Assignment 1

1402 Words Mar 12th, 2013 6 Pages
Assignment# 3 by Nedim Halilagic

Chapter 6

14. Freely Floating Exchange Rates. Should the governments of Asian countries allow their currencies to float freely? What would be the advantages of letting their currencies float freely? What would be the disadvantages?

ANS: Given that Asian countries are rising economies and that floating exchange rate systems allows currency values to reflect a nation’s economic fundamentals gradually and efficiently, I would say that they should allow their currencies to float freely. Advantages of freely floating exchange rate system are insulation form the inflation of other countries and from unemployment problems in other countries. However, freely floating exchange rate system can adversely affect a
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The following information is available:
• You have $500,000 to invest
• The current spot rate of the Moroccan dirham is $.110.
• The 60-day forward rate of the Moroccan dirham is $.108.
• The 60-day interest rate in the U.S. is 1 percent.
• The 60-day interest rate in Morocco is 2 percent.

a. What is the yield to a U.S. investor who conducts covered interest arbitrage? Did covered interest arbitrage work for the investor in this case?
b. Would covered interest arbitrage be possible for a Moroccan investor in this case?

ANS:
a. Covered interest arbitrage (for US based investor) would involve the following steps:

1. Convert dollars to Moroccan dirham: $500,000/$.11 = MD4,545,454.55
2. Deposit the dirham in a Moroccan bank for 60 days. You will have MD4,545,454.55 × (1.02) = MD4,636,363.64 in 60 days.
3. In 60 days, convert the dirham back to dollars at the forward rate and receive MD4,636,363.64 × $.108 = $500,727.27

The yield to the U.S. investor is $500,727.27/$500,000 – 1 = .15%. As the yield is smaller than the US interest rate 1%, the covered interest arbitrage did not work for the investor in this case. The lower Moroccan forward rate more than offsets the higher interest rate in Morocco.
OR
$500,000 invested in the US for 60 days will become $505,000 (=$500000 x 1.01) which is higher than the amount generated by covered interest arbitrage.

b. Yes, covered interest arbitrage would be possible for a Moroccan investor.

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