FIN306 Tutorial 7 Q

Question1

Suppose that three-month interest rates (annualized) in Japan and the United States are 7 percent
and 9 percent, respectively. If the spot rate is 142:$1 and the 90-day forward rate is 139:$1:

a) Where would you invest and borrow?

b) Assuming no transaction costs, what would be your arbitrage process or technique and
your net return?

c) Suppose now that transaction costs in the foreign exchange market equal 0.2% per
transaction. Do unexploited covered arbitrage profit opportunities still exist?

Question 2

a) Assume that the three-month forward exchange rate is $2.00/ and a speculator believes
that the spot rate in three months will be $2.05/. How can this person speculate in the forward
market? Also assume that the speculator is willing to take a position of about $20 million or 10
million. How much will the speculator earn if he or she is correct?

b) The current spot exchange rate is $1.14/Euro. The current 90-day forward exchange rate
is $1.11/Euro. How could a U.S firm, who must repay a 40 million Euro loan in 90 days, use a
forward exchange contract to hedge its risk exposure?