Lecture 5.

Arbitrage, Parity Conditions, and Currency Forecasting

1. Assume the following information
Polish Zloty
Bank A
Bid
Ask
$.2612
$.2844

Bank B
Bid
Ask
$.2388
$.2501

Given this information, is locational arbitrage possible? If so, explain the steps involved in
locational arbitrage, and compute the profit from this arbitrage if you had $100,000 to use.
2. Assume the following information for a particular bank:
Value of the euro in U.S. dollars
Value of Swiss francs in U.S. dollars
Value of euros in Swiss francs

Quoted price
$1.0483
$ .7239
SF 1.4181

Given this information, is triangular arbitrage possible? If so, explain the steps that would
reflect triangular arbitrage, and compute the profit from this strategy if you have $100,000 to
use.
3. Assume the following information:
Spot rate of British pound
90-day forward rate of Canadian dollar
90-day Canadian interest rate
90-day U.S. interest rate

= $1.6097
= $1.5898
= 5%
= 2%

Given this information, what would be the yield to a U.S. investor who used covered interest
arbitrage? (Assume the investor invests $100,000.)
4. Assume that the spot exchange rate of the Danish krone is $.1414. How will this spot rate
adjust according to PPP if the Denmark experiences an inflation rate of 8% while the U.S.
experiences an inflation rate of 2%?
5. Assume that the spot exchange rate of the Japanese yen is $.008437. The one-year interest
rate is 7% in the U.S. and 2% in Japan. What will the spot rate be in one year according to
IFE?
Lecture 6: Foreign Exchange Exposures and Transaction Exposure
1. Ingam Corp. expects to pay 28,000,000 Japanese yen in 90 days. The current spot rate is
$.008448, the 90-day forward rate is $.008473, and the spot rate turns out to be $.008318 in
90 days. What is the amount paid if Ingam hedged their position? What is the unhedged
cost?

2. Hathoot Corp has two subsidiaries. One has net inflows of Brazilian real of 30,000,000. The
other subsidiary has net outflows in Brazilian reals of 18,000,000. What is the net inflow or
outflow in U.S. dollars for Hathoot if the current exchange rate is $.3463?
3. Clark Co. will need to pay 2,500,000 in 180 days. Assume the following information:
180-day U.S. interest rate
180-day European interest rate
180-day forward rate
Spot rate
Call option premium
Call exercise price
Expected spot price in 180-days

=
=
=
=
=
=
=

6%
4%
$1.1036
$1.1273
$.02
$1.09
$1.11

Compare the forward hedge, money market hedge, option hedge, and an unhedged position.
Which is optimal?
4. Assume that Bradley Corp expected to pay 1,200,000 Malaysian ringgit in one year. The
existing spot rate of the Malaysian ringgit is $.2632. The one-year forward rate of the
Malasian ringgit is $.28. Bradley created a probability distribution for the future spot rate in
one year as follows:
Future Spot
Probability
.26
15%
.29
65%
.31
20%
Assume that one-year put options on Malaysian ringgit are available of with an exercise price
of $.29 and a premium of $.02. One-year call options are available with an exercise price of
$.24 and a premium of $.02. Assume the following money market rates:
U.S.
Malaysia
Deposit rate
5%
6%
Borrowing rate
7%
8%
Given this information, determine whether a forward hedge, money market hedge, or
currency options hedge would be most appropriate. Then, compare the most appropriate
hedge to an unhedged strategy, and decide whether Bradley should hedge its payables
position.
5. Using the information in the previous problem, assume that Colvig Corporation expects to
receive MR2,000,000 in one year. Determine whether a forward hedge, money market
hedge, or currency options hedge would be most appropriate. Then, compare the most
appropriate hedge to an unhedged strategy, and decide whether Colvig should hedge its
receivables position.
Lecture 7. Economic Exposure

1. The Roten Corporation does business in the U.S. and Canada. In attempting to assess its
economic exposure, it compiled the following information.
A.

Rotens U.S. sales are affected by the value of the Canadian dollar because it
faces competition from Canadian exporters. It forecasts the U.S. sales based on the
following three exchange rate scenarios
Exchange rate
C$ = $.70
C$ = $.73
C$ = $.76

B.
C.
D.

Revenue from U.S. business

$125,000,000
$133,000,000
$140,000,000

Its Canadian dollar revenue on sales to Canada is expected to be C$70,000,000.

Its anticipated cost of goods sold is estimated at $20,000,000 from the purchase of
U.S. materials and C$10,000,000 from the purchase of Canadian materials.
Fixed operating expenses are estimate at $3,000,000.

E.

Variable operating expenses are estimated at 18% of total sales (after including
Canadian sales, translated to a U.S. dollar amount).

F.

Interest expense is estimated at $3 million on existing U.S. loans, and the

company has no existing Canadian loans.
Create a forecasted income statement for Roten Co. under each of the three exchange rate
scenarios. Explain how Rotens projected earnings before taxes are affected by possible
exchange rate movements. Explain how it can restructure its operations to reduce the
sensitivity of its earnings to exchange rate movements without reducing its volume of
business in Canada.

Lecture 8. Translation Exposure and Hedging Strategies

1. Assume that Klark Corp. needs 500,000 Swiss francs 180 days from now. Klark has
developed the following probability distribution for the Swiss franc:
Possible value of Swiss franc
.67
.70
.73
.75
.77

Probability
5%
15
40
30
10

The 180-day forward rate of the Swiss franc is $.74. Develop a table showing the probability
distribution and costs of hedging. Also, determine the expected value of the additional cost
of hedging.

Lecture 5. Arbitrage, Parity Conditions, and Currency Forecasting

1. $100,000/$.2501 = Z 399,840
2.

Z 399,840 x $.2612 = $104,438

$100,000/$.7239
SF 138,141 / SF 1.4181
E97,412 x $1.0483

3.

$100,000/$1.0697
62,123 x 1.05
65,230 x $1.5898

4.
ef

1 i 1
h

1 i

= SF 138,141
= E 97,412
= $102,117

= 62,123
= 65,230
= $103,702

$2,117 profit

3,702/100,000 = .037

ef = (1.02/1.08) 1 = -.0556

$.1414(1 + -.0556) = $.1335

5.
ef

1 I 1
h

1 I

(1.07/1.02) 1 = .049

.008437(1 + .49) = $.00885

Lecture 6: Foreign Exchange Exposures and Transaction Exposure
1.

Hedged: 28,000,000 x .008473 = $237,244

Unhedged: 28,000,000 x .008318 = $232,904
Cost of Hedging: 237,244 232,904 = 4,340

2.

BR12,000,000 x .3463 = $4,155,600 inflow

3.

Forward

2,500,000 x 1.1036 = $2,759,000

Money Market

Discount 2,500,000/1.04 = 2,403,846

Convert 2,403,846 x $1.1273 = $2,709,856
Take out $2,706,856 x 1.06 = $2,872,447

Call Option

2,500,000 x (1.09 + .02) = $2,775,000

Unhedged

2,500,000 x 1.11 = $2,775,000

The forward hedge costs the least.

4.

Forward

MR1,200,000 x $.28 = $336,000

$4,438 profit

3.7%

Money market hedge

Invest
Convert
Pay loan

MR1,200,000/1.06 = MR1,132,075
MR1,132,075 x .2632 = $297,962
$297,962 x 1.07 = $318,820

Call Option
Spot
$.26
$.29
$.31

Premium
.02
.02
.02

Unhedged
Spot
$.26
$.29
$.31

Ex.
Y
Y
Y

Per Unit
Paid
$.26
$.26
$.26

Total Paid
$312,000
$348,000
$372,000

Total
Amount
$312,000
$312,000
$312,000

Probability
15%
65%
20%

Probability
15%
65%
20%

The call option hedge costs the least of the hedge alternatives. The call option hedge
costs less than the unhedged position 85% of the time.
5.

Forward Hedge

Sell MR2,000,000 x $.28 = $560,000

Money market hedge

1. Borrow
2. Convert
3. Invest

MR2,000,000/1.08 = MR1,851,852
MR1,851,852 x $.2632 = $487,407
$487,407 x 1.05 = $511,778

Put Option
Spot
$.26
$.29
$.31

Premium
.02
.02
.02

Unhedged
Spot
$.26
$.29
$.31

Ex.
Y
-N

Per Unit
Received
$.27
$.27
$.29

Total Received
$520,000
$580,000
$620,000

Total
Amount
$540,000
$540,000
$580,000

Probability
15%
65%
20%

Probability
15%
65%
20%

Of the hedging alternatives, the forward hedge receives the higher amount 80% of the
time. An unhedged strategy is better than the forward hedge 85% of the time.
Lecture 7. Economic Exposure
1.

C$ = $.70
Sales

C$ = $.73

C$ = $76

U.S.
Canada
Total
Cost of goods sold
U.S.
Canada
Total

$125
C$70 = 49
$174

Operating expenses
U.S. Fixed
U.S. Variable (18% of sales)
Total

Interest expense
U.S.
Canada
Total
Earnings before taxes

$140
C$70 = 53
$193

$20
7
$27

$20
C$10 = 8
$28

$147

$157

$165

$3
31
$34

$3
33
$36

$3
35
$38

$113

$121

$127

$3
0
$3

$3
0
$3

$3
0
$3

$111

$118

$124

C$10 =

Gross profits

EBIT

$133
C$70 = 51
$184

$20
7
$27

C$10 =

The forecasted income statements show that Roten Co. is favorable affected by a strong
Canadian dollar. Roten could reduce its economic exposure without reducing its
Canadian revenues by shifting expenses from the U.S. to Canada. In this way, its C$
outflow payments would be more similar to its C$ inflow payments.
Lecture 8. Translation Exposure and Hedging Strategies
1.

Cost of hedging = SF500,000 x $.74 = $370,000

Spots
.67
.70
.73
.75
.77

Cost of Hedging
370,000
370,000
370,000
370,000
370,000

Amount needed
Cost of
if unhedged
Hedging
Probability
335,000
35,000
.05
= 1,750
350,000
20,000
.15
= 3,000
365,000
5,000
.40
= 2,000
375,000
-5,000
.30
= -1,500
385,000
-15,000
.10
= -1,500
Expected value of the cost of hedging = 3,750

There is a 65% chance that the cost of hedging will be higher than remaining unhedged.