1.

Answer: It can be both true or false, depending on the meaning of floating.

 free floating: the market forces determine the currency’s value  law of demand and supply
 managed floating: the government
influences the market, so, yes, it wants to
exercise a lot of control

1.2. From looking at the graph:

a) How many € did you have to pay for 1$ on
Jan 1, 2003?
Answer: €1/$1
b) How many € did you have to pay for 1$ on
Jan 1, 2015?
Answer: €0.8/$1

4.1 If American quote S($/£) =1.073, what is S(£/$) European quote?

The quote 1.073, is expressed in American terms, so to get the reciprocal – the quote in European terms- we
must use this formula
1 1
S ( £ / $ )= = =0.9320
()
S
$
£
1.073

4.2. Using the American term quotes from Exhibit 5.4, calculate the one-, three-, and six-month forward
cross-exchange rates between the Australian dollar and the Swiss franc. State the forward cross-rates in
“Australian” terms

Answer: Australian terms means that we will quote prices as FN (AUD/CHF)

We can use this formula: FN (AUD/CHF) = FN ($/CHF) / FN ($/AUD)  this formula uses American term
forward exchange rates

F1 (AUD/CHF) = F1 ($/CHF) / F1 ($/AUD) = 1.0617/0.9521 = 1.1151

F3 (AUD/CHF) = F3 ($/CHF) / F3 ($/AUD) = 1.0624/ 0.9482 = 1.1204

F6 (AUD/CHF) = F6 ($/CHF) / F6 ($/AUD) =1.0636/0.9425 = 1.1285

 Cross Rates
A cross-exchange rate (or simply cross rate) is an exchange rate between a currency pair where neither
currency is the $  we typically always use the dollar as the basis for currency exchange rates, and then if
we need to have quotations that doesn’t involve dollars we arrive at those quotations using indirectly the
US dollar
This method simplifies the amount of quotations you need to track for  it simplifies your job
The cross-exchange rate can be calculated from the $ exchange rates for the two currencies
Example with the American term quote
S ($ /£ ) 1.5405
 S( € /£)= =S( $ /£)∗S (€ /$ )=S( $ /£∗€ / $)  1.1767=
S($ /€ ) 1.3092
 There is no direct way to see S(€/£) from the exhibit, I need the calculation above
Example with the European term quote
S( € /$) 0.7638
 S( € / £)=  1.1767=
S (£ / $) 0.6491
 Notice in both examples that the “$”s is cancel.
Example with the American term quote
S( $ / € ) 1.3092
 S( £ / € )=  0.8499=
S ($ / £ ) 1.5405
Example with the European term quote
S (£ / $) 0.6491
 S( £ /€ )=  0.8499=
S( € /$) 0.7638

 Notice in both examples that the “$”s is cancel.
One may find it easier to think of cross-exchange rates as the product of an American term and a European
term. We can see this if we use the same rates as in the previous example:
S( $ /£)=1.5405 and S( $ /€ )=1.3092
S( j/k )=S($ /k)∗S ( j /$)
S(€ /£)=S ($ /£ )∗S( € /$)
For example:
S ($ / £ ) ($ /£ )∗1
S( € /£)= =S =S($ / £ )∗S(€ / $)
S($ / € ) S ($/ € )
¿ 1.5405∗0.7638=1.1766

4.3. Why does most interbank currency trading worldwide involve the US dollar?
Because most foreign exchange transaction involve the US dollar because so much of international
commerce takes place in the US dollar (importing goods from the US, selling goods to US, trading
commodities…) Banks help their clients buy and sell FX

4.4 What is meant by a currency trading at a discount or at a premium in the forward market.
PREMIUM = forward price is higher than current spot price  the currency will appreciate = Currencies
at premium will be more expensive to buy forward (relative to spot price)
DISCOUNT = forward price is lower than current spot price  the currency will depreciate = Currencies
at discount will be less expensive to buy forward (relative to spot price)

4.5. Given the following info, what are the NZD/SGD currency against currency bid-ask quotations?

The relationship between bid and ask quotes:

Sb (NZD/SGD) = Sb ($/SGD) * Sb (NZD/$) = 0.6135 * 1.3751 = 0.8436
= AMERICAN * EUROPEAN

We know also that the reciprocal is

Sa (SGD/NZD) = 1/ Sb (NZS/SGD) = 1/0.8436=1.1854

Analogously, it is implied that:

Sa (NZD/SGD) = Sa ($/SGD) * Sa (NZD/$) = 0.6140*1.3765 = 0.8452
=american * european

The reciprocal:
1/ Sa (NZD/SGD) = Sb (SGD/NZD) = 1/ 0.8452 = 1.1832

Thus, the NZD/ SGD bid-ask spread is: NZD 0.8436 – NZD 0.8452
And the SGD/ NZD bid-ask spread is: SGD 1.1832 – SGD 1.1854

How do I know when I should divide or multiply an amount of a currency with the FX quotation?
It depends on whether the exchange rate is expressed as a direct or indirect quote!
American terms: S ($/£) = 1.5406
European terms: S ( £/$) = 0.6491
If I have £200: how many $ are my £ worth??
In American terms = direct quote= MULTIPLY = £200 * S ($/£) = £200 * ($1.5406/£) = $308.12
In European terms= indirect quote = DIVIDE= £200 / S (£/$) = £200/ (£0.6491/$) = $308.12

IN GENERAL: we are just using the basic principles for calculating prices and quantities:
1. How much you must pay for a certain quantity of something (indirect quote: divide). For ex, if an
apple costs €2 (€2/apple) and you have €100, then you will be able to buy: €100/(€2/apple) = 50
apples for your money
2. How much you get paid if you sell a certain quantity (direct quote: multiply). For ex, if an apple
costs €2 and you have 50 apples to sell then you get: 50 apples * (€2/apple) = €100 euro for your
apples
The spot price for an apple can be expressed as S (€/apple) = 2 ( it is a direct quote in terms of € and
an indirect quote in terms of apples)

INTEREST RATE PARITY EXAMPLE

Suppose that you work as an investment analyst in NY and your boss tells you that you should invest $1
over a 1-year period in a default -free investment (risk-free investment). Consider 2 alternatives:
1) Invest domestically at the US interest rate
2) Invest in a foreign country (UK) at the foreign interest rate and use a forward contract to eliminate
the exchange risk
The UK investment coupled with forward hedging is a perfect substitute for the domestic US investment
because both investments yield the same cash flow.

US investment:
- the value of $1 would be $1(1 + i$) in the future
UK investment:
1) Exchange $1 for a pound amount, that is £ (1/S)  where S=S ($/£)
 2) Invest the pound amount at the UK interest rate (i£) with the maturity value of £(1/S)(1+i£)
3) Sell the maturity value of the UK investment forward in exchange for a predetermined dollar
amount, that is, $[(1/S)(1+i£)]F  F is F=F($/£)  this step is called hedging

F ( $ /£)
The arbitrage equilibrium would dictate that (1+i$) = (1+i£)
S ($/ £)
1+i $
Which is the same as F($/£)= S($/£) [ ]
1+i £

Alternatively, IRP can be derived constructing an arbitrage portfolio which involves no net investment and
no risk (so it should not generate any profitable cash flow)
For our example, this would consist of

THE FORMULA TO USE TO CHECK IF IRP HOLDS

(F/S) ( 1+i£) = (1+i$)

CIA PROCEDURE AND EXAMPLE

1) Identify which currency you should borrow in and which currency you should invest in (IRP) 
lowest side of the inequality ( the cheaper one)
2) Borrow in the currency found in n° 1
3) Exchange the currency you have borrowed at the spot rate into the currency that you want invest in
4) Invest in the currency obtained in n° 3
5) Sell the maturity value of the currency n° 4 with forward contract
6) Wait until the forward delivery date and collect the maturity value from your investment in n° 4. Use
that money to deliver the currency as per the forward contract. Receive the other currency as per the
forward contract and use part of this money to repay the loan took in n°2

EXAMPLE: arbitrager can carry out the following transactions:

 cheaper side $ so start borrowing in USA
i$= 5% i£=8% S ($/£) = 1,80 F12 ($/£) = 1.78
1) In the USA, borrow $1,000,000. Repayment in one year will be $1.050.000, because interest
rate=1.05
2) Buy £ 555.5566 spot using $1.000.000
3) Invest £555.556 in the UK  the maturity value will be £555.556*1.08 = £ 600.000
4) Sell £600.000 forward in exchange for dollar
600.000∗$ 1,78
£ =$ 1.068 .000
£
You made profit!!
 5) Repay $1,050,000 for the US loan
6) Arbitrage profit = $1.068.000-$1.050.000= $18.000

EXERCISES LECTURE 6

6.1 Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for 6 months. The
interest rate is 8 percent per annum in the US 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?

Answer:
1) The first step in this case is to calculate the interest for 6 moths 
- In Usa: 8% is for 12 months so 8/2= 4% per 6 months  i$= 4%
- In Germany: 7/2= 3,5% per 6 months  i€= 3,5%
- The sport exchange rate is S(€/$) = €1.01/$
- The forward exchange rate after 6 months is F6(€/$) = €0.99/$

If $100,000,000 are invested in USA:

 the maturity value in 6 months will be= $100,000,000*(1+0.04) = $104,000,000

If $100,000,000 are invested in Germany  to check here the maturity value, we must cover first in euros
and then invest at the German interest rate, with the euro maturity value sold forward.

 convert $100,000,000 *€1.01/$ = 101.000.000€

 in 6 months €101.000.000*(1+0.035) = 104.535.000€
Reconvert in dollar at the forward rate  104.535.000*(1/€0.99/$) = $105.590,909

Clearly is better to invest $100,000,000 in Germany with exchange risk hedging. This is an example of
a deviation from the IRP

6.2. Currently the spot exchange rate is $1.50/£ and the 3-month forward exchange rate is $1.52/£. The
interest rate is 8.0% per annum in the US and 5.8% per annum in the UK. Assume that you can borrow as
much as $1,500 or £1,000,000
a) Determine whether the interest rate parity is currently holding
b) If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and
determine the arbitrage profit
c) Explain how the IRP will be restored as a result of covered arbitrage activities

Data:
S ($/£) = 1.50/£ F3($/£) = $1.52/£
U.S. interest rate = 8%
UK = 5.8%
3months interest  USA= 2% and UK=1,45%

Answer:

a) To see if the IRP is holding apply the formula

(F/S) (1+i£) = (1+i$)

1+i$= 1+ 0,02 = 1.02

(F3/S) (1+i£) = (1.52)/(1,50) * (1+0,0145) = 1,01333*1,0145= 1,0280

 The IRP is not holding exactly! It is cheaper to borrow in USA!

b) CIA Procedure

 cheaper side $ so start borrowing in USA

i$= 2% i£=1,45% S ($/£) = 1,50 F3 ($/£) = 1.52

1) In the USA, borrow $1,500,000. Repayment in one year will be $1,500,000*(1+0,02) = $1,530,000,
because interest rate=2%
2) Buy £  spot using $1.500.000 / $1,5/£ = 1.000.000£
3) Invest £1.000.000 in the UK  the maturity value will be £1.000.000*(1+ 0.0145) = £1.014.500
4) Sell £1.014.500 forward in exchange for dollar
.500∗$ 1.52
£ 1.014 =$ 1.542.040
£
You made profit!!
5) Repay $1,530,000 for the US loan
6) Arbitrage profit = $1.542.040-$1.530.000= $12.040

C) The IRP will be restored trough market adjustments, which will continue until the IRP is restored:

- The dollar interest rate will rise

- The pound interest rate will fall
- The spot exchange rate will rise
- The forward exchange rate will fall
These adjustments will continue until the IRP is restored

DAILY RESETTLEMENT: EXAMPLE 1

- Consider a long (buyer) position on a $/€ contract (written on €125,000)
- FUTURES PRICE: $1.3000/€ and the maturity is 3 months
- INITIATION MARGIN ACCOUNT: €20,000
- Tomorrow futures rate = $1.2000/€ (your position’s value drops)

- original agreement: buy €125,000* $1.3000/€= $162,5000

- Now, €125,000 is worth €125,000*$1.2000/€= 150,000
- You have lost $12,500:
- The $12,500 comes out of your $20,000 margin account
DAILY RESETTLEMENT: EXAMPLE 2
 - Consider a long (buyer) position in a British pound futures contract
- Written on £62,500 and price is quoted in dollars per £
- FUTURE PRICE: $1.3000/£
- INITIAL PERFORMANCE BOND: $1,625 = 2%*$1.3000/£* £62,500
- MAINTENANCE PERFORMANCE BOND: $1,300 this means that you get a margin call if your
performance bond account falls below $1,300
 Longs get margin calls when the future’s price falls
Shorts get margin calls when the future’s price rises

Each day’s losses are subtracted from investor’s account. Each day’s gains are added to the account.
The maintenance amount is 1,300 and the initial performance bond is 1,625, so if the investors loses from
1,625 more than 325$, the investor has to maintain the long position by adding more funds or the position
will be closed out with an offsetting short position
 if you lose funds, you must bring up the funds to the initial margin!

At the end of the 1st 3 days, we have 3 ways of computing gains and losses:
1. Sum of daily gains and losses  -$325= $62.50 - $187.50 - $200
2. Contract size times the difference between initial contract price and last settlement price = -
$325=($1.2948/£-$1.3000/£)*£62,500
3. Ending balance on the account minus beginning balance on the account, adjusted for deposits or
withdrawals= -$325= $1,3000-$1,625
Da stampare
SPECULATING AND HEDGING: EXAMPLE

1. Trader takes a position on June 5, 2013 in a futures contract (always €125,000 when not specified) at
$1.3094/€ on September 2013. He holds the position until the last day, when the spot price is
$1.2939/€
Is a profit or a loss?
It depends on whether the trader was long or short and whether the trader is a speculator or
hedger

TRADER HAD A LONG SPECULATIVE POSITION RISK  BUYER (HOPES PRICES

INCREASE)
 LOSS: of ($1.2939/€ - $ 1.3094/€) * €125,000 = - $1,937.5
 the cumulative loss has been subtracted from the margin account as a result of daily making-to-market

If the trader takes delivery of the €125,000 the payment remains is:
($1.3094/€ * €125,000)- $1,937.5 = $163,675 - $1,937.5 = $ 161,737.5 which is the same as the spot
market value on the final trading day

TRADER HAD A SHORT SPECULATIVE POSITION  SELLER (HOPES PRICES DECREASE)

 GAIN: ($1.3094/€ - $1.2939/€) * €125,000 = $1,927.5

The cumulative gain has been added to the margin account as a result of daily marking-to-market
If the trader takes delivery of the €125,000 the remaining sum to receive is: ( $1.3094/€ * €125,000) -
$1,937.5 = $163,675- $1,937.5 = $161,737.5 which is the same as the spot market value on the final trading
day

TRADER HAD A LONG-HEDGED POSITION NO RISK  BUYER

The trader wanted to buy €125,000 on September 18
 prepared to pay $1.3094/€ * €125,000 = $163,675 to lock in the purchase price
 neither any loss nor gain

TRADER HAD A SHORT-HEDGED POSITION  SELLER

The trader wanted to sell €125,000 on Sep 18
Prepared to sell for ($1.3094/€ * €«25,000) = $ 163,675 to lock in the sale price
Neither any loss nor gain!

POSSIBILITIES SUMMARIZED IN THE GRAPH

BASIC OPTION PROFIT PROFILES: EXAMPLE 1

- The August EUR European call option (buyer= hope prices increase) has a current premium (ptice)
of CE of 2.52 cents ($0.0252) per €
- Unit size is €10,000
- Exercise price, E, is 130 cents per € ($1.30/€) on August 17
- Suppose that the spot rate, St, at expiration on August 17 is $1.3425/€
- We can see that E is less than St (in the money situation= making profit)
- Formula to apply  CT= ST-E = $1.3425/€ - ($1.30/€) = $0.0425/€
- PROFIT PER OPTION
= CT- CE = $0.0425/€
- $0.0252/€ =
$0.0173/€
- Total profit on all
options =
$0.0173/€*10,000=
$173

BASIC OPTION PROFIT

PROFILES: EXAMPLE 2
 - Suppose instead that the spot rate at expiration St on August 17 is $1.2827/€
- The call option is OUT OF THE MONEY
- Formula to apply  CT = MAX [St-E,0]
- MAX [$1.2827/€ - ($1.30/€) , 0 ] = MAX [-$0.0173/€,0] = 0
- The trader should let the call option expire worthless, or with 0 value
- The loss is limited to the option premium paid of 2.52 cents per € (=$252 since we bought options
on 10,000€)

BUYERS PERSPECTIVE WRITERS (SELLER) PERSPECTIVE

PROBLEMS
10.1 Explain the basic difference between the operation of a currency forward market and a future market

Answer: There are several differences between the 2, but the most basic and important ones to remember
are the following:
Forwards:
1. The forward contract for purchase or sale of foreign currency is tailor-made between the client and
its international bank
2. No money changes hands until maturity date of the contract when delivery and receipt of the
currencies are typically made
Futures:
1. A futures contract is an exchange-traded instrument with standardized features specifying
contract size and delivery date
2. Futures contracts are marked to market daily to reflect changes in the settlement price

10.2 Is it true that a derivatives market such as the futures FX market needs only speculators to be able to
function efficiently? If you think this statement is false, explain why you think so

Answer: This statement is false because a derivative market needs both speculators (who attempts to
profit from a change in the futures price) and hedgers (who want to avoid changes in prices) The hedger
passes off the risk of price variation to the speculator who is better able, or at least willing, to bear this risk.
For example, a speculator would not be able to buy a specific future if there is not a hedger willing to sell
that specific future.
10.3. Assume today’s settlement price on a CME EUR futures contract is $1.3140/€. You have a short
position (seller: hope prices decrease) in one contract. Your performance bond account currently has a
balance of $1,700. The next three days ‘settlement prices are
D1: $1.3126/€, D2: $1.3133/€ D3: $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. Do you need to take any action based on the balance of
your performance bond account?

Answer: first, we need to remember that €125,000 is the contractual size of one EUR contract. Second, it is
important to note that we have a SHORT position.
Then, we can calculate each day’s change to the original account balance:

DAY 1: (SETTLEMENT PRICE – D1) * CONTRACTUAL SIZE = ($1.3140/€. - $1.3126/€) * €125,000 = 0,0014*
125.000 = $175

DAY 2: (D1-D2)* CONTRACTUAL SIZE = : ($1.3126/€, - $1.3133/€) *125,000= - $87.5

DAY 3: (D2-D3) * C.SIZE = $1.3133/€ - $1.3049/€ * 125,000 = $1,050

PUTTING IT ALL TOGHETER GIVES THE NEW BALANCE OF THE PERFORMANCE BOND ACCOUNT:

Initial balance +/- days performance  $1,700+$175 - $87.5 + $1,050 = $2,837.5

We do not need to take any action since the balance of our performance bond account is increasing. In
fact, we can see that the price is decrease from Settlement price to D3 price, as the wish of the seller in
short position, who hopes that prices decrease,

10.4. Assume today’s settlement price on a CME EUR future contract is $1.3140/€. You have a long
position (buyer= hope prices increase) in one contract. Your performance bond account currently has a
balance of $1,700. The next three-day settlement is:
D1: $1.3126/€, D2: $1.3133/€ D3: $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. Do you need to take any action based on the balance of
your performance bond?

DAY 1: D1 – SETTLEMENT PRICE * C.SIZE = ($1.3126/EUR - $1.3140/EUR) × EUR125,000 = -$175

DAY 2: D2-D1 * C.SIZE= ($1.3133/EUR - $1.3126/EUR) × EUR125,000 = $87.5

DAY 3: D3-D2 * C.SIZE= ($1.3049/EUR - $1.3133/EUR) × EUR125,000 = -$1,050

New balance performance= $1,700 – $175 + $87.5 – $1,050 = $562.50

SINCE the balance of your performance bond account is decreasing, we will need to put more money into
the account if the accumulated losses bring us below the maintenance performance bond.

NOTA BENE: QUANDO SEI SHORT GIORNO 1- GIORNO 2. QUANDO SEI LONG GIORNO 2- GIORNO 1
10.5. You buy June EUR call option at the current premium of $0.0223/€. The unit size is €10,000 and the
exercise price is $1.23/€ on June 16. Suppose that the spot rate at expiration is $1.27/€.
What is your total profit?
Ce= $0.0223/€ E= $1.23/€ St= $1.27/€

Answer: By buying the call option the trader shows its long position, meaning that he hopes that in the
future the prices will increase. The Spot rate at expiration is higher than the exercise price, therefore we
are in the money and the trader is making profit. We can apply the formula  Ct= St-e

CT= $1.27/€ - $1.23/€ = $0.04/€ (the margin you gain)

Subtract the premium (price) for each option  $0.04€ - $0.0223/€ = $0.0177/€

Total profit = $0.0177/€ * €10,000 = $177

10.6 You buy June EUR call option at the current premium of $0.0172/€. The unit size is €10,000 and the
exercise price is $1.32/€ on June 16. Suppose that the spot rate at expiration is $1.27/€. What is your total
profit?

current premium: $0.0172/€. E= $1.32/€ St= $1.27/€.

We can see immediately that we are in an out-of- the money situation, given the fact that the St is lower
than the E, and as buyer we would need the exact opposite for making profit.

Therefore, we can apply the formula Ct= MAX [St- E,0]

= MAX [$1.27/€ - $1.32/€, 0] = MAX [$-0.05/€,0] = 0

Then consider the loss per option, which is $0/€ – $0.0172/€ = -$0.0172/€
Total loss: -$0.0172/€ *10,000 = -172$

Since the exercise price is higher than the spot rate, the trader should let the call option expire worthless.
The loss is limited to the premium paid for buying the options.

11.1. How can it be possible for a Japanese company to have a bank account denominated in ¥ in
Singapore?
Because of the existence of eurocurrency markets, i.e. international banks give companies the possibility
to deposit money in a certain currency in a country which has not issued that currency

11.2. Your company is depositing €1 million for 6 months with a bank in London at the interest rate LIBOR +
0.10%. If LIBOR is 0.20%, how much will you have earned in interest over the 6-month period? Remember
that the interest rates are always reported in annual terms.

Answer: The annual interest rates that will apply to our company is
LIBOR + 0.10% = 0.30% 0.003
We deposit the money for 6 months so (1/2 of a year), therefore the interest rate applied is
For 6 months = 0.003/2 = 0.0015
Earned in interest in 6 months = €1 million * 0.0015 = €1,500

12.1 Is it true that Eurobonds are bonds issued by a foreign borrower to investors in another country and
denominated in the currency of that country? If you think that this statement is false, discuss how the
statement should be corrected so that it is true.

Answer: No, this statement is false because it gives a description of foreign bonds and not Eurobonds

12.2 Why might an Italian firm that wants to set up a subsidiary in Japan prefer to issue a Dual-currency
bond in euro with principal to be paid back in yen instead of issuing a Samurai bond?

Answer: The Dual-currency bond can be attractive for an Italian MNC to finance the subsidiary because the
€ raised from selling the bond can be easily converted in Yen to finance the subsidiary. In the initial years of
the subsidiary, when there’s not so much profit, coupons can be paid by the parent company in €. Then
when the bond matures, probably and hopefully the subsidiary is profitable and able to pay back the
principal in Yen.

The Samurai bond provides access to Yen, but we will have to pay both the coupons and the principal in
Yen. This can be problematic if the subsidiary does not become profitable quickly

14.1. Why might an investor in the US prefer to buy an ENI S.p.A ADR rather than to buy the actual share of
the stock exchange in Milan?

Answer:
An ADR can be purchased in the U.S., so in this case on the investor’s domestic exchange. Thus, the investor
can purchase the ADR directly from her domestic broker, rather than having to deal with an overseas
broker and the necessity of obtaining € to make the foreign stock purchase.
Additionally, dividends are received in the local currency, $, rather than in €, that would need to be
converted into $.

15.1. Consider the following interest rates

a) How much would the German MNC pay in interest every year to the US MNC?
b) How much would the US MNC pay in interest every year to the German MNC?

Answer:
a) The German MNC will pay $3,120,000 in interest every year to the US MNC (6% of $52 m)
b) The US MNC will pay €1,600,000 in interest every year to the German MNC (4% of €40m)
Logic:
We see from the table that it is cheaper for the US firm to borrow in US than for the German firm to
borrow there. For the German MNC it is cheaper to borrow in Germany capital market, while for the US
firm in the Germany capital market it is more expensive.

The swap bank would instruct the 2 MNCs to borrow in their national capital markets and then exchange
the principal sums with each other

16.1. Cray Research sold a supercomputer to the Max Institute in Germany on credit and invoiced €10
millions payable in six months. Currently, the 6-month forward exchange rate is $1.10/€ and the foreign
exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/€ in 6 months. What is
the expected gain/ loss from the forward hedging?

Answer: If the sport rate in 6 months is $1.05/€, then this means that Cray Research will receive
$1.05/€ *€ 10 mil in 6 months

However, if the future €10 mil is sold through a forward contract already today, then Cray Research know
that they will receive $1.10/€ * €10 mil =$11.0 mil in 6 months

Thus, the expected gain is the difference between the 2 amounts:

Expected gain: €10 million ($1.10/€ - $1.05/€) = $0.5 mil

16.2. IBM purchased computer chips from NEC, a Japanese concern, and was billed ¥250 million payable in
3 months. Currently, the spot exchange rate is ¥105/$ and the 3-month forward rate is ¥100/$. The three-
month money market interest rate is 8 percent per annum in the US and 7% per annum in Japan.
The management of IBM decided to use the money market hedge to deal with this yen account payable.
a) Compute the dollar cost of meeting the yen obligation
b) Conduct the cash flow analysis of the money market hedge

1anno = 4 parti = 3 mesi ¼ dell’interesse annuale = (8/4 = 2) per US e (7/4= 1,75) per Japan

Answer: Let’s first compute the present value of ¥250 million. The maturity is 3 months
Interest value in japan = 1,75%

Present value: ¥250 million/ 1,0175 = ¥ 245, 700,245.70

So, if the above yen amount is invested today at the Japanese interest rate for 3 months, the maturity
value will be exactly equal to ¥250 million which is the amount payable for the computer chips.
To buy the above yen amount today, it will cost in $:
$2,340,002.34 = ¥245,700,245.70/ (¥105/$)
Thus, the dollar cost of meeting this yean obligation is $2,340,002.34 as of today

b)
transaction Cash Flow 0 Cash Flow 3 months
Buy ¥ spot with $ -$2,340,002.34 +¥245,700,245.70
Invest in Japan -¥245,700,245.70 +¥250,000,000
Pay ¥ -¥250,000,000
Net cash flow -$2,340,002.34 0
16.3. You are the CEO of a US company, and you plan to visit Lugano in 3 months to attend a conference.
You expect to incur the total cost of CHF 5,000 for hotel and meals during your stay. Today, the spot
exchange rate is $0.60/CHF, and the 3-month forward rate is $0.63/CHF.
You can buy the 3-month call option on CHF with the exercise rate of $0.64/CHF for the premium of $0.05
per CHF. Assume that your expected future spot exchange rate is the same as the forward rate.
The 3-month interest rate is 6% per annum in the US and 4% per annum in Switzerland.

a) Calculate your expected dollar cost of buying CHF 5,000 if you choose to hedge via call option on
CHF
b) Calculate the future dollar cost of meeting this CHF obligation if you decide to hedge using a
forward contract

a) It is important to note that we must value the expected cost, so we need to consider the time value
of money.
Total option premium = $0.05/CHF * CHF 5,000 = $250

The interest rate over 3 months in the USA = 6% / 4 = 1.5%. In three months $250 is worth $250 * 1.015
= $253.75

At the expected future spot rate of $0.63/CHF, which is less than the exercise price of $0.64/CHF, you
do not expect to exercise the option (we buy the option in case what we expect to happen, does not
actually happen). Rather, you expect to spend $0.63/CHF*CHF 5,000 = $3,150

Thus, the total expected cost of buying CHF 5,000 will be the sum of $3,150 and $253.75, i.e. $3,403.75

b) The costs of meeting a future obligation of CHF 5,000 in 3 months with a forward is simply the price
of the forward contract times the number of contracts:

$3,150 = $0.63/CHF * CHF 5,000

16.4. Suppose that you are an Italian investor who just sold Microsoft shares that you had bought six
months ago. You had invested €10,000 to buy Microsoft shares for $120 per share when the exchange rate
was $1.15/€. You sold the stock for $135 per share and converted the dollar proceeds into € at the
exchange rate of $1.06/€. Compute the realized return on your investment in €-terms

Answer: We are looking from the viewpoint of a European investor. Thus, to be able to apply the formula

We need to know:
Ri which is here the local currency return in the US and
ei which is here the rate of change in the exchange rates between the $ and €, in European terms

n.b. It is important to always remember the relation between American and European terms

Ri  the stock increased from $120 to $135, so the return in $ is: (135 – 120) / 120 = 0.125 or (12.5%)

ei  The $ appreciated from $1.15/€ to $1.06/€, so in terms of the €, it has changed from 1/ ($1.15/€) =
€0.8696/$ to 1/($1.06/€) = €0.9434/$

So, the change in FX rates is: (€0.9434/$ - €0.8696/$) = 0.0849 (or 8.49%)
Hence: Rie = (1+ Ri) (1 + ei) -1 = (1+0.125) (1+0.0849) – 1 = 0.221 (or 22.1%)

18.1. Read the article on the following slide and answer the following three questions by using the
terminology from the lecture notes: