International Monetary Relations

Unit 4 - International Monetary Relations, part 1

Assignment Type: Individual Project

Due Date: 8/7/2004


Part 1:

Assume that the 180-day interest rate is 1% and 3%, respectively in the U.S. and Japan. Also, the spot rate and 180-day forward rate are equivalent at 120 yen per one U.S. dollar ($.008333 per one Japanese yen). Discuss how you, as a trader for a commercial bank with $1,000,000 to invest, could earn a risk-free return by engaging in covered interest arbitrage? Be sure to show your calculations.

As a trader for a commercial bank there are several ways to invest in foreign currency to make a profit for the bank. One way that investors know to invest in a foreign investment is comparing the rates of return of foreign investments with those of domestic investment. If rates of return from a foreign investment are larger, the smart investor will shift funds abroad. Interest arbitrage refers to the process of moving funds into foreign currencies to take advantage of higher investment yields abroad. (Carbaugh) There is a risk associated with this process due to the fluctuation of the exchange rate. The risk can be eliminated by using the covered interest arbitrage. This is done in two separate processes. Initially exchange is made with domestic currency for a foreign currency that has a higher current spot and interest rate than the domestic currency at the time. This currency is then used to finance a foreign investment. As you’re doing this you also will contract in the forward market to sell the foreign currency that is expected from the investment. (Carbaugh) You want this to coincide with the maturity of the investments.

Assume that you had 1 million dollars that you wanted to invest and the interest rate is 1% in the U.S. and 3% in Japan for 180 days. Assume that the spot rate and the 180 day forward rate are equivalent at 120 yen per one U.S. dollar. (.00833 yen) With the interest rates being better in Japan the wise investment would be in the Japanese market. By investing using the covered arbitrage it will earn a risk-free investment return profit of 2% or 240,000 yens which would equal 2000 US dollars.

Extra return = (Japan interest rate- U.S. interest rate)

3% - 1% = 2%

Exchange Rate = Yen/dollar

120 yen = one dollar

240,000/120 = 2000

240,000 x .008333 = 1999.92

The covered interest arbitrage reduces the normal risk of any depreciation of the dollar during the 3 month period by allowing the investor to sell enough of the yen on the forward market to coincide with anticipated proceeds of the investment. By doing this the cost of the forward cover equals the difference. At the same time if the yen appreciates the profit margin can increase even more; earning the investor a risk free profit.

Extra return = (Japan interest rate - U.S. interest rate) + % appreciation of the yen

The investment opportunities usually do not last long, so normally investors do not invest for long periods of time because the net profit margin disappears. The spot rate will begin to rise and concurrently the sale of the forward currency will push the forward rate down. This results in the cost of covering the exchange rate to increase in risk.

Part 2:

The inflation rate in the U.S. and Japan are 4% and 2%, respectively and the current spot rate is $.0083333 per one Japanese yen or 120 Japanese yen per one U.S. dollar. How much does the U.S. dollar have to depreciate in order to maintain purchasing power parity? Be sure to show your calculations.

A theory stating that over the long term the exchange rate between two currencies adjusts to relative price levels, that is, relative purchasing power. (Carbaugh) In other words, an identical good in different countries should cost the same after adjusting for currency. In the United States, interest rates are decided by the Federal Reserve.

Interest rates directly affect the credit market (loans) because higher interest rates make borrowing more costly. By changing interest rates, a country is trying to achieve maximum employment, stable prices, and a good level growth. As interest rates drop, consumer spending increases and this in turn stimulates economic growth.

The purchasing power parity predicts that the foreign-exchange value