Multinational Finance Homework

Q1. Law of One Price Terry Lamoreaux has homes in both Sydney, Australia and Phoenix, Arizona. He travels between the two cities at least twice a year. Because of his frequent trips he wants to buy some new, high quality luggage. He's done his research and has decided to go with a Briggs & Riley brand three-piece luggage set. There are retails stores in both Phoenix and Sydney. Terry was a finance major and wants to use purchasing power parity to determine if he is paying the same price no matter where he makes his purchase. If the price of the 3-piece luggage set in Phoenix is $850 and the price of the same 3-piece set in Sydney is A$930, using purchasing power parity, is the price of the luggage truly equal if the spot rate is A$1.0941/$?

Q2. The Big Mac Index Some people read tea leaves to predict the future, The Economist magazine prefers hamburgers. The magazine started the Big Mac Index in 1986 as a light-hearted guide to test whether currencies are at their "correct" exchange rate based on the Law of One Price. Under the Law of One Price, the price of the Big Mac should be the same if its local price is converted into dollars at the current exchange rates. In July 2014, the average price of a Big Mac was £2.80 in Britain and $4.20 in the U.S. The actual exchange rate was $1.60/£. Please answer the following questions:

1) Where can you buy cheaper hamburgers: Britain or U.S.?

2) Calculate the "correct or right" exchange rate, based on the law of one price.

3) Based on the PPP, was the British pound overvalued or undervalued and by how much?

Q3. Interest Rate Parity and Arbitrage

Suppose you have the following information:

Current spot rate: S = $1.30/€

Interest rate on dollars: i^$ = 5%

Interest rate on euros: i^€ = 2%

1) Please calculate 1-year forward exchange rate, based on the Interest Rate Parity.

2) If the actual 1-year forward rate is quoted at $1.34/€, is there any covered interest arbitrage opportunity? Please explain.

3) If yes, how can you make an arbitrage profit? Assume you can borrow up to $1,300,000 or €1,000,000. Please show all transactions necessary to make the profit.