Question

1. You observe that one U.S. dollar is currently equal to 3.6 Brazilian reals in the spot market.  The one year US interest rate is 7% and the one year Brazilian interest rate is 4%. One year later, you observe that one U.S. dollar is now equal to 3.2 Brazilian reals in the spot market. You would have made a profit if you had:

		Borrowed U.S. dollars and invested in U.S. dollars
		Borrowed Brazilian reals and invested in Brazilian reals
		Borrowed U.S. dollars and invested in Brazilian reals
		Borrowed Brazilian reals and invested in U.S. dollars

2. __________ refers to the arbitrage strategy wherein an investor uses a forward contract to lock in future exchange rates and take advantage of interest rate differentials between two countries.

		Triangular arbitrage
		Uncovered interest arbitrage
		Locational arbitrage
		Covered interest arbitrage

3. __________ posits that changes in relative expected inflation rates between two countries will be reflected by changes in the spot exchange rate of the two countries.

		Absolute purchasing power parity
		International Fisher effect
		Domestic Fisher effect
		Relative purchasing power parity

4. The International Fisher Effect suggests that

		an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country.
		the nominal interest rate differential reflects the expected change in the exchange rate.
		any forward premium or discount is equal to the actual change in the exchange rate.
		any forward premium or discount is equal to the expected change in the exchange rate.

5. Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in Germany, and that the spot exchange rate is $1.60/€ and the forward exchange rate, with one-year maturity, is $1.58/€. Assume that an arbitrager can borrow up to $1,000,000 or €625,000. If an astute trader finds an arbitrage, what is the net cash flow in one year?

		$238.65
		$14,000
		$46,207
		$7,000

6. You observe that the expected rate of inflation over the next year is 3.53% and current one year Treasury bills are yielding 5.82%. Based on the domestic Fisher effect, what is the approximate one year real rate of interest?  Submit your answer as a percentage to two decimal places (Ex. 0.00%).

7. Suppose you observe a spot exchange rate of $1.20/€. If interest rates are 9% APR in the U.S. and 3% APR in the euro zone, what is the no-arbitrage 1-year forward rate?

		€1.34/$
		$1.27/€
		€1.20/$
		$1.13/€

8. As of today, the spot exchange rate between China and the U.K. is 1 GBP = 9.5 CHY.  Rates of inflation expected to prevail for the next year in China and the U.K. are 2% and 4%, respectively. What is the one-year forward rate that should prevail?

		1 GBP = 9.69 CHY
		1 GBP = 9.55 CHY
		1 GBP = 9.32 CHY
		1 GBP = 9.18 CHY

Answer 1

(1) Current Exchange Rate = 3.6 Real/$, Brazilian Interest Rate = 4 % and US Interest Rate = 7 %

Expected Exchange Rate as per IRP = [(1.04) / (1.07)] x 3.6 = 3.499065 Real/$

Actual Exchange Rate = 3.2 Real / $

As is observable, the Brazilian Real is over valued with respect to the US $.

Hence, an arbitrage can be executed by the following the steps given below:

- Borrow 1 $ and convert the same into Reals at the current exchange rate to get (1x3.6) = 3.6 Reals

- Invest Reals at the Brazilian Interest Rate to yield = 1.04 x 3.6 = 3.744 Reals after one year.

- Convert Reals into $ at the actual exchange rate of 3.2 Reals/$ to yield = 3.744 / 3.2 = $ 1.17

- Dollar Borrowing Liability = 1.07 x 1 = $ 1.07

- Arbitrage Profit = 1.17 - 1.07 = $ 0.1

Hence, the correct option is (c).

NOTE: Please raise separate queries for solutions to the remaining unrelated questions.