Assume that you are a currency trader with $10m at your disposal and you have received the following exchange rate quotations: Bank A is quoting ¥107-110/$ Bank B is quoting CHF1.50-57/$ Bank C is quoting ¥75-79/CHF Required: (i) Give a definition of ‘arbitrage’.
Answer two questions only.
The word limit for each question is 1000 words
Question 1
(A)
Assume that you are a currency trader with $10m at your disposal and you have received the following exchange rate quotations:
Bank A is quoting ¥107-110/$ Bank B is quoting CHF1.50-57/$ Bank C is quoting ¥75-79/CHF
Required:
(i) Give a definition of ‘arbitrage’.
(5 marks)
(ii) Without doing any calculations, explain why you can profit from the three quotations above.
(5 marks)
(iii) Calculate the $ profit that can be produced with $10 million through triangular arbitrage. You need to show all your workings. Ignore the time value of money.
(10 marks)
(iv) Now assume that you have ¥1,200m instead of $10m. Calculate the ¥ profit that can now be made through triangular arbitrage. You need to show all your workings. Ignore the time value of money.
(10 marks)
(v) In the real world where there are transaction costs, there is always a positive bid-ask spread. Without doing any calculations, how the bid- price of Currency X in terms of Currency Y is the ask-price of Currency Y in terms of Currency X.
(5 marks)
(vi) Briefly discuss whether triangular arbitrage should be considered as a mechanism to make profits or as a mechanism to restore competitive market equilibrium (or a combination or both).
(10 marks)
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Assignment?
Module code: LUBS5006M
(B)
Baloon Plc is a UK company that has the following expected transactions:
One month: One month: Three months:
Expected receipt of $330,000 Expected payment of $250,000 Expected receipt of $410,000
The company’s finance director has collected the following information:
Spot rate:
One month forward: Three months forward:
$1.6840 – 1.6842/£ 0.0019 – 0.0020 discount 0.0036 – 0.0038 discount
Money market rates for the company at the present time are:
One year £ interest rate: One year $ interest rate:
Borrowing 2.9% 3.4%
Deposit 2.6% 3.1%
Note: Assume there are 360 days in a year.
Required:
(i) Calculate the expected sterling receipts in one month and in three months if the company chooses to hedge its transaction exposure using the forward market.
(15 marks)
(ii) Calculate the expected sterling receipts in three months if the company chooses to hedge its transaction exposure using a money market hedge and comment on your findings in (i) and (ii).
(20 marks)
(iii) Briefly explain how each of the following can be used to forecast future foreign exchange rates:
(a) interest rates; (b) inflation rates.
(20 marks)
Module code: LUBS5006M
Question 2
(A)
A currency trader sees the following information on his computer screen:
Spot Rate:
3-month forward rate:
US 3-month Treasury Bill rate:
Norwegian 3-month Treasury Bill rate:
NKr6.2280/$
NKr6.2640/$
1.4%
1.8%
The currency trader can borrow up to Nkr6.228m (or the equivalent of $1m).
Required:
(i) As implied by market prices, state how the value of the $ is expected to change over the next three months.
(5 marks)
(ii) Calculate the annualised forward premium/discount at which the NKr is trading against the $.
(5 marks)
(iii) Explain why theory suggests that Interest Rate Parity (IRP) should hold between countries and demonstrate (with calculations) whether or not IRP is currently holding between Norway and the US.
(15 marks)
(iv) Demonstrate (with calculations) how a covered interest arbitrage profit can be achieved in this situation, stating clearly the amount of the profit that can be achieved.
(15 marks)
(v) Explain precisely how IRP will be restored as a result of such covered interest arbitrage activities, stating clearly the impact on interest rates in the two countries and the spot and forward exchange rates between the two currencies.
(10 marks)
Module code: LUBS5006M
(B)
Oakley Inc is a US company that has recently agreed to buy a small marketing business based in Belgium for €13.4m, with the purchase price due to be paid in three months’ time, subject to the satisfactory outcome of a due diligence exercise by an accounting firm.
In order to deal with the foreign exchange risk associated with the purchase of the Belgian business, the company is considering the following choices:
- The use of euro futures contracts that are currently priced at €0.7750/$. The contract size is €75,000 (and should be rounded to the nearest whole number of contracts).
- The purchase of an over-the-counter option contract at an exercise price of €0.8000/$ with a premium cost of $2.4 per €100.
The current spot rate is €0.7812/$.
Note: Assume there are 360 days in a year.
Required:
Assuming that in three months’ time the spot rate is €0.7998/$ and the futures price is €0.7860/$:
(i) Calculate the cost of the Belgian purchase if the company uses the futures contract.
(20 marks)
(ii) Calculate the cost of the Belgian purchase if the company uses the option contract.
(20 marks)
(iii) Comment on the appropriateness of the futures contract and the option contract as hedging instruments for Oakley Inc in this particular situation.
(10 marks)
(Total 100 marks)
Module code: LUBS5006M
Question 3
Goro Inc (Goro), a US firm, has an outstanding contractual obligation with its French supplier for a total amount of €6 million to be paid in nine months. The firm is thinking of hedging its position by buying option contracts (contract size is €250,000) at a strike price of €0.769/$ in order to protect against the risk of the rising euro. The option premium is 1.7 dollar cents per euro.
Alternatively, Goro can sign nine-months futures contracts (contract size €0.6 million) at a
futures price of €0.762/$. The current sport rate is € 0.769/$. The financial director has been advised by one forex expert that the most likely value for the euro in 270 days is € 0.771/$, but she also believes that the euro could go as high as €0.754 or as low as €0.775 against the $.
Note: Assume there are 360 days in a year.
Required:
(i) Indicate which type of option contract Goro should buy. Prepare a profit/loss diagram on the option position and the futures position within the range of expected future spot prices.
(30 marks)
(ii) Calculate what Goro would gain or lose on the option and futures position if the euro settled at its most likely value. What is Goro’s break-even future spot price on the option contract?
(30 marks)
(iii) Prepare a diagram of the corresponding profit and loss and break-even positions on the futures and option contracts for the sellers of these contracts.
(15 marks)
(iv) Briefly discuss the advantages and disadvantages of using currency futures versus currency options to hedge exchange rate risk.
(25 marks)
(Total 100 marks)
Module code: LUBS5006M
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Question 4
The finance director of Flatpack plc, a rapidly expanding company based in the UK, is considering how to hedge sales revenues of €45m, which are due to be received in 270 days. The company has been quoted the following exchange and interest rates by one of its banks:
Spot rate (€/£)
270 day forward rate (€/£)
Euro interest rate
Sterling interest rate
1.2655 – 1.2682
1.2821 – 1.2843
2.0 % per annum
1.25 % per annum
A foreign currency dealer at the bank has also privately provided the finance director with her own estimate of the €/£ spot rate in 270 days. Her estimate is 1.2725 – 1.2732.
Note: Assume there are 360 days in a year.
Required:
(i) Calculate the hedged value of the company’s euro receivables if Flatpack plc decides to: (a) use a forward market hedge to manage its foreign currency exposure;
(b) use a money market hedge to manage its foreign currency exposure.
(30 marks)
(ii) Explain to the finance director which hedging strategy is preferable for the company, and, holding all other information unchanged, calculate the forward exchange rate for €/£ under which the forward market hedge would yield an identical sterling value to the money market hedge for the company’s euro receivables.
(15 marks)
(iii) Given the estimated €/£ spot rate provided by the foreign currency dealer, discuss, with reasons, whether or not the company should hedge the receipt of its euro receivables in this situation.
(15 marks)
(iv) Distinguish between transaction risk, translation risk and economic risk and identify and discuss the various operational techniques available to managers that may be of assistance to them in managing exposure to transaction risk.
(40 marks)
(Total 100 marks)
Formula Sheet
Currency Depreciation
Currency Appreciation
Forward Premium/Discount
Purchasing Power Parity
International Fisher Effect
Interest Rate Parity
Exposure Coefficient
Unhedged Variance
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Assignment?
(St – St+1) St+1
(St+1 – St ) St
(F –St ) 360
St #days contract
E(e) = p$ – p£
E(e) = i$ – i£
(F-S)/S = ( i$ – i£) / (1 + i£)
b = Cov(P,S) / Var(S)
Var(P) = b2Var(S) + Var(e)
