Study Questions
Question 1
Assume you are an importer in Turkey. You have imported washing and cleaning
preparations worth of $300,000. Your payment to the US firm (in US dollar) is due in three
months.
Three month maturity TRY interest rate is 17% (annual) and same maturity USD interest rate
is 0.25% (annual). For simplicity assume that the borrowing and lending interest rates are the
same. Spot exchange rate is 7.08TL/US$ and three-month forward exchange rate is
7.36TL/US$ in the foreign exchange market. The company is cash rich and in case of excess
need for cash the company gives up interest income rather than borrowing.
There are also currency options available in the financial market.
Exercise price of a call option with a maturity of 3 months is 7.40TL per US$. The call
premium is 0.1121TL per US$.
Exercise price of a put option with a maturity of 3 months is 7.40TL per US$. The put
premium is 0.2623TL per US$.
What can you do in order to hedge this exchange rate exposure so that you can redenominate
this three-month payable into a Turkish Lira denominated payable with three-month maturity?
Describe your possible strategies to hedge this transaction exposure. Please show your
computations and pick the best strategy under the given financial conditions above. If possible
draw a chart, showing possible outcomes of your transaction exposure strategies under
different levels of exchange rate possibilities in three months.
Answer 1
300.000USD Payable owed to be paid in 3 months. TRY interest rate is 17% and USD
interest rate is 0.25%. Spot Rate is 7.08TRY/USD and 3 mo forward rate is 7.36TL/US$.
Relative hedging instrument is the call option. Strike is 7.40TL per USD and premium is
0.1121TL per USD.
1) Remain unhedged (Uncertain outcome)
The greater the depreciation the higher will be your payable. Worse for your exposure.
2) Buy your $300K payable forward.
300,000 x 7.36= 2,208,000TRY cost will be fixed/guaranteed 3 months later
3) Money Market Hedge
Need to buy PV(300,000USD)=300,000/(1+,0025/4)=299,812.62 USD
Costs 2,122,672TRY at spot 7.08TRY/USD today.
Will cost 2,212,887TRY in 3 months @17% annual interest in 3 months.
C1
Study Questions
4) Option Hedge
Buy call options for 300,000 USD.
Premium is 0.1121 TRY per USD. Total premium paid today for $300K is
33,630TRY. Equivalent cost in 3mos is 35,059TRY=33,630*(1+0,17/4)
When exchange rate is greater than 7,40, the call option will be exercised at strike
price 7,40TRY/USD and $300K payable will cost 2,220,000TRY, which will be the
maximum cost for the payable. If the exchange rate will be lower than the strike price,
then the option will not be exercised and instead the $300K will be purchased at the
spot market which is cheaper. Hence the maximum cost will be
2,220,000+35,059TRY=2,255,059TRY.
Option Hedge=Forward Hedge
7,2431*300,000+35,059TRY= 2,208,000TRY
7,2431 is the exchange rate when the importer is indifferent between a forward hedge
and option hedge.
7,2594*300,000+35,059TRY= 2,212,887TRY
7,2594 is the exchange rate when the importer is indifferent between a money market
hedge and option hedge.
Forward hedge costs less than money market hedge. Hence forward hedge dominates
money market hedge.
C2
Study Questions
7,2431 forward hedge=option hedge
7,2594 money market hedge=option hedge
7,3600 forward hedge=remain unhedged
7,3763 money market hedge=unhedged
7,5169 option hedge=unhedged
Question 2
The practice of investing in a currency that offers the higher return on a covered basis is
known as covered interest arbitrage. Currently, the six month Euro Libor rate is -0.52% per
annum, and the six month TR libor rate is 18.06% per annum. If the spot rate is 8.5013TRY
per Euro and the forward rates are as stated below,
Forward Points
EURTRY 1M FW
1003
D
EURTRY 3M FW
3411
D
EURTRY 6M FW
7096
D
EURTRY 1Y FW 1450
D 7
a) What is 6M Forward rate for euro?
b) Do you have a covered interest arbitrage opportunity?
c) If yes, how?
d) How much is the arbitrage amount you can enjoy if you can borrow upto 1 million
euros or its equivalent Turkish Lira?
C3
Study Questions
Answer 2
a) 8,5013+0,7096=9,2109
b) Interest rate difference=18,58% Forward Premium=2*0,7096/8,5013=16,69%
Yes since interest rate difference is greater than forward premium
c) Since interest rate difference is greater than forward premium, invest in higher
yielding currency(₺) and borrow (€).
d)
Arbitrage is either 8,904€ or 82,013₺. If you long 997,400 € right enough to payback
your € loan, you will end up with extra 82,016₺(9,268,967-9,186,952) extra money. If
you sell all your accumulated ₺, you end up with extra 8,904€ (1,006,304-997,400)
more than enough to payback your € loans.
Today 6 months later
-0,52%
Borrow 1 million € Payback 997,400 €
Sell € @S= 8,5013₺/€ Buy € @F= 9,2109₺/€
18,06%
8,501,300₺ invested 9,268,967₺ accumulated
C4
Study Questions
Question 3
Assume the following bid-ask quotes and calculate how the market trader can now make an
intermarket arbitrage profit.
Bid/Ask
EUR/USD 1.2097-99
USD/JPY 104.79-81
EUR/JPY 126.65-67
Assumptions Values
Funds available USD 1.000.000,00
Answer 3
EUR/USD 1,2097 1,2099 sell € at this rate
USD/JPY 104,79 104,81
EUR/JPY 126,65 126,67
No Arbitrage 1,2084 1,2088
start with 1.000.000 USD
buy yens 104.790.000 JPY
buy euro 827.268 EUR
sell euro 1.000.746 USD
arbitrag
746 e
C5