IF CH 7

Explain the concept of interest rate parity (IRP). 

• Interest rate parity suggests that the interest rates in different countries should always be the same, regardless of the currency exchange rate.

• Interest rate parity indicates that the difference between the interest rates in two countries is equal to the forward premium or discount on their currencies.

• Interest rate parity implies that investors cannot profit from differences in interest rates between countries when using forward contracts to hedge against exchange rate risk.

• Interest rate parity means that the interest rate on foreign deposits will always be higher than the interest rate on domestic deposits.

Why do you think currencies of countries with high inflation rates tend to have forward discounts?

• High inflation causes the country's central bank to lower interest rates, which directly leads to a forward discount.

• High inflation causes these currencies to have high interest rates, which cause forward rates to have discounts as a result of interest rate parity

• High inflation leads to higher exports, which strengthens the currency and causes a forward discount.

• High inflation causes domestic demand for foreign currency to decrease, which pushes the currency into a forward discount.

Explain the concept of locational arbitrage and the scenario necessary for it to be plausible.

• Locational arbitrage involves taking advantage of different interest rates in two countries by borrowing in one currency and lending in another to earn risk-free profits.

• Locational arbitrage can occur when the spot rate of a given currency varies among locations.  Specifically, the ask rate at one location must be lower than the bid rate at another location.

• Locational arbitrage refers to the practice of profiting from differences in the forward exchange rate and spot exchange rate between two currencies over time.

• Locational arbitrage is a strategy where an investor profits from differences in stock prices between two stock exchanges that are located in different countries.

Explain the concept of triangular arbitrage

• Triangular arbitrage involves using the difference between interest rates in three different countries to earn risk-free profits from currency exchange.

• Triangular arbitrage occurs when a trader converts one currency into another, then into a third currency, and finally back into the original currency to exploit price differences among the three currencies.

• Triangular arbitrage takes advantage of the price discrepancies between a forward rate and the spot rate for a currency, allowing an investor to earn a profit.

• Triangular arbitrage involves borrowing in one currency, converting it into two other currencies, and earning a profit from differences in interest rates between the three.

What factors can affect the gains from triangular arbitrage?

• Gains from triangular arbitrage are solely determined by differences in forward and spot exchange rates.

• Triangular arbitrage profits arise from capitalizing on discrepancies in the cross-exchange rates between two currencies, but transaction costs such as the bid/ask spread can reduce or eliminate these gains.

• Triangular arbitrage profits are unaffected by transaction costs like the bid/ask spread because arbitrage opportunities are always risk-free.

• Gains from triangular arbitrage are maximized when there is a large discrepancy in interest rates between countries.

In triangular arbitrage, what is the role of the spot market?

• It is used to conduct futures contracts for currencies.
  
  

• It allows traders to buy and sell currencies immediately at current market rates.

• It provides long-term investment options for currency traders.

• It has no role in triangular arbitrage transactions.

What is covered interest arbitrage primarily defined as?

• The process of investing in foreign stocks while avoiding currency risk.

• The process of capitalizing on the interest rate differential between two countries while hedging exchange rate risk with a forward contract.

• A method of trading currency futures to maximize profits.

• The practice of exchanging currencies without consideration for interest rate differences.

What is the purpose of using a forward contract in covered interest arbitrage?

• To maximize profit by speculating on future exchange rates.
  

• To hedge the position against exchange rate risk.

• To invest in multiple currencies simultaneously.

• To increase exposure to foreign markets.