Question

Suppose S0$∕£=$1.25∕£,F1$∕£=$1.20∕£,i£=11.56 percent, and i$=9.82percent. You are to receive £100,000 in one year on a shipment of Cornish hens.

a.Form a forward market hedge. Identify which currency you are buying and which currency you are selling forward. When will currency actually changeh ands—today or in one year?

b.Form a money market hedge that replicates the payoff on the forward hedge by using the currency and Eurocurrency markets. Identify each contract inthe hedge. Does the hedge eliminate your risk exposure?

c.Are these currency and Eurocurrency markets in equilibrium? How would you arbitrage the difference from the parity condition?

Please have an explanation for each

Answer 1

(a) :- Form a forward market hedge. Identify which currency you are buying and which currency you are selling forward. When will currency actually changeh ands—today or in one year?

You are getting £100,000 in one year, so sell £100,000 forward and purchase dollars. In one year, you will get £100,000 from sale of Cornish hens. You would then be able to convert this sum into (£100,000)($1.20/£) = $120,000 through the forward contract. You have disposed of your exposure to the value of the pound.

(b) :- Form a money market hedge that replicates the payoff on the forward hedge by using the currency and Eurocurrency markets. Identify each contract inthe hedge. Does the hedge eliminate your risk exposure?

A money market fence borrows in one currency, invests in another, and nets the transactions in the spot market. The result is the equivalent of a forward contract. The forward contract that you need to replicate is a forward sale of £100,000. This can be replicated as follows:

Borrow (£100,000)/(1 + i£) = £89,638 at the i£ = 11.56% pound authentic interest rate.

Convert to (£89,638) ($1.25/£) = $112,047 at S0$/£ = $1.25/£

Put resources into dollars at the U.S. dollar rate of i$ = 9.82%

The net result is replicated forward contract to purchase dollars with selling pounds.

Note this is on more ideal terms than the forward contract. Forward costs are not in equilibrium with the interest rate differential. In this circumstance, it is smarter to support through the money markets than through the forward markets.

(c) :- Are these currency and Eurocurrency markets in equilibrium? How would you arbitrage the difference from the parity condition?

These markets are not in equilibrium. F1$/£/S0$/£ = ($1.20/£)/($1.25/£) = 0.96 <= 0.98440 = (1.0982)/(1.1156) = (1 + i$)/(1 + i£), so you should purchase pounds at the generally low forward value, sell pounds at the moderately high spot cost, put resources into dollars at the moderately high dollar interest rate, and borrow pounds at the moderately low pound interest rate. Through these transactions, you can win covered interest arbitrage of $3,050.

Borrow (£100,000)/(1 + i£) = £89,638 at the i£ = 11.56% pound real interest rate.

Convert to (£89,638) ($1.25/£) = $112,047 at S0$/£ = $1.25/£

Put resources into dollars at the U.S. dollar rate of i$ = 9.82%

Purchase pound at F = $1.20/£

As should be obvious, the covered interest arbitrage is $3,050.

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