mt1_fall_2008_q2_sol - USD 0.0327 <== millions...

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Question 2 (20 points) Market Data Bid Ask Spot NOK/USD 8.100 8.200 3 month fwd NOK/USD 8.200 8.250 3 month Eurodollar rate 0.030 0.032 3 month EuroKrone rate 0.060 0.063 Notional NOK 50.00 Part A (15 points). The future cost of the forward hedge is obtained by applying the 3 month forward ask price, USD/NOK, onto the NOK notional principal: Forward hedge cost USD 6.0976 The cost of the money market hedge is obtained by borrowing USD x, converting at the spot bid price in NOK/USD, investing in a 3-month NOK Eurodeposit (and receiving the bid interest rate), and ensuring that this deposit pays exactly the NOK principal. The value of x is: Amount of USD to be borrowed 6.081615277 These USD must be paid back, inclusive of interest. The USD ask rate must be applied: Amount of USD owed 6.130268199 This last quantity is the cost of the money market hedge. It is what the hedger must pay in order to receive the NOK principal with certainty. The difference between the forward and money market hedge is: Difference (MM less forward) in millions
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Unformatted text preview: USD 0.0327 <== millions of USD Difference USD 32,707.22 <== USD Percent difference 0.533127745 Basis points 53.31277451 The answer is that the money market hedge is more expensive by 53 basis points, or USD 32,707. Grading: if a student demonstrates an understanding of the idea behind a money market hedge (borrow now, convert at spot, lend in FOREX) they should get no less than 8 points. Part B (5 points). Grading: for full marks, the student should show some understanding of `netting:' when one party in a forward agreement (or equivalently a swap) does not pay, neither does the other. The money market hedge is more susceptible to credit risk if the loan which the hedger makes in NOK is held by a different financial institution that the loan they received in USD. If this is the case, then a default by the former institution will result in a far greater loss than on the forward, where if one party does not pay the other party does not pay....
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