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Rafael Tauil

FIN-426
06/20/2014
Dr. Alhenawi
Final Exam
PART I
Chapter 7
Solution to Continuing Case Problem: Blades, Inc.
1. My Analysis:
In this first question the first arbitrage opportunity is locational arbitrage. We can see that there
are two banks offering different spot rate quotes. Blades, Inc. can benefit from this locational
arbitrage by buying Thai Baht from Minzu bank and then sell Thai Baht to Sobat bank. This can
be seen in the calculations shown below; we used $100,000 as the amount that Blades will be
using in these exchanges:

I. Buy Thai baht from Minzu Bank at the ask rate of $0.0227
$100,000/0.0227 = Thai baht 4,405,286.34
II. Sell Thai Baht to Sobat Bank at the bid rate of $0.0228
Thai Baht 4,405,286.34 x 0.0228= $100,440.53
III. Profit made
P = $100,440.53 - $100,000
P = $440.53
My Recommendation:
I would recommend to Blades, Inc. to take advantage of the different spot rates that the two
banks have and make a profit before the rates even out and there is no profit to be made.
2. My Analysis:
In this question we will use the triangular arbitrage to show how Blades can also make a profit
out of the cross exchange rate between the Thai Baht and Japanese yen. We will be using the
rates that the Minzu bank offered Blades. First, we will exchange the same $100,000 to Thai
Baht (just as we did in the last question). Second, we will turn the Thai baht into Japanese yen.
Third, we will exchange the Japanese yen back into dollars. Lastly, we will see how much profit
can be made by using this method.

I. Buy Thai Baht with the initial amount of $100,000 at the $0.0227 rate
$100,000/$0.0227 = Thai Baht 4,405,286.34
II. Exchange the Thai baht into Japanese yen
Thai Baht 4,405,286.34 x jy 2.69 = Jy 11,850,220.25
III. Exchange Japanese yen into dollars
Jy 11,850,220.25 x $0.0085 = $100,726.87
IV. Profit made
$100,726.87 - $100,000 = 726.87

My recommendation
Just like the first question the exchange rates are not appropriate; so there is a profit to be
made. I would recommend Blades to benefit from this because in the future the rates will be
adjusted and there will not be a profit to be made. The profit in the triangular arbitrage is even
higher than the one in the locational arbitrage.

3. My analysis:
In this question we will use the covered interest arbitrage. This is another type of arbitrage that
we can use to determine if the rates are appropriate or not. If they are not, then there is a profit
that can be made in the different exchanges. We will start with the same first step in which we
buy Thai Baht, but now we will also set up a 90-day deposit. After the 90 days, the deposit will
mature and the Thai baht can be converted into U.S dollars at the mentioned forward rate. Last,
we would compare how much profit can be made in comparison to a 90 day deposit in the USA.

I. Day 1: Buy Thai baht and set up a 90-day deposit account at a Thai bank
$100,000/$0.0227 = Thai Baht 4,405,286.34
II. Day 90: The Thai deposit will mature
Thai Baht 4,405,286.34 x 1.0375 = Thai Baht 4,570,484.58
III. Convert the Thai Baht to dollars at forward mentioned rate
Thai Baht 4,570,484.58 x $0.0225 = $102,835.90
IV. 90 day deposit in USA
$100,000 x 1.02 = $102,000
V. Profit made
$102,835.90 102,000 = 835.90
My recommendation
As we can see in the above calculations, Blades can make a profit by doing the converted
interest arbitrage. I would suggest him to also take advantage of this arbitrage because the rates will
balance and there will not be a profit to be made in the future.
4. My analysis
Using the covered interest arbitrage as an example involving the immediate purchase and
forward sale of the baht we can explain how the arbitrage would disappear. The exchange rates
are dictated by the market forces, meaning that if the demand of a rate is higher than the supply
the rate will go up and vice versa. By having this arbitrage opportunity we will able to notice
how the spot rate of the Thai baht will go up due to the fact that individuals would want to
purchase the Thai baht at the spot rate to later sell in the forward rate. Also, the forward rate
will depreciate because the individuals will tend to sell in the forward rate in order to make a
profit. Eventually, the appreciation of the spot rate and the depreciation of the forward rate will
eliminate the arbitrage and there will not be a profit to be made.
My recommendation
I would recommend Blade to take advantage of the arbitrage opportunities if possible because
the market will soon eliminate them. However, Blades should take into account the fact that there are
some other costs that arise from the transactions that can reduce or eliminate the profit made in the
trades. After analyzing all the costs and restrictions he can make the decision to take advantage of the
arbitrage or not (depending on if there is a substantial profit or not).

Chapter 8
1. My analysis:
The purchasing power parity helps us explain the relationship that exists between the
exchange rates and the relative inflation levels of the two countries. First, if a countrys inflation
rates goes up compared to another country, the demand for the currency of the inflated country
will go down due to the fact that exports will decrease and imports will increase. Due to the fact
that Thai baht is a freely floating currency, the revenue made by Blades will be affected in a
negative way because the Thai will be converted into less dollars. Also, the cost of goods sold
will increase which will lead to a reduction in Blades overall net cash flows.
My recommendation
I would recommend Blades to set some type of contract in which he can lock specific rates in
which he can exchange the Thai baht to dollars and vice versa. This would protect him from abrupt
changes in the currency for the period of time that the contract is in place. The worst thing that can
happen to Blades would be to have uncertainty on the value of the currency because he will not be able
to adjust his price accordingly. The contract will allow him to reduce the risk that comes with the
inflation.
2. My analysis:
There are other factors that affect PPP such as, national income levels, government
controls, and relative interest rates. Due to all of these, PPP might not hold. Also, there
are goods that PPP does not affect because there are substitute goods in the countries.
By having a trade agreement, PPP will not hold because the prices would be fixed and
inflation would not affect them.
My recommendation:
I would recommend Blades, Inc. to work some type of trade agreements in order to set a
certain fixed price that will protect him from inflation. That is the best way to reduce the different risks.
3. My analysis
Because there are high level of real interest rate, the currency of the Thai will appreciate
thanks to the foreign investors that will be attracted by the interest rates. However, the Thai
baht will depreciate due to the high level of nominal interest rate that comes with the increased
inflation rate. The currency will depreciate enough to offset the effect of the nominal interest
rate between US and Thailand.
My recommendation
I would recommend Blades, Inc to analyze the rates to later figure out if there is some type of
interest arbitrage that can be taken advantage of before the rates are level and there is no profit to be
made.
4. My analysis
The company should be concerned with PPP due to the fact that in the long run it works
reasonably well. Blades has a 3 year contract in place that shows how they are planning to
continue to do business in Thailand for the time being. He will definitely be affected by PPP in
the long run.
My recommendation
Because Blades has future plans in Thailand he should engage in some agreements that will
allow him to lock some prices and eliminate the PPP effects in the short run. He should do it every year
maybe in order to reduce the uncertainty that comes with the inflation.
PART III
CHAPTER 5
Rafael Tauil Corp. is a toy manufacturing company from the United States. Rafael Tauil Corp.
imports raw materials from Colombia. The company needs to order the supplies 3 months ahead of the
delivery date. An option that is considering now is a Colombian supplier order that requires a payment
of 10 million pesos payable as of the date of delivery. There are two options that the company has in
order to hedge its risk.
Buy two call options contracts (since each option contract represents 5,000,000 pesos)
Buy one futures contract (which represents 10,000,000 pesos)
The peso historically has had a discount from the existing spot rate. However, Rafael Tauil Corp.
would like to use currency options to hedge payable in Colombian pesos for transactions 3 months in
advance. RT would rather hedge the pesos payable position because it is uncomfortable from the history
that the Peso has in which there is a high volatility in its value. Rt would remain unhedged if the Peso
becomes stable in the future.
Rafael Tauil, RTs CFO, would rather have flexibility that options offer over forward contracts or future
contracts because he can let the options expire if the peso depreciates. Rafael would like to use an
exercise price that is about 4% above the existing spot rates for a transaction three months beyond its
ordered date.
Generaly, options on the Peso have required a premium of about 1% of the total transaction
amount that would be added to the cost if the option is excercised. For example, recently the peso spot
rate was $0.0100, and call option within exercise price of $0.0104, which is 4% above the existing rate.
The premium was $0.000104, which is 1 percent of the price to be paid per peso if the option is
excercised.
Recently, an event caused more uncertainty about the value of the Peso. The event did not
affect the spot or the future or forward rates of the Peso. Spot rate remains the same, but the option
premium for a call option within exercise price of $0.000104 went to $0.000208. There is an alternative
call option that has a premium of $0.000104, but the exercise price is of $0.0110
The table below shows the options and future information available to Rafael Tauil Corp.:
Before event After event
Spot rate $0.0100 $0.0100 $0.0100
Option information
Exercise price ($) $0.0104 $0.0104 $0.0106
Exercise price (%
above spot)
4% 4% 6%
Option premium per
Peso ($)
$0.000104 $0.000208 $0.000104
Option premium (% of
exercise price)
1% 2% 1%
Total premium ($) $1040 $2080 $1040
Amount paid for
Pesos if option is
exercised (not
including premium
$104,000 $104,000 $106,000
Futures contract
information

Future prices 0.0095 0.0095

Now, as an analyst for Rafael Tauil Corp. you have been asked on how to hedge. Number of
questions are as follows:
1. If Rafael Tauil Corp. uses options to hedge its pesos payables, should it use the call option
with the exercise price of $0.0104 or the call option with the exercise price of $0.0106?
Describe the trade-off.
Rafael Tauil has to make a decision, or he pays more than the 4 percent above the spot rate that
he prefers or he pays more than the 1 percent premium that they prefer. The company has to
decide if they want to pay higher premiums for the lower limit of payables or lower premium for
higher limit of payables.
Alternative 1
Pay premium of $.000208 x 10,000,000 = $2,080
Payable amount of $.0104 x 10,000,000 = $104,000
Alternative 2
Pay premium of $,000104 x 10,000,000 = $1040
Payable amount of $,0106 x 10,000,000 = $106,000

As an analyst is better to take the Alternative one because is better to pay the higher premiums in order
to have lower payables.
2. Should Rafael Tauil Corp. allow its pesos position to be unhedged? Describe the trade-off
Due to the fact that the company wanted to hedge before the event, now they should be more
inclined than before to hedge. There is more uncertainty in the economical environment of the peso
that can lead to changes in the prices that would not favor the company. RT could have some alternative
contracts that would allow the company to lock some rates in order to eliminate the uncertainty.
3. Assume there are speculators who attempt to capitalize on their expectation of the Peso
movements over the 3 months between the order and delivery date, either buying or selling
Pesos futures now and buying or selling pesos at the futures spot rate, what is the expectation
on this?
Speculators would cause the future spot rate to be the same as the futures rate. If the Peso
appreciates, it would be beneficial to buy pesos futures now and sell in the future spot rate and vice
versa if the opposite happens. That pressure will lead to the future rate be the same as the future spot
rate which is $0,0095
4. How many alternatives Rafael Tauil Corp. have, what would be its optimal choice?
Alternative 1 Remain Unhedged
Expected Spot Rate $0.0100
Amount of Pesos payable $ 10,000,000
Cost in three months ($0.0100 x 10,000,000) $100,000
Alternative 2 Purchase one futures contract
Futures price per unit $0.0095
Units in contract $10,000,000
Cost in three months ($0.0095 x 10,000,000) $95,000
Alternative 3 Purchase Two options
Options In formation Option 1 Option 2
Exercise price $0.0104 $0.0106
Premium per unit $0.000208 $0.000104
Units in contract 5,000,000 5,000,000
Calculations Column A Column B Column C Column D
Total Premium Exercise Amount paid for Total Paid
(Premuim per unit x (Is Spot rate Pesos (Exercise (Column A+
Units) > Exercise price) price * Units) Column C)
Two Option, Exercise 2080 No $104,000 $106,080
Price of $ 0.0104
Two Options, Exercise 1040 No $106,000 $107,040
Price of $0.0106
The best decision is to hedge using future contracts because is less expensive than all the other
options.
5. Will your choice from the answer of question 4 be optimal or not?
It does not have to be the optimal strategy, but it protects the company from risks that can show up due
to the high volatility of the Peso. The optimal strategy would be determined if the Peso appreciates or
depreciates in the future.
6. Assume historical standard deviation of the Peso is about $0.0004. Based on your
assessment that future spot rate will be more than two and half standard deviation above
the expected spot rate by the delivery date. Future price remains constant, what is the
optimal hedge for it?
Again the answer for this question is to Hedge with futures contract because is the least
expensive option and the one that eliminates the uncertainty created by the volatility of the
Peso. Is always better to unnecessary risks and by hedging, the risks are somewhat contained.