What actions you need to take to speculate in forward market

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Reference no: EM133568637

Assignment: Business & Finance

I. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at 12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be 2 francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this situation? What would be the effect of shipping costs?

II. There are arguments for and against the alternative exchange rate regimes.

1. List the advantages of the flexible exchange rate regime.
2. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed exchange rate regime.
3. Rebut the above criticism from the viewpoint of the proponents of the flexible exchange rate regime.

Problems

I. The current spot exchange rate is $1.95/£ and the three-month forward rate is $1.90/£. On the basis of your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/£ in three months. Assume that you would like to buy or sell £1,000,000.

1. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation?

2. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.86/£?

II. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-month interest rate is 8.0 percent per annum in the U.S. and 5.8 percent per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.

1. Determine whether interest rate parity is currently holding.

2. If IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.

3. Explain how IRP will be restored as a result of covered arbitrage activities.

III. In the October 23, 1999, issue, The Economist reports that the interest rate per annum is 5.93 percent in the United States and 70.0 percent in Turkey. Why do you think the interest rate is so high in Turkey? On the basis of the reported interest rates, how would you predict the change in the exchange rate between the U.S. dollar and the Turkish lira?

IV. Omni Advisors, an international pension fund manager, uses the concepts of purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates. Omni gathers the financial information as follows:

• Base price level 100
• Current U.S. price level105
• Current South African price level111
• Base rand spot exchange rate$0.175
• Current rand spot exchange rate$0.158
• Expected annual U.S. inflation7%
• Expected annual South African inflation5%
• Expected U.S. one-year interest rate10%
• Expected South African one-year interest rate8%

Calculate the following exchange rates (ZAR and USD refer to the South African rand and U.S. dollar, respectively):

I. The current ZAR spot rate in USD that would have been forecast by PPP.

II. Using the IFE, the expected ZAR spot rate in USD one year from now.

III. Using PPP, the expected ZAR spot rate in USD four years from now.

Reference no: EM133568637

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