Question:
a) With the help of illustrative and numerical examples explain fully the concepts of spatial and triangular parity and arbitrage in the context of foreign exchange.
b) Derive the covered interest parity condition between 3-month Swiss Franc deposits and 3-month US$ deposits, using the following notation. The direction of arbitrage can be assumed to be from Swiss Francs to US Dollars. Transaction costs are zero.
S($/SF) - Spot exchange rate between US$ and Swiss Francs
F3/12($/SF) - 3 month forward exchange rate between US$ and Swiss Francs.
i$ - 3 month dollar rate(% per annum)
iSF -3 month Swiss Franc rate(% per annum)
c) The Parson Company is a US company with jewellery stores located across the US. In April 2004, the company signed a contract with Swiss Watch Inc. to purchase 100,000 watches in 3 months' time at a cost of 30SF per watch. The payment is to be made upon delivery. Current $ and SF rates are both 6% per annum. The $/SF spot exchange rate is $0.66667/SF. Forward rates are determined by interest parity.
i) What is the exchange rate risk facing Parson company?
ii) Using the covered interest parity condition derived in part(a), obtain the 3 month $/SF forward rate.
iii) Explain carefully how the Parson's company could hedge its exchange rate risk using forward contracts.
iv) The Management of Pearson Plc has heard of a money market hedge which can be used to cover the above transaction. Assuming that borrowing interest rate and deposit rate in Switzerland are 8% and 6% respectively and that in the US are 10% and 6% respectively. Explain to your manager the process of a money Markey hedge, making clear any assumptions.