ask price for a currency is greater than another bank’s bid price for
the currency.
459
, B) One bank’s bid price for a currency is greater than another bank’s ask price for
the currency.
C) One bank’s ask price for a currency is less than another bank’s ask price for
the currency.
D) One bank’s bid price for a currency is less than another bank’s bid price for the
currency.
ANSWER: B
6. When using _______, funds are not tied up for any length of time.
A) covered interest arbitrage
B) locational arbitrage
C) triangular arbitrage
D) locational arbitrage or triangular arbitrage
ANSWER: D
7. When using _______, funds are typically tied up for a significant period of time.
A) covered interest arbitrage
B) locational arbitrage
C) triangular arbitrage
D) locational arbitrage or triangular arbitrage
ANSWER: A
8. Assume that the interest rate in the home country of Currency X is a much higher
interest rate than the U.S. interest rate. According to interest rate parity, the
forward rate of Currency X:
A) should exhibit a discount.
B) should exhibit a premium.
C) should be zero (i.e., it should equal its spot rate).
D) should exhibit a premium or should be zero.
ANSWER: A
9. If the interest rate is higher in the U.S. than in the United Kingdom, and if the
forward rate of the British pound (in U.S. dollars) is the same as the pound’s spot
rate, then:
A) U.S. investors could possibly benefit from covered interest arbitrage.
B) British investors could possibly benefit from covered interest arbitrage.
C) neither U.S. nor British investors could benefit from covered interest arbitrage.
D) U.S. and British investors could possibly benefit from covered interest
arbitrage.
ANSWER: B
,10. If the interest rate is lower in the U.S. than in the United Kingdom, and if the
forward rate of the British pound is the same as its spot rate:
A) U.S. investors could possibly benefit from covered interest arbitrage.
B) British investors could possibly benefit from covered interest arbitrage.
C) neither U.S. nor British investors could benefit from covered interest arbitrage.
D) U.S. and British investors could possibly benefit from covered interest
arbitrage.
ANSWER: A
11. Assume that the U.S. investors are benefiting from covered interest arbitrage due
to high interest rates on euros. Which of the following forces should result from
the act of this covered interest arbitrage?
A) downward pressure on the euro’s spot rate.
B) downward pressure on the euro’s forward rate.
C) downward pressure on the U.S. interest rate.
D) upward pressure on the euro’s interest rate.
ANSWER: B
12. Assume that Swiss investors are benefiting from covered interest arbitrage due to
a high U.S. interest rate. Which of the following forces results from the act of this
covered interest arbitrage?
A) upward pressure on the Swiss franc’s spot rate.
B) upward pressure on the U.S. interest rate.
C) downward pressure on the Swiss interest rate.
D) upward pressure on the Swiss franc’s forward rate.
ANSWER: D
13. Assume that a U.S. firm can invest funds for one year in the U.S. at 12% or invest
funds in Mexico at 14%. The spot rate of the peso is $.10 while the one-year
forward rate of the peso is $.10. If U.S. firms attempt to use covered interest
arbitrage, what forces should occur?
A) spot rate of peso increases; forward rate of peso decreases.
B) spot rate of peso decreases; forward rate of peso increases.
C) spot rate of peso decreases; forward rate of peso decreases.
D) spot rate of peso increases; forward rate of peso increases.
ANSWER: A
14. Assume the bid rate of a New Zealand dollar is $.33 while the ask rate is $.335 at
Bank X. Assume the bid rate of the New Zealand dollar is $.32 while the ask rate
is $.325 at Bank Y. Given this information, what would be your gain if you use
$1,000,000 and execute locational arbitrage? That is, how much will you end up
with over and above the $1,000,000 you started with?
, A) $15,385.
B) $15,625.
C) $22,136.
D) $31,250.
ANSWER: A
SOLUTION: $1,000,000/$.325 = NZ$3,076,923 × $.33 = $1,015,385. Thus, the
profit is $15,385.
15. Based on interest rate parity, the larger the degree by which the foreign interest
rate exceeds the U.S. interest rate, the:
A) larger will be the forward discount of the foreign currency.
B) larger will be the forward premium of the foreign currency.
C) smaller will be the forward premium of the foreign currency.
D) smaller will be the forward discount of the foreign currency.
ANSWER: A
16. Assume the following information:
You have $1,000,000 to invest
Current spot rate of pound = $1.30
90-day forward rate of pound = $1.28
3-month deposit rate in U.S. = 3%
3-month deposit rate in Great Britain = 4%
If you use covered interest arbitrage for a 90-day investment, what will be the
amount of U.S. dollars you will have after 90 days?
A) $1,024,000.
B) $1,030,000.
C) $1,040,000.
D) $1,034,000.
E) none of these.
ANSWER: A
SOLUTION: $1,000,000/$1.30 = 769,231 pounds × (1.04) = 800,000 pounds ×
1.28 = $1,024,000
17. Assume that the U.S. interest rate is 10%, while the British interest rate is 15%. If
interest rate parity exists, then:
A) British investors who invest in the United Kingdom will achieve the same
return as U.S. investors who invest in the U.S.
B) U.S. investors will earn a higher rate of return when using covered interest
arbitrage than what they would earn in the U.S.
