Forex question-strategic financial management-ca final

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.

Replies (4)

 

 

Option 2 is better

Borrow $ 1000    
       
Repay $ @ 4% 1040    
       
convert $0.8924 per EUR 1120.573734 EUR  
       
Invest EUR for 6 months @ 3.5% 1159.793814    
       
Sell FWD EUR   $0.8750 per EUR  
       
Getting $ 1014.819588    
       
Arbitrage Loss $ -25.18041237    
       
       
Option 2      
       
Borrow EUR 1000    
       
Repay EUR 1045    
       
convert $0.8924 per EUR 892.4 $  
       
Invest $ for 6 months @ 3% 919.172    
       
Sell FWD EUR   $0.8750 per EUR  
       
Getting EUR 1050.482286    
       
Arbitrage Gain EUR 5.48228571    

This was my answer

 (A) Borrow $, convert to euro, invest in euro, sell euro investment proceeds forward.

The above option has an arbitrage opportunity of earning profit in the money market.

Let us assume that $ 1000 is to be borrowed to find if there is any arbitrage opportunity.

1) Borrow $ 1000,this amount after interest will add upto =$1000 * 1.04 (4% US $ borrowing rate) = $ 1040

2) convert to EURO= $ 1000 * 0.8924 = EURO 892.4

3) Invest in Euro, total after interest = EURO 892.4 * 1.035 (3.5% EURO lending rate) =EURO 923.63

4) Sell EURO investment proceeds forward,so finally we receive in hand,

= EURO 923.63 / $ 0.8750(forward rate) = $ 1055.58

Arbitrage profit

What we pay       = $ 1040.00

what we receive = $ 1055.58

profit earned      = $    15.58

( Note=The point( b) is not an arbitrage opportunity because it incurs loss)

Originally posted by : shweta
This was my answer

 (A) Borrow $, convert to euro, invest in euro, sell euro investment proceeds forward.

The above option has an arbitrage opportunity of earning profit in the money market.

Let us assume that $ 1000 is to be borrowed to find if there is any arbitrage opportunity.

1) Borrow $ 1000,this amount after interest will add upto =$1000 * 1.04 (4% US $ borrowing rate) = $ 1040

2) convert to EURO= $ 1000 * 0.8924 = EURO 892.4

3) Invest in Euro, total after interest = EURO 892.4 * 1.035 (3.5% EURO lending rate) =EURO 923.63

4) Sell EURO investment proceeds forward,so finally we receive in hand,

= EURO 923.63 / $ 0.8750(forward rate) = $ 1055.58

Arbitrage profit

What we pay       = $ 1040.00

what we receive = $ 1055.58

profit earned      = $    15.58

( Note=The point( b) is not an arbitrage opportunity because it incurs loss)

Initially i did the same as you, but after reading FX quote I changed it..

quote = $ 0.8924 per EUR

EUR 1000 = 892.4 $

or 

$ 1000 = 1000/0.8924 = 1120.57 EUR

Got it..!!!!!!!thanks!!!!!

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