Chapter 7: International Arbitrage and Interest Rate Parity 459
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.
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
,460 International Financial Management
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
, Chapter 7: International Arbitrage and Interest Rate Parity 461
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.
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.
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
,460 International Financial Management
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
, Chapter 7: International Arbitrage and Interest Rate Parity 461
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.
