Download Set 4 The foreign exchange market

Dr Bartłomiej Rokicki
Open Economy Macroeconomics
Set 4
The foreign exchange market
We will write 3,60 PLN/USD as an exchange rate of dollar expressed in Polish zloty.
We will define the arbitrage condition for three different currencies j,k,m, as:
ejkekmemj = 1
where e stands for nominal exchange rate
From the above it follows that:
∆e jk
e jk
+
∆ekm ∆emj
+
=0
ekm
emj
Question 1. A US dollar costs 7.5 Norwegian kroner, but the same dollar can be
purchased for 1.25 Swiss francs. What is the Norwegian kroner/Swiss franc exchange
rate?
Question 2. On the first of January 1 EUR cost 1.3855 USD, and at the same time 1
EUR cost NOK 8.3122. During the year Norwegian kroner has appreciated by 4%
while USD has depreciated by 18%. Calculate spot exchange rates at the end of the
year.
Question 3. Suppose the quotations (note that USD/EUR 1.2597 means 1 EUR is
worth USD 1.2597) of bilateral exchange rates between US dollar, euro and yen are
given in the table below. Explore the possibility of three-point arbitrage. Suppose you
have 1,000,000 USD. How would you realize your profits? Show the example of such
transaction.
USD/EUR 1.2597
JPY/USD 119.06
JPY/EUR 150.08
Dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 4. In reality there is a small spread between bid and ask rates. Suppose that
the exchange rates between euro, U.S. dollar and the yen are given in the table below.
Explore the possibility of three-point arbitrage between these currencies once you
have $1,000,000.
Bid
Ask
USD/EUR
1.2596
1.2599
JPY/USD
119.04
119.08
JPY/EUR
149.96
150.00
Question 5. In the table below you can find the quotations in two periods. Verify the
arbitrage condition using the relative change of exchange rates.
t0
t1
EUR/USD
1.2596
1.2256
USD/JPY
119.04
121.18
EUR/JPY
149.94
148.52
Question 6. In table below you can find the price of “The Economist” in three
different countries:
price
exchange rate
USA
4.95 USD
Italy
3.55 EUR
1.2541 USD/EUR
Japan
670 JPY
119.51 JPY/USD
-
a) Calculate the price in US dollars.
b) Calculate what should be the price in each country if there were no transport costs
and purchase parity condition held.
c) Which currency is overvalued and which undervalued against US dollar? Why?
Question 7. How has changed the real exchange rate of euro against US dollar if euro
appreciated 3% in nominal terms and the prices in US have grown faster than in the
EU by about 1.6%?
Dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 8. The current spot exchange rate is 1.95$/£ 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$/£.
Question 9. What are the main differences between currency forwards and currency
futures?
Question 10. Show different operations on currency futures and forwards if you have
to pay €10m in three months for a delivery of parts from Germany invoiced in euros
and you want to avoid a currency risk. Suppose that both 3-month euro futures and
forwards contracts are priced at 1.2550$/€. Show what will happen if the euro is
1.30$/€ in 3 months. What will occur if the euro is 1.20$/€ in 3 months?
Question 11. Discuss the basic motivations for a counterparty to enter into interest
rate futures.
Question 12. Treasurer learns on March 3, 2005 that his company will receive $20m
in June 2005 from the sale of merchandise, and these funds will need to be invested
for 3 months in the money market. Current 3-month LIBOR is 2.95% and expected
3-month LIBOR in June 2005 according to futures trading is 3.44%. Treasurer
decides to lock in at that rate to eliminate interest rate risk, taking a LONG position
(BUYS Eurodollar futures contracts at a price of 96.56 to lock in 3.44% rate). To
hedge the entire amount of $20m, he buys 20 Eurodollar contracts worth $1m. What
interest income will guarantee this strategy? What will happen if at expiration, 3month LIBOR is only 3.10%? What will happen if at expiration, 3-month LIBOR is
3.50%?
Dr Bartłomiej Rokicki
Open Economy Macroeconomics
Question 13. Consider the euro call options for June 2005 (€62,500 per contract).
Premium = 0.0459$/€, with an Exercise Price = 1.30$/€. One contract costs €62,500
x 0.0459$/€ = $2,868.75, which gives you the right to buy euros at $1.30. What will
be your profit if the euro sells at $1.36 on expiration? What will be your profit if the
euro sells at $1.29 on expiration?
Question 14. Discuss the basic motivations for a counterparty to enter into a currency
swap.
Question 15. The Centralia Corporation is a U.S. manufacturer of small kitchen
electrical appliances. It has decided to construct a wholly owned manufacturing
facility in Zaragoza, Spain, to manufacture microwave ovens for sale to the European
Union market. The plant is expected to cost €4,920,000, and to take about one year to
complete. The plant is to be financed over its economic life of eight years. The
borrowing capacity created by this capital expenditure is $1,700,000; the remainder of
the plant will be equity financed. Centralia is not well known in the Spanish or
international bond market; consequently, it would have to pay 9 percent per annum to
borrow euros, whereas the normal borrowing rate in the euro zone for well-known
firms of equivalent risk is 7 percent. Centralia could borrow dollars in the U.S. at a
rate of 8 percent.
Suppose a Spanish MNC has a mirror-image situation and needs $1,700,000 to
finance a capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a
9 percent fixed rate in the United States for dollars, whereas it can borrow euros at 7
percent. The exchange rate has been forecast to be 1.20$/€ in one year. Set up a
currency swap that will benefit each counterparty and calculate the contractual
exchange rate for the initial exchange, the contractual rate for annual debt services
exchanges and the contractual rate of final currency exchange.