Northwestern University Kellogg School of Management Tal Mofkadi Problem Set 1 The Market for Foreign Exchange Please

refer to the following tables in your answers: source: http://markets.ft.com/research/Markets/Currencies Finance 470

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Ex1: International Finance Tal Mofkadi

Question 1 (Bid-Ask spread): 1) Calculate the Bid-Ask spread for each currency in the European market (11 currency pairs). What is the average bid-ask spread? 2) If an investor would like to sell $10M and buy Russian Rubles, how many Rubles can she buy? 3) If an investor would like to buy $10M and pay with Russian Rubles, how many Rubles should he pay? 4) Assume the average international bank is trading $10M on each dollar-euro transaction. a) What is the profit in dollars for each transaction for the international bank? b) What is the cost for each transaction to the average customer?

Question 2 (triangular arbitrage without bid-ask spread) For this question please use the Exchange cross rates table as the relevant information source (no bid-ask spreads). Also, assume that you can buy and sell currencies using these exchange rates. The question is investigating the relationship in three markets: Dollar-Euro, Euro-SKr, and Dollar-SKr. (Where SKr is Swedish Krona). 1) What are the direct quotation (American terms) and the indirect quotation (European quotation) exchange rates in each market? 2) Are markets in equilibrium? Explain. 3) If the answer to section 2 above is no show how you can construct arbitrage strategy. What are your gains in this strategy? (Your gains should be presented in currency and in percentage). Question 3 (triangular arbitrage with bid-ask spread) For this question please use the Dollar spot forward against the dollar table as the relevant information source (do not ignore bid ask quotations). The question is investigating the relationship in three markets: Dollar-Euro, Euro-SKr, and Dollar-SKr. (Where SKr is Swedish Krona). 1) Are the markets in equilibrium? Explain. (Hint: show that you can/cannot generate arbitrage profits in these markets; remember that there are two directions to check). 2) Assume that you are the CFO of a Swedish company. Also assume that you would like to purchase $10M and pay in SKr. a) What are your alternatives? (Hint: there are two). b) How much SKr did you save when you chose the best alternative for the company? 3) Assume that you are the CFO of an American company. Also assume that you would like to sell $10M and buy SKr. a) What are your alternatives? (Hint: there are two). b) How much SKr did you save when you chose the best alternative for the company?

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Ex1: International Finance Tal Mofkadi

Question 4 (FX appreciation/depreciation and International trade) Please read the Financial-Times article titled: Argentina: blue dollar hits new high (Source: http://blogs.ft.com/beyond-brics/2013/03/20/argentina-black-market-dollar-hits-newhigh/#ixzz2Q6502EjL, free registration may be required) and answer the following questions: 1) The article states that the market exchange rate was 8.08 (Pesos/$) on Monday and 8.75 (Pesos/$) on Wednesday. a) What was the peso depreciation rate? b) What was the dollar appreciation rate? 2) Assume there is one tradable product (say crude oil barrel) trading at a price of $100/unit. We cannot use Argentinian credit card to purchase dollars directly. However we can use the credit card to purchase the product in Argentina and also in the US. When we buy or sell the product in the official markets, we pay the official exchange rate (5.1 Peso/Dollar). When we purchase/sell dollars in the black market, we pay the blue dollar rate of 8.75 (Peso/Dollar). Assume we can trade the product in the US market and in the Argentinian market. a) Assume that you are living in Argentina and consume in Pesos. Also assume that since the 20% surcharge is tax deductible, it is irrelevant to your decision making (i.e. for the purpose of this section ignore the surcharge). Show how you can make arbitrage profits in the market. b) Now assume that the 20% surcharge is effective. Can you still make arbitrage profits in the market? c) What is the minimal surcharge the government should levy in order to eliminate arbitrage opportunities?

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Ex1: International Finance Tal Mofkadi