You would like to hedge your risk

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Reference no: EM132003977

CIRP, UIRP and UH

You are a Northern Italian company specializing in luxury products that is exposed to exchange rate risk due to operations in USA. The area where you are located (Padania) has recently declared independence from Italy. The new currency is the Celtic Franc (CLF) and it’s free floating. The USDCLF exchange rate is 10.6. The new government starts issuing gov’t bonds; the 90 days bond offers 2.5%. A US bond with 90 days of maturity offers, instead, 1.5%.

A. You would like to hedge your risk, but there is practically no market for USDCLF forwards. How can you fabricate a forward and what would be the 90 days forward rate?

B. Assume that there are transactions costs. The USDCLF spot rate is 10.5/13.0. Buying (i.e. lending) a Padania bond with 90 days of maturity yields 2.5%, selling (i.e. borrowing) costs 3.0%. The lending and borrowing rate for the US are, respectively, 1.5% and 2.0%. What is the best 90 days forward bid that would be consistent with no-arbitrage.

Reference no: EM132003977

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