MBA 642: May 1 Assignments and Readings on Interest Rate Parity and Arbitrage

Interest rate parity is the situation that exists when the expected rate of return on riskless securities is the same in all countries. If the expected rate was higher in one country than another, money would flow to the country with the higher rate. The process would increase the rates in the low-rate country and lower rates in the high-rate country. The process (arbitrage) would continue until rates were equal (parity existed).

For example, say $856.90 is converted to Canadian dollars at an exchange rate of 1.1670 CDW to $1 to buy a CDW1,000 6-month bond that pays an annual rate of 4%. At the end of 6 months, the investor would receive CDW1,020. If the exchange rate remains the same, the Canadian dollars can be converted into $874.03 (1,020/1.1670), which translates into a 4% annual rate of return. But suppose the Canadian dollar is expected to appreciate against the U.S. dollar, and so the forward rate is 1.1614 CDW per U.S. dollar. Then, the CDW1,020 will buy $878.22 (1,o20/1.614). This gives an annual rate of return of 4.98%. Thus, the investor earns 4% on the Canadian investment and then gains 0.98% on the appreciation of the CDW that leaves the net return of 4.98%. Therefore, given the prior assumptions, a 4% Canadian rate implies that the U.S. riskless rate on a 6-month bond should be 4.98%. If the U.S. and Canadian rates were the same 4%, then U.S. money would flow to Canada, driving down Canadian rates and driving up U.S. rates, until equilibrium has been reached (interest rate parity).

For Tuesday, May 1, read pages 944-966 of Chapter 27 "Multinational Financial Management." Focus your attention on the section entitled, "Trading in Foreign Exchange -- Interest Rate Parity." Do the following problems for Chapter 27: 2, 3, 9, 10, and 11.

In addition, refer back to the post of April 23 entitled, "Interest Rate Parity" and answer the question on the Indian INR arbitrage. Also, complete the arbitrage question from the handout on the Dollar and SF.

MBA 642: Interest Rate Parity

The spot rate for the Indian INR is 48.50/$1. The current interest rate in India for a 3-month CD is 10%. In the U.S., the rate is 4%. What is the implied 3-month forward rate? If you are quoted a 3-month forward rate of 48.75/$1, what should you do?

A good site for a currency converter on over 164 currencies is at Oanda.

MBA 642: De-Leverage ???

Leveraged investors have borrowed in a number of currencies to invest in higher rates of return in the world. Specific currencies of interest in the “carry trade” would include the Yen and Dollar. If the de-leveraging process were to become meaningful, we would expect the Yen to rise in value as part of the unwinding process. In other words, levered investors would be selling assets and buying the Yen. Keep an eye on the relative performance of the S&P 500 relative to the Yen ($SPX:$XJY) for possible clues about the chances of de-leveraging as it relates to the unwinding of the Yen carry trade. Also, monitor the FXI, which is the ETF for the Shanghai Composite Index, for additional clues to the de-leveraging process.

For Tuesday, April 24, be prepared to comment on the outlook for the Yen and Dollar.

You may want to check out the following link for the dollar.

MBA 642 Financial Management

For Tuesday, April 17, we will focus on "Lease Financing" (Chapter 19). The problems for this chapter are 3 and 4.

In addition, we will review for your assessment next week. You will be responsible for the following concepts: DuPont Formula and its Applications, P/E Valuations, Cost of Capital Applications, Evaluating Cost of Equity through CAPM, NPV with Replacement Chain Analysis, and Coefficient of Variation.

Note: Please remember those families who have lost love ones at Virgin1a Tech.

Risk Management Indicators

The following chart comes from “BigCharts.com,” which is an excellent “free” charting service by the way. Please draw your attention to the 17 and 43 exponential moving averages. These moving averages just might make or save you a bundle of money.

What does the above S&P 500 chart with its moving averages demonstrate and how can it assist you in making investment decisions? First, the 17 and 43 weekly exponential moving averages (EMA) do not cross every week. However, when they do (17 EMA crosses below 43 EMA), investors better take notice! Second, using the 17 and 43 weekly EMA, an investor would have gotten out of the S&P 500 in October 2000 when the 17 EMA crossed below the 43 EMA and stayed out until early May 2003 when the 17 EMA crossed above the 43 EMA and would have been fully invested ever since. Not too bad of an indicator because the investment game is won by “minimizing” one’s losses.

Along with the Halloween Indicator, this indicator has proven to be a real “winner.”

MBA 642: Assignments

For Tuesday, April 10, be prepared to discuss the problems from Chapter 12 that were assigned. Also, for Chapter 12, read and study pages 418 to 422 on "Cash Flow Evaluation with Unequal Lives and Economic Life vs. Physical Life (Optimal Life)." Then, look at the "Minicase" on pages 432-433 and do "k and l."

In addition, read pages 454 to 464 (Chapter 13) on "Techniques for Measuring Stand-Alone Risk." Then, do problems 7 and 8.