Reference no: EM133188077

Foreign exchange

Question 1. What are the key differences between spot and forward FX markets? Suppose the direct quote for USD ($) in London is 0.6750-0.6760. What is the direct quote for GBP (£) in New York? Compute the bid-ask spread.

Question 2. One form of the interest rate parity equation appears as:

1 + r_US = 1/S_t*(1 + r_UK)*F_t

where both the spot and forward rates are expressed in terms of dollars for pounds or direct exchange rates. The local currency is the US dollar in this case. How would the equation be written if the exchange rates were indirect - that is pounds for dollars?

Question 3. Explain the concept of interest rate parity. What does this concept imply about the long-run profit opportunities from investing in international markets? What market conditions must prevail for the concept to be valid?

Question 4. Interest rate parity states that the relationship between interest rates, spot and forward rates is in equilibrium. Check weather this is true considering the following information. Consider the dollar is the domestic currency.

Current spot exchange rate $/£	1.2020
Interest rate in the UK	0.5%
Interest rate in the US	0.25%
Forward rate $/£	1.2027

Question 5. Lets do some arbitrage! The following table provides details for the $/£exchange rate and UK and US interest rates. Assume you can invest £1,000,000. Consider the dollar is the domestic currency.

 

Current spot exchange rate $/£	1.56
Interest rate in the UK	2.5%
Interest rate in the US	3.5%
Forward rate $/£	1.50
Amount to invest	£1,000,000

 

 

a. Check whether interest rate parity holds.
b. Construct an arbitrage strategy and determine the expected profit.

Question 6. Citybank recently purchased $10,000,000 worth of euro denominated one-year CDs that pay 10% interest annually. The current spot rate of the US dollars for euros is $1.104/€1.

a. What will be the return on the one-year CD if the dollar appreciates to the euro such that the spot rate of US dollars for euros at the end of the year is $1.004/e 1?

b. What will be the return on the one-year CD if the dollar depreciates relative to the euro such that the spot rate of US dollars for euros at the end of the year is $ 1.204/e 1?

Question 7 Wells Fargo has been borrowing in the US markets and lending abroad, thereby in- curring foreign exchange risk. In a recent transaction, it issued a one-year $2 million CD at 6% and is planning to fund a loan in British pounds at 8% for a 2% expected spread. The spot rate of US dollars for British pounds is $1.32/£1.

a. However, new information now indicates that the British pound will appreciate such that the spot rate of US dollars for British pounds is $1.30/£1 by year-end. What should the bank charge on the loan to maintain the 2% spread?

b. The bank has an opportunity to hedge using one-year forward contracts at 1.33 US dollars for British pounds. What is the spread if the bank hedges its forward foreign ex- change exposure?

c. How should the loan rates be increased to maintain the 2% spread if the bank intends to hedge its exposure using the forward rates?