EC3100 EXTRA CREDIT ASSIGNMENT
Due: Friday, August 17, 2007
The two tables below give London Inter-Bank Offer Rates (LIBOR) and bid and ask spot and forward
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exchange rates on Monday, July 2.
Table 1: LIBOR (annualized) Rates on Short Term (45 day) Borrowing in Different Currencies,
July 2, 2007
Australia (Australian dollars = $AUS) 6.21250% Japan (yen = ¥) 0.64438%
Britain (British pounds =£) 5.92125% Switzerland (Francs = SwF) 2.61500%
Canada (Canadian dollars = $C) 4.47667% USA (US dollars = $US) 5.320%
Europe (euros = €) 4.11438%
Table 2: Spot and Forward Bid-Ask Rates. July 2, 2007
Spot Rate ($US/FX1) 1-Month Forward Rate ($US/FX1)
Bid Ask Bid Ask
Australian dollar $US0.85800/$Aus1 $US0.8587/$Aus1 $US0.858030/$Aus1 $US0.858670/$Aus1
British pound $US2.0126/£1 $US2.01500/£1 $US2.011720/£1 $US2.013510/£1
Canadian dollar $US0.9491/$C1 $US0.9499/$C1 $US0.949700/$C1 $US0.950710/$C1
Euro $US1.36200/€1 $US1.36330/€1 $1.363380/€1 $US1.367520/€1
Japanese yen $US0.00820/¥1 $US0.008200/¥1 $US0.008170/¥1 $US0.008180/¥1
(¥121.95/$US1) (¥121.95/$US1) (¥122.40/$US1) (¥122.25/$US1)
Swiss francs $US0.8258/SwF $US0.8264/ SwF $0US.825800/SwF $US0.826410/SwF
Borrowing/Lending Rates
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LIBOR is the "London Inter-Bank Offered Rate" paid by banks on their Eurocurrency loans from other
banks in London. It is the basis for interest rates changed on retail borrowing of currencies.
LIBID is the "London Inter-Bank Bid Rate" on Eurocurrencies paid by banks on their Eurocurrency
deposits. It is normally one-eighth of a percentage point lower than LIBOR.
The spread between LIBOR and LIBID provide bank earnings on their borrowing and lending activities.
Both LIBOR and LIBID reflect credit and interest rate conditions in the country that issues the currency.
For example, the July 2 US dollar LIBOR rate (5.34%) reflects current US short term credit conditions
while the yen Libor rate (0.70%) reflects much looser credit conditions in Japan.
For purposes of this homework assignment, assume that you borrow currencies at LIBOR and lend
currencies at LIBID (= LIBOR - 0.125%). For example, you can borrow Eurodollars at 5.34% and earn
5.215% on 45 day US dollar deposits (on an annual basis).
Exchange Rates
The spot and forward rates are exchange rates ($US/unit of foreign currency) for immediate delivery
(usually two days) and for delivery in 30 days.
The bid rate is the rate that banks pay you when you buy dollars, i.e., when you convert (sell) foreign
currency into US dollars. It is the rate that banks 'bid' for US dollars. For example, on July 2, $Aus1
converted to $US0.858 or $Aus1.1655 [=$Aus1 / ($US0.878/$Aus1)] was needed to buy one US dollar.
The ask rate is the rate that you receive when you buy foreign currency (sell dollars) It is the rate that
banks "ask" for their foreign currency. For example, on July 2, $US0.8587 converted to one Australian
dollar or $US1 converted to $Aus1.16455.
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Sources: Financial Times website at http://www.ft.com/marketdata/bondsandrates/moneyrates for
LIBOR and OzForex Pty Ltd website at http://www.ozforex.com.au/ for exchange rates.
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A Eurocurrency is foreign currency denominated deposits in countries where the currency is not the
national currency, e.g., Eurodollars are dollar deposits in London (or other foreign) banks.
To distinguish between the two rates, think of the ask rate as the rate that you pay when you travel to
another country (say the UK) and convert dollars to pounds. The bid rate is what you receive when you
leave the UK and want to sell your pounds for dollars. The spread between bid and ask prices provide
bank earnings from foreign exchange trading. For example, the $Aus-$US spread is $Aus1.1655 -
$Aus1.16455 = $Aus0.00095. Banks earn $Aus0.00095 on each US dollar bought and sold.
Your tasks for this homework assignment are:
Part 1: Determine if the interest and exchange rates given in Tables 1 and 2 provide opportunities
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for a US bank to engage in profitable covered interest arbitrage in each currency on July 2, 2007.
(Note: If markets work "efficiently," then there should be few, in any opportunities for profitable interest
arbitrage)
In each case, suppose that the US covered interest arbitrageur begins with borrowing $1 million
in the US or the equivalent of $1 million of each country's currency. Then compare returns if:
(1) you borrow $1 million, convert these dollars to a foreign currency in the spot market, invest
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that foreign currency for 30 days in the foreign country, and simultaneously sell the foreign
currency proceeds of your investment (principal and interest earned) for dollars in the forward
market against returns if: (2) you borrow $1 million worth of foreign currency, convert the
currency to dollars in the spot market, invest in the US for 30 days, and simultaneously sell
enough US dollars in the forward market to repay your foreign currency loan after 30 days.
You can do these calculations immediately, rather than waiting until August, since the two tables
give you all the information needed to answer this question.
Part 2: Now suppose that you are a speculator who believes that the US dollar will weaken
against each of the currencies in the second table between July 2 and August 2.
A. Would you buy or sell dollars in the forward market on July 2 for future delivery on August 2?
Explain why you would do so. An example might help your explanation.
B. Find the spot rates for each currency for August 2 (use the OzForex website given in footnote 1).
1. Calculate the percentage change in the value of the US dollar from July 2 to August 2 (be
certain that you compare either July bid and August bid rates or July ask and august ask
rates).
2. Identify if the US dollar weakened or strengthened against each currency (i.e., the
percentage change in the spot rate from July 2 to August 2).
C. Suppose your forward transaction in Part A was valued at $1 million. Determine how large a
profit or loss that you will realize on August 2 from your speculation that the US dollar will weaken
against each currency (there are six answers). Be certain that you use the correct combination
of bid-ask prices in the spot and forward markets in your calculations. For example, if you sell
yen for dollars 30 days forward, then you are selling yen (buying dollars) at the forward bid price.
To cover this transaction, you will need to buy yen (sell dollars) in the spot market in August at
the spot ask price.
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See Appendix 14.2 of the text for a discussion of covered interest arbitrage.
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Remember that you borrow currencies at LIBOR and lend currencies at LIBIB (=LIBOR – 0.125%).