08 Jun Question Table 2: Spot, forward exchange rates
Question
Table 2: Spot, forward exchange rates and annual interest rates
Date Japan Turkey USA
iYenEYen/$FYen/$EeYen/$ iLiraELira/$ FLira/$EeLira/$ i$
January 2013 0.48 88.50 88.13 88.20 7.56 1.77 1.85 1.98 0.81
January 2014 0.37 104.48 104.16 104.22 11.50 2.19 2.38 2.44 0.57
Note that i stands for the interest rate for a deposit denominated in the given currency, E is the yen (lira) versus the US Dollar exchange rate defined as Yens (Liras) per US Dollar ($), F is the corresponding one-year forward exchange rate on a one-year forward contract, and Ee is the expected one-year ahead spot exchange rate.
Suppose that you are given the information about the spot exchange rate, annual interest rates, and the forward exchange rates between the US Dollar against Japanese Yen and Turkish lira at the given dates in Table 2. Suppose that a US investor with 10,000 dollars to place in either of the following: (i) a bank deposit in the USA; (ii) a bank deposit in Japan with a forward yen-cover; (iii) a bank deposit in Turkey with a forward lira-cover; and (iv) a bank deposit of 5000 dollars in Japan with a forward yen-cover and 5000 dollars in Turkey with a forward lira-cover. Suppose further that the investor considers investing at the beginning of 2013 (i.e., consider the starting date of investment to be January 2013 for a holding period of one year). Please use the information provided here and in Table 2 to answer the following questions. Hint: You will have to use the exact formulas related to CIP and UIP conditions in this question.
a. What is the dollar-denominated return on dollar deposits for this investor (under investment strategy (i))?
b. What is the (riskless) dollar-denominated return under investment strategy (ii)?
c. What is the (riskless) dollar-denominated return under investment strategy (iii)?
d. Are there an arbitrage opportunities under investment strategies (ii) and (iii)? In each case explain why or why not? Is the Yen-Dollar forward exchange rate market in equilibrium? How about Lira-Dollar forward market? Why or why not?
e. How can you explain the results in (c) and (d)?
f. What is the (riskless) dollar-denominated return under investment strategy (iv)?
g. Based on your answers to (a-e) which investment strategy seems to provide higher return? Which strategy would you suggest an investor to choose why?
h. Does uncovered interest rate parity hold for the Yen-Dollar and Lira-Dollar exchange rate markets as of January 2013? Why or why not?
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