Refer to the following information
A Company has just signed a contract to buy equipment from B Company in Germany for €1,250,000. The contract was signed in June with payment due six months later in December. The firm is considering several hedging alternatives to reduce the exchange rate risk arising from the transaction. To help the firm make a hedging decision you have gathered the following information.
The spot exchange rate is $0.8924/€
The six month forward rate is $0.8750/€
The annualized Euro 6-month borrowing rate is 9% (or 4.5% for 6 months)
The annualized Euro 6-month lending rate is 7% (or 3.5% for 6 months)
The annualized U.S. 6-month borrowing rate is 8% (or 4% for 6 months)
The annualized U.S. 6-month lending rate is 6% (or 3% for 6 months)
1. A Co could hedge the Euro payables in the money market. Using the information given, how much would the firm pay in six months through money market hedge?
a. $1,120,888.89
b. $1,110,162.68
c. $1,110,111.11
d. $1,099,488.04
2. Given the information, which of the following is correct about a possible arbitrage opportunity?
a. Borrow $, convert to euro, invest in euro, sell euro investment proceeds forward.
b. Borrow euro, convert to $, invest in $, sell $ investment proceeds forward.
c. Don’t bother – there is no arbitrage opportunity.
I wanted to confirm the right answer for Q 2. Please provide the explanation for the answer.
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