Assignment# 3 by Nedim Halilagic
14. Freely Floating Exchange Rates. Should the governments of Asian countries allow their currencies to float freely? What would be the advantages of letting their currencies float freely? What would be the disadvantages?
ANS: Given that Asian countries are rising economies and that floating exchange rate systems allows currency values to reflect a nation’s economic fundamentals gradually and efficiently, I would say that they should allow their currencies to float freely. Advantages of freely floating exchange rate system are insulation form the inflation of other countries and from unemployment problems in other countries. However, freely floating exchange rate system can adversely affect a country that has high unemployment.
Locational Arbitrage. Assume the following information:
Bid price of New Zealand dollar
Ask price of New Zealand dollar
Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of locational arbitrage?
Yes. One could purchase New Zealand dollars at Yardley Bank for $.40 and sell them to Beal Bank for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased at Yardley Bank. These New Zealand dollars could then be sold to Beal Bank for $1,002,500, thereby gener¬ating a profit of $2,500.
The large demand for New Zealand dollars at Yardley Bank will force this bank's ask price on New Zealand dollars to increase. The large sales of New Zealand dollars to Beal Bank will force its bid price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank, locational arbitrage will no longer be beneficial.
Triangular Arbitrage. Assume the following information:
Value of Canadian dollar in U.S. dollars
Value of New Zealand dollar in U.S. dollars
Value of Canadian dollar in New Zealand dollars
Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of triangular arbitrage?
Yes. The appropriate cross exchange rate should be 1 Canadian dollar = 3 New Zealand dollars. [US$/CAD x 1/(US$/NZD) = NZD/CAD] Thus, the actual value of the Canadian dollars in terms of New Zealand dollars is more than what it should be. One could obtain Canadian dollars with U.S. dollars, sell the Canadian dollars for New Zealand dollars and then exchange New Zealand dollars for U.S. dollars. With $1,000,000, this strategy would generate $1,006,667 thereby representing a profit of $6,667.
The value of the Canadian dollar with respect to the U.S. dollar would rise. The value of the Canadian dollar with respect to the New Zealand dollar would decline. The value of the New Zealand dollar with respect to the U.S. dollar would fall.
Covered Interest Arbitrage. Assume the following information:
Spot rate of Canadian dollar
90 day forward rate of Canadian dollar
90 day Canadian interest rate
90 day U.S. interest rate
Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1,000,000.) What market forces would occur to eliminate any further possibilities of covered interest arbitrage?
$1,000,000/$.80 = C$1,250,000 × (1.04)
= C$1,300,000 × $.79
Yield = ($1,027,000 – $1,000,000)/$1,000,000 = 2.7%, which exceeds the yield in the U.S. over the 90 day period. The Canadian dollar's...
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