Reference no: EM131696916

Question: Read the market example below and answer the following questions that relate to it. Proprietary dealers are betting that Euribor, the proposed continental European-based euro money market rate, will fix above the Euro BBA LIBOR alternative... The arbitrage itself is relatively straightforward. The proprietary dealer buys the Liffe September 1999 Euro mark contract and sells the Matif September 1999 Pibor contract at roughly net zero cost. As the Liffe contract will be referenced to Euro BBA LIBOR and the Matif contract will be indexed to Euribor, the trader in effect receives Euribor and pays Euro BBA LIBOR. The strategy is based on the view that Euribor will generally set higher than Euro BBA LIBOR. Proprietary dealers last week argued that Euribor would be based on quotes from 57 different banks, some of which, they claimed, would have lower credit ratings than the eight LIBOR banks. In contrast, Euro BBA LIBOR will be calculated from quotes from just 16 institutions. (From Thomson Reuters IFR, December 18, 1998)

a. Show the positions of the proprietary dealers using position diagrams.

b. In particular, what is on the horizontal axis of these diagrams? What is on the vertical axis?

c. How would the profits of the "prop" dealers be affected at expiration, if in the meantime there was a dramatic lowering of all European interest rates due, say, to a sudden recession?