Compute the synthetic forward rate
Course:- Financial Management
Reference No.:- EM131811069

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Questions -

Q1. Consider the following spot exchange rate quotes for the U.S. dollar (USD), the British pound (GBP), and the Euro (EUR)

EUR/USD  0.7725-30

GBP/USD  0.6205-10

GBP/EUR  0.8030-40

a) Is it possible to make triangular arbitrage profits trading at these quotes? (Avoid rounding in any of the intermediate calculations).

b) Use the EUR/USD and the GBP/EUR quotes to compute the bid and ask cross spot exchange rate GBP/USD.

c) Your client, David Hockney, a British painter, wants to convert 10 million USD from the sale of a painting into GBP. What is the best way to execute this transaction from the standpoint of your client, to use the direct GBP/USD quote or the cross rate computed in b)?

2. Consider the following quotes for the U.S. dollar and the Malaysian Ringgit pound (MYR):

One-year interest rate U.S.: 1.00 percent per annum.

One-year interest rate Malaysian Ringgit: 3.00 percent per annum.

Spot exchange rate: 0.3230 USD/MYR

One-year forward exchange rate: 0.3220 USD/MYR

a) Suppose you want to sell 1 million MYR forward. Compute the synthetic forward rate and compare it with the outright forward rate. Which is better?

b) Duit, a Malasyan company, is currently borrowing 1 million MYR in Malaysia at an interest rate of 4.0 percent. Would the company be better off if it borrowed dollars from a U.S. bank? (The amount of dollars borrowed has to be such that the company will still get 1 million MYR today).

3. GrowUP, a U.S. company is considering investing in a production plant in Poland. The investment costs 50 million U.S. dollars in year zero and generates an expected constant cash flow of 100 million Polish Zlotys (PLN) between year one and year three, inclusive.  The residual value of the project is zero.  You gathered the following data:

Risk free rate U.S.: 2 percent per annum

Risk free rate Poland: 6 percent per annum

Beta of the project: 0.8

Equity premium, U.S.: 3 percent per annum

Spot exchange rate: 3.3380 PLN/USD

a) Compute the cost of capital that is appropriate to discount the project's cash flows that are expressed in Polish Zlotys.

b) Compute the net present value of the project in U.S. dollars.

4. Oakly is an American winery that just sold 10 million Euros of Chardonnay wine to a European hotel chain. The payment will be received in three months, but, given the travails of the Euro area, Oakly wants to hedge its exchange rate risk.  You collected the following data:

Spot exchange rate: 1.3000 USD/EUR

Price of a put on the Euro with strike price 1.3 USD/EUR: 0.0617 USD

Price of a call on the Euro with strike price 1.3 USD/EUR: 0.0575 USD

U.S. interest rate: 1 percent APR

Euro interest rate: 2 percent APR

a) Assume that covered interest parity holds. Compute the three months forward rate.

b) Suppose that Oakly fully hedges with a forward contract, using the forward rate computed in a). How much revenue in USD will the company receive in three months?

c) Suppose that Oakly fully hedges with options. Which option should the company use, a call or a put on the EUR? What is the minimum revenue in USD (net of the cost of the options) that the company will receive in three months?

d) Draw a graph with the full hedge with forwards and the full hedge with options. Please be sure to label the axes appropriately.

International Finance problems including arbitrage, options and hedging in multiple currencies.

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