Week 8-9: Tutorial Problem Set 8

(Solution Guide ) *

April 14, 2022

Topic: International Arbitrage

1. The following exchange rates are quoted in Sydney and London at the
same time:
Center Quote
Sydney (AU D/GBP ) 2.5600
London (GBP/AU D ) 0.3500

(a) Is there a possibility for two-point arbitrage?

Solution:
Center Quote
Sydney (AU D/GBP ) 2.5600
London (GBP/AU D ) 0.3500
London (AU D/GBP ) 2.8571
First we make sure that rates are read in the same quote in both Cen-
ters. In London, (AU D/GBP ) = 2.8571 6= 2.5600, the price of GBP
in Sydney. , In fact the price of GBP is higher in London. The
equilibrium condition is violated.

(b) If so, what will arbitragers do?

Solution: Since the AU D/GBP exchange rate is higher in London
than it is in Sydney, it follows that the pound is more expensive in
London. Arbitragers will buy the pound in Sydney and sell it in
London. The demand for GBP in Sydney and supply of GBP in the
London center will increase. Hence the AU D/GBP exchange rate in
Sydney will increase and in London, it will decrease. The process will
continue until the exchange rates are equal in both nancial centers,
at which time arbitrage will come to an end.

* Prepared by: Course Coordinator Dr. Ronald R. Kumar - Semester 1, 2022-FM303,

School of Accounting, Finance and Economics, The University of the South Pacic, Laucala
Campus, Suva, Fiji

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

(c) What is the prot earned from arbitrage?

BuyGBP in Sydney at 2.5600 (AU D/GBP ) and sell GBP in Lon-
2.8571, realizing a gross prot of (2.8571 − 2.5600) AU D/GBP ×
don at
1GBP = 0.2971 AU D per 1 GBP.
2. The following exchange rates are quoted simultaneously in Sydney, Frank-
furt and Zurich:
Center Quote Rate
Sydney AU D/EU R 1.6400
Frankfurt CHF/AU D 0.8700
Zurich CHF/EU R 1.4600

(a) Is there a possibility for two-point arbitrage?

Solution: There is no possibility for two-point arbitrage since the
exchange rates are equal (and unique?) across nancial centers.In
other words, there is no possibility of gaining through a single pair
of currency.

(b) Is there a possibility for three-point arbitrage?

AU D/EU R = 1.6400 (AU D) for one euro in Sydney ⇒ EU R/AU D =
0.60975 euro for 1 AU D in Sydney
CHF/AU D = 0.8700 CHF for one AU D in Frankfurt ⇒ AU D/CHF =
1.14943 (AU D) for one Swiss-franc in Frankfurt
CHF/EU R = 1.46 CHF for one euro in Zurich ⇒ EU R/CHF =
0.68493 euros for 1 CHF in Zurich
Now we calculate using cross rates:
1
AU D/EU R = AU D/CHF × CHF/EU R = 0.87 × 1.46 = 1.67816 6=
(>)1.64000 in Sydney. We can do other cross rates to show that they
do not match with a rate of one of centers to compare the rates at
the respective centers.
CHF/EU R = CHF/AU D × AU D/EU R = 0.87 × 1.64 = 1.4268 6=
(<)1.4600 in Zurich.
1
AU D/CHF = AU D/EU R × EU R/CHF = 1.64 × 1.46 = 1.12329 6=
(<)1.14943in Frankfurt.
∴ there is a possibility for three-point arbitrage.

(c) If so, what is the protable sequence?

From (b), it is clear that AU D/EU R is lower in Sydney than the
cross rate, which means EU R is cheaper in Sydney than via cross
rate. So we can buy euros (the cheaper currency) at Sydney, and
CHF , and then sell CHF in Franfurt for
then sell it in Zurich for
AU D.
• Sell 1 AU D in Sydney (0.60975 euros) → Sell EU R (0.60975 ×
1.4600 = 0.8090235 CHF) in Zurich → Sell CHF (0.8090235× 0.87
1
=
1.023258621) AU D in Frankfurt. So we started by selling 1AU D,
and ended up getting more than 1 AUD. The protable sequence is:

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

AU D → EU R → CHF → AU D

(d) What is the prot earned from arbitrage?

Solution: An arbitrager starting with one AU D will end up with
about 1.0233 AU D. So the prot earned per AU D is AU D 0.0233or
2.33 cents.

(e) How do the three exchange rates change as a result of arbitrage?

Solution: Selling AU D against the euro leads to a rise in the AU D/EU R
rate (due to increase in the demand for euros). Selling the euro
against the Swiss franc leads to a fall in the CHF/EU R rate (due
to increase in the supply of euros). Selling the Swiss franc against
the Australian dollar leads to a rise in the CHF/AU D rate (due to
increase in demand of AU D).
(f ) What is the value of the CHF/EU R exchange rate that eliminates
the possibility for protable arbitrage?
Solution: The value of the CHF/EU R rate that eliminates the
possibility for protable arbitrage is calculated in (b) as 1.4268. It
is easy to verify that there is no protable sequence at this exchange
rate.

Question was revised) The following exchange rates are quoted in Syd-
3. (
ney and London at the same time:
Center Quote Rate
Sydney AU D/GBP 2.5575 − 2.5625
London GBP/AU D 0.3475 − 0.3525

(a) Is there a possibility for two-point arbitrage?

Solution: Arbitrage is triggered by the violation of the equilibrium
condition in the presence of bidoer spreads. In order to check
whether or not this condition holds, we must rst calculate the bid
AU D/GBP rate in London. The bid rate is calculated as:
Center Quote Rate
Sydney AU D/GBP 2.5575 − 2.5625
London GBP/AU D 0.3475 − 0.3525
1 1
London AU D/GBP 0.3525 − 0.3475
London AU D/GBP 2.8369 − 2.8777
which is dierent from the bid-oer rates in Sydney, implying the
violation of the equilibrium condition and the presence of a prof-
itable arbitrage operation. Note that it is sucient to show that
the dierence in at least one (bid or oer) rate can trigger arbitrage
opportunity.

(b) If so, what will arbitragers do?

Solution: Arbitragers will buy the pound in Sydney at the rate of
2.5625 and sell it in London at the 2.8369. Here, arbitragers are price
takers, and the quote are given.

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

(c) What is the prot earned from arbitrage?

Solution: Π = 2.8369 − 2.5625 = 0.2744AU D per unit of GBP .
(d) Compare the results with those obtained from question 1.

4. The following exchange rates are quoted:

Quote Rate
JP Y /AU D 67.16
GBP/AU D 0.3484
CHF/AU D 0.8012
CAD/AU D 0.8711

(a) Calculate all possible cross rates.

Solution:
1
• JP Y /GBP = JP Y /AU D × AU D/GBP = 67.16 × 0.3484 = 192.77
1
• JP Y /CHF = JP Y /AU D × AU D/CHF = 67.16 × 0.8012 = 83.82
1
• JP Y /CAD = JP Y /AU D × AU D/CAD = 67.16 × 0.8711 = 77.10
1
• GBP/CHF = GBP/AU D × AU D/CHF = 0.3484 × 0.8012 =
0.4348
1
• GBP/CAD = GBP/AU D × AU D/CAD = 0.3484 × 0.8711 =
0.4000
1
• CHF/CAD = CHF/AU D × AU D/CAD = 0.8012 × 0.8711 =
0.9198
(b) Using the calculated cross rates, show that there is no opportunity
for three-point, four-point or ve-point arbitrage.
Solution:
Start with one unit of any currency. If you end up with one unit of
the same currency after going through two, three or four currencies
there is no arbitrage opportunity. There is no two point arbitrage
since the rates are not quoted dierently.

Sell AU D for JP Y , Sell

Consider three-point arbitrage involving,
JP Y for GBP , Sell GBP for AU D. Starting with one AU D: Sell
AU D1.00 → JP Y 67.16 → GBP 0.3484 → AU D1.00

Similarly, four-point arbitrage and ve-point arbitrage starting with

one AU D give the following:
• AU D1.00 → JP Y 67.16 → GBP 0.3484 → CAD0.8710 → AU D1.00
• AU D1.00 → JP Y 67.16 → GBP 0.3484 → CAD0.8710 → CHF 0.8710 →
AU D1.00
(c) If the cross rates were 10% higher than those obtained in (a), show
that there are opportunities for protable three-point, four-point or
ve-point arbitrage
Solution:
1
• JP Y /GBP = JP Y /AU D × AU D/GBP = 67.16 × 0.3484 × 1.10 =
212.04

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

1
• JP Y /CHF = JP Y /AU D × AU D/CHF = 67.16 × 0.8012 × 1.10 =
84.46
1
• JP Y /CAD = JP Y /AU D × AU D/CAD = 67.16 × 0.8711 × 1.10 =
92.21
1
• GBP/CHF = GBP/AU D×AU D/CHF = 0.3484× 0.8012 ×1.10 =
0.4783
1
• GBP/CAD = GBP/AU D×AU D/CAD = 0.3484× 0.8711 ×1.10 =
0.4399
1
• CHF/CAD = CHF/AU D×AU D/CAD = 0.8012× 0.8711 ×1.10 =
1.012

Consider three-point arbitrage involving AU D , JP Y and GBP ,

⇒ Sell AU D, Sell GBP , Sell JP Y .
AU D1.00 →GBP 0.3167 → JP Y 73.876 → AU D1.100 > AU D1.00.
Refer to Excel Sheet, Q4, on Moodle.

AU D, JP Y and GBP ,
Consider four-point arbitrage involving
⇒ Sell AU D,Sell CHF , Sell GBP , Sell JP Y .
AU D1.00 →CHF 0.8012 → GBP 0.3832 → JP Y 81.2636 → AU D1.21 >
AU D1.00. Refer to Excel Sheet, Q4, on Moodle.

AU D, JP Y and GBP ,
Consider ve-point arbitrage involving
⇒ Sell AU D,Sell CHF , Sell GBP , Sell CAD, Sell JP Y
AU D1.00 →CHF 0.8012 → GBP 0.3832 → CAD0.8711 → JP Y 73.876 →
AU D1.10 > AU D1.00. Refer to Excel Sheet, Q4, on Moodle.
5. The price of a commodity in New Zealand is N ZD10 while the price of
the same commodity in Australia is AU D6. The current exchange rate
(N ZD/AU D) is 1.15.

(a) Is there a violation of the LOP?

Solution: P = SP ∗ ,
LOP:
PN ZD = 10, and PAU = 6, and S = 1.15 (N ZD/AU D). this
amounts to SPAU = 1.15(N ZD/AU D) × 6AU D = 6.9N ZD < (6=
)PN ZD = 10N ZD, which means that Law of One Price (LOP) is
violated.

(b) If so, what will happen?

Solution:
The price of the commodity in New Zealand dollar terms is lower in
Australia than in New Zealand. In New Zealand, the price is N ZD10
whereas the same commodity is 6.9N ZD in Australia.
Thus, arbitragers will buy the commodity in Australia at N ZD6.90
and sell it in New Zealand at N ZD10.00, making prot of N ZD3.10
per unit. The increase in demand in Australia for the commodity in
Australia will put pressure on the price to rise while the increase in
supply in New Zealand will put pressure on the price to fall, until

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

they are equal.

(c) What is the Australian dollar price compatible with the LOP at the
current exchange rate?
Solution: PAU = PN Z × AU D/N ZD = N ZD10 × 1.15
1
≈ 8.70AU D
(d) At the current Australian dollar price, what is the exchange rate
compatible with the LOP?
Solution: S(N ZD/AU D) = 1.15, PN Z N ZD10
PAU = AU D6 = 1.67(N ZD/AU D) <
1.15. This means the Australian dollar is undervalued (since based
on LOP, the price of same commodity is cheaper in Australia). Side
note: There's has been a view that China's currency has been un-
dervalued. Here's a link providing an interesting reading: Is the
Renminbi Undervalued or Overvalued?

6. You are given the following information:

Spot exchange rate (AU D/EU R) 1.60
One year forward rate (AU D/EU R) 1.62
One year interest rate on the Australian dollar 8.5%
One year interest rate on the euro 6.5%

(a) Is there any violation of CIP?

Solution: Since the forward exchange rate (1.62) is higher than the
spot rate (1.60), the EUR is selling at a premium. Since interest on
the euro is lower (6.5%), there is no `qualitative' violation of CIP in
the sense that the low interest currency (euro) sells at a premium,
not at a discount. To investigate `quantitative' violation of CIP, we
examine the answers of other parts (b-e).

(b) Calculate the covered margin (going short on the AU D).

Covered margin is the dierence between investment in foreign cur-
rency (covered due to forward rate) in domestic terms and investment
in domestic asset (at t = 1).
Solution: Going short on the AU D means that we borrow AU D
and invest in EU R. The covered margin (going short on the AU D)
is calculated as:
• t = 0 : Borrow AU D: say AU D1
• t = 1 : Loan (amount borrowed or due) in AU D is: AU D1×(1+i) =
AU D1.085
Foreign investment:
1
• t = 0 : Convert AUD1 into EUR: 1AU D ×EU R/AU D = 1× 1.60 =
EU R0.6250
• t = 1 :Value of foreign investment is: EU R0.6250 × (1 + i∗ ) =
EU R0.6250 × 1.065 = EU R0.665625,
• t = 1 : Converting back to AU D using forward rate at t = 1:
EU R0.665625 × 1.62(AU D/EU R) = AU D1.0783125

Covered margin: Amount from foreign investment minus the amount

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

borrowed (all in domestic terms). AU D1.0783125 − AU D1.085 =

−0.0066875 ≈ −AU D0.0067 < 0. Since the covered margin is not
equal to zero, there is a violation of CIP.
K ∗
Also, we can use the formula of Covered margin
S (1 + i ) F −
=
K(1 + i), where K= 1. Refer to Short Notes on International Arbi-
trage

(c) Calculate the interest parity forward rate and compare it with the
actual forward rate.
Solution:
h i Recall from Short Notes on International Arbitrage F̄ =
1+i 1.085
S 1+i∗ = 1.60 × 1.065 = 1.6301 > 1.62 = F . Since F̄ > F ⇒
deviations from CIP.

(d) Calculate the forward spread and compare it with the interest dier-
ential.
Solution: Recall from Short Notes on International Arbitrage, For-
ward spread: f = FS − 1, and interest spread: i − i∗ .
f = 1.60 −1 = 0.0125 ≡ 1.25% and i−i∗ = 0.085−0.065 = 0.02 ≡ 2%.
1.62
∗
Since f 6= i−i , that is, forward spread dierential and interest dier-
ential are not equal, this implies quantitative violation of CIP. Also,
f >0⇒ foreign currency (euro) sells at a premium. Refer to Short
Notes on International Arbitrage

(e) What would arbitragers do?

Solution: We have seen that going short in AU D results in a
loss, when we calculated the covered margin (b). So we reverse
the currency to short. That is, we take a short position in eu-
ros. Arbitragers will borrow the 1 euro (at t = 0) at the rate
of 6.5%, convert it into Australian dollar (AU D1.60) and invest
the proceeds at 8.5% for one year (t = 1). Upon the maturity
of the investment, the proceeds are converted back into the euro
1


AU D1.60 × (1 + 0.085) × 1.62 (EU R/AU D) = EU R1.0716049382 at
the forward rate, the loan amount is EU R1.065. Net arbitrage prot
Π = EU R1.0716049382 − EU R1.065 = EU R0.006049382, which is
the covered margin. In terms of percentage points, the covered mar-
gin isπ = i − i∗ − i∗ × f − f = 0.66875%, and using approximation,
π = i − i∗ − f ⇒ 0.085 − 0.065 − 0.0125 = 0.0075 ≡ 0.75%. Note that
to explain the arbitrage, we can also use an arbitrary units of euros,
for example, EU R1000.
7. You are given the following information:
Spot exchange rate (AU D/CHF ) 1.1500
Three month forward rate (AU D/CHF ) 1.1585
Australian three month interest rate 10.5% p.a
Swiss three month interest rate 6.5% p.a.

(a) Is there any violation of CIP?

Solution: Since the forward exchange rate F is higher than the

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Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

spot rate S, the CHF is selling at a premium. Since it oers a lower

interest rate, there is no `qualitative' violation of CIP, in the sense
that the low interest currency sells at a premium, not at a discount.
To investigate `quantitative' violation of CIP, we examine the answers
of other parts (b-e).

(b) Calculate the covered margin (going short on the AU D).

Solution:
• t = 0 : Borrow AU D: say AU D1
• t = 41 :Loan (amount
 borrowed or due) in AU D is:
i i 0.105



AU D1× 1 + 12/N = AU D1 × 1 + 4 = AU D1 × 1 + 4 =
1
AU D1.02625, where t is in years, so t= 4 ≡3 months = N.
Foreign investment:
1
• t = 0 : Convert AU D to CHF , 1AU D ×CHF/AU D = 1× 1.1500 =
20


CHF 23
∗
• t = 14
: Value of foreign 20
× (1 + i4 ) =


investment: CHF
23
20
× 1 + 0.065 813



CHF 23 4 = CHF 920 ,
1
• t = 4 : Converting to AU D using forward rate: CHF 813


920 ×
1.1585(AU D/CHF ) = AU D1.023761413.

AU D1.023761413−AU D1.02625 = −0.002488586957 ≈

Covered margin:
−AU D0.0025 < 0. Since the covered margin is not equal to zero,
there is a violation of CIP. Also, we can use the formula of Covered
K ∗
margin =
S (1 + i ) F − K(1 + i). Refer to Short Notes on Interna-
tional Arbitrage

(c) Calculate the interest parity forward rate and compare it with In
terms of percentage points, the covered margin is π = i − i∗ − i∗ × f −
∗
f = 0.249%, and using approximation, π = i−i −f ⇒ 0.105 0.065
4 − 4 −
0.00739 = 0.0075 ≡ 0.26%. Note that to explain the arbitrage, we
can also use an arbitrary units of Swiss-franc, for example, CHF 1000.
the actual forward rate.
Solution: Recall from Short Notes on International Arbitrage, F̄ =
(1+ 0.105
4 )
h i
1+i
S 1+i∗ = 1.1500 × 1+ 0.065 = 1.1613 > 1.1585 = F . Since F̄ >
( 4 )
F ⇒ deviations from CIP.

(d) Calculate the forward spread and compare it with the interest dier-
ential.
Solution: Recall from Short Notes on International Arbitrage, For-
ward spread: f = FS − 1, and interest spread: i − i∗ .
f= 1.1585
1.1500 − 1 = 0.00739 ≡ 0.74% and i − i∗ = 0.105
4 − 4
0.065
= 0.01 ≡
1%.
Since f 6= i − i∗ , that is, forward spread dierential and interest
dierential are not equal, this implies quantitative violation of CIP.
Also, f = i − i∗ > 0 ⇒ foreign currency (CHF ) sells at a premium.
Refer to Short Notes on International Arbitrage

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 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

(e) What would arbitragers do?

Solution: We have seen that going short in AU D results in a loss,
when we calculated the covered margin (b). So we reverse the cur-
rency to short.
That is, we short Swiss-franc (CHF ). Arbitragers will borrow the
1 unit Swiss-franc (at t = 0) at the rate of 6.5% p.a. for 3 months,
convert it into Australian dollar at spot rate (AU D1.15) and invest
1
the proceeds for 3 months at 10.5% (t =
4 ). Upon the maturity of
the investment, the proceeds are converted back into the Swiss-franc
AU D1.15 × (1 + 0.105 1


4 ) × 1.1585 (CHF/AU D) = CHF 1.018720328 at
0.065


the forward rate, the loan amount is CHF 1 + = CHF 1.01625.
4
Net arbitrage prot Π = CHF 1.018720328−CHF 1.01625 = CHF 0.0027432801 ≈
CHF 0.003, which is the covered margin. In terms of percentage
points, the covered margin is π = i − i∗ − i∗ × f − f = 0.249%, and
using approximation, π = i − i∗ − f ⇒ 0.105
4 − 0.065
4 − 0.00739 =
0.0075 ≡ 0.26%. Note that to explain the arbitrage, we can also use
an arbitrary units of Swiss-franc, for example, CHF 1000.
8. You are given the following information:
Spot exchange rate (CAD/GBP ) 2.42
Six month forward rate (CAD/GBP ) 2.46
Canadian six month interest rate 8% p.a.
UK six month interest rate 10% p.a.

(a) Is there any violation of CIP?

Solution: Since the forward exchange rate F = 2.46 is higher than
the spot rate (S = 2.42), the GBP is selling at a premium. Also, we
∗
can see that GBP oers a higher interest rate (i = 10% p.a.) than
the CAD interest rate (i = 8%), there is a qualitative violation of
CIP.

(b) Calculate the covered margin from a Canadian perspective (going

short on the CAD).
Solution:
• t = 0 : Borrow CAD: say CAD1
• t = 21 :Loan (amount
 borrowed or due) in CAD is:
i i 0.08



CAD1× 1 + 12/N = CAD1 × 1 + 2 = CAD1 × 1 + 2 =
1
CAD1.04, where t is in years, so t= 2 ≡6 months = N.
Foreign investment:
• t = 0 : Convert CAD
to GBP. ⇒ CAD1 ⇒ 1CAD×GBP/CAD =
1 50
1 × 2.42 = GBP 121
∗
• t = 12 :
Value of foreign 50
× (1 + i2 ) =


investment: GBP
121
50
× 1 + 0.10 105



GBP 121 2 = GBP 242 ,

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Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

• t = 12 : Converting to CAD
using forward rate: GBP 242

105


×
2.46(CAD/GBP ) = CAD 2583 2420 ≈ CAD1.067355
Covered margin: CAD1.067355−CAD1.04 = 0.0273553719 ≈ CAD0.0274.
Since the covered margin is not equal to zero, there is a violation of
CIP.
K ∗
Also, we can use the formula of Covered margin = S (1 + i ) F −
K(1 + i), where K= 1. Refer to Short Notes on International Arbi-
trage

(c) Calculate the interest parity forward rate in direct quotation from a
Canadian perspective and compare it with the actual forward rate.
Solution: Recall from Short Notes on International Arbitrage, F̄ =
(1+ 0.08
2 )
h i
1+i
S 1+i∗ = 2.42× 1+ 0.10 = 2.397−AU D0.00250 < 2.46 = F . Since
( 2 )

F̄ < F ⇒ deviations from CIP.

(d) Calculate the forward spread and compare it with the interest dier-
ential from a Canadian perspective.
Solution: Recall from Short Notes on International Arbitrage, For-
ward spread: f = FS − 1, and interest spread: i − i∗ .
2.46 ∗ 0.08 0.10
f= 2.42 − 1 = 0.01653 ≡ 1.653% and i − i = 2 − 2 = −0.01 ≡
1%, on six-month basis.
∗
Since f 6= i − i , that is, forward spread dierential and interest
dierential are not equal, this implies quantitative violation of CIP.
Also, f = i − i∗ < 0 ⇒ foreign currency (GBP ) sells at a discount.
Short Notes on International Arbitrage (Updated)

(e) What would arbitragers do?

Solution: Solution is similar to (b). CAD. In
That is, we short
π = i∗ − i × f + f =
terms of percentage points, the covered margin is
1.65%, and using approximation, π = i∗ − i + f ⇒ 0.10
2 − 2 +
0.08

0.01653 = 0.02653 ≡ 2.653%. Here, the gains are from i∗ and f .

Note that to explain the arbitrage, we can also use an arbitrary units
of Swiss-franc, for example, CAD1000.
(f ) Redo all the calculations from a UK perspective (going short on the
GBP). ,
Spot exchange rate (GBP/CAD ) 1/2.42 = 0.41322
Six month forward rate (GBP/CAD ) 1/2.46 = 0.40650
Canadian six month interest rate 8% p.a.
UK six month interest rate 10% p.a.
i. Calculate the covered margin from a Canadian perspective (going
short on the GBP).
Solution:
f = FS − 1 = 0.10650
0.41322 − 1 = −0.01626 ≡ −1.626%. And f =
i − i∗ = 10% − 8% = 2% > 0 ⇒ CAD sells at a premium.
• t = 0 : Borrow GBP : say GBP 1

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Economics and Finance, The University of the South Pacic

1
•t= :Loan (amount
2  borrowed or due) in GBP is:

GBP 1× 1 + 12/N = GBP 1 × 1 + 2i = GBP 1 × 1 +

i 0.10



2 =
1
GBP 1.05, where t is in years, so t= 2 ≡6 months = N.
Foreign investment:
• t = 0 : Convert GBP to CAD. 1GBP × CAD/GBP = 1 ×
2.42 = CAD2.42
i∗
• t = 21 : Value of foreign investment: CAD2.42 × (1 +
2) =
CAD2.42 × 1 + 0.08 1573



2 = CAD 625 ,
• t = 12 : Converting to GBP using 1573


forward rate: CAD
625 ×
1 3146


2.46 (GBP/CAD) = GBP 3075 ≈ GBP 1.0230894
3146


Covered margin: GBP
3075 − GBP 1.05 = −0.02691056911 ≈
−GBP 0.0269.
K ∗
Also, we can use the formula of Covered margin =
S (1 + i ) F −
K(1 + i), where K = 1. Refer to Short Notes on International
Arbitrage. In terms of percentage points, the covered margin
isπ = i − i∗ × i∗ f − f = 1.65%, and using approximation,
π = i∗ − i + f ⇒ 0.08 0.10
2 − 2 − 0.01626 = −0.02626 ≡ −2.626%.
Here, the losses are from i and f . Note that to explain the
arbitrage, we can also use an arbitrary units of Swiss-franc, for
example, GBP 1000.

9. You are given the following information:

Spot exchange rate (AU D/EU R) 1.59501.6050
One year forward rate (AU D/EU R) 1.61501.6250
One year interest rate on the Australian dollar 8.258.75
One year interest rate on the euro 6.256.75

(a) Calculate the covered margin (going short on the AU D).

Solution:
• t = 0 : Borrow AU D: say AU D1
• t = 1 : Loan (amount borrowed or due) in AU D is:
AU D1×(1 + i) = AU D1 × (1 + 0.0875) = AU D1.0875, where t is in
years.
Foreign investment:
1
• t = 0 : Convert AU D to EU R, 1AU D × EU R/AU D = 1 × 1.6050 =
200


EU R 231
200


• t = 1 : Value of foreign investment: EU R
231 × (1 + 0.0625) =
EU R 425


642 ,
425


• t = 1 : Converting to AU D using forward rate: EU R
642 ×
5491


1.6150(AU D/EU R) = AU D 5136 ≈ AU D1.06912.

5491


Covered margin:
5136 −AU D1.0875 = −0.018380 ≈ −AU D0.0184
AU D <
0. Since the covered margin is not equal to zero, there is a vi-
olation of CIP. Also, we can use the formula of Covered margin
Fb
= Sa (1 + i∗b ) − (1 + ia ). Refer to Short Notes on International Arbi-

11
 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

trage

(b) What would arbitragers do?

Solution: Since the covered margin is negative there is no incentive
to indulge in arbitrage from theAU D to the EU R. Let's check the
arbitrage from EU R to AU D is protable.
• t = 0 : Borrow EU R: say EU R1
• t = 1 : Loan (amount borrowed or due) in EU R is:
EU R1×(1 + i) = EU R1 × (1 + 0.0675) = EU R1.0675, where t is in
years.
Foreign investment:
• t = 0 : Convert EU R to AU D, 1EU R×AU D/EU R = 1×1.5950 =
AU D1.5950
• t = 1 : Value of foreign investment: AU D1.5950 × (1 + 0.0825) =
AU D1.7265875,
• t = 1 : Converting to EU R using forward rate: AU D1.7265875 ×
1
1.6250 (EU R/AU D) ≈ EU R1.062515385.

Covered margin: EU R1.062515385 − EU R1.0675 = −0.00498 ≈

−EU R0.005 < 0. Since the covered margin is not equal to zero,
there is a violation of CIP. Since the covered margin is negative there
is no incentive to indulge in arbitrage from the EU R to the AU D
either. Refer to Short Notes on International Arbitrage

(c) Compare the results with those obtained by solving question 6.

Solution: In the presence of bidoer spreads, arbitrage from the
AU D to the EU R results in a bigger loss when compared with ques-
tion 6. The protability of arbitrage in the opposite direction can be
conrmed in a similar manner.

10. You are given the following information:

Spot exchange rate (AU D/CHF ) 1.14501.1550
Three month forward rate (AU D/CHF ) 1.15351.1635
Australian three month interest rate 10.2510.75 p.a.
Swiss three month interest rate 6.256.75 p.a.
(a) Calculate the covered margin (going short on the AU D).
Solution:
• t = 0 : Borrow AU D: say AU D1
• t = 41 : Loan
(amount borrowed or due)

in AU D is:
AU D1× 1 + 4i = AU D1 × 1 + 0.1075 4 = AU D1.026875, where t is
in years.
Foreign investment:
1
• t = 0 : Convert AU D to CHF , 1AU D ×CHF/AU D = 1× 1.1550 =
200


CHF 231
• t = 14 : Value 200
× (1 + 0.0625


of foreign investment: CHF
231 4 ) =
1625


CHF 1848 ,

12
 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

• t = 14 : Converting to AU D using 1625

forward rate: CHF 1848 ×
9997
1.1535(AU D/CHF ) = AU D 9856 ≈ AU D1.01431.

AU D 9997


Covered margin:
9856 − AU D1.026875 = −0.01256899351 ≈
−AU D0.0126 < 0. Since the covered margin is not equal to zero,
there is a violation of CIP. Also, we can use the formula of Covered
Fb
margin = Sa (1 + i∗b )−(1+ia ). Refer to Short Notes on International
Arbitrage

(b) What would arbitragers do?

Solution: Since the covered margin is negative there is no incentive
to indulge in covered arbitrage from the AU D to the CHF . Let's
check whether arbitrage in the opposite direction is protable:
Calculate the covered margin (going short on the CHF ).
• t = 0 : Borrow CHF : say CHF 1
• t = 41 : Loan (amount borrowed or due) in CHF is:
CHF 1× 1 + 4i = CHF 1× 1 + 0.0675 1627



4 = CHF 1600 = CHF 1.016875,
where t is in years.
Foreign investment:
• t = 0 : Convert CHF to AU D, 1CHF ×AU D/CHF = 1×1.1450 =
AU D1.1450
• t = 41 : Value of foreign investment: AU D1.1450 × (1 + 0.1025
4 ) =
AU D1.17430625,
• t = 41 : Converting to CHF using forward rate: AU D1.17430625 ×
1
1.1635 (CHF/AU D) ≈ CHF 1.009317254.

CHF 1.009317254−CHF 1.016875 = −0.007557746 ≈

Covered margin:
−CHF 0.008 < 0. Since the covered margin is not equal to zero, there
is a violation of CIP. Since the covered margin is negative there is no
incentive to indulge in arbitrage from the CHF to the AU D. Refer
to Short Notes on International Arbitrage

(c) Compare the results with those obtained by solving question 7.

Solution: In the presence of bid-oer spreads, arbitrage from the
AU D to the CHF results in a bigger loss (−AU D0.0126) when com-
pared with question 7 (−AU D0.0025). Similarly, the opposite posi-
tion (short CHF) is protable in question 7, but due to the bid-oer
spreads, is not protable in this case. We can see that in reality,
abitrage opportunity is not regularly present and is temporary.

11. You are given the following information:

Spot exchange rate (CAD/GBP ) 2.41502.4250
Six month forward rate (CAD/GBP ) 2.45502.4650
Canadian six month interest rate 7.758.25 p.a
UK six month interest rate 9.7510.25 p.a.
(a) Calculate the covered margin from a Canadian perspective (going
short on the CAD).

13
Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

Solution:
• t = 0 : Borrow CAD: say CAD1
• t = 12 : Loan
(amount borrowed or due)

in CAD833is:

CAD1× 1 + 2i = CAD1× 1 + 0.0825 2 = CAD 800 = CAD1.04125,
where t is in years.
Foreign investment:
1
• t = 0 : Convert CAD to GBP , 1CAD × GBP/CAD = 1 × 2.4250 =
40


GBP 97 = GBP 0.412371134
• t = 12 : Value 40 0.0975


of foreign investment: GBP
97 × (1 + 2 ) =
839


GBP 1940 ,
• t = 12 : Converting to CAD using forward rate: GBP 1940 839


×
2.4550(CAD/GBP ) = CAD1.061724227 ≈ CAD1.06172.

993


Covered margin: CAD1.061724227−CAD1.04125 = CAD 48500 ≈
CAD0.0205 > 0. Since the covered margin is not equal to zero, there
is a violation of CIP. Also, we can use the formula of Covered margin
Fb ∗
= Sa (1 + ib ) − (1 + ia ). Also, this is a protable strategy. Refer to
Short Notes on International Arbitrage

(b) Calculate the covered margin from a UK perspective (going short on

the GBP ).
Solution:
• t = 0 : Borrow GBP : say GBP 1
• t = 12 : Loan
(amount borrowed or due)

in GBP841is:

GBP 1× 1 + 2i = GBP 1× 1 + 0.1025 2 = GBP 800 = GBP 1.05125,
where t is in years.
Foreign investment:
• t = 0 : Convert GBP to CAD, 1GBP ×CAD/GBP = 1×2.4150 =
CAD2.4150
• t = 21 : Value of foreign investment: CAD2.4150 × (1 + 0.0775
2 ) =
CAD2.50858125,
• t = 12 : Converting to GBP using forward rate: CAD2.50858125 ×
1
2.4650 (GBP/CAD) = GBP 1.01768001 ≈ GBP 1.01768.

GBP 1.01768001−GBP 1.05125 = −GBP 0.03356997972 ≈

Covered margin:
−GBP 0.03357 < 0. Since the covered margin is not equal to zero,
there is a violation of CIP. Also, we can use the formula of Covered
Fb ∗
margin = Sa (1 + ib ) − (1 + ia ). This is not a protable strategy.
Refer to Short Notes on International Arbitrage

(c) What would arbitragers do?

Solution: Arbitragers will borrow Canadian dollar and invest in
pound-denominated assets. Refer to part (a).

(d) Compare the results with those obtained by solving question 8.

Solution: The protability arbitrage is lower (CAD0.0205) in the
presence of bidoer spreads, when compared with question 8 (CAD0.0274).

14
 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

Similarly, the losses are higher in the opposite position, in the pres-
ence of bid-oer spreads (−GBP 0.03357, see part (b)) than otherwise
(−GBP 0.0269) (see question 8, part f ).

12. You are given the following information:

Spot exchange rate (U SD/GBP ) 1.46
Spot exchange rate (U SD/CAD ) 0.64
US one year interest rate 6%
UK one year interest rate 8%
Canadian one year interest rate 10%

(a) Calculate the one year forward rate between the Canadian dollar and
the UK pound (CAD/GBP) by adjusting the spot rate for the inter-
est rate dierential.
Solution: The spot rate between Canadian dollar and UP pound is
computed as:
CAD U SD 1 73



S(CAD/GBP ) = S U SD × S GBP = 0.64 × 1.46 = 32 ≈ 2.2813.
To calulate the forward rate, this will be:
h i
F (CAD/GBP ) = S(CAD/GBP ) × 1+i CAD 73
1+iGBP = 32 ×
1.10
1.08 = 4015
1728 ≈
2.3235. Refer to Section 5 of of the Short Notes on International
Arbitrage

(b) Calculate the same forward rate as a cross rate. Do you obtain the
same answer? Why or why not?

   
CAD U SD
F (CAD/GBP ) = F ×F
U SD GBP
         
CAD 1 + iCAD U SD 1 + iU SD
= S × × S ×
U SD 1 + iU SD GBP 1 + iGBP
     
1 1 + 0.10 1 + 0.06
= × × 1.46 ×
0.64 1 + 0.06 1 + 0.08
1375
= × 1.432962963
848
4015
= ≈ 2.3235
1728

which is same as part (a).

13. The current AU D/EU R exchange rate is 1.60, the Australian three month
interest rate is8.5% p.a. and the three month interest rate on the euro is
6.5% p.a. Where will the exchange rate be in three months' time if UIP
holds?
Solution: S(AU D/EU R) = 1.60.

15
 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

The de-annualized interest dierential is: i − i∗ = 0.085

4 − 4
0.065
= 0.005 ≡
0.5%. The exchange rate should rise by 0.5% to 1.60×(1 + 0.005) = 201 125 =
1.608 (appreciation of the euro). Refer to Section 7 of the Short Notes on
International Arbitrage

14. Reconsider question 13 by assuming that the exchange rate in three months'
time turned out to be 1.68. Calculate the uncovered margins obtained by
going short on the Australian dollar and long on the euro, and vice versa.
Solution: S0 (AU D/EU R) = 1.60 and S3 (AU D/EU R) = 1.68. We com-
pute the the covered margin by going short on the Australian dollar and
long on the euro.

The covered margin (going short on the AU D) is calculated as:

• t = 0 : Borrow AU D: say AU D1
i
• t = 41 : Loan (amount

borrowed or due) in AU D is: AU D1×(1+ AU D ) =
4
0.085 817


AU D1 × 1 + 4 = AU D 800 = AU D1.02125
Foreign investment:
1
• t = 0 : Convert AU D1 into EU R: AU D × EU R/AU D = 1 × 1.60 =
EU R0.6250
i∗
• t = 41 :Value of foreign investment is: EU R0.6250 × (1 + EU R ) =
4
EU R0.6250 × 1 + 0.065 813



4 = EU R 1280 ≈ EU R0.6352,
• t = 14 : Converting back to AU D using realized spot in three-month:
813


EU R 1280 × 1.68(AU D/EU R) = AU D1.0670625

Covered margin: Amount from foreign investment minus the amount bor-
rowed (all in domestic terms).AU D1.0670625−AU D1.02125 = AU D0.0458125 ≈
AU D0.046 > 0. In percentage points, this is 4.6%. We can use the formula
π = i − i∗ − Ṡ to approximate of the covered margin. Refer to section 7.1
⇒: Short Notes on International Arbitrage

The covered margin (going short on the EU R) is calculated as:

• t = 0 : Borrow EU R: say EU R1
iEU R
• t = 14 : Loan (amount

borrowed
or due) in EU R is: EU R1×(1+ 4 ) =
0.065 813
EU R1 × 1 + 4 = EU R 800 = EU R1.01625
Foreign investment:
• t = 0 : Convert EU R1 into AU D: EU R × AU D/EU R = EU R1 ×
1.60(AU D/EU R) = AU D1.60
i∗
• t = 41 :Value of foreign investment is: AU D1.60×(1+ AU D ) = AU D1.60×
4
1 + 0.085 = AU D 817



4 500 = AU D1.634,
• t = 41 :
Converting back to EU R using realized spot in three-month:
AU D 817 1 817


500 × 1.68 (EU R/AU D) = EU R 840 ≈ EU R0.9726

Covered margin: Amount from foreign investment minus the amount bor-
817 813



rowed (all in domestic terms). EU R 840 −EU R 800 = −EU R0.04363095238 ≈
−0.044 > 0. In percentage points, this is 4.4%.

16
 Compiled by Dr. Ronald R. Kumar, FM303-Semester 1, 2022, School of Accounting,
Economics and Finance, The University of the South Pacic

15. The following information is available:

Spot exchange rate (CAD/GBP) 2.32
Canadian six month interest rate 8% p.a.
UK six month interest rate 10% p.a.
Calculate the uncovered margin obtained by going short on the Canadian
dollar if the exchange rate assumes the following values in six months:

(a) 2.25;

(b) 2.28;

(c) 2.32;

(d) 2.35; and

(e) 2.38.

(f ) Do the same by going short on the pound.

Solution:
⇒ Short CAD, use π = SS10 (1 + i∗ ) − (1 + i)
⇒ Short GBP, use π = SS01 (1 + i) − (1 + i∗ )
Refer to Excel Sheet, Q15 on Moodle.

16. The following information is available:

Spot exchange rate (CAD/GBP) 2.31502.3250
Canadian six month interest rate 7.758.25 p.a.
UK six month interest rate 9.7510.25 p.a.
Calculate the uncovered margin by going short on the Canadian dollar if
the exchange rate assumes the following values in six months:

(a) 2.24752.2525;
(b) 2.27752.2825;
(c) 2.31752.3225;
(d) 2.34752.3525; and

(e) 2.3775 − 2.3825.

(f ) Do the same by going short on the pound.
Refer to Excel Sheet, Q16, Refer to Excel Sheet, Q15 on Moodle.

17