Q1. James Clark is a foreign exchange trader with Citibank. He notices the following quotes.

Spot exchange rate SFr1.2051/$

Six-month forward exchange rate SFr1.1922/$
Six-month $ interest rate 2.5% per year
Six-month SFr interest rate 2.0% per year
a. Is the interest rate parity holding? You may ignore transaction costs.
b. Is there an arbitrage opportunity? If yes, show what steps need to be taken to make
arbitrage profit. Assuming that James Clark is authorized to work with $1,000,000,
compute the arbitrage profit in dollars.

Q2. Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to
invest for six months. The six-month interest rate is 8 percent per annum in the United
States and 7 percent per annum in Germany. Currently, the spot exchange rate is
€1.01 per dollar and the six-month forward exchange rate is €0.99 per dollar. The
treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest
to maximize the return?

Q3. While you were visiting London, you purchased a Jaguar for £35,000, payable in
three months. You have enough cash at your bank in New York City, which pays
0.35% interest per month, compounding monthly, to pay for the car. Currently, the spot
exchange rate is $1.45/£ and the three-month forward exchange rate is $1.40/£. In
London, the money market interest rate is 2.0% for a three-month investment. There
are two alternative ways of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three
months so that the maturity value becomes equal to £35,000.
Evaluate each payment method. Which method would you prefer? Why?

Q4. Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company, and billed $30
million payable in six months. Airbus is concerned with the euro proceeds from
international sales and would like to control exchange risk. The current spot exchange
rate is $1.05/€ and six-month forward exchange rate is $1.10/€ at the moment. Airbus
can buy a six-month put option on U.S. dollars with a strike price of €0.95/$ for a
premium of €0.02 per U.S. dollar. Currently, six-month interest rate is 2.5% in the euro
zone and 3.0% in the U.S.
a. Compute the guaranteed euro proceeds from the American sale if Airbus decides to
hedge using a forward contract.
b. If Airbus decides to hedge using money market instruments, what action does Airbus
need to take? What would be the guaranteed euro proceeds from the American
sale in this case?
c. If Airbus decides to hedge using put options on U.S. dollars, what would be the
‘expected’ euro proceeds from the American sale? Assume that Airbus regards the
current forward exchange rate as an unbiased predictor of the future spot exchange
rate.
d. At what future spot exchange rate do you think Airbus will be indifferent between
the option and money market hedge?

Q5. A speculator is considering the purchase of five three-month Japanese yen call
options with a striking price of 96 cents per 100 yen. The premium is 1.35 cents per
100 yen. The spot price is 95.28 cents per 100 yen and the 90-day forward rate is
95.71 cents. The speculator believes the yen will appreciate to $1.00 per 100 yen over
the next three months. As the speculator’s assistant, you have been asked to prepare
the following:
1. Graph the call option cash flow schedule.
2. Determine the speculator’s profit if the yen appreciates to $1.00/100 yen.
3. Determine the speculator’s profit if the yen only appreciates to the forward rate.
4. Determine the future spot price at which the speculator will only break even.

Q6. Assume today’s settlement price on a CME EUR futures contract is $1.3140/EUR.
You have a short position in one contract. Your performance bond account currently
has a balance of $1,700. The next three days’ settlement prices are $1.3126, $1.3133,
and $1.3049. Calculate the changes in the performance bond account from daily
marking-to-market and the balance of the performance bond account after the third
day.

Q7. Due to the integrated nature of their capital markets, investors in both the U.S.
and U.K. require the same real interest rate, 2.5%, on their lending. There is a
consensus in capital markets that the annual inflation rate is likely to be 3.5% in the
U.S. and 1.5% in the U.K. for the next three years. The spot exchange rate is currently
$1.50/£.

a. Compute the nominal interest rate per annum in both the U.S. and U.K., assuming
that the Fisher effect holds.
b. What is your expected future spot dollar-pound exchange rate in three years from
now?
c. Can you infer the forward dollar-pound exchange rate for one-year maturity?