Question

You played a fierce game of H-O-R-S-E against Dr. Van Weaver and lost $100,000. Thank goodness you won $100,000 from Dr. Li betting on UEFA Champions League matches. Dr. VW has given you 90 days to pay and Dr. Li will pay you later today in U.S. dollars. Your F/X broker gives you following exchange and interest rate quotes.

a. What is the 90 day forward premium/discount on the Norwegian krones?

b. Obtain a forecast of the krone-dollar 3 month ahead spot exchange rate. What is the basis of your forecast? Briefly explain the rationale.

Taking Dr. Li’s payment, you decide to play the F/X or the U.S. money market to see if you can make some $$ before you have to pay Dr. VW.

c. First, carefully describe the steps you would take to make some profits with Dr. Li’s money before you have to pay Dr. VW. (No calculations needed.)

d. Now, calculate the actual profits you might earn using your investment strategy outlined in part c. (Hint: You should construct a chart to help guide you with calculations. For full credit, show all your formula and calculations.)

e. Given the above, describe how the F/X and the money markets in the two currencies will adjust. Why do you think the markets will adjust in this way? (Hint: You need not be exact – saying “up” or “down” will be sufficient.)

Answer 1

1)

I assume here that USD is the domestic currency and Krone is the foreign currency. Thus, we have Fwd premium or discount = Fwd rate( 90 days hence) – Spot rate

= 6.0186 – 6.0312 = -0.0126

Negative sign indicates it’s forward discount = $0.0126 which makes sense as the foreign risk free rate is less than the domestic risk free rate.

2)

The forward rate is actually the forecast of the spot rate 3 months from now. Thus, 6.0186 is the forecast. The basis of this forward rate ( forecasted spot rate ) is the covered interest parity ensuring that no arbitrage opportunity to make riskless profit exists in the foreign exchange market.

3)

For this I assume that you are in Norway and Krone is the domestic currency. Steps.

-Take the money today from Mr. Li, convert it into krones using the Spot rate today.

- Invest the money for 3 months at the Norwegian rate of 4.45%

- Enter into a forward contract to buy 100,000 USD 3 months from today at the fwd rate of 6.0186 Krones / USD.

- Pay Dr. Weaver 100K at the end of 90 days and pocket the difference

4.

Here are the actual calculations of steps above.

You convert into Krones today to get 6.0312*100,000 = 603120 Krones

Invest it. The total amount you end up with after 90 days = 603120 *[1+ (90/360)*0.0445] = 609829.71

After 90 days, you can buy get the USD at 6.0186. You pay 6.0186 * 100,000 = 601860 Krones

You pocket 609829.71 - 601860 = 7969.71 Krones. That’s your gain.