Chap07 Pbms MBF12e
Chap07 Pbms MBF12e
Chap07 Pbms MBF12e
This textbook has used The Economist magazine's Big Mac Index for many years. Below are the Big Mac prices and actual exchange rates
for select Latin American countries as printed in previous editions. Use the data in the table to complete the calculation of the implied PPP
value of the currency versus the U.S. dollar and the calculation as to whether that currency is undervalued (-%) or overvalued (+%) versus
the U.S. dollar.
Notes: Column 3 = Column 1 ÷ Column 2; Column 4 = Column 1 ÷ Big Mac US$ Price; Column 5 = Column 4 ÷ Column 2.
Problem 7.6 Argentine Peso and PPP
The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In
January 2002 the Argentine peso was floated. On January 29, 2003 it was trading at Ps3.20/$.
During that one year period Argentina's inflation rate was 20% on an annualized basis. Inflation in
the United States during that same period was 2.2% annualized.
Assumptions Value
Spot exchange rate, fixed peg, early January 2002 (Ps/$) 1.0000
Spot exchange rate, January 29, 2003 (Ps/$) 3.2000
US inflation for year (per annum) 2.20%
Argentine inflation for year (per annum) 20.00%
a. What should have been the exchange rate in January 2003 if PPP held?
The rapid decline in the value of the Argentine peso was a result of not only inflation,
but also a severe crisis in the balance of payments (see Chapter 4).
Problem 7.7 Akira Numata -- CIA Japan
Akira Numata, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage
possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars
and Japanese yen. He faced the following exchange rate and interest rate quotes:
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
This tells Toshi Numata that he should borrow yen and invest in the HIGHER yielding currency, the U.S. dollar, to
lock-in a covered interest arbitrage (CIA) profit.
Akira Numata generates a CIA profit by investing in the higher interest rate currency, the dollar, and simultaneously
selling the dollar proceeds forward into yen at a forward premium which does not completely negate the interest
differential.
Problem 7.8 Akira Numata -- UIA Japan
Akira Numata, Credit Suisse (Tokyo), observes that the ¥/$ spot rate has been holding steady, and both dollar and yen
interest rates have remained relatively fixed over the past week. Akira wonders if he should try an uncovered interest
arbitrage (UIA) and thereby save the cost of forward cover. Many of Akira's research associates -- and their computer
models -- are predicting the spot rate to remain close to ¥118.00/$ for the coming 180 days. Using the same data as in
the previous problem, analyze the UIA potential.
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
This tells Akira Numata that he should borrow yen and invest in the HIGHER yielding currency, the U.S. dollar, to
potentially gain on an uncovered basis (UIA).
a) Akira Numata generates an uncovered interest arbitrage (UIA) profit of ¥1,079,000 if his expectations about the
future spot rate, the one in effect in 180 days, prove correct.
b) The risk Akira is taking is that the actual spot rate at the end of the period can theoretically be anything, better or
worse for his speculative position. He in fact has very little "wiggle room," as they say. A small movement will cost
him a lot of money. If the spot rate ends up any stronger than about 117.79/$ (a smaller number), he will lose money.
(Verify by inputting ¥117.70/$ in the expected spot rate cell under assumptions.)
Problem 7.9 Joseph Yazzie and Japanese/United States Parity Conditions
Joseph Yazzie is attempting to determine whether US/Japanese financial conditions are near parity. The current spot rate is a flat
¥120.00/$, while the 360-day forward rate is ¥115.40/$. Forecast inflation is 1.000% for Japan, and 5.000% for the US. The 360-day euro-
yen deposit rate is 4.000%, and the 360-day euro-dollar deposit rate is 8.000%. Use the following data to diagram and calculate whether
international parity conditions hold between Japan and the United States. What is the forecasted change in the Japanese yen/US dollar (¥/$)
exchange rate one year hence?
Assumptions Value
Forecast annual rate of inflation for Japan 1.000%
Forecast annual rate of inflation for United States 5.000%
One-year interest rate for Japan 4.000%
One-year interest rate for United States 8.000%
Spot exchange rate (¥/$) 120.00
One-year forward exchange rate (¥/$) 115.40
Approximate Form
Forecast change in
Forward rate as spot exchange rate Purchasing
an unbaised ↔ ↔ 4.0% ↔ ↔ power
predictor (E) (Dollar expected to weaken) parity (A)
↕ ↕
↕ ↕ ↕
↕ ↕ ↕
↕ ↕ ↕
↕
Forward premium ↕ Forecast difference
on foreign currency International in rates of inflation
4.0% Fisher Effect (C) -4.0%
(Japanese yen at a premium) ↕ (US higher than Japan)
↕
↕ ↕ ↕
↕ ↕ ↕
↕
Interest rate ↔ ↔ Difference in nominal ↔ ↔ Fisher
parity (D) interest rates effect (B)
-4.0%
(higher in United States)
As is the always the case with parity conditions, the future spot rate is implicitly forecasted to be equal to the forward rate, the implied rate
from the international Fisher effect, and the rate implied by purchasing power parity. According to Yazzie's calculations, the markets are
indeed in equilibrium -- parity -- and the future spot rate is projected to be ¥115.40/$.
Problem 7.10 XTerra exports and Pass-Through
Assume that the export price of a Nissan XTerra from Osaka, Japan is ¥3,250,000. The exchange rate is ¥115.20/$.
The forecast rate of inflation in the United States is 2.2% per year and is 0.0% per year in Japan. Use this data to
answer the following questions on exchange rate pass through.
Steps Value
Initial spot exchange rate (¥/$) 115.20
Initial price of a Nissan Xterra (¥) 3,250,000
Expected US dollar inflation rate for the coming year 2.200%
Expected Japanese yen inflation rate for the coming year 0.000%
Desired rate of pass through by Nissan 75.000%
a) What is the export price for the XTerra at the beginning of the year expressed in U.S. Dollars?
Year-beginning price of an XTerra (¥) 3,250,000
Spot exchange rate (¥/$) 115.20
Year-beginning price of a XTerra ($) $ 28,211.81
b) Assuming PPP holds, what should the exchange rate be at the end of the year?
Initial spot rate (¥/$) 115.20
Expected US$ inflation 2.20%
Expected Japanese yen inflation 0.00%
Expected exchange rate at end of year assuming PPP (¥/$) 112.72
c) Assuming 100% pass-through, what should be the dollar price of an Xterra at the end one year?
Price of XTerra at beginning of year (¥) 3,250,000
Japanese yen inflation over the year 0.000%
Price of XTerra at end of year (¥) 3,250,000
Expected spot rate one year from now assuming PPP (¥/$) 112.72
Price of XTerra at end of one year in ($) $ 28,832.47
d) Assuming 75% pass-through, what should be the dollar price of an Xterra at the end one year?
Price of XTerra at end of year (¥) 3,250,000
Amount of expected exchange rate change, in percent (from PPP) 2.200%
Proportion of exchange rate change passed through by Nissan 75.000%
Proportional percentage change 1.650%
Effective exchange rate used by Nissan to price in US$ for end of year 113.330
Price of XTerra at end of one year in ($) $ 28,677.30
Problem 7.11 Copenhagen CIA (A)
John Duell, a foreign exchange trader at JPMorgan Chase, can invest $5 million, or the foreign currency equivalent of
the bank's short term funds, in a covered interest arbitrage with Denmark. Using the following quotes can John Duell
make a covered interest arbitrage (CIA) profit?
Assumptions Value
Arbitrage funds available $5,000,000
Spot exchange rate (kr/$) 6.1720
3-month forward rate (kr/$) 6.1980
US dollar 3-month interest rate 3.000%
Danish kroner 3-month interest rate 5.000%
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
This tells John Duell that he should borrow dollars and invest in the HIGHER yielding currency, the Danish kroner,
for CIA profit.
5.000%
Danish kroner interest (3-month)
John Duell generates a covered interest arbitrage (CIA) profit because he is able to generate an even higher interest
return in Danish kroner than he "gives up" by selling the proceeds forward at the forward rate.
Problem 7.12 Copenhagen CIA (B) ----------- Part a
John Duell is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note that
anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make CIA
profit one way or another.)
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
This tells John Duell that he should borrow Danish kroner and invest in the LOWER interest rate currency, the dollar,
gaining on the re-exchange of dollars for kroner at the end of the period.
a) John Duell generates a covered interest arbitrage profit of kr54,150 because, although U.S. dollar interest rates are
lower, the U.S. dollar is selling forward at a premium against the Danish krone.
Problem 7.12 Copenhagen CIA (B) ----------- Part b
John Duell is now evaluating the arbitrage profit potential in the same market after interest rates change. (Note that
anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make CIA
profit one way or another.)
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
This tells John Duell that he should borrow US dollars and invest in the HIGHER interest rate currency, the kroner,
gaining on the re-exchange of kroner for dollars at the end of the period.
6.000%
Danish kroner interest (3-month)
b) If the Danish kroner interest rate increases to 6.00%, while the U.S. dollar interest rate stays at 3.00% and spot and
forward rates remain the same, John Duell's CIA profit is $16,210.87.
Problem 7.13 Luis Pinzon -- CIA New York
Luis Pinzon is a foreign exchange trader for a bank in New York. He has $1 million (or its Swiss franc equivalent)
for a short term money market investment and wonders if he should invest in U.S. dollars for three months, or make a
covered interest arbitrage investment in the Swiss franc. He faces the following quotes:
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
This tells Luis Pinzon he should borrow U.S. dollars and invest in the LOWER yielding currency, the Swiss franc, in
order to earn covered interest arbitrage (CIA) profits.
3.200%
Swiss franc interest rate (3-month)
a) Luis Pinzon makes a net profit, a covered interest arbitrage profit, of $1,538.46 on each million he invests in the
Swiss franc market (by going around the box). He should therefore take advantage of it and perform covered interest
arbitrage.
b) Assuming a $1 million investment for the 90-day period, the annual rate of return on
this near risk-less investment is: 0.62%
Problem 7.14 Luis Pinzon -- UIA
Luis Pinzon, using the same values and assumptions as in the previous question, now decides to seek the full 4.800%
return available in US dollars by not covering his forward dollar receipts -- an uncovered interest arbitrage (UIA)
transaction. Assess this decision.
Since Luis is in the US market (starting point), if he were to undertake uncovered interest arbitrage he would be first
exchange dollars for Swiss francs, investing the Swiss francs for 90 days, and then exchanging the Swiss franc
proceeds (principle and interest) back into US dollars at whatever the spot rate of exchange is at that time. In this case
Luis will have to -- least in his mind -- make some assumption as to what the exchange rate will be at the end of the
90 day period.
3.200%
Swiss franc interest rate (3-month)
If Luis assumed the spot rate at the end of 90 days were the same as the current spot rate (SFr1.2810/$), the UIA
transaction would not make much sense. The lower Swiss franc interest rate would yield final dollar proceeds of only
$1,008,000, a full $4,000 less than simply investing in the US (straight across the top of the box).
For an UIA transaction to result in higher dollar proceeds at the end of the 90 day period, the ending spot rate of
exchange would have to be SF1.2759/$ or less (a stronger and stronger Swiss franc resulting in more and more US
dollars when exchanged).
Should Luis do it? Well, depends on his bank's policies on uncovered transactions, and his beliefs on the future spot
exchange rate. But, given that he is invested in a foreign currency with a lower interest rate, not a higher one, so he is
placing all of his 'bets' on the exchange rate, it is not a speculation for the weak of heart.
Problem 7.15 Luis Pinzon -- 30 Days Later
One month after the events described in the previous question, Luis Pinzon once again has $1 million (or its Swiss
franc equivalent) to invest for three months. He now faces the following rates. Should he again ener into a covered
interest arbitrage (CIA) investment?
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
This tells Luis Pinzon he should borrow U.S. dollars and invest in the LOWER yielding currency, the Swiss franc,
and then sell the Swiss franc principal and interest forward three months locking in a CIA profit.
3.625%
Swiss franc interest rate (3-month)
Yes, Luis should undertake the covered interest arbitrage transaction, as it would yield a risk-less profit (exchange
rate risk is eliminated with the forward contract, but counterparty risk still exists if one of his counterparties failed to
actually make good on their contractual commitments to deliver the forward or pay the interest) of $5,238.13 on each
$1 million invested.
Problem 7.16 Langkawi Island Resort
You are planning a 30-day vacation on Langkawi Island, Malaysia, one year from now. The present charge for a
luxury suite plus meals in Malaysian ringgit (RM) is RM1,050/day. The Malaysian ringgit presently trades at
RM3.75/$. Hence, the dollar cost today for a 30-day stay would be $8,400. The hotel has informed you that any
increase in its room charges will be limited to any increase in the Malaysian cost of living. Malaysian inflation is
expected to be 4% per annum, while U.S. inflation is expected to be only 1%.
Assumptions Value
Charge for suite plus meals in Malaysian ringgit (RM) 1,050.00
Spot exchange rate (RM/$) 3.7500
US$ cost today for a 30 day stay $8,400.00
a. How many dollars might you expect to need one year hence for your 30-day vacation?
Expected spot rate one year from now based on PPP (RM/$) 3.861386
Hotel charges expected to be paid one year from now for a 30-day stay (RM) 32,760.00
The dollar cost has risen by the US dollar inflation rate. This is a result of your estimation of the future suite
costs and the exchange rate changing in proportion to inflation (relative purchasing power parity).
Problem 7.17 Statoil of Norway's Arbitrage
Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and
petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it
considers the U.S. dollar as its functional currency, not the Norwegian krone. Ari Karlsen is a currency trader for
Statoil, and has immediate use of either $4 million (or the Norwegian krone equivalent). Faced with the following
market rates, and he wonders whether he can make some arbitrage profits in the coming 90 days.
Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected
change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is
less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.
This tells Ari Karlsen he should borrow U.S. dollars and invest in the LOWER yielding currency, the Norwegian
krone, selling the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.
5.625%
START U.S. dollar interest rate (3-month) END
Ari Karlsen can make $2,106.83 for Statoil on each $4 million he invests in this covered interest arbitrage (CIA)
transaction. Note that this is a very slim rate of return on an investment of such a large amount.
Money and foreign exchange markets in London and New York are very efficient. The following
information is available:
a. What do the financial markets suggest for inflation in Europe next year?
According to the Fisher effect, real interest rates should be the same in both Europe and the U.S.
b. Estimate today's one-year forward exchange rate between the dollar and the euro.
You are planning a ski vacation to Mt. Blanc in Chamonix, France one year from now. You are
negotiating the rental of a chateau. The chateau's owner wishes to preserve his real income against
both inflation and exchange rate changes, and so the present weekly rent of €9,800 (Christmas
season) will be adjusted upward or downward for any change in the French cost of living between
now and then. You are basing your budgeting on purchasing power parity (PPP). French inflation
is expected to average 3.5% for the coming year, while U.S. dollar inflation is expected to be
2.5%. The current spot rate is $1.3620/€. What should you budget as the U.S. dollar cost of the
one week rental?
Assumptions Value
Spot exchange rate ($/€) $1.3620
Expected US inflation for coming year 2.500%
Expected French inflation for coming year 3.500%
Current chateau nominal weekly rent (€) € 9,800.00
Note: Students may inquire as to whether the euro, a currency for a multitude of countries which
may actually have substantial differencies in inflation locally, really will react to inflationary
pressures and differentials as PPP would predict. A good question.
Problem 7.20 East Asiatic Company -- Thailand
The East Asiatic Company (EAC), a Danish company with subsidiaries all over Asia, has been funding its Bangkok
subsidiary primarily with U.S. dollar debt because of the cost and availability of dollar capital as opposed to Thai
baht (B) funds. The treasuer of EAC-Thailand is considering a one-year bank loan for $350,000. The current spot rate
is B42.84/$. One year loans are 14.00% in baht but only 8.885% in dollars.
Assumptions Value
Current spot rate, Thai baht/$ 42.84
Expected Thai inflation 4.500%
Expected dollar inflation 2.200%
Loan principal in U.S. dollars $350,000
Thai baht interest rate, 1-year loan 14.000%
US dollar interest rate, 1-year loan 8.885%
First, it is necessary to forecast the future spot exchange rate for the baht/$.
Different expectations of the future spot exchange rate, either PPP for part a), or an expected devaluation for
part b), allow the isolation of exactly how many Thai baht would be required to repay the dollar loan.
a) Assuming a purchasing power parity forecast of the future spot rate, B43.8041/$, it will take 16,693,633 baht to
repay the U.S. dollar loan. The implied cost of funds, in baht terms, is 11.335%.
b) Assuming a future spot rate for the baht which is 5% weaker than the current spot rate (B42.84/$ ÷ ( 1 - .05), or
B45.0947/$), the implied cost is 14.616%. (This is found by plugging in this new forecast spot rate in the expected
spot rate cell on the right-hand-side of the box.)
Current 42.8400
Pct Chg -5.00%
New spot = old spot ÷ ( 1 - .05) Forecast 45.0947
c) Part a and part b are both cheaper than borrowing at 14.00%. However, both are highly risky given that the future
spot rate is not known until a full year has passed.
Problem 7.21 Maltese Falcon: March 2003-2004
The infamous solid gold falcon, initially intended as a tribute to the King of Spain by the Knights of Rhodes in
appreciation for his gift of the island of Malta to the order in 1530, has recently been recovered. The falcon is 14
inches in height and solid gold, weighing approximately 48 pounds. Gold prices in late 2002 and early 2003,
primarily as a result of increasing political tensions, have risen to $440/ounce. The falcon is currently held by a
private investor in Istanbul, who is actively negotiating with the Maltese government on its purchase and prospective
return to its island home. The sale and payment are to take place in March 2004, and the parties are negotiating over
the price and currency of payment. The investor has decided, in a show of goodwill, to base the sales price only on
the falcon's specie value -- its gold value.
The current spot exchange rate is 0.39 Maltese lira (ML) per U.S. dollar. Maltese inflation is expected to be about
8.5% for the coming year, while U.S. inflaiton, on the heels of a double-dip recession, is expected to come in at only
1.5%. If the investor bases value in the U.S. dollar, would he be better off receiving Maltese lira in one year --
assuming purhcasing power parity, or receiving a guaranteed dollar payment assuming a gold price of $420 per
ounce?
The purchasing power parity forecast of the Maltese lira/dollar exchange rate:
If the investor bases his gross sales proceeds in U.S. dollars, the guaranteed dollar payment at $420/ounce yields a
larger amount ($322,560) than accepting Maltese lira assuming PPP ($316,116).
Investor Receives
in March 2004
Current Value Assuming PPP
$ 337,920 $ 316,119
↓ ↑
↓ ↑
↓ ↑
↓ ↑
↓ ↑
Spot (ML/$) ---------------> 360 days ----------------> Expected Spot (ML/$)
0.3900 0.4169
↓ ↑
↓ ↑
↓ ↑
131,788.80 131,788.80
Maltese lira
Problem 7.22 London Money Fund
Tim Hogan is the manager of an international money market fund managed out of London. Unlike many money
funds that guarantee their investors a near risk-free investment with variable interest earnings, Tim Hogan's fund is a
very aggressive fund that searches out relatively high interest earnings around the globe, but at some risk. The fund is
pound-denominated.
Tim is currently evaluating a rather interesting opportunity in Malaysia. The Malaysian government has been
enforcing a number of currency and capital restrictions since the Asian Crisis of 1997 to protect and preserve the
value of the Malaysian ringgit (RM). The current spot rate of RM3.75/$ has been adjusted only recently (July 2005)
from its previously fixed value of RM3.80/$. Local currency (RM) time deposits of 180-day maturities are earning
9.600% per annum ($500,000 minimum deposit). The London eurocurrency market for pounds is yielding 4.200%
per annum on similar 180-day maturities. The current spot rate on the British pound is $1.7640/£, and the 180-day
forward rate is $1.7420/£. What do you recommend Tim Hogan do about the Malaysian money market opportunity
assuming he is investing £1 million?
Assumptions Values
Principal investment, British pounds £1,000,000.00
Spot exchange rate ($/£) $1.7640
180-day forward rate ($/£) $1.7420
Malaysian ringgit 180-day yield 9.600%
Spot exchange rate, Malaysian ringgit/$ 3.7500
The initial pound investment implicitly passes through the dollar into Malaysian ringgit. The ringgit is fixed against
the dollar, hence the ending RM/$ rate is the same as the current spot rate. The pound, however, is not fixed to either
the dollar or ringgit. Tim Hogan can purchase a forward against the dollar, allowing him to cover the dollar/pound
exchange rate.
If Tim Hogan invests in the Malaysian ringgit deposit, and accepts the uncovered risk associated with the RM/$
exchange rate (managed by the government), and sells the dollar proceeds forward, he should expect a return of
6.124% on his 180-day pound investment. This is better than the 4.200% he can earn in the euro-pound market.
Interestingly, if Tim Hogan chose to NOT sell the dollars forward, and accepted the uncovered risk of the $/£
exchange rate as well, he may or may not do better than 6.124%. For example, if the spot rate remained unchanged at
$1.7640/£, Tim's return would only be 4.800%. This demonstrates that much of the added return Tim is earning is
arising from the forward rate itself, and not purely from the nominal interest differentials.
Problem 7.23 The Beer Standard
In 1999 The Economist magazine reported the creation of an index or standard for the evaluation of currency values in Africa. Beer was chosen as the product
for comparison because McDonald's had not peneterated the African continent beyond South Africa, and beer met most of the same product and market
characteristics required for the construction of a proper currency index. Investec, a South African investment banking firm, has replicated the process of
creating a measure of purchasing power parity (PPP) like that of the Big Mac Index of The Economist, for Africa.
The index compares the cost of a 375 milliliter bottle of clear lager beer across sub-Sahara Africa. As a measure of PPP the beer needs to be relatively
homogeneous in quality across countries, needs to possess substantial elements of local manufacturing, inputs, distribution, and service, in order to actually
provide a measure of relative purchasing power. The beers are first priced in local currency (purchased in the taverns of the local man, and not in the high-
priced tourist centers), then converted to South African rand. The prices of the beers in rand are then compared to form one measure of whether the local
currencies are undervalued (-%) or overvalued (+%) versus the South African rand. Use the data in the exhibit and complete the calculation of whether the
individual currencies are under- or over-valued.
Notes:
1. Beer price in South African rand = Price in local currency / spot rate on 3/15/99.
2. Implied PPP exchange rate = Price in local currency / 2.30.
3. Under or overvalued to rand = Implied PPP rate / spot rate on 3/15/99.
Problem 7.24 Brynja Johannsdottir and the Icelandic Carry-Trade
Brynja Johannsdottir is Icelandic by birth, but is working for Magma Capital, a currency hedge fund run out of New
York. The high money market rates offered in Iceland have been supporting the carry trade, as investors borrow in
cheaper currencies (nearly any currency at this point) and invest for the short-term in Icelandic krona. But they do so
on an uncovered basis. Brynja believes that -- at least for the coming 3 to 6-month period -- the krona will continue to
stay strong, sticking at kr.70/$. Her bank requires that any position she takes yield at least 4.0% for the period in
question (16% annually). Using the following assumptions, she wishes to evaluate the uncovered interest arbitrage
(UIA) potential.
Using the $2 million principal, Brynja can indeed make her numbers work. If she changes the $2 million into Iceland
krona, invests in the krona for 90 days, and then exchanges the krona back to dollars at the end of the period at the
spot exchange rate, she expects to make about a 4.2% return -- IF her expectations about the spot rate of kr.70/$ hold
true.
12.020%
Icelandic krona interest rate (3-month)
Problem 7.25 Plummeting Yen Carry-Trade
The Japanese yen, long the home of the global carry trade as the lowest interest cost source of funds of any major
industrial market, began strengthening in August 2007. The yen had remained relatively quiet and above ¥118/$ for
several months. Most analysts and arbitragers believed it would stay at 118, maybe falling to 120.As the U.S.
subprime mortgage crisis hit in August 2007, U.S. dollar interest rates starting rising, initially adding some
momentum to the carry-trade.
But then on August 14, the rising concerns over the financial health of the U.S. economy caused a fall in the
dollar, and the yen starting appreciating significantly against the dollar (rising quickly to ¥114/$). This was
devastating for the carry-trade, as a rising yen undermined the uncovered interest arbitrage benefits. Within days,
things worsened. In an effort to increase the liquidity of the U.S. financial sector fearing rising mortgage-backed
securities defaults, the U.S. Federal Reserve lowered the discount rate which caused a fall in short-term interest rates.
Using the following inputs, show using a $1,000,000 notional principal (or Japanese yen equivalent), how the
Japanese yen carry trade results in a negative investment return after the rise of the yen and the fall of US dollar
interest rates:
4.800%
U.S. dollar interest rate (3-month)
After inputting the original values -- which show a yen carry trade profit when the expected spot rate is ¥118/$,
change the end of period spot rate to ¥114/$. Even without reducing the US dollar interest rate, the yen carry trade is
no longer profitable.