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Microsoft Word - Module 1

The treasurer of IBM has $100 million to invest for 6 months. Interest rates are higher in the US (8% annually) than Germany (6% annually). The spot exchange rate is €1.01/$ and 6-month forward rate is €0.99/$. Investing in Germany and hedging exchange risk using the forward contract yields the highest return of $105.59 million.

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228 views

Microsoft Word - Module 1

The treasurer of IBM has $100 million to invest for 6 months. Interest rates are higher in the US (8% annually) than Germany (6% annually). The spot exchange rate is €1.01/$ and 6-month forward rate is €0.99/$. Investing in Germany and hedging exchange risk using the forward contract yields the highest return of $105.59 million.

Uploaded by

sshreyas
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© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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1.

Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest
for six months. The six-month interest rate is 8 percent per annum in the United States
and 6 percent per annum in Germany. Currently, the spot exchange rate is 1.01 per
dollar and the six-month forward exchange rate is 0.99 per dollar. The treasurer of
IBM does not wish to bear any exchange risk.
Where should he/she invest to maximize the return?

The market conditions are summarized as follows:


I$ = 4%; i = 3.5%; S = 1.01/$; F = 0.99/$.
If $100,000,000 is invested in the U.S., the maturity value in six months will be $104,000,000
= $100,000,000 (1 + .04).
Alternatively, $100,000,000 can be converted into euros and invested at the German interest
rate, with the euro maturity value sold forward. In this case the dollar maturity value will
be
$105,590,909 = ($100,000,000 x 1.01)(1 + .035)(1/0.99)
Clearly, it is better to invest $100,000,000 in Germany with exchange risk hedging.

2.While you were visiting London, you purchased a Jaguar for 35,000, payable in three
months. You have enough cash at your bank in New York City, which pays 0.35% interest
per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is
$1.45/ and the three-month forward exchange rate is $1.40/. In London, the money
market interest rate is 2.0% for a three-month investment.
There are two alternative ways of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy 35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three
months so that the maturity value becomes equal to 35,000.
Evaluate each payment method. Which method would you prefer? Why?

3. Currently, the spot exchange rate is $1.50/ and the three-month forward exchange rate
is $1.52/. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per
annum in the U.K. Assume that you can borrow as much as $1,500,000 or 1,000,000.
a. Determine whether the interest rate parity is currently holding.
b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all
the steps and determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of covered arbitrage activities.

Solution:
Lets summarize the given data first:
S = $1.5/; F = $1.52/; I$ = 2.0%; I = 1.45%
Credit = $1,500,000 or 1,000,000.
a. (1+I$) = 1.02
(1+I)(F/S) = (1.0145)(1.52/1.50) = 1.0280
Thus, IRP is not holding exactly.

b. (1) Borrow $1,500,000; repayment will be $1,530,000.


(2) Buy 1,000,000 spot using $1,500,000.
(3) Invest 1,000,000 at the pound interest rate of 1.45%;
maturity value will be 1,014,500.
(4) Sell 1,014,500 forward for $1,542,040
Arbitrage profit will be $12,040

c. Following the arbitrage transactions described above,


The dollar interest rate will rise;
The pound interest rate will fall;
The spot exchange rate will rise;
The forward exchange rate will fall.
These adjustments will continue until IRP holds.

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:
a. (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 800000
3. Invest 800000at the euro interest rate of 1.35 % for three months and receive 810800
at maturity.
4. Sell 810800 forward 1037758 $.
Arbitrage profit = $1037758 - $1,014,000 = $23758

5. In the issue of October 23, 1999, the Economist reports that the interest rate per annum is
5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so
high in Turkey? Based on the reported interest rates, how would you predict the change of
the exchange rate between the U.S. dollar and the Turkish lira?

Solution:
A high Turkish interest rate must reflect a high expected inflation in Turkey. According to
International Fisher effect (IFE),
We have E(e) = i$ - iLira
= 5.93% - 70.0% = -64.07%
The Turkish lira thus is expected to depreciate against the U.S. dollar by about 64%.

6. As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is
R$1.95/$. The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year
period is 2.6% and 20.0%, respectively. How would you forecast the exchange rate to be at
around November 1, 2000?

Solution:
Since the inflation rate is quite high in Brazil, we may use the purchasing power parity to
forecast the exchange rate.
E(e) = E($) - E(R$)
= 2.6% - 20.0%
= -17.4%
E(ST) = So(1 + E(e))
= (R$1.95/$) (1 + 0.174)
= R$2.29/$

7. (CFA question)
Omni Advisors, an international pension fund manager, uses the concepts of purchasing
power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange
rates.
Omni gathers the financial information as follows:

Base price level 100


Current U.S. price level 105
Current South African price level 111
Base rand spot exchange rate $0.175
Current rand spot exchange rate $0.158
Expected annual U.S. inflation 7%
Expected annual South African inflation 5%
Expected U.S. one-year interest rate 10%
Expected South African one-year interest rate 8%
Calculate the following exchange rates (ZAR and USD refer to the South African and U.S.
dollar, respectively).
a. The current ZAR spot rate in USD that would have been forecast by PPP.
b. Using the IFE, the expected ZAR spot rate in USD one year from now.
c. Using PPP, the expected ZAR spot rate in USD four years from now.

Solution:
a. ZAR spot rate under PPP = [1.05/1.11](0.175) = $0.1655/rand.
b. Expected ZAR spot rate = [1.10/1.08] (0.158) = $0.1609/rand.
c. Expected ZAR under PPP = [(1.07)4/(1.05)4] (0.158) = $0.1704/rand.

8. 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/.
a. Compute the nominal interest rate per annum in both the U.S. and U.K., assuming that
the Fisher effect holds.
b. What is your expected future spot dollar-pound exchange rate in three years from now?
c. Can you infer the forward dollar-pound exchange rate for one-year maturity?

Solution.
a. Nominal rate in US = (1+) (1+E($)) 1 = (1.025)(1.035) 1 = 0.0609 or 6.09%.
Nominal rate in UK= (1+) (1+E()) 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/.

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