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L QUESTION 4 (UNIT 2) (25 MARKS) a) Assume the following information: Bank Bid Price of New Ask Price of New Zealand Dollar Zealand Dollar JP Morgan Bank USD0
L QUESTION 4 (UNIT 2) (25 MARKS) a) Assume the following information: Bank Bid Price of New Ask Price of New Zealand Dollar Zealand Dollar JP Morgan Bank USD0.6533 USDO.6563 Well Fargo USD0.6503 USDO.6523 Justify whether locational arbitrage is possible. If so, explain the steps involved in locational arbitrage, and estimate the profit from this arbitrage if you had USD1,000,000 to use. Discuss market forces factors that would occur to eliminate any further possibilities of locational arbitrage. (6 marks) b) Quoted Price USDO.7381 Currency Pair Value of Canadian Dollar (CAD) in US Dollars (USD) Value of New Zealand Dollar (NZD) in US Dollars (USD) Value of Canadian Dollar in New Zealand Dollars (NZD) USDO.6537 NZD1.1305 Referring to the information given, explain the steps that would reflect triangular arbitrage. If you had USD2,500,000 to use in triangular arbitrage, compute the profit from this strategy. Justify the steps taken to prevent any further possibilities of triangular arbitrage. (7 marks) Given the following information, calculate the yield (percentage return) to a U.S. investor who used covered interest arbitrage. Assume the investor invests USD2,000,000 determine the profit or loss in this transaction. You are required to analyse the market forces determinants occur in order to protect from any further possibilities of covered interest arbitrage. c) Currency pairs and Interest Rate Spot Rate of Canadian Dollar (CAD) 90-day forward rate of Canadian dollar 90-day Canadian interest rate 90-day U.S. interest rate Quoted Price USDO.7381 USDO.7252 3.25% 1.75% (8 marks) - d) Assume that interest rate parity exists. You expect that the one-year nominal interest rate in the U.S. is 1.995%, while the one-year nominal interest rate in Australia is 3.695%. The spot rate of the Australian dollar is USD0.6939. You will need 15 million Australian Dollars in one year. Today, you purchase a one-year forward contract in Australian Dollars. Estimate how many U.S. Dollars (USD) will you need in one year to fulfill your forward contract. (4 marks)
Expert Solution
Answer a)
AT JP MORGAN BANK 1 NZ$ = 0.6533/0.6563 USD
AT WELL FARGO BANK 1 NZ$ = 0.6503/0.6523 USD
Option 1:- If We buy NZ$ from JP Morgan Bank and sell at Well Fargo Bank:-
Buy NZ$ from JP Morgan Bank at ask Price 1NZ$ = 0.6563 USD
1,000,000/0.6563 = 1523693.43 NZ$
AND SELL AT Well Fargo Bank at Bid Price 1NZ$ = 06503 USD
1523693.43 X 0.6503 = 990857.84 USD
Option 2:- If We buy NZ$ from Well Fargo Bank and sell at JP Morgan Bank:-
Buy NZ$ from Well Fargo Bank at ask Price 1NZ$ = 0.6523 USD
1,000,000/0.6523 = 1533036.94 NZ$
AND SELL AT JP Morgan Bank at Bid Price 1NZ$ = 06533 USD
1523693.43 X 0.6533 = 1001533.04 USD
As per Option 2 the above calculation is it clearly shows that if someone buy NZ$ From Well Fargo Bank and Sell at JP Morgan Bank it will earn Rs. 1001533.04-1000000 = 1533.04 USD
Answer b)
1 CAD = 0.7381 USD
1 NZD = 0.6537 USD
1 CAD 1.1305 NZD
If We convert 2,500,000 USD to CAD to NZD to again USD
2,500,000 USD X 1/0.7381 X 1.1305 X 0 .6537 = 2503074.95 USD
Than we get 2503074.95 USD and this results gain of USD 3074.95 (2503074.95-2500000)
Answer c)
SPOT RATE 1CAD = 0.7381 USD
F/W RATE 1CAD = 0.7252 USD
Investor Borrow from Canada and invest in US for 90 days
Borrow from Canada at interest Rate of 3.25 %
Invest in US at interest rate of 1.75 %
To Invest 2,000,000 USD in US he should borrow 2709659.94 CAD (2000000/0.7381) at spot rate (1CAD = 0.7381 USD)
Step 1 Borrow from Canada
2,000,000 X 1/0.7381 = 2709659.94 CAD
Step 2 Invest in US
2709659.94 X 0.7381 = 2,000,000 USD
AFTER 90 DAYS:
Step 3 HE WILL GET FROM US =
2,000,000 + (2,000,000 X 90/365 x 1.75/100) = 2008630.14 USD
Step 4 Repay loan amount in Canada along with interest:
2709659.94 + (2709659.94 X 3.25/100 X 90/365) = 2731374.34 CAD
Step 5 Profit from Interest Arbitrage:
2731374.34 CAD X 0.7252 = 1980792.67 USD
2008630.14 – 1980792.67 = 27837.47 USD Profit
Answer d)
US Interest Rate 1.995%
Australia Interest Rate 3.695%
Spot Exchange Rate 1AUD = 0.6939 USD
AUD Required after one year = 1,500,000
Step 1 Borrow From US at 1.995% interest USD 1,500,000
Step 2 Convert USD to AUD
1,500,000 X 1/0.6939 = 2161694.77 AUD
Step 3 Invest 2161694.77 AUD in Australia
AFTER ONE YEAR
Step 4 Get invested money along with interest from Australia: -
2161694.77 + (2161694.77 X 3.695/100) = 2241569.39 AUD
Step 5 Repay Loan taken from US
1,500,000 + (1,500,000 X 1.995/100) = 1529925 USD
From the above calculation is clear that we need 1529925 USD in one year to fulfil forward contract.
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