Problems

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?

 Solution:
The market conditions are summarized as follows:
I$ = 4%; i = 3.5%; S = 1.01/$; F = 0.99/$.
If $100,000,000 is invested in the U.S., the maturity value in
six months will be $104,000,000 = $100,000,000 (1 + .04).
Alternatively, $100,000,000 can be converted into euros and
invested at the German interest rate, with the euro
maturity value sold forward.
In this case the dollar maturity value will be $105,590,909 =
($100,000,000 x 1.01)(1 + .035)(1/0.99)
Clearly, it is better to invest $100,000,000 in Germany with
exchange risk hedging.

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 threemonth forward exchange rate is $1.40/.
In London, the money market interest rate is 2.0% for a threemonth 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) (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.
(c) Evaluate each payment method. Which method would you
prefer? Why?

The problem situation is summarized as follows:

A/P = 35,000 payable in three months
iNY = 0.35%/month, compounding monthly
iLD = 2.0% for three months
S = $1.45/; F = $1.40/.
Option a: When you buy 35,000 forward, you will need
$49,000 in three months to fulfill the forward contract. The
present value of $49,000 is computed as follows: $49,000/
(1.0035)3 = $48,489. Thus, the cost of Jaguar as of today is
$48,489.
Option b: The present value of 35,000 is 34,314 =
35,000/(1.02). To buy 34,314 today, it will cost $49,755 =
34,314x1.45. Thus the cost of Jaguar as of today is $49,755.
You should definitely choose to use option a, and save
$1,266, which is the difference between $49,755 and
$48489.

 Currently, the spot exchange rate is $1.50/ and the

three-month forward exchange rate is $1.52/. The threemonth interest rate is 8.0% per annum in the U.S. and
5.8% per annum in the U.K.
Assume that you can borrow as much as $1,500,000 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.

S = $1.5/; F = $1.52/;
I$ = 2.0%; I = 1.45%
Credit = $1,500,000 or 1,000,000.
a. (1+I$) = 1.02
(1+I)(F/S) = (1.0145)(1.52/1.50) = 1.0280
Thus, IRP is not holding exactly.
Since (1+I$) = 1.02 is cheaper, borrow USD directly.
b. (1) Borrow $1,500,000; repayment will be
$1,530,000.
(2) Buy 1,000,000 spot using $1,500,000.
(3) Invest 1,000,000 at the pound interest rate of
1.45%; maturity value will be 1,014,500.
(4) Sell 1,014,500 forward for $1,542,040
Arbitrage profit will be $12,040

 Following the arbitrage transactions

described above,
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
IRP holds.

 Suppose that the current spot exchange rate is 0.80/$ and

the three-month forward exchange rate is 0.7813/$.
The three-month interest rate is 5.6 percent per annum in
the United States and 5.40 percent per annum in France.
Assume that you can borrow up to $1,000,000 or 800,000.
a. Show how to realize a certain profit via covered interest
arbitrage, assuming that you want to realize profit in terms
of U.S. dollars. Also determine the size of your arbitrage
profit.
b. Assume that you want to realize profit in terms of euros.
Show the covered arbitrage process and determine the
arbitrage profit in euros.

 In the issue of October 23, 1999, the

Economist reports that the interest
rate per annum is 5.93% in the United
States and 70.0% in Turkey. Why do
you think the interest rate is so high in
Turkey? Based on the reported interest
rates, how would you predict the
change of the exchange rate between
the U.S. dollar and the Turkish lira?

 A high Turkish interest rate must

reflect a high expected inflation in
Turkey. According to international
Fisher effect (IFE), we have
E(e) = i$ - iLira = 5.93% - 70.0% =
-64.07%
The Turkish lira thus is expected to
depreciate against the U.S. dollar by
about 64%.

 As of November 1, 1999, the

exchange rate between the Brazilian
real and U.S. dollar is R$1.95/$. The
consensus forecast for the U.S. and
Brazil inflation rates for the next 1year period is 2.6% and 20.0%,
respectively. How would you forecast
the exchange rate to be at around
November 1, 2000?

 Since the inflation rate is quite high in Brazil, we

may use the purchasing power parity to forecast
the exchange rate.
E(e) = E(P$) - E(PR$)
= 2.6% - 20.0%
= -17.4%
Brazil Real depreciates 17.4% against USD
E(ST) = So(1 + E(e))
= (R$1.95/$) (1 + 0.174)
= R$2.29/$
(Since the exch rate is specified in terms of USD/R$)

 Suppose that the current spot exchange rate is 1.50/

and the one-year forward exchange rate is 1.60/. The
one-year interest rate is 5.4% in euros and 5.2% in
pounds. You can borrow at most 1,000,000 or the
equivalent pound amount, i.e., 666,667, at the current
spot exchange rate.
a. Show how you can realize a guaranteed profit from
covered interest arbitrage. Assume that you are a eurobased investor. Also determine the size of the arbitrage
profit.
b. Suppose you are a pound-based investor. Show the
covered arbitrage process and determine the pound
profit amount.

First, note that (1+i ) = 1.054 is less than (F/S)(1+i ) =

(1.60/1.50)(1.052) = 1.1221.
You should thus borrow in euros and lend in pounds.
1) Borrow 1,000,000 and promise to repay 1,054,000 in one
year.
2) Buy 666,667 spot for 1,000,000.
3) Invest 666,667 at the pound interest rate of 5.2%; the maturity
value will be 701,334.
4) To hedge exchange risk, sell the maturity value 701,334
forward in exchange for 1,122,134.
The arbitrage profit will be the difference between 1,122,134 and
1,054,000, i.e., 68,134.
The pound-based investor will carry out the same transactions 1),
2), and 3) in a. But to hedge, he/she will buy 1,054,000 forward
in exchange for 658,750. The arbitrage profit will then be
42,584 = 701,334 - 658,750.

Compare this to 1.0150; IRP doesnt hold

IF IRP doesnt hold, can we see which one is cheaper not
always, but in this case :
Because 1.0133 < 1.0150, we can say that the SFr interest
rate quote is more than what it should be as per the quotes
for the other three variables. Equivalently, we can also say
that the $ interest rate quote is less than what it should be
as per the quotes for the other three variables. Therefore,
the arbitrage strategy should be based on borrowing in the $
market and lending in the SFr market.

Borrow $1,000,000 for six months at 3.5% per year. Need to pay
back $1,000,000 (1 + 0.0175) = $1,017,500 six months
later.
Convert $1,000,000 to SFr at the spot rate to get SFr 1,662,700.
Lend SFr 1,662,700 for six months at 3% per year. Will get back
SFr 1,662,700 (1 + 0.0150) = SFr 1,687,641 six months later.
Sell SFr 1,687,641 six months forward. The transaction will be
contracted as of the current date but delivery and settlement
will only take place six months later.
So, six months later,
exchange SFr 1,687,641 for SFr 1,687,641/SFr 1.6558/$ =
$1,019,230.
The arbitrage profit six months later is 1,019,230 1,017,500 =
$1,730.

 Rolls-Royce, the British jet engine manufacturer,

sells engines to U.S. airlines and buys parts
from U.S. companies. Suppose it has accounts
receivable of $1.5 billion and accounts payable
of $740 million. It also borrowed $600 million.
The current spot rate is $1.5128/.
a. What is Rolls-Royce's dollar transaction
exposure in dollar terms? In pound terms?
Suppose the pound appreciates to $1.7642/.
What is Rolls-Royce's gain or loss, in pound
terms, on its dollar transaction exposure?

 Rolls-Royce has $160 million in dollar

transaction exposure ($1.5 billion - $740
million - $600 million). In pound terms, its
transaction exposure equals 105.76
million (160,000,000/1.5128).
Translated at the new exchange rate, the
value of its transaction exposure is now
90.69 million. Compared to the former
value of its transaction exposure, the
result is a loss of 15.07 million (90.69
million - 105.76 million).

 Company X is a high risk firm who wants a

fixed rate, long term loan. Its borrowing rate is
11.50 % in the fixed rate market. It is presently
borrowing at a floating rate of prime plus 2.00
%. Company Y prefers a floating rate loan,
where it can borrow at prime plus 0.50 %, yet
it is currently paying a rate of 9.75 % in the
fixed rate market. You are the manager of a
swap desk for a major bank. Work out a swap
which would generate a 5 basis point profit to
the bank, and split the rest equally between
both counter parties (companies X and Y).
Draw up all the swap transactions

Fixed
Floating
X 11.5 P+2.00
Y 9.75 P+.5
Diff 1.75 1.5
Diff = 25 bp, split as 5 bp to bank, 10
to each X/Y
X effective 11.4; bank pays P+2
Y effectiveP+.4; bank pays Y 9.75%;

 Dell Computers would like to borrow pounds, and Virgin

Airlines wants to borrow dollars. Because Dell is better
known in the United States, it can borrow on its own
dollars at 7 percent and pounds at 9 percent, whereas
Virgin can on its own borrow dollars at 8 percent and
pounds at 8.5%
Suppose Dell wants to borrow 10 million for two years,
Virgin wants to borrow $16 million for two years, and the
current exchange rate is $1.60. What swap transaction
would accomplish this objective? Assume the
counterparties would exchange principal and interest
payments with no rate adjustments.
What savings are realized by Dell and Virgin?

Dollar

Pound

Dell

Virgin

8.5

QSD is 1.5 : here, no firm has absolute advantage; both have only relative
advantage
Virgin would borrow 10 million for two years and Dell would borrow $16
million for two years. The two companies would then swap their proceeds
and payment streams.
Assuming no interest rate adjustments, Dell would pay 8.5% on the 10
million and Virgin would pay 7% on its $16 million. Given that its alternative
was to borrow pounds at 9%, Dell would save 0.5% on its borrowings, or an
annual savings of 50,000. Similarly, Virgin winds up paying an interest rate
of 7% instead of 8% on its dollar borrowings, saving it 1% or $160,000
annually.

Dell

Give 16 USD, get 10

GBP; get 7% int; get
back 16 USD
Give 10 GBP, get 8.5%
GBP; int; get back 10
GBP

Virgin

Dollar

Pound

Dell

Virgin

8.75

9.5

QSD 2.25; dell has absolute adv

Suppose, in fact, that Dell can borrow dollars at 7 percent and
pounds at 9 percent, whereas Virgin can borrow dollars at 8.75
percent and pounds at 9.5 percent. What range of interest rates
would make this swap attractive to both parties?
Ignoring credit risk differences, Virgin would have to provide Dell
with a pound rate of less than 9%. Given that Virgin has to borrow
the pounds at 9.5%, it would have to save at least 0.5% on its
dollar borrowing from Dell to make the swap worthwhile. If Dell
borrows pounds from Virgin at 9% - x. then Virgin would have to
borrow dollars from Dell at 8.75% - (0.5% + x) to cover the 0.5%
+ x difference between the interest rate at which it was
borrowing pounds and the interest rate at which it was lending
those pounds to Dell.
Therefore max that virgin can pay for its dollars is 8.25

 Based on the scenario in part (c), suppose Dell borrows

dollars at 7 percent and Virgin borrows pounds at 9.5
percent. If the parties swap their current proceeds, with
Dell paying 8.75 percent to Virgin for pounds and Virgin
paying 7.75 percent to Dell for dollars, what are the cost
savings to each party?
Under this scenario, Dell saves 0.25% on its pound
borrowings and earns 0.75% on the dollars it swaps with
Virgin, for a total benefit of 1% annually. Virgin loses
0.75% on the pounds it swaps with Dell and saves 1% on
the dollars it receives from Dell, for a net savings of
0.25% annually.
Is there any component of exchange rate risk? ALM risk?

 In May 1988, Walt Disney Productions sold to Japanese investors

a 20-year stream of projected yen royalties from Tokyo
Disneyland. The present value of that stream of royalties,
discounted at 6 percent (the return required by the Japanese
investors), was 93 billion. Disney took the yen proceeds from
the sale, converted them to dollars, and invested the dollars in
bonds yielding 10 percent. According to Disney's chief financial
officer, Gary Wilson, "In effect, we got money at a 6 percent
discount rate, reinvested it at 10 percent, and hedged our royalty
stream against yen fluctuations--all in one transaction.
At the time of the sale, the exchange rate was 124 = $1. What
dollar amount did Disney realize from the sale of its yen
proceeds?
What kind of product is this?
Is Gary Wilson right?

 Disney realized 93,000,000,000/124 = $750,000,000

from the sale of its future yen proceeds.
In a currency/interest rate swap, one party trades a
stream of payments in one currency, at one interest
rate, for a stream of payments in a second currency,
at a second interest rate. Disney's stream of yen
royalties can be treated as a yen bond, which it
traded for a dollar bond, with dollar payments. The
only difference between the Disney swap and a
traditional swap is that the latter usually involve cash
outflows whereas the Disney swap involves cash
inflows.

 Gary Wilson is comparing a 6% yen

interest rate with a 10% dollar interest
rate. The international Fisher effect
tells us that the most likely reason that
the yen interest rate is 4 percentage
points less than the equivalent dollar
interest rate is because the market
expects the dollar to depreciate by
about 4% annually against the yen.

Interest and currency rate

swap
Suppose that IBM would like to borrow fixedrate yen, whereas Korea Development Bank
(KDB) would like to borrow floating-rate
dollars. IBM can borrow fixed-rate yen at 4.5
percent or floating-rate dollars at LIBOR +
0.25 percent. KDB can borrow fixed-rate yen
at 4.9 percent or floating-rate dollars at LIBOR
+ 0.8 percent.
a. What is the range of possible cost savings
that IBM can realize through an interest
rate/currency swap with KDB?

Fixed yen

FRN dollar

KDB

4.9

L+0.8

IBM

4.5

L+0.25

Difference

0.4

0.55

Absolute adv : IBM;

relative adv : floating dollar: IBM; fixed yen: KDB
IBM wants : fixed yen, KDB wants : floating dollar
Differential : 0.15
Decide the swap such that IBM gets 0.1 and KDB
gets 0.05 advantage
Effective rates
IBM will pay 4.5 0.1 = 4.4% yen;
KDB will pay L+0.75 dollar
IBM transaction: -(L+.25)-4.4+(L+0.25) = -4.4
KDB -4.9 + 4.4 (L+0.25) = - (L+0.75)

 Companies A and B face the following interest

rates
A
B
U.S. Dollars
(floating rate)
Canadian
dollars (fixed
rate)

LIBOR +
0.5%

LIBOR + 1.0%

5%

6.50%

Assume that A wants to borrow U.S. dollars at a

floating rate of interest and B wants to borrow
Canadian dollars at a fixed rate of interest. A
financial institution is planning to arrange a swap
and requires a 50-basis point spread. If the swap
is equally attractive to A and B, what rates of
interest will A and B end up paying?

 Type: simple Currency + interest

swap
Differential spread 1.5 - .5 = 1%
Each gets 25 bp and FI gets 50 bp in
the swap
Eff rates: A L+0.25; B 6.25, FI 50
bp
A: - 5 + 5 (L+0.25) = -(L+0.25)
B : -(L+1) - 6.25 + (L+1) = 6.25

Value of swap to the bank

Suppose that the term structure of Libor/swap
interest rates is flat in both Japan and the United
States. The Japanese rate is 4% per annum and
the US rate is 9% per annum (both with
continuous compounding). Sometime ago a
financial institution has entered into a currency
swap in which it receives 5% per annum in yen
and pays 8% per annum in dollars once a year.
The principals in the two currencies are $10
million and 1,200 million yen. The swap will last
for another 3 years and the current exchange rate
is 110 yen = $1. Compute the value of this swap.

Value of swap to the bank

Libor

Principal
amount ($)

Rate

US

9%

$100,00,000

8%

Japan

4%

12000,00,000

5%

Time

CF on dollar
bonds

PV ($)

CF on Yen bond
(yen)

Exchange rate =

PV (yen)

$8,00,000

$7,31,144.95

600,00,000

576,47,366.35

$8,00,000

$6,68,216.17

600,00,000

553,86,980.78

$108,00,000

$82,44,498.54

12600,00,000

11175,19,750.26

Total

$96,43,859.66

Value of swap =

$15,42,995.77

12305,54,097.40

110 yen/dollar

Equity investment
Suppose you are a euro-based investor who just
sold Microsoft shares that you had bought six
months ago. You had invested 10,000 euros to
buy Microsoft shares for $120 per share; the
exchange rate was $1.15 per euro. You sold the
stock for $135 per share and converted the dollar
proceeds into euro at the exchange rate of $1.06
per euro. First, determine the profit from this
investment in euro terms. Second, compute the
rate of return on your investment in euro terms.
How much of the return is due to the exchange
rate movement?

This indicates that this euro-based investor benefited from an

appreciation of dollar against the euro, as well as from an
appreciation of the dollar value of Microsoft shares. The
profit in euro terms is about C2,100, and the rate of return
is about 21% in euro terms, of which 8.5% is due to the
exchange rate movement.

Mr. James K. Silber, an avid international

investor, just sold a share of Nestl, a
Swiss firm, for SF5,080. The share was
bought for SF4,600 a year ago. The
exchange rate is SF1.60 per U.S. dollar
now and was SF1.78 per dollar a year
ago. Mr. Silber received SF120 as a cash
dividend immediately before the share
was sold. Compute the rate of return on
this investment in terms of U.S. dollars.

 Mr. Silber must have paid $2,584.27

(=4,600/1.78) for a share of Nstle a
year ago. When the share was
liquidated, he must have received
$3,250 [=(5,080 + 120)/1.60].
Therefore, the rate of return in dollar
terms is:
R($) = [(3,250-2,584.27)/2584.27] x 100
= 25.76%.

In the above problem, suppose that Mr.

Silber sold SF4,600, his principal
investment amount, forward at the
forward exchange rate of SF1.62 per
dollar. How would this affect the dollar
rate of return on this Swiss stock
investment? In hindsight, should Mr. Silber
have sold the Swiss franc amount forward
or not?
Why or why not?

The dollar profit from selling SF4,600

forward is equal to:
Profit ($) = 4,600 (1/1.62 1/1.60)
= 4,600 (0.6173 0.625)
= -$35.42.
Thus, the total return of investment is:
R($) = [(3,250-2,584.2735.42)/2584.27] x 100 = 24.39%.

Zeda, Inc., a U.S. MNC, is considering making a

fixed direct investment in Denmark. The Danish
government has offered Zeda a concessionary
loan of DKK15,000,000 at a rate of 4 percent per
annum. The normal borrowing rate is 6 percent in
dollars and 5.5 percent in Danish krone. The loan
schedule calls for the principal to be repaid in
three equal annual installments. What is the
present value of the benefit of the concessionary
loan? The current spot rate is DKK5.60/$1.00 and
the expected inflation rate is 3% in the U.S. and
2.5% in Denmark.

 Use IFE to calculate the expected rates for DKK/USD 1, 2, 3 yrs

into the future
E(e) = Inf USD Inf DKK = 3.0 2.5 = 0.5 appreciation in DKK;
Expected rate = So(1-E(e))^t

The dollar value of the concessionary loan is $2,678,574 =

DKK15,000,000 5.60. The dollar present value of the
concessionary loan payments is $2,605,366. Therefore, the
present value of the benefit of the concessionary loan is
$73,208 = $2,678,574 2,605,366.

FRA
A bank sells a three against six $3,000,000 FRA for a
three-month period beginning three months from
today and ending six months from today. The purpose
of the FRA is to cover the interest rate risk caused by
the maturity mismatch from having made a threemonth Eurodollar loan and having accepted a sixmonth Eurodollar deposit. The agreement rate with
the buyer is 5.5 percent. There are actually 92 days in
the three-month FRA period. Assume that three
months from today the settlement rate is 0.4875
percent. Determine how much the FRA is worth and
who pays who--the buyer pays the seller or the seller
pays the buyer.

FRA
Since the settlement rate is less than
the agreement rate, the buyer pays
the seller the absolute value of the
FRA. The absolute value of the FRA
is:
$3,000,000 x [(.04875-.055) x
92/360] /
[1 + (.04875 x 92/360)]
= $3,000,000 x [-.001597/(1.012458)]
= $4,732.05.

A three-against-nine FRA has an

agreement rate of 4.75 percent. You
believe six-month LIBOR in three months
will be 5.125 percent. You decide to take a
speculative position in a FRA with a
$1,000,000 notional value. There are 183
days in the FRA period. Determine whether
you should buy or sell the FRA and what
your expected profit will be if your forecast
is correct about the six-month LIBOR rate.

Since the agreement rate is less than

your forecast, you should buy a FRA.
If your forecast is
correct your expected profit will be:
$1,000,000 x [(.05125-.0475) x
183/360]/
[1 + (.05125 x 183/360)]
= $1,000,000 x [.001906/(1.026052)]
= $1,857.61

Bonds and FX
Consider 8.5 percent Swiss franc/U.S.
dollar dual-currency bonds that pay
$666.67 at maturity per SF1,000 of par
value. What is the implicit SF/$ exchange
rate at maturity? Will the investor be
better or worse off at maturity if the
actual SF/$ exchange rate is
SF1.35/$1.00?
Implicit exchange rate : SF1.5, worse off if
SF 1.35/USD