Suppose Japanese yen money market annual rate is .60% and U.S. money market has

Question

Suppose Japanese yen money market annual rate is .60% and U.S. money market has an annual rate of 4.50%.

1). The predictions on the spot rate in 6 months made by financial analysts X and Y are ¥116/$ and ¥114/$ respectively. If the spot rate today is ¥115/$, which prediction do you think is more reasonable, why?

2). What should be the spot rate in 6 months based on parity condition?

3). If the forward rate in 6 months is ¥113/$, will there be arbitrage opportunity, why? If yes then which investment strategy will offer you profit (hint: borrow or lend, dollar or yen, buy or sell forward)?

4). Suppose you adapt the correct arbitrage strategy with the starting investment value of $43,478.2609 or ¥5,000,000, what will be the net proceeds? Please show each step clearly.

5). If financial analyst X believes his prediction is right, then what he would do to explore the market profit opportunity?

6) What is the key difference between the strategy adopted by analyst X in part 5 and the strategy in part 4?

Explanation / Answer

Solution:

Part 1

International Fishers Effect predicts the expected spot rate and states that the country with higher nominal rate will depreciate its currency in this case the rate of US is higher.

Thus, the prediction of the analyst which shows depreciation of dollar is more accurate. In this case such prediction is ¥116/$.

Part 2

Spot rate based on parity condition = 115*(1.0225)/(1.003) = 117.24

Thus, the estimated spot rate based on parity condition is ¥117.24/$.

Part 3

6 month forward rate = ¥113/$

Estimated Spot Rate based on parity condition = ¥117.24/$

Thus, there exist an arbitrage opportunity that is available. Following steps should be performed –

Part 4

Net Profit = Yen (5023586.86-5015000) = Yen 8587

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