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INTERNATIONAL FINANCIAL MANAGEMENT

FIN 672
Exam I (Part 2)

Question 1:
An arbitrager at Deutsche Bank notices that the yield on Brazilian Real 6-month risk
free bills is 5.5% per annum and the yield on U.S. 6-month T-bills is 7% per annum. The
arbitrager also observes that the spot exchange rate is $0.6507/BRL and 6-month forward
exchange rate is $0.6617/BRL. Assume that the borrowing and lending rates are the same
in each currency.
a. Given the above quotes, how would you infer from the forward differential and
interest rate differential whether a covered interest arbitrage opportunity exists. And what
these differentials that you obtained imply for funds flow in order to realize arbitrage
profits.
The forward differential = (0.6617-0.6507) / 0.6507=0.0169
The interest differential = (0.01/2 -0.055/2) / (1+0.055/2)=0.0073
Because we have the forward premium on BRL/dollar is 1.69% and the interest rate
differential in favor of dollar is 0.73%, or we can say the forward differential is higher
than the interest differential, thus the IRP does not hold. As the result, the arbitrager at
Deutsche Bank can use covered interest rate arbitrage to make profit.
Even though the interest rate is lower in the Brazil, the compensation from forward
differential is higher (0.0169 > 0.0073) thus we should borrow from US and invest in
Brazil.
B. What transactions will the arbitrageur undertake to realize arbitrage profits in
dollars net of transaction cost? Show all the steps and calculations. Assume that the bank
has allowed a transaction size of $10 million or its BRL equivalent at the current spot rate.
Also assume that the transaction cost is 0.2% of the transaction size to be deducted from
the gross arbitrage profits at the end of 6-month period.
1. Borrow $ 10 million in the US with interest of 7%
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2. Sell $10 million to buy BRL in spot market. We will have money in BRL =
10,000,000/0.6507 = 15,368,065.16 (BRL)
3. Buy forward contract to cover dollar in 6 month
4. Invest in Brazil with interest if 5.5%. After 6 month we will have: BRL
15,368,065.16 * (1+0.055/2) = BRL 15,790,686.95
5. Exercise the forward contract and get back dollar. We will have 15,790,686.95 *
0.6617 = 10,448,697.56 ($)
6. Profit before transaction cost = 10,448,697.56 interest (10,000,000 $) =
10,448,697.56 10,000,000 * (1+0.07/2) = 10,448,697.56 10,350,000 = 98,697.56 $
7. Profit after transaction cost = 98,697.56 0.2 % * 10,000,000 = 78, 697.56$
C. Show how the collective actions of arbitragers in response to the given quotes
restore the market equilibrium.
1. Increased borrowing in dollar leads to increase the demand for dollar in the money
market causing i$ to rise (i$ )
2. We use these $ to buy BRL in the FX market will lead to increase demand for BRL
in the FX market. This raised S0 (S0)
3. The supply of BRL in the money market will increase, thus puts downward
pressure on iBRL (iBRL )
4. Finally, investors would like to sell BRL at maturity to get dollar and get dollar
profits. The selling of BRL takes place through the forward contract, so the forward rate
must decline (F).
The above adjustments continue until all the four variables are aligned so that the
equilibrium is restored in the markets. Then IRP would hold and there will be no arbitrage
opportunities left in the market
D. Suppose the nominal interest rates stay at the levels quoted above, what should be
the no-arbitrage annualized forward premium/discount on BRL against $?
We have the interest differential = 0.0073
To calculate no-arbitrage annualized forward: The forward differential = the interest
differential
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(FWD-0.6507)/0.6507 = 0.0073 -> FWD = 0.0073*0.6507+0.6507 = 0.6555
Therefore, the no-arbitrage annualized forward premium/discount on BRL against $ =
[(forward rate - spot rate) / spot rate] * [12 / number of months forward] * 100%
= ((0.6555-0.6507)/0.6507)*12/6) = 0.01475 (1.475 %)

Question 2:
NZD NZD1.6860-1.7000/$
Swiss Francs CHF1.5350-1.5500/$
Calculate quickly NZD/Swiss Francs
Answer:
We have CHF 1.5350-1.5500/S -> $1/1.5500-1/1.5350/CHF
Anh NZD 1.6860-1.7000/$
Bid price: NZD/CHF 1.6860*1/1.5500 = 1.0877
Ask price: NZD/CHF 1.7000*1/1.5350 = 1.1075
Therefore, NZD/CHF cross-rate bid-ask quote for Jennifer is NZD 1.0877 1.1075
/CHF
Question 3:
a) Audi imported by buying dollars in the futures market at the current March futures
price of 1.1109/$.
At the futures prices, Audi will sell 7,776,300 = 7,000,000*1.1109. The number of
future contracts = 7,776,300/ 125,000 = 62.21 -> They should buy 63 contracts
b) On March 4, Audi can buy 63 contracts at total cost is 63 x 125,000= 7,875,000;
or 7,875,000/1.1109 = 7,088,846 ($) at the March future price of 1.1109/$
At the current futures rate of 1.1151/$, Audi must pay out 7,875,000/1.1151 =
7,062,146
Therefore, Audi has a net gain of $7,062,146 - $7,088,846 = $26,700 on its future
contracts.
At the current spot rate of 1.1171/$, this amount of profit will be (in a gain of )
23,901.17 (26,700 / 1.1171 = 23,901.17)
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Question 4:
Intrinsic value = 0.
WE have ST-E=1.5200 - 1.5705<0 thus intrinsic value =0. Or we can say that:
As we have intrinsic value is Max (ST - E, 0) = Max (1.5200-1.5705, 0)
= Max (-0.0505, 0) = 0
Question 5:
A. What is the dollar cost of SF payables if CT adopts a forward market hedge?
The dollar cost of SF payables through forward hedge = SF 500,000 x $ 0.63/SF =
315,000 $
B. What is the dollar cost of SF payables if CT adopts a money market hedge?
- Borrow SFs: the present value of SF 500,000. CT needs to borrow enough to repay
both principal and interest with the sale proceeds (SF 500,000). The interest is 6% (1.5%
for 3 months)
PV= SF 500,000 / (1+0.015) = SF 492,610.84
Thus, CT should borrow SF 492,610.84.
After 3 months, the interest = 492,610.84 * 0.06 / 4 = SF 7,389.16
- Exchange SF 492,610.84 for $ at the current spot rate of $0.60/SF and receive:
$492,610 x $0.60/SF = $295,566.50
- Invest in $ money market at the 3-month rate of 2% for 3 months or 8% for a year
FV= $295,566.50 x (1+0.02) = $301,477.83
Compared with the forward market hedge, money market hedge is more considerable.
The cost in dollar in money market hedge is less than that in the forward market hedge.
Since the IRP does not hold, under the given conditions, money market hedge is more
desirable.
c) Option hedge.
Assume that the contract size is 500,000 SF
Premium cost = $0.02/SF x 500,000 SF (=10000 ($))
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SF against dollar, at any exchange rate about $0.62/SF (the exercise price), CT would
allow to exercise its option and the total cost is SF 500,000 *0.62+500,000*0.02 =
500*(0.62+0.02) = $320,000