1. Suppose you expect the Croatian currency, the Kuna, to appreciate 5% relative
ID: 2773027 • Letter: 1
Question
1. Suppose you expect the Croatian currency, the Kuna, to appreciate 5% relative to the USD over the next 6 months. What additional information would you need in order to decide whether it is a good time to buy Kuna? Suppose you find out in the newspapers that the interest rate on Kuna deposits is 7%. What is the expected dollar return on Kuna deposits? What must the US interest rate be if the uncovered interest parity condition holds? 2. You are a foreign exchange trader specialized in the US dollar Swiss franc market (USD/CHF). One morning, you notice that the one-year dollar interest rate is 4%, while the one-year interest rate on Swiss francs is 2.7%. Today’s USD/CHF rate is $1.7. (a) What spot rate do you expect for the USD/CHF in one year? (b) You log onto your electronic brokerage account and find that the current quote for the 360- day forward rate on USD/CHF is 1.79. Is there an arbitrage opportunity? If so, describe how you would take profit from it and how much you would get if you invested $1. What do you anticipate if all of your fellow traders start doing the same?
Explanation / Answer
Answer :-
1.) a.) Decide whether you should buy Kuna, you need to know the interest differential between a Croatian Deposit and USD Deposit.
b.) The expected Dollar Return(R%) on Kuna deposits is R%(kuna) + Appreciate by 5% = 7% + 5% = 12%.The dollar depreciates by 5% relative to the Kuna.
c.) If uncovered Interest parity holds, The US Interest rate must be 12%.
2.) a.) Expected Spot Rate (after 1 year) = [Spot rate * (1 + interest rate of USD)] / ( 1 + interest rate of CHF)
= [ $ 1.7 * ( 1 + .04)] / ( 1 + .027)
= 1.768 / 1.027
= $ 1.72
= $ 1.72 / 1 CHF
b.) Yes, there does exist an arbitrage opportunity. Assume this year is period 1, next year is period 2. Then you can either:
Invest $1 at 4% to earn 1.04 in period 2, (or)
Convert $1 into CHF at the current exchange rate = 1/1.7.
Invest this at the CHF interest rate of 2.7% and you end up with = ( 1 / 1.7 ) * 1.027.
Buy USD at the forward rate for the second period (that equals the expected exchange rate) of 1.79 :-
(1/1.7) * 1.027 * 1.79 = 1.0814.
So, you have the opportunity to make a profit of 1.0814 1.04 = 0.0414 dollars for each dollar invested.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.