Multinational Finance Butler 5th Edition

FIN4306/FIN5306 Summer 2014 On-Line course International Finance
I. Answer #4.1 through #4.11 from the conceptual questions on p.98. Focus your explanation, and do NOT use more than two sentences.

4.1 The law of one price is the principle that equivalent assets sell for the same price and have the same required return. Market participants
promote the law of one price through arbitrage and through speculation.

4.2 Arbitrage profit is profit through arbitrage which is the simultaneous purchase and sale of the same or equivalent security in order to
ensure a profit with no net investment or risk.

4.3 Locational arbitrage is conducted between two or more locations, triangular arbitrage is conducted between three exchange rates and
covered interest arbitrage takes advantage of disequilibrium in interest rate parity.

4.4 Interest rate parity is a reliable relation in the interbank markets. Each of the prices in the IRP relation (F
t
d/f
/ S
0
d/f
) = [(1+i
d
) / (1+i
f
)]
t
is a
traded contract in the interbank markets, and so covered interest arbitrage is able to enforce the no-arbitrage condition within the bounds of
transaction costs (which are small in the interbank market).

4.5 RPPP is relative purchasing power parity which is a form of the law of one price in which the expected change in the spot exchange rate
is influenced by the difference in expected inflation according to E [S
t
d/f
] / S
0
d/f
= [(1+E[p
d
]) / (1+E[p
f
])]
t

4.6 Forward rates are poor predictors of future spot rates over short-term forecast horizons, because exchange rate volatility masks the signal from the
international parity condition. Over longer forecast horizons, the signal-to-noise ratio improves and the forecast performance of forward rates (as well as inflation
differentials from RPPP) improves.

4.7 The International Fisher relations says that if real interest rates are constant across currencies, nominal interest rates should reflect inflation differentials
according to [(1+i
d
) / (1+i
f
)]
t
= [(1+E[p
d
]) / (1+E[p
f
])]
t

4.8 Real exchange rate changes reflect changes in currencies relative purchasing power.

4.9 Real exchange rates show large and persistent deviations from purchasing power parity. These deviations can last for several years.

4.10 A real appreciation of the domestic currency increases the wealth and purchasing power of domestic residents relative to foreign residents. It can also hurt
the economy by raising the price of domestic goods relative to foreign goods.

4.11 A nominal appreciation in the domestic currency is likely to have little effect on domestic importers and exporters, but a real appreciation of the domestic
currency can hurt domestic exporters by raising the price of domestic goods relative to foreign goods. Domestic importers will see their purchasing
power increase relative to foreign competitors, and so are likely to be helped by a real appreciation of the domestic currency.

II. Answer the following problem solving questions on pp.99 - 101.

4.5
a. Japanese Yen quote for the peso: (28.77/MXN 28.74/MXN)/(28.74/MXN) = 0.00104, or 0.104%.
Mexican Peso quote for yen: (MXN0.03420/ MXN0.03416/)/(MXN0.03416/) = 0.00117, or 0.117%

b. The Mexican banks yen quote can be converted into a quote for the Mexican peso as follows:
S
/MXN
= 1/(MXN0.03416/) 29.27/MXN bid on the yen and ask on the peso.
S
/MXN
= 1/(MXN0.03420/) 29.24/MXN as on the yen and bid on the peso.
So MXN0.03416/ BID and MXN0.03420/ ASK on the yen is equivalent to 29.24/MXNBID and 29.27/MXN ASK on
the Mexican peso.
The best strategy is to buy pesos from the Tokyo bank at the 28.77/MXN ask price for pesos and sell pesos (and buy yen) to the
Mexican bank at the 29.24/MXN bid price for pesos. Buying pesos in Tokyo yields (1,000,000)/(28.77/MXN) = MXN34,758.
Selling pesos in Mexico City yields (MXN34,758)(29.24/MXN) = 1,016,336. Your arbitrage profit is16,336 yen, or about MXN559
at the Mexican banks 29.24/MXN bid price for pesos.

4.7
a. From interest rate parity, (210/$)/(190/$) = (1+i
) / (1.15) i
= 27.11%

b. Because the forward rate of 210/$ is greater than the spot rate of 190/$, the dollar is at a
forward premium. If forward rates are unbiased predictors of future spot rates, the dollar is likely toappreciate against the yen by
(210/$)/(190/$)1 = 10.526%

4.11
a. F
t
Bt/$
/ S
0
Bt/$
= (1 + i
Bt
)
t
/ (1 + i
$
)
t
= (Bt 25.64/$)/(Bt 24.96/$) = (1 + i
Bt
)/(1.06125) 1.02724 = (1 + i
Bt
)/1.06125
i
Bt
= 9.02%

b. F1
Bt/$
/S
0
Bt/$
= (Bt25.64/$)/(Bt24.96/$) = 1.027 < (1+i
Bt
)/(1+i
$
) = (1.1)/(1.06125) = 1.037. So, borrow at i
$
and lend at i
Bt
.

+Bt24,960,000 Convert to baht at the spot exchange rate

-$1,000,000
Invest at the 10% baht interest rate +Bt27,456,000

-Bt24,960,000

+$1,000,000 Borrow at the 6.125% dollar interest rate

$1,061,250

Cover baht forward +$1,070,827

Bt27,456,000
This leaves a net gain at time 1 of $1,070,827 $1,061,250 = $9,577, which is worth $9,577/1.06125 = $9,024 in present value.

4.15
a. The percentage change in the nominal value of the Swiss franc is: S
/SFr
= (S
0
/SFr
) / (S
1
/SFr
) 1 = (155/SFr)/(160/SFr) 1 = 3.125%

b. Using rppp, the rate should have been:
E[S
0
/SFr
] = (S
1
/SFr
) [(1+p
) / (1+p
SFr
)] = (160 / SFr) [(1.02) / (1.03)] = 158.45.

c. The percentage change in the real exchange rate would have been:
X
/SFr
= ((S
0
/SFr
) / (S
1
/SFr
)) ((1+p
SFr
)/(1+p
)) 1
= ((155/SFr)/(160/SFr)) ((1.03)/(1.02)) 1 = 2.18%

d. The franc depreciated by 2.18% in purchasing power.

e. Because the SFr fell by 2.18% in real terms, the yen rose by 1 / (10.0218) 2.23%
X
SFr/
= ((S
0
SFr/
) / (S
1
SFr/
)) ((1+p
) / (1+p
SFr
)) 1
= ((S
0
/SFr
) 1/ (S
1
/SFr
)
1
) ((1+p
) / (1+p
SFr
)) 1
= ((155/SFr)
1
/ (160/SFr)
1
) ((1.02)/(1.03)) 1 = +2.23%
= ((SFr.0064516/)/(SFr.00625000/)) ((1.02)/(1.03)) 1 = +2.23%.
III. How do you evaluate the existence of the RPPP from Figure 4.5 and Figure 4.6 on p.84. Explain your answers.

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FIN4306/FIN5306 Summer 2014 On-Line course International Finance

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