Midterm test - SOLUTION

Financial strategies in international business

Name:
-------------------------------------------------------------------------------------------------------------------------------Exercise 1 (3 points)
Lets assume the following bid ask quotations in international foreign exchange markets:
bid
ask
EUR/CZK
24.960
24.980
USD/CZK
16.452
16.463
EUR/USD
1.5310
1.5360
We dont account for any other transaction costs. Answer following questions:
Is there any market discrepancy we could capitalize on?
If so, what would be your steps you take when exercising a triangular arbitrage, if you
had 15 million EUR at disposal?
----------------------------------------------------------------------------------------------------------------/
> /
/
/
< /
/
24.960
1.5360
16.463
24.980
< 1.5310
16.452
15 000 000 1.5310 22 965 000
22 965 000 16.452 377 820 180
377 820 180
15 124 907
24.980
----------------------------------------------------------------------------------------------------------------Exercise 2 (4 points)
Lets assume following quoted prices:
3-month US (USD) deposit rate

2.52 % p. a.

3-month US (USD) loan rate

3-month French (EUR) deposit rate
3-month French (EUR) loan rate
Spot rate

2.56 % p. a.
2.59 % p. a.
2.63 % p. a.
1.4000 EUR/USD (bid quote)
1.3942 EUR/USD (ask quote)
1.3942 EUR/USD (bid quote)
1.3955 EUR/USD (ask quote)

3-month forward rate

We dont account for any other transactional cost and USD is our home currency. Answer the
following questions:
Is there any market discrepancy we could capitalize on?
If so, what would be your steps you take when exercising a covered interest arbitrage, if
you could borrow 14 million USD (10 million EUR respectively)?
----------------------------------------------------------------------------------------------------------------1 +

+1
> (
)

1 +
2.56
1 + 4 100
1.3942 > 1.3942 (
)
2.59
1 + 4 100
1.3942 1.4013

+1

<

1 +
(
)
1 +

2.52
1 + 4 100
1.3955 < 1.4000 (
)
2.63
1 + 4 100
1.3955 < 1.3996
10 000 000 (1 +

2.63
) = 10 065 750 ( )
4 100

10 000 000 1.4000 = 14 000 000

14 000 000 (1 +

2.52
) = 14 088 200
4 100

14 088 200
10 095 449 ( )
1.3955
10 095 449 10 065 750 29 699 ( )

----------------------------------------------------------------------------------------------------------------Exercise 3 (3 points)
Lets assume that our US-based company is in long position regarding EUR (receivable that
amounts to 10 million EUR). Current spot rate is 1.3400 EUR/USD. Expected percentage change
of the exchange rate within one week is 0.18 %. Standard deviation of these week changes is
0.75 %. Our next presumption is that percentage changes of EUR/USD have normal distribution.

Using VaR method, calculate the Maximum expected loss on the value of our receivable
within one week on the 95 % confidence level. Explain the result.
How would the result change, if we were in short position regarding EUR (payable in the
same value)? Explain the result.

--------------------------------------------------------------------------------------------------------------------Long position:
= 1.65
= 0.18 1.65 0.75 = 1.4175 %
=

( )
100

1.4175 %
10 000 000 1.34000 = 189 945
100

Short position:
= + 1.65
= 0.18 + 1.65 0.75 = 1.0575 %
=

( )
100

1.0575 %
10 000 000 1.34000 = 141 705
100

--------------------------------------------------------------------------------------------------------------------Exercise 4 (3 points)
Lets assume that our US-based company is in long position regarding EUR (receivable that
amounts to 12 million EUR and is due in three months). Current spot rate is 1.3300 EUR/USD,
dollar interest rate is 6 % p.a. and euro interest rate is 4 % p.a.

How can the company hedge using money market? Illustrate the principle and calculate
the effective exchange rate.

-----------------------------------------------------------------------------------------------------------------

To a future currency inflow we need to create a future currency outflow (loan that we have to
pay off).
12 000 000
= 11 881 188
0.04
(1 + 4 )
11 881 188 1.3300 = 15 801 980
15 801 980 (1 +
16 039 010 USD
12 000 000 EUR

0.06
) = 16 039 010
4

= 1.3366 (effective exchange rate)

----------------------------------------------------------------------------------------------------------------Exercise 5 (4 points)
Suppose that a US-based company has a receivable in the value of 2 million EUR, since it
exported some goods to Spain. The invoice is due in 1 month. Actual SR is 1.28 USD = 1 EUR and
the price of FED contracts with suitable due date is 129.00 USD per 100 EUR.

How can the US company assure its position using FED contracts?
Calculate the cash flow of the company after hedging and at the due date the prices are
following:
a) EUR/USD 1.32 and PFED = 133.00
b) EUR/USD 1.23 and PFED = 122.50

--------------------------------------------------------------------------------------------------------------------In this case we would sell 100 FED contracts to assure the purchasing price for EUR (= our
payable). Since the size of one contract is 20,000 EUR we need 100 of them to cover 2 million
EUR. The situation both in futures and spot market must be assessed:
a) USD depreciation means a profit for us, because it raises the value of our receivable by
80,000 USD. On the other hand, the increase in the price of FED contract brings us loss,
since we can close out our position by purchasing the contracts at a higher price
compared to our selling price we will lose 80,000 USD ((129-133)/100*20000*100),
which completely offsets the profit based on USD depreciation.
b) USD appreciation means a loss for us, because it reduces the value of our receivable by
100,000 USD. On the other hand, the decrease in the price of FED contract brings us
profit, since we can close out our position only by purchasing the contracts at a lower
price compared to our selling price we will gain 130,000 USD ((129124.5)/100*20000*100), which more than offsets the loss based on USD appreciation.

--------------------------------------------------------------------------------------------------------------------Exercise 6 (4 points)
Lets assume that your US-based company is in short position regarding EUR (payable that
amounts to 1 million EUR and is due in one month). Actual spot rate is 1.3604 EUR/USD.

What option strategy could we use in this situation to hedge our open position?

What will the contingency graph (graph of profit/loss depending on the value of the spot
exchange rate on expiration date) for this option strategy look like if SP = 1.3598
EUR/USD (1 month term of expiration), premium amounts to 0.0005 USD / 1 EUR?

Draw the EER graph of this option strategy and also of the risk reversal strategy when we
would combine the previous strategy with a short option with SP = 1.3563 EUR/USD.

----------------------------------------------------------------------------------------------------------------We would use in this case the long call strategy.

1.3598
1.3603
-0.0005

E on expiration date of the option

EER for payables

open position

LC
1.3603

SR +
0.0005

1.3598

E on expiration date of the option

-----------------------------------------------------------------------------------------------------------------

Exercise 7 (4 points)
Lets assume that your US-based company is in long position regarding EUR (receivable that
amounts to 10 million EUR and is due in one month). Actual spot rate is 1.3552 EUR/USD.

What option strategy could we use in this situation to hedge our open position?

What will the contingency graph (graph of profit/loss depending on the value of the spot
exchange rate on expiration date) for this option strategy look like if SP = 1.3546
EUR/USD (1 month term of expiration), premium amounts to 0.0005 USD / 1 EUR?

Draw the EER graph regarding this option strategy also of the risk reversal strategy when
we would combine the previous strategy with a short option with SP = 1.3573 EUR/USD.

----------------------------------------------------------------------------------------------------------------We would use in this case the long put strategy.

1.3546
E on expiration date of the option

1.3541
-0.0005

EER for receivables

open position

LP

SR 0.0005
1.3541

1.3512

E on expiration date of the option