Problems -

1. Triangular Arbitrage

Suppose you observe the following posted exchange rates on the Japanese yen (¥) and South African ran (R) against the US dollar:

JPY - ¥97.3702/$

ZAR - R10.1453/$

The posted cross rate between the yen and the rand is currently ¥9.00/R.

a. Calculate the correct cross rate and determine whether arbitrage opportunity exists. If so, specify which currency is overvalued or undervalued under the quoted cross rate, and describe how you would conduct the arbitrage.

b. Explain the realignment process and how are the spot rates (¥/$) and (R/$), and cross rate (¥/R) affected.

c. Calculate your arbitrage profits.

2. Uncovered interest Rate Parity (UIRP)

a. Explain what the forward rate unbiasedness hypothesis (FRUH) postulates and the arguments behind the hypothesis.

b. What does UIRP predict about the expected movement of the currency with the higher Interest rate? Discuss the evidence concerning this prediction using short-term vs. long-term exchange rate returns and interest rate data.

c. In Chapter 6, the book states: "Central banks have commonly raised then interest rates [to very high levels] if their count, experiences a currency crisis [in the hope of preventing] a major flow of funds out of the country." As such, do you think UIRP is more likely to hold in the short-term during times of crises? Explain briefly.

3. Covered Interest Arbitrage

The spot rate between the Canadian dollar and New Zealand dollar is currently C$ .8646/NZ$, with i^C$ = 2% and i^NZ$ = 6%. The quoted forward rate is C$ .90/NZ$. Determine your arbitrage profits (in either C$ or NZ$), if an arbitrage opportunity exists.