HW 2 Solutions

HW 2 Solutions - Suggested Solution to HW 2 Slide 14 of...

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1 Suggested Solution to HW 2 Slide 14 of Lecture 3 : The market conditions are summarized as follows: i $ = 3%; i £ = 2.49%; S = $2/£; F 360 ($/£)=??? If F 360 ($/£) > $2.01/£, then (1 + i $ ) < ( F $/ £ / S $/ £ )(1 + i ). Thus, the trader can arrange the following transactions to make profit: 1. Borrow $1,000 at t = 0 at i $ = 3%. 2. Exchange $1,000 for £500 at the prevailing spot rate (note that £500 = $1,000 ÷ $2/£); invest £500 at 2.49% ( i £ ) for one year to achieve £500×(1+2.49%)=£512.45. 3. Sell the £512.45 in forward at F 360 ($/£) to translate pounds back to dollars: £512.45× F 360 ($/£). If F 360 ($/£) > $2.01/£, then £512.45 will be more than enough to repay your debt of $1,000×(1+3%)=$1,030. Similarly, if F 360 ($/£) < $2.01/£, then (1 + i $ ) > ( F $/ £ / S $/ £ )(1 + i ). Thus, the trader can arrange the following transactions to make profit: 1. Borrow £500 at t = 0 at i £ = 2.49%. 2. Exchange £500 for =£500×$2/£ =$1,000 at the prevailing spot rate; invest $1,000 at 3% for one year to achieve $1,000×(1+3%)=$1,030. 3. Buy the forward at F 360 ($/£) to translate $1,030 back into pounds: $1030/ F 360 ($/£); if F 360 ($/£) < $2.01/£, then $1,030 will be more than enough to repay your debt of £500×(1+2.49%)= £512.45. Problem 6.1 : 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 × 1.01)(1 + .035)(1/0.99) Clearly, it is better to invest $100,000,000 in Germany with exchange risk hedging. Problem 6.2
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This note was uploaded on 02/27/2012 for the course FIN 4604 taught by Professor Samiquemarch during the Spring '11 term at FIU.

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HW 2 Solutions - Suggested Solution to HW 2 Slide 14 of...

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