Lecture3

4 hedging transacfon risk in the money market hedging

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Unformatted text preview: ert $10M to yen: $10M * ¥82.67/$ = ¥826.7M •  Invest for 3 months 0.46 * (1/100) * (90/360) = 0.00115 ¥826.7M * 1.00115 = ¥827,650,705 •  Sell forward (enter into forward contract) (827,650,705)/ (¥82.6495/$) = $10,013,983 •  Compare to what we would make in U.S. $10,013,983 - ($10M * 1.002775) = - $13,767 We lose money this way – no arbitrage this way, but borrowing yen results in losses as well •  $10M to invest Bid Ask Spot (¥/$) 82.67 82.71 Forward (¥/$) 82.5895 82.6495 Dollar int. rate 0.91 1.11 Yen int. rate 0.46 0.58 6.2 Covered Interest Rate Parity in PracFce •  Does covered interest rate parity hold? –  Prior to 2007, documented violaFons of interest rate parity were very rare –  Frequency, size and duraFon of apparent arbitrage opportuniFes do increase with market volaFlity 6.3 Why DeviaFons from Interest Rate Parity May Seem to Exist •  Too good to be true? –  Default risks – risk that one of the counterparFes may fail to honor its contract –  Exchange controls •  LimitaFons •  Taxes –  PoliFcal risk •  A crisis in a country could cause its government to restrict any exchange of the local currency for other currencies. •  Investors may also perceive a higher default risk on foreign investments. Exhibit 6.4 Covered Interest Parity DeviaFons During the Financial Crisis 6.4 Hedging TransacFon Risk in the Money Market •  When Interest Rate Parity holds, there are two ways to hedge a transacFon (either a liability or a receivable) •  Real forward – we talked about t...
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