Empirical Finance

Assignment

Foreign Exchange Assignment∗

1. Spot-rate arithmetic

Attached are some data on Iraqi Dinar (IQD) exchange rates. These data arefrom the Central Bank of Iraq. More information is available at http://www.cbi.iq/.At the end of the problem set is a NYT article that is not required for the prob-lem set, but interesting nevertheless.

(a) Compute the implicit USD/EUR and EUR/USD exchange rates and fillout the following table.

Bid Ask

USD/EUR

EUR/USD

(b) What is the size of the USD/EUR bid-ask spread, in basis points? (Hints:(i) a basis point is 1/100th of a percentage point, (ii) do the currencyround trip, from USD into EUR and back to USD, as in the lecture notes).Briefly show your calculations.

Spread size = b.p.

Calculations:

∗Revised: February 28, 2013.

Foreign Exchange Assignment 2

(c) Compute the implied arbitrage bounds on the EUR/USD bid-ask spread.That is, fill out the following (there are three arbitrage restrictions and thefirst is given to you).1

1. Bid must be less than ask

2. Bid must be less than EUR/USD

3. Ask must greater than EUR/USD

(d) Suppose that a EUR/USD ‘cross-rate’ dealer posts firm quotes of

Bid AskUSD/EUR 1.2934 1.2939

You have line of credit of USD 20 million. How much money can you makeby doing a ‘triangular arbitrage?’

Profit = USD

Please show your calculations and explain the details of your arbitragetrade:

1If you find that your answers seem the same as those in part (a), you have not necessarily made amistake. What is different here is the context. In part (a) we ask “what are the implicit USD/EUR(and EUR/USD) rates?” That is, by trading through IQD, at what rate can we exchange EURfor USD? In part (c) we ask “if we were to actually start quoting EUR/USD then, given the IQDrates, which quotes will represent arbitrage opportunities?” This is, conceptually, a very differentquestion. For example, there are many answers to the part (c) question (i.e., a range of bid and askprices which don’t admit arbitrage), but only one for part (a).

Foreign Exchange Assignment 3

2. CIP arbitrage arithmetic

Attached are three pages of quotes for spot and forward exchange rates andeurocurrency interest rates, for the U.S. and Australia. The exchange rates areUSD/AUD (price of AUD in units of USD).

(a) This question asks you to incorporate the bid-ask spread into the calcula-tions we used in class to derive the covered interest rate parity relationship.Using the 9 month USD and AUD interest rates, and the spot exchangerates, your job is to derive arbitrage bounds on the forward USD/AUDbid and ask prices. What you should provide are two inequalities:

• F bUSD/AUD ≤ y

• F aUSD/AUD ≥ x

where x < y are the numbers you need to compute, and F bUSD/AUD and

F aUSD/AUD denote USD/AUD bid and ask forward prices, respectively. Af-

ter computing your bounds check to see if the actual forward rates fromBloomberg violate them.2

(b) Suppose that a forward-rate dealer is quoting F bUSD/AUD = 1.0087 and

F aUSD/AUD = 1.0089.3 You are an arbitrageur with a line of credit of either

USD 9 million or AUD 9 million. Design a zero-cost arbitrage portfolioand state how much money you can make. Your answer should be in futurevalue, 9 months hence, and can be in either USD or AUD units.

(c) Next, here is why these calculations can be important for risk-managementdecisions. Suppose that you are a U.S.-based corporate treasurer whoknows that you must make a payment of AUD 40 million in 6 months. Youwant to hedge this payment (against appreciation in AUD) immediately.There are two ways you could do this:

(i) Enter into a forward contract to receive AUD 40 million in 6 monthstime (this is called a forward hedge).

2 Hint. Consider two trades. First borrow the present value of USD 1, convert into spot AUD,lend the AUD and sell the AUD proceeds in the forward market. The inequality arises from ensuringthat you don’t end up with more than USD 1. The second trade is the mirror image of this one:borrow the present value of AUD 1, convert into USD, lend the USD and sell the USD proceedsforward. Make sure you don’t end up with more than AUD 1. The tricky parts are to be sure thatyou are always trading at the right prices. A good rule of thumb is that you will always be on thelousy side of the spread.

3Yes, these are the actual forward rates from the Bloomberg page! Yes, there is an arbitrageopportunity inherent in these quotes. According to my friends in industry, this is a reflection ofthe extraordinary activities of the ECB and the Fed in providing short-term financing to Europeanbanks. Effectively, this says that, for the time being, the interbank lending markets are sufficientlydisrupted to make for ‘apparent’ arbitrage opportunities, but where banks really aren’t in a positionto take advantage of them. You and I, of course, do not have access to the markets that arerepresented in this data. For the purposes of this question, we will pretend we do! And we will arbthem!

Foreign Exchange Assignment 4

(ii) Borrow an appropriate amount of USD now, convert the proceeds toAUD immediately, and then invest the AUD in a AUD-denominatedEurocurrency deposit (this is called a money market hedge).

Which of these options is more advantageous? How much can you gainby choosing the appropriate hedge? Express your answer in future-valuedUSD (i.e., how many extra USD will you have to pay in 6 months bychoosing the more expensive hedge?). Also, express your answer in basispoints.

(d) Suppose that in 6 months time the spot exchange rate is exactly what itis today. Will you regret having hedged? Why or why not?

Data Conventions

• Interest rate conventions. Eurocurrency interest rates are expressed in termsof annualized percentage. To ‘un-annualize’ a Eurocurrency interest rate, theconvention is to use ‘simple interest.’ That is, if the ‘ask’ for 6 month USD Liboris quoted at 6.26%, the interest one would pay on one dollar, after 6 months,would be USD 1 × 6.26/200 = USD 0.0313.4 You will need to incorporate thisin your covered interest parity calculations. Recall also that the ‘bid’ (the lowernumber) is the rate at which the bank will borrow and the ‘ask’ (sometimescalled the ‘offer’) is the rate at which they’ll lend.

• Forward rate conventions. Interbank forward rates are quoted as ‘discount mar-gins:’ numbers by which the currency in question is discounted in the forwardmarket relative to the spot market. The confusing thing is that, in spite of theword ‘discount,’ you always add the margins to the spot rates to arrive at theforwards.

Here’s a simple EUR example. If the spot rate bid/ask is 1.2129/1.2130, andthe forward margins were −28.44/− 28.14,

F bUSD/EUR = 1.2129 +

−28.44

10, 000= 1.2101

F aUSD/EUR = 1.2130 +

−28.14

10, 000= 1.2102

Note that if this were JPY we’d divide by 100, not by 10,000

4In practice, one needs to be more precise by counting the number of days between now and 6months from now. In our class, dividing by 200 is just fine.

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CURRENCY CODE SELL BUY

US dollar USD 1166.000 1164.000

Euro EUR 1552.995 1552.219

British pound GBP 1870.264 1869.329

Canadian dollar CAD 1175.759 1175.171

Swiss franc CHF 1291.681 1291.035

Swedish krona SEK 176.544 176.455

Norwegian krone NOK 205.680 205.577

Danish krone DKK 208.717 208.613

Japanese yen JPY 14.048 14.041

SpecialDrawing Rights

SDR 1805.586 1804.683

Indicative rates - 03.04.2012

ECONOMIC DATA

Interest ratesCBI policy rate (valid from 1 Apr 2010) 6%IQD 7 day deposit 4%Primary credit facility 8%

Economic indicatorsCore inflation (YoY): Feb 2012 6.30%Inflation (YoY): Feb 2012 5.73%M2 growth (YoY): Dec 2011 19.8%

For 2012F:GDP - real growth rate 12.6%Budget deficit/GDP 11.0%Current account deficit/GDP 4.5%Net foreign reserves $60B

BANKNOTES & COINS

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Assignment 5 8

Billions Over Baghdad - New York Times http://www.nytimes.com/2007/02/27/opinion/27taylor.html?_r=1&oref=slogin&pagewanted=all

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OP-ED CONTRIBUTOR

Billions Over BaghdadBy JOHN B. TAYLORPublished: February 27, 2007

Stanford, Calif.

EARLIER this month, the House

Committee on Oversight and

Government Reform held a hearing that

criticized the decision to ship American

currency into Iraq just after Saddam

Hussein’s government fell. As the

committee’s chairman, Henry Waxman of California, put it

in his opening statement, “Who in their right mind would

send 360 tons of cash into a war zone?” His criticism

attracted wide attention, feeding antiwar sentiment and

even providing material for comedians. But a careful

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Joe Morse investigation of the facts behind the currency shipment

paints a far different picture.

The currency that was shipped into Iraq in the days after the fall of Saddam Hussein’s

government was part of a successful financial operation that had been carefully planned

months before the invasion. Its aims were to prevent a financial collapse in Iraq, put the

financial system on a firm footing and pave the way for a new Iraqi currency. Contrary to

the criticism that such currency shipments were ill advised or poorly monitored, this

financial plan was carried out with precision and was a complete success.

The plan, which had two stages, was designed to work for Iraq’s cash economy, in which

checks or electronic funds transfers were virtually unknown and shipments of tons of cash

were commonplace.

In the first stage, the United States would pay Iraqi government employees and

pensioners in American dollars. These were obtained from Saddam Hussein’s accounts in

American banks, which were frozen after he attacked Kuwait in 1990 and amounted to

about $1.7 billion. Since the dollar is a strong and reliable currency, paying in dollars

would create financial stability until a new Iraqi governing body was established and

could design a new currency. The second stage of the plan was to print a new Iraqi

currency for which Iraqis could exchange their old dinars.

The final details of the plan were reviewed in the White House Situation Room by

President Bush and the National Security Council on March 12, 2003. I attended that

meeting. Treasury Secretary John Snow opened the presentation with a series of slides.

“As soon as control over the Iraqi government is established,” the first slide read, we plan

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to “use United States dollars to pay civil servants and pensioners. Later, depending on the

situation on the ground, we would decide about the new currency.” Another slide

indicated that we could ship $100 million in small denominations to Baghdad on one

week’s notice. President Bush approved the plan with the understanding that we would

review the options for a new Iraqi currency later, when we knew the situation on the

ground.

To carry out the first stage of the plan, President Bush issued an executive order on March

20, 2003, instructing United States banks to relinquish Mr. Hussein’s frozen dollars.

From that money, 237.3 tons in $1, $5, $10 and $20 bills were sent to Iraq. During April,

United States Treasury officials in Baghdad worked with the military and the Iraqi

Finance Ministry officials — who had painstakingly kept the payroll records despite the

looting of the ministry — to make sure the right people were paid. The Iraqis supplied

extensive documentation of each recipient of a pension or paycheck. Treasury officials

who watched over the payment process in Baghdad in those first few weeks reported a

culture of good record keeping.

On April 29, Jay Garner, the retired lieutenant general who headed the reconstruction

effort in Iraq at the time, reported to Washington that the payments had lifted the mood

of people in Baghdad during those first few confusing days. Even more important, a

collapse of the financial system was avoided.

This success paved the way for the second stage of the plan. In only a few months, 27

planeloads (in 747 jumbo jets) of new Iraqi currency were flown into Iraq from seven

printing plants around the world. Armed convoys delivered the currency to 240 sites

around the country. From there, it was distributed to 25 million Iraqis in exchange for

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their old dinars, which were then dyed, collected into trucks, shipped to incinerators and

burned or simply buried.

The new currency proved to be very popular. It provided a sound underpinning for the

financial system and remains strong, appreciating against the dollar even in the past few

months. Hence, the second part of the currency plan was also a success.

The story of the currency plan is one of several that involved large sums of cash. For

example, just before the war, Saddam Hussein stole $1 billion from the Iraqi central bank.

American soldiers found that money in his palaces and shipped it to a base in Kuwait,

where the United States Army’s 336th Finance Command kept it safe. To avoid any

appearance of wrongdoing, American soldiers in Kuwait wore pocket-less shorts and

T-shirts whenever they counted the money.

Later, American forces used the found cash to build schools and hospitals, and to repair

roads and bridges. Gen. David Petraeus has described these projects as more successful

than the broader reconstruction effort.

But that wasn’t the only source of dollars. Because the new Iraqi dinar was so popular, the

central bank bought billions of United States dollars to keep it from appreciating too

much. As a result, billions in cash accumulated in the vaults of the central bank. Later,

with American help, the Iraqi central bank deposited these billions at the New York

Federal Reserve Bank, where they could earn interest.

Finally, when Iraq started to earn dollars selling oil, the United States transferred the cash

revenue to the Finance Ministry, where it was used to finance government operations,

including salaries and reconstruction. Many of these transfers occurred in 2004, long

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after the financial stabilization operation had concluded. Iraqi Finance Ministry officials

had already demonstrated that they were serious about keeping the controls they had in

place. The 360 tons mentioned by Henry Waxman includes these transfers as well as the

237.3 tons shipped in 2003 in the stabilization.

One of the most successful and carefully planned operations of the war has been held up

in this hearing for criticism and even ridicule. As these facts show, praise rather than

ridicule is appropriate: praise for the brave experts in the United States Treasury who

went to Iraq in April 2003 and established a working Finance Ministry and central bank,

praise for the Iraqis in the Finance Ministry who carefully preserved payment records in

the face of looting, praise for the American soldiers in the 336th Finance Command who

safely kept found money, and yes, even praise for planning and follow-through back in the

United States.

John B. Taylor, under secretary of the Treasury from 2001 to 2005, is the author of

“Global Financial Warriors.”

TipsTo find reference information about the words used in this article, double-click on any word, phrase or name. Anew window will open with a dictionary definition or encyclopedia entry.

Past CoverageLives Entwined by War Enter a Long, Arduous Chapter: Recovery (February 25, 2007)U.S. Seizes Son of a Top Shiite, Stirring Uproar (February 24, 2007)Iraq Rebels Expected to Use More Chlorine Gas in Attacks (February 23, 2007)GRAPHIC; Struggle for Baghdad (February 23, 2007)