# 8. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal, you notice that Dresdner Bank is quoting 7627/ 00 and Credit Suisse is offering s 1806/ 00

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PROBLEMS

8. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal, you notice that Dresdner Bank is quoting €0.7627/\$1.00 and Credit Suisse is offering SF1.1806/\$1.00. You learn that UBS is making a direct market between the Swiss franc and the euro, with a current €/SF quote of .6395. Show how you can make a triangular arbitrage profit by trading at these prices. (Ignore bid-ask spreads for this problem.) Assume you have \$5,000,000 with which to conduct the arbitrage. What happens if you initially sell dollars for Swiss francs? What €/SF price will eliminate triangular arbitrage?

Solution: To make a triangular arbitrage profit the Deutsche Bank trader would sell \$5,000,000 to Dresdner Bank at €0.7627/\$1.00. This trade would yield €3,813,500= \$5,000,000 x .7627. The Deutsche Bank trader would then sell the euros for Swiss francs to Union Bank of Switzerland at a price of €0.6395/SF1.00, yielding SF5,963,253 = €3,813,500/.6395. The Deutsche Bank trader will resell the Swiss francs to Credit Suisse for \$5,051,036 = SF5,963,253/1.1806, yielding a triangular arbitrage profit of \$51,036.

If the Deutsche Bank trader initially sold \$5,000,000 for Swiss francs, instead of euros, the trade would yield SF5,903,000 = \$5,000,000 x 1.1806. The Swiss francs would in turn be traded for euros to UBS for €3,774,969= SF5,903,000 x .6395. The euros would be resold to Dresdner Bank for \$4,949,481 = €3,774,969/.7627, or a loss of \$50,519. Thus, it is necessary to conduct the triangular arbitrage in the correct order.

The S(/SF) cross exchange rate should be .7627/1.1806 = .6460. This is an equilibrium rate at which a triangular arbitrage profit will not exist. (The student can determine this for himself.) A profit results from the triangular arbitrage when dollars are first sold for euros because Swiss francs are purchased for euros at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss francs are purchased for only €0.6395/SF1.00 instead of the no-arbitrage rate of €0.6460/SF1.00. Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs are sold for euros at too low a rate, resulting in too few euros. That is, each Swiss franc is sold for €0.6395/SF1.00 instead of the higher no-arbitrage rate of €0.6460/SF1.00.
9. The current spot exchange rate is \$1.95/£ and the three-month forward rate is \$1.90/£. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be \$1.92/£ in three months. Assume that you would like to buy or sell £1,000,000.

a. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation?

b. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be \$1.86/£.

Solution:

a. If you believe the spot exchange rate will be \$1.92/£ in three months, you should buy £1,000,000 forward for \$1.90/£. Your expected profit will be:

\$20,000 = £1,000,000 x (\$1.92 -\$1.90).

b. If the spot exchange rate actually turns out to be \$1.86/£ in three months, your loss from the long position will be:

-\$40,000 = £1,000,000 x (\$1.86 -\$1.90).

10. Omni Advisors, an international pension fund manager, plans to sell equities denominated in Swiss Francs (CHF) and purchase an equivalent amount of equities denominated in South African Rands (ZAR). Omni will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate the risk that the ZAR will appreciate relative to the CHF during this 30-day period. The following exhibit shows current exchange rates between the ZAR, CHF, and the U.S. dollar (USD).

Currency Exchange Rates

 ZAR/USD ZAR/USD CHF/USD CHF/USD Maturity Bid Ask Bid Ask Spot 6.2681 6.2789 1.5282 1.5343 30-day 6.2538 6.2641 1.5226 1.5285 90-day 6.2104 6.2200 1.5058 1.5115

1. Describe the currency transaction that Omni should undertake to eliminate currency risk over the 30-day period.

2. Calculate the following:

• The CHF/ZAR cross-currency rate Omni would use in valuing the Swiss equity portfolio.

• The current value of Omni’s Swiss equity portfolio in ZAR.

• The annualized forward premium or discount at which the ZAR is trading versus the CHF.

CFA Guideline Answer:

1. To eliminate the currency risk arising from the possibility that ZAR will appreciate against the CHF over the next 30-day period, Omni should sell 30-day forward CHF against 30-day forward ZAR delivery (sell 30-day forward CHF against USD and buy 30-day forward ZAR against USD).

1. The calculations are as follows:

• Using the currency cross rates of two forward foreign currencies and three currencies (CHF, ZAR, USD), the exchange would be as follows:

--30 day forward CHF are sold for USD. Dollars are bought at the forward selling price of CHF1.5285 = \$1 (done at ask side because going from currency into dollars)

--30 day forward ZAR are purchased for USD. Dollars are simultaneously sold to purchase ZAR at the rate of 6.2538 = \$1 (done at the bid side because going from dollars into currency)

--For every 1.5285 CHF held, 6.2538 ZAR are received; thus the cross currency rate is 1.5285 CHF/6.2538 ZAR = 0.244411398.

• At the time of execution of the forward contracts, the value of the 3 million CHF equity portfolio would be 3,000,000 CHF/0.244411398 = 12,274,386.65 ZAR.

• To calculate the annualized premium or discount of the ZAR against the CHF requires comparison of the spot selling exchange rate to the forward selling price of CHF for ZAR.

Spot rate = 1.5343 CHF/6.2681 ZAR = 0.244779120

30 day forward ask rate 1.5285 CHF/6.2538 ZAR = 0.244411398

The premium/discount formula is:

[(forward rate – spot rate) / spot rate] x (360 / # day contract) =

[(0.244411398 – 0.24477912) / 0.24477912] x (360 / 30) =

-1.8027126 % = -1.80% discount ZAR to CHF

PROBLEMS

4. Suppose that the current spot exchange rate is €0.80/\$ and the three-month forward exchange rate is €0.7813/\$. The three-month interest rate is 5.6 percent per annum in the United States and 5.40 percent per annum in France. Assume that you can borrow up to \$1,000,000 or €800,000.

a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit.

b. Assume that you want to realize profit in terms of euros. Show the covered arbitrage process and determine the arbitrage profit in euros.

Solution:

1. (1+ i \$) = 1.014 < (F/S) (1+ i ) = 1.053. Thus, one has to borrow dollars and invest in euros to make arbitrage profit.

1. Borrow \$1,000,000 and repay \$1,014,000 in three months.

2. Sell \$1,000,000 spot for €1,060,000.

3. Invest €1,060,000 at the euro interest rate of 1.35 % for three months and receive €1,074,310 at maturity.

4. Sell €1,074,310 forward for \$1,053,245.

Arbitrage profit = \$1,053,245 - \$1,014,000 = \$39,245.

1. Follow the first three steps above. But the last step, involving exchange risk hedging, will be different.

1. Buy \$1,014,000 forward for €1,034,280.

Arbitrage profit = €1,074,310 - €1,034,280 = €40,030

8. Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate is €1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot exchange rate.

1. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit.

2. Discuss how the interest rate parity may be restored as a result of the above

transactions.

1. Suppose you are a pound-based investor. Show the covered arbitrage process and

determine the pound profit amount.
Solution:

a. First, note that (1+i ) = 1.054 is less than (F/S)(1+i ) = (1.60/1.50)(1.052) = 1.1221.

You should thus borrow in euros and lend in pounds.

1. Borrow €1,000,000 and promise to repay €1,054,000 in one year.

2. Buy ₤666,667 spot for €1,000,000.

3. Invest ₤666,667 at the pound interest rate of 5.2%; the maturity value will be ₤701,334.

4. To hedge exchange risk, sell the maturity value ₤701,334 forward in exchange for €1,122,134. The arbitrage profit will be the difference between €1,122,134 and €1,054,000, i.e., €68,134.

b. As a result of the above arbitrage transactions, the euro interest rate will rise, the pound

interest rate will fall. In addition, the spot exchange rate (euros per pound) will rise and the forward rate will fall. These adjustments will continue until the interest rate parity is restored.

c. The pound-based investor will carry out the same transactions 1), 2), and 3) in a. But to hedge, he/she will buy €1,054,000 forward in exchange for ₤658,750. The arbitrage profit will then be ₤42,584 = ₤701,334 - ₤658,750.
9. Due to the integrated nature of their capital markets, investors in both the U.S. and U.K. require the same real interest rate, 2.5%, on their lending. There is a consensus in capital markets that the annual inflation rate is likely to be 3.5% in the U.S. and 1.5% in the U.K. for the next three years. The spot exchange rate is currently \$1.50/£.

1. Compute the nominal interest rate per annum in both the U.S. and U.K., assuming that the Fisher effect holds.

2. What is your expected future spot dollar-pound exchange rate in three years from now?

3. Can you infer the forward dollar-pound exchange rate for one-year maturity?

Solution.

a. Nominal rate in US = (1+ρ) (1+E(π\$)) – 1 = (1.025)(1.035) – 1 = 0.0609 or 6.09%.

Nominal rate in UK= (1+ρ) (1+E(π)) – 1 = (1.025)(1.015) – 1 = 0.0404 or 4.04%.

b. E(ST) = [(1.0609)3/(1.0404)3] (1.50) = \$1.5904/₤.

c. F = [1.0609/1.0404](1.50) = \$1.5296/₤.

PROBLEMS

1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced €10 million payable in six months. Currently, the six-month forward exchange rate is \$1.10/€ and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be \$1.05/€ in six months.

(a) What is the expected gain/loss from the forward hedging?

(b) If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? Why or why not?

(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not?

Solution: (a) Expected gain(\$) = 10,000,000(1.10 – 1.05)

= 10,000,000(.05)

= \$500,000.

(b) I would recommend hedging because Cray Research can increase the expected dollar receipt by \$500,000 and also eliminate the exchange risk.

(c) Since I eliminate risk without sacrificing dollar receipt, I still would recommend hedging.

2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million payable in three months. Currently, the spot exchange rate is ¥105/\$ and the three-month forward rate is ¥100/\$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen account payable.

(a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.

(b) Conduct the cash flow analysis of the money market hedge.

Solution: (a). Let’s first compute the PV of ¥250 million, i.e.,

250m/1.0175 = ¥245,700,245.7

So if the above yen amount is invested today at the Japanese interest rate for three months, the maturity value will be exactly equal to ¥25 million which is the amount of payable.

To buy the above yen amount today, it will cost:

\$2,340,002.34 = ¥250,000,000/105.

The dollar cost of meeting this yen obligation is \$2,340,002.34 as of today.

(b)

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Transaction CF0 CF1

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1. Buy yens spot -\$2,340,002.34

with dollars ¥245,700,245.70

2. Invest in Japan - ¥245,700,245.70 ¥250,000,000

3. Pay yens - ¥250,000,000

Net cash flow - \$2,340,002.34

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