FIN 3410 Lecture 3: Day 3 Notes

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Day 3 Notes
EX 6.1-3: Covered Interest Arbitrage
1. Borrow $1,500,000 for 3m @ i$3m = 2%
a. $(loan + interest) = $1,500,000 * (1 + .02)
b. = $1,530,000
2. Exchange borrowed $1,500,000 for L @ s = $1.50/L
a. $1,500,000 / ($1.50/L) = 1,000,000 L
3. Invest 1,000,000 L in the UK
a. FV(UK1L) = 1,000,000 L * (1 + 0.0145)
b. = 1,014,500 L
4. To protect against possible L depreciation, sell FV(UK1L) forward for $ @ F =
$1.52/L
a. 1,014,500 L * ($1.52/L) = $1,542,040
5. Pay back $(loan + interest) @ $1,530,000
a. Arbitrage profit = $ proceeds - $ costs
b. $1,542,040 - $1,530,000 = $12,040
i$3m = 2% > iL3m = 1.45%
o Invest in the UK since L is expected to appreciate
How will IRP be restored?
o (1 + i$3m) / (1 + iL3m) < F3m($/L) / S($/L)
1.0054 < 1.0133
o IRP will be restored if inequality becomes equality
(1 + i$3m) / (1 + iL3m) GO UP
F3m($/L) / S($/L) GO DOWN
PPP and Exchange Rate Determination
I$ = 3% and IE = 5%
So = $1.25/E
$1.25/E * (1.03) * (1.05)
PPP
o (1 + I$) / (1 + IE) = F1($/E) / So($/E)
o E[St($/E)] = [(1 + I$) / (1 + IE)]^t * So($/E)
EX 6.1-1
Background
V$ = $1,000,000 extra cash reserve
T = 6 months
i$ = 8% per annum
o I$6m = 8%/2 = 4%
iE = 7% per annum
o I$6m = 7%/2 = 3.5%
So = E1.01/$
F6m = E0.99/$
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