1. Would covered interest arbitrage profit increase or decrease, or remain unchanged if we assume that there is a bid-ask spread in interest rates for each currency (i.e. borrowing rate is not equal to lending rate for each currency)? Why? (The answer should not exceed 10 sentences.)
Covered interest arbitrage profit would increase if we assume that there is a bid-ask spread in interest rates for each currency. This can be achieved by borrowing a foreign currency at a lower interest rate than our domestic currency and transfer it into the domestic currency. You can then invest this into a local government bond which pays a higher return than the interest being paid on the borrowed foreign currency causing a profit to be made on the money borrowed internationally. However along with this you would need exchange rate bid ask spread to be less than the difference in interest rates in order to make a profit. Commissions and fees would also need to be taken into account when determining whether or not it is a profitable exercise.

2. Suppose the following information is given:
The exchange rate is S(USD/AUD)=1.0291-94,
The bond yield on 1-year Australian bond is 3.26%,
The bond yield on 1-year US bond 0.10%.

Find the implied forward bid rate, i.e. the forward bid rate at which there is no arbitrage profit. =

=

= 1.0294 x 0.9694 = 0.9979 3. On 30 January 2014, http://www.fxstreet.com/rates-charts/forward-rates/?id=eur%2fhkd provided the following exchange rates:

Name
Bid
Ask

EUR/HKD Spot
EUR/HKD 12M Forward

10.2358
133.3100

10.2385
195.0900

a) Why does a dealer (or a market maker) sell and buy currency at different rates, i.e. why is the bid quote (e.g., 10.2358) not equal to the ask quote (e.g., 10.2385)?
A dealer sells currency and buys currency at different rates in order to make a return on buying and selling currencies. For example if a dealer wanted to buy EUR100,000 it would cost the dealer HKD1,023,580 and if he wanted to sell the EUR100,000 it would cost the buyer HKD1,023,850 meaning the dealer would make a profit of HKD270 ignoring any commission or fees.

b) Find the indirect spot and forward quotes from the perspective of European investors.
S(HKD/EUR) = 10.2358 – 85

F(HKD/EUR) =

= (10.2358 + 0.0134 – (10.2385 + 0.0195) = 10.2492 – 10.2580

c) Find the direct spot and forward quotes from the perspective of European investors.
S(EUR/HKD) =

= 0.097670557 – 0.09769632 = 0.09767 – 0.09769

F(EUR/HKD) =

= 0.09748 – 0.09757

d) Calculate the bid-ask spread (in percent and in currency units) for the spot rate, using indirect quotes from the perspective of European investors.
=
= 10.2385 – 10.2358
= 0.0027

=

=

=

= 0.026%

e) What factors impact the magnitude of the bid-ask spread?
Liquidity is the largest factor on the magnitude of the bid-ask spread. If the currency is traded regularly, at large volumes and on a daily basis it is said to be liquid and the bid-ask spread will tend to be a lot narrower than an illiquid currency.

Another factor to impact the magnitude of the bid-ask spread is volatility. Volatility increases during times of rapid market advances and declines. At times of large volatility the bid-ask spread will be a lot wider