DERIVATIVES AND RISK MANAGEMENT

Class 3

TOPIC: Forward/Futures on foreign currencies and stock indices

READING:
1. An Integrated approach to the Determination of Forward Prices, Ivey technical note
handed out last class. Leave out the discussion of convenience yields on
commodities (last bullet point on page 8 and Section 6 on page 9) for next class.

2. Ch. 5, sections 5.6, 5.9, 5.10, and 5.12 Fundamentals of Futures and Options Markets

ASSIGNMENT:
1. Chapter 5: questions 5.4, 5.7, 5.12, and 5.14.

2. On Friday, January 16, 2004, the spot U.S. dollar rate was Cdn$1.3002 and the three-
month forward rate was Cdn$1.3050. The three-month treasury bill rate in the United
States was 0.9 per cent per year expressed with annual compounding (0.896 per cent
with continuous compounding; verify this yourself) and the rate of a three-month
Canadian treasury bill was 2.4 per cent per year with annual compounding ( 2.3717
per cent with continuous compounding). Assume you work for a large money center
bank which can borrow in either market at a rate very close to (suppose the same as)
the respective treasury rates.

a) Since interest rates were lower in the U.S., would it be profitable to borrow U.S.
dollar for three months, convert to Cdn$ and then invest the proceeds in Canadian
treasury bills? If yes, how certain are your profits? To answer the question, work
with 1 million U.S. dollars and calculate interest expense and income using the
continuous compounding method.

b) What would be the profit from borrowing U.S. dollar, converting to Cdn$ and
investing in Canadian treasury bills, and simultaneously buying U.S. dollar three-
month forward to lock in a conversion rate for the Cdn$ investment?.

3. Lookup current 3-month LIBOR rates on US dollar and Yen, as well as spot and 3-
month forward USD-Yen exchange rates (expressed as how many yen per one dollar).
What profit will you make if you repeat part (b) trades starting with borrowing Yen,
converting into USD,etc? Be prepared to answer this question on the board and
to hand-in the solution to me.

You can obtain LIBOR rates from the Intercontinental Exchange website:
https://www.theice.com/marketdata/reports/170, from Bloomberg, and many other
websites. Spot and forward exchange rates can be obtained from Bloomberg. Make
sure the LIBOR rates and F/X rates are for the same day. Print a screen capture of your
data source.