Today's date is 1st December 2011. Reynolds Manufacturing has just imported $500,000 of Raw materials from an American company with payment due in three months time. The board are concerned about the adverse economic news relating to the UK economy and fear a steep depreciation of sterling, hence they are considering alternative ways to hedge their exposure.

Market Data at 1st December 2011

£/$ Exchange Rates Spot $1.5693

1m Forward $1.5689

3m Forward $1.5679

Currency Futures Prices (CME £62500 Sterling Contract)

March $1.5725

June $1.5712

Reynolds could also purchase a currency option to purchase $500,000 at an exchange rate of $1.5700 for a premium of £0.0191 per $.

Required

a) Explain the difference between OTC and exchange traded derivatives, clearly identifying the different risk associated with each.

b) From the above data set up the following hedges.

i) A forward hedge.

ii) A futures hedge.

iii) An option hedge.

c) Evaluate the outcome of the hedges in 12 months time if market rates have moved to:

i) Spot rate $1.6193

Futures Price $1.6205

ii) Spot rate $1.5193

Futures Price $1.5199

Your answer should include both a numerical and a written evaluation.

a) 'The process of arbitrage is of fundamental importance in international financial markets .'

Making reference to TWO important parity conditions in international financial markets fully explain the above statement.

b) The following market data was available on 20th December 2011

£/€ Exchange Rates

Spot €1.1971 12m Forward€1.1880

12m LIBOR Interest Rates

Sterling 1.8% Euro 2%

Required

i) Determine whether interest rate parity (IRP) is currently holding. ii) If IRP is not holding, how would you carry out covered interest arbitrage?

Show all the steps and determine the arbitrage profit.

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