1. Calculate the following exchange rates:
Euro to Swiss franc
Euro to Japanese yen
Euro to British pound
Swiss franc to Japanese yen
|Exhibit 5.4 (p.117)||Exchange Rates||January 4, 2008|
|Country||in US $||per US $|
Ex. Japanese yen per British pound: = 108.46 yen/.5072 pounds
Canada dollar in US$ per $
1-mos forward 1.0040 0.9960
3-mos forward. 0027 0.9973
6-mos forward 1.0003 0.9997
Swiss Franc in US$ per $
1-mos forward 1.0600 0.9431
3-mos forward 1.0609 0.9426
6-mos forward 1.0619 0.9417
Data from The Wallstreet Journal Jan 26, 2011
Swiss Franc in Canada $ per Canada $
1-mos forward 1.0561 0.9469
3-mos forward 1.0580 0.9452
6-mos forward 1.0616 0.9420
6. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the Canadian dollar versus the U.S. dollar using American term quotations. For simplicity, assume each month has 30 days. What is the interpretation of your results? The forward premium or discount for the Canadian dollar versus the U.S dollar using American term quotations.
Spot Rate .9984
This shows that the Canadian dollar is selling at a premium to the dollar. The premium is increasing out to the 3-month mark. The U.S. dollar will depreciate compared to the Canadian dollar for 3 months and than appreciate compared to the Canadian dollar at month 6.
1-month forward premium=(.9986-.9984)/.9984*(360/30)=.240%
3-month forward premium=(.9988-.9984)/.9984*(360/60)=.240%
6 month forward premium=(.9979-.9984)/.9984*(360/180)=-.100%
9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?
Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate. Certain banks specialize in making a direct market between nondollar currencies, pricing at a narrower bid-ask spread than the cross rate-spread. If their direct quotes are not consistent with cross-exchange rates, a triangular arbitrage profit is possible.
10. Doug Bernard specializes in cross-rate arbitrage. He notices the following quotes:
Swiss franc/dollar = SFr 1.5971/$
Australian dollar/U.S. dollar = A$ 1.8215/$
Australian dollar/Swiss franc = A$ 1.1440/SFr
Ignoring transaction costs, does Doug Bernard have an arbitrage opportunity based on these quotes? If there is an arbitrage opportunity, what steps would he take to make an arbitrage profit, and how much would he profit if he has $1,000,000 available for this purpose?
Ignoring transaction costs, Doug has an arbitrage opportunity of $3,064.73 trading with $1,000,000. He would trade from US dollar to Swiss franc, from Swiss franc to Australian dollar, and then from Australian dollar to US dollar
SFr 1,597,100 Sell US dollars for Swiss francs
A$ 1,827,082.4 Sell Swiss francs for Australian dollars
$ 1,003,064.73 Sell Australian dollars for US dollars
$ 3,064.73 Arbitrage Profit
12. The current spot exchange rate is $1.95/pound and the three-month forward rate is $1.90/pound. On the basis of your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/pound in three months. Assume that you would like to buy or sell 1,000,000 pounds.
A. What actions do you need to take to speculate in forward market? What is the expected dollar profit from speculation?
– If you believe the spot exchange rate will be $1.92/pound in three months, you should short the three-month $/pound contract. By doing, you can by for $1.92/pound and then deliver it for $1.90/pound. This means you’ve made a profit of .02 per unit. The total profit is then $20,000.
B. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.86/pound?
– If the spot exchange rate actually turns out to be $1.86/pound, you’ve lost money. This means you are forced buy at $1.86/pound and then sell it at $1.90/pound. This means you would lose $40,000.
St=F, gains or losses are 0.
Firm can eliminate foreign exchange exposure without sacrificing any expected dollar proceeds from the foreign sale. The firm would be inclined to hedge as long as it is averse to risk. Valid when the forward exchange rate is an unbiased predictor of the future spot rate.
Firm’s expected future spot exchange rate is less than the forward rate; the firm expects a positive gain from forward hedging. Since the firm expects to increase the dollar proceeds, while eliminating exchange exposure, it would be even more inclined to hedge under this scenario than under the first scenario. Implies that the firm’s management issues from the market’s consensus forecast of the future spot exchange rate as reflected in the forehand rate.
Firm can eliminate exchange exposure via the forward contract only at the cost of reduced expected dollar proceeds for the foreign sale. Firm less inclined to hedge under this scenario.
From perspective of a hedging firm, the reduction in the expected dollar proceeds can be viewed implicitly as an “insurance premium” paid for avoiding the hazard of exchange risk. The firm can use a currency futures contract, rather than a forward contract, to hedge. A future contract is not as suitable as a forward contact for hedging purpose for
- Unlike forward contracts that tailor-made to firms specific needs, future contracts are standardized instruments in terms of contract size, delivery date, et. Can hedge only approximately.
- Due to the marketing-to-marketing property, there are interim cash flows prior to the maturity date of the future contract that may have to be invested at uncertain interest rates.
Money Market Hedge
Firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency. Transactions: Borrow pounds-the maturity value of borrowing should be the same as the pound receivable; the amount to borrow can be computed as the discounted present value of the pound receivable.
Buy dollar spot with pounds, invest in the United States, Collect pound receivable=Net Cash Flow
Apart from possible transactions, it is fully self-financing
Options Market Hedge
Shortcoming of forward and money market hedges is that these methods completely eliminate exchange exposure. Currency options provide such a flexible “optional” hedge against exchange exposure. The firm (receivables). Main advantage of options hedging is that the firm can decide whether to exercise the option based on the relaxed spot exchange rate on the expiration date. The options hedge allows the firm to limit the downside risk while preserving the upside potential. When a firm has an account payable rather than a receivable, in terms of a foreign currency, the firm can set a ceiling for the future dollar cost of buying the foreign currency amount by buying a call option on the foreign currency amount. Break-even spot rate.
- Economic Exposure- the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Changes in exchange rates can have a profound effect on the firm’s competitive position in the world market and thus on its cash flows and market value.
- Translation exposure-the potential that the firms’ consolidated financial statements can be affected by changes in exchange rates. Involves translation of subsidiaries’ financials statements from local currencies to the home currency. Resultant translation gains and losses represent the accounting system’s attempt to measure economic exposure ex post. It does not provide a good measure of ex ante economic exposure.