Question

1. A U.S. company expects to pay 1 million Euros in six months. How can they use forward contracts to hedge against the exchange rate risk? 2. The price of gold is currently $660 per ounce. The forward price for delivery in one year is $700. An arbitrage trader can borrow or lend money at 10% per annum. Identify an arbitrage strategy. 3. A trader owns one unit of gold. The trader can buy gold at $50 per ounce and sell it at $40 per ounce in the spot market. She can borrow money at 6% per year and can invest money at 5% per year. For what range of one-year gold forward price F does this trader have no arbitrage opportunities?

Answer 1

Ans 1.

US Company expects to pay Euro 1 mn in six month

This company is not worried about scenario when Euro becomes cheaper with respect to dollars but with the other case when Euro becomes stronger than dollar

Therefore to avoid this scenario and hedge this exchange rate risk US company should get inolved into forward contracts where underlying asset is exchange rate USD/EUR

This US company should fix USD/EUR exchange rate to be accounted vaild on predetermined date in near future with the help of interest rate differentials in both these countries for duration of 6 months.

If actual exchange rate is lower than denoted in contract then USD is stroner then EUR and profit is booked whereas if USD/EUR actual exchage rate is higher than contracted one then company have not to worry because they are going to trade in forward contracted exchange rate of USD/EUR hence prominant losses are escaped due to forward contracts

Ans 2)

One can short sell gold in market today for $660 per ounce and invest that money into bank account which pays rate of 10% therefore after a year we have 660(1.1)=726 dollars in bank account. Now gold rate is 700/ounce which we can buy gold and complete the short sell contract and earn zero risk positive profit of 726-700=$26