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Covered Interest Arbitrage in Annualized Terms

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Mary Joe has a credit line of $1,000,000 (or equivalent in major currencies) for arbitrage. She had access to the following rates, and she managed to generate CIA profits. Replicate her arbitrage and calculate her profits based on the following rates:
Assumptions
Value
SFr. Equivalent
Arbitrage funds available
$1,000,000
SFr. 1,281,000
Spot exchange rate (SFr./$)
1.2810
3-month forward rate (SFr./$)
1.2740
U.S. dollar 3-month interest rate
4.800%
pa
Swiss franc3-month interest rate
3.200%
pa

Note that interest rates are expressed in annualized terms!
A. $1,538.46
B. SFr 1,538.46
C. $1936.44
D. SFr 1936.44

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Solution Summary

The solution solves a covered interest arbitrage question with step-by-step workings and explanations in an excel file.

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A company had beginning retained earnings $63,100. During the year, the company reported sales $127,800, costs of goods sold $89,900, depreciation $11,200, dividends $28,000, and interest expenses $3,400. The tax rate is 35%. What is the retained earnings balance at the end of the year?
a. $50,245
b. $76,425
c. $68,455
d. $75,445
e. $53,615

Question 12
A company is considering remodeling a building which they own. The remodeling costs are estimated at $1,420,000. The building contains 75 rentals units. The company will increase the rent on each unit such that his total rental income increases by $400,000 a year for the next 5 years. At a discount rate 15%, what is the benefit of the remodeling project to the company?
a. -$32,145.91
b. -$46,767.61
c. -$49,922.17
d. -$79,137.96
e. -$76,824.57

Question 13
A company is investing $259,000 in a new project. The firm expects the project will produce cash flow $50,000 a year for the first two years, and $80,000 a year for the following three years. How long will it take the company to recover its initial investment in this project?
a. 2.98 years
b. 3.99 years
c. 2.74 years
d. 3.14 years
e. 5.21 years

Question 14
The spot rate between the U.K. and the U.S. is £0.5428 = $1, while the 1-year forward rate is £0.5320 = $1. The risk-free rate in the U.K. is 4.1%. The risk-free rate in the U.S. is 5.7%. How much profit can you earn on a loan of $10,000 by utilizing covered interest arbitrage?
a. $101.26
b. $51.33
c. $21.50
d. $26.80
e. $57.94

Question 15
A portfolio that is adequately diversified should produce a return which:
a. is superior to the overall market if the portfolio beta has been reduced to 1.0.
b. is equal to the risk-free rate.
c. is equivalent to beta multiplied by the market risk premium.
d. lies at a point on the security market line given the portfolio's beta.
e. is equal to the risk-free rate plus the standard deviation times the market risk premium

Question 16
Which of the following statements is false?
a. If interest rates are expected to decrease in the future, the graph depicting the term structure of interest rates will be downward-sloping.
b. A bond investor believes, based on statements made by the Federal Reserve governors, that interest rates will increase in the future. Therefore, this investor will demand an interest rate risk premium if they purchase a bond today.
c. All else equal, a bond with a rating of B will have a larger default risk premium than a bond with an A rating.
d. The liquidity premium is the portion of a nominal interest rate that represents compensation for the difference between short-term and long-term tax rates.
e. To offset the decreasing value of a dollar over time, bond investors demand an inflation premium.

Question 17
A company offers credit terms of 2/10, net 60. What is the effective annual rate on a $15,000 purchase if you forgo the discount?
a. 15.89%
b. 56.71%
c. 39.43%
d. 76.34%
e. 23.48%

Question 18
A year ago, Brad purchased 300 shares of ELX stock for $15,000. The stock is currently selling for $36 a share and Brad has decided to sell all of his shares. What is total return that Brad has earned on this investment if he received a special dividend $5 a share?
a. -18.00%
b. -19.00%
c. -17.38%
d. -19.50%
e. -14.58%

Question 19
You can exchange ?100 for $127.08 currently. The inflation rate in Euroland is expected to be 5.2% as compared to 4.6% in the U.S. Assuming that relative purchasing power parity exists, the exchange rate 3 years from now should be:
a. ?0.7827/$1
b. ?0.8128/$1
c. ?0.7903/$1
d. ?0.7811/$1
e. ?0.8011/$1

Question 20
Which one of the following situations is most apt to create an agency problem?
a. the company president receives a bonus based on the profits of the firm
b. a manager receives a bonus because he or she has hired the most new employees in the past year
c. an employee is paid twice the normal wage for working overtime to complete a special project on time for a customer
d. an employee receives a pay raise based on his or her extraordinary contributions to the firm
e. a manager is rewarded because the employees in his or her department had no accidents for a year

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