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# Exchange Rate Behavior

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1. As an employee of the foreign exchange department for a large company, you have been given the following information.

Beginning of Year

Spot rate of £ = \$1.596
Spot rate of Australian dollar (A\$) = \$.70
Cross exchange rate: £1 = A\$2.28
One-year forward rate of A\$ = \$.71
One-year forward rate of £ = \$1.58004
One-year U.S. interest rate = 8.00%
One-year British interest rate = 9.09%
One-year Australian interest rate = 7.00%

Determine whether triangular arbitrage is feasible, and if so, how it should be conducted to make a profit.

2. Using the information in question 1, determine whether covered interest arbitrage is feasible and, if so, how it should be conducted to make a profit.

3. Based on the information in question 1 for the beginning of the year, use the international Fisher effect (IFE) theory to forecast the annual percentage change in the British poundâ??s value over the year.

4. Assume that at the beginning of the year, the poundâ??s value is in equilibrium. Assume that over the year the British inflation rate is 6 percent while the U.S. inflation rate is 4 percent. Assume that any change in the poundâ??s value due to the inflation differential has occurred by the end of the year. Using this information and the information provided in question 1, determine how the poundâ??s value changed over the year.

5. Assume that the poundâ??s depreciation over the year was attributed directly to central bank intervention. Explain the type of direct intervention that would place downward pressure on the value of the pound.

#### Solution Preview

Triangular Arbitrage

Triangular arbitrage can be defined as the ability of taking advantage with the unmatched currency exchange rates between three foreign exchange markets. To make the triangular arbitrage one currency is converted in another foreign currency and again in third foreign currency. Finally it is converted in the original currency within a short time period. The riskless profit arises due to unmatched currency's exchange rates. Most of the traders use advanced computer equipments or programs to take the advantage of this type of arbitrage opportunities (Madura, 2008). The information provided by the foreign exchange department of a large company will not be effective to generate a triangular arbitrage profit.
Triangular arbitrage is not with the given exchange rates as cross exchange rate between pound and Australian Dollar is properly specified. The given exchange rates are as follow =
1 pound = 1.596 USD
1 Australian \$ = 0.70 USD
1 Pound = 2.28 Australian \$
For triangular arbitrage exchange rates between foreign currencies should not match. But the cross exchange rate is properly matched with given spot rates.
Cross exchange rate = Spot rate of £/ Spot rate of A\$
= \$1.596/\$0.70
= 2.28
Thus, triangular arbitrage is not feasible.