009 - 9 Foreign Currency Futures Answers to Questions and...

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57 Answers to Questions and Problems 1. The current spot exchange rate for the dollar against the Japanese yen is 146 yen per dollar. What is the corresponding US dollar value of one yen? The dollar value per yen is simply the inverse of the yen per dollar rate: 1/146 5 $.0068 per yen 2. You hold the current editions of The Wall Street Journal and The Financial Times, the British answer to the WSJ. In the WSJ, you see that the dollar/pound 90-day forward exchange rate is $2.00 per pound. In The Financial Times, the pound 90-day dollar/pound rate is £.45 per US dollar. Explain how you would trade to take advantage of these rates, assuming perfect markets. These rates are inconsistent because a rate of $2.00 per pound implies that the cost of one dollar should be £.50. Therefore, an arbitrage opportunity is available by trading as follows: 9 Foreign Currency Futures Geographical Arbitrage Transactions t 5 0 In New York, using the WSJ rates, sell $2.00 for £1.00 90 days forward. $0 In London, using The Financial Times rates, sell £1.00 for $2.22 90 days forward $0 Total Cash Flow $0 t 5 90 In New York, fulfill the forward contract by delivering 2 $2.00 $2.00 and collecting £1.00 1 £1.00 In London, fulfill the forward contract by delivering £1.00 2 £1.00 and collecting $2.22 1 $2.22 Total Cash Flow 1 $.22 3. In problem 2, we assumed that markets are perfect. What are some practical impediments that might frus- trate your arbitrage transactions in problem 2? Transaction costs would be the major impediment. Every trade of foreign exchange faces a bid-asked spread. In addition, there is likely to be some commission to be paid, either in the form of an outright commission or in the form of an implicit commission for maintaining a trading function. In addition, forward contracts sometimes require margin, and this would be an additional cost that the potential arbitrageur must bear.
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58 CHAPTER 9 FOREIGN CURRENCY FUTURES 4. In the WSJ, you see that the spot value of the German mark is $.63 and the Swiss franc is worth $.72. What rate of exchange do these values imply for the Swiss franc and German mark? Express the value in terms of marks per franc. The rate of $.63 per mark implies a value of the mark equal to DM 1.5873 per $. The rate of $.72 per franc implies a value of the franc equal to SF 1.3889 per $. Therefore, DM 1.5873 and SF 1.3889 are equivalent amounts, both equal to $1. As a consequence, the value of the DM per SF must equal 1.5873/1.3889 5 1.1429. 5. Explain the difference between a pegged exchange rate system and a managed float. In a pegged exchange rate system, the value of a pegged currency is fixed relative to another currency. For example, many Caribbean countries peg the value of their currency to the US dollar. In a managed float, the value of the currency is allowed to fluctuate as market conditions require. This is the floating part of the pol- icy. In a managed float, the central bank intervenes in the market to influence the value of the currency by
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009 - 9 Foreign Currency Futures Answers to Questions and...

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