Forex question-strategic financial management-ca final

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shweta

82 Points Joined September 2008

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)

CA. Sandeep Kumawat

341 Points Joined September 2007

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

shweta

82 Points Joined September 2008

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)

CA. Sandeep Kumawat

341 Points Joined September 2007

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)