ProblemsSuppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months. The six-month interest rate is percent per annum in the !nite" States an" # percent per annum in $erman%. &urrentl%, the spot exchan'e rate is (1.01 per "ollar an" the six-month for)ar" exchan'e rate is (0.** per "ollar. The treasurer of IBM "oes not )ish to bear an% exchan'e ris+. ,here shoul" he-she invest to maximi.e the return/ Solution0 The mar+et con"itions are summari.e" as follo)s0 I$ 1 234 i( 1 5.634 S 1 (1.01-$4 7 1 (0.**-$. If $100,000,000 is investe" in the !.S., the maturit% value in six months )ill be $102,000,000 1 $100,000,000 81 9 .02:. ;lternativel%, $100,000,000 can be converte" into euros an" investe" at the $erman interest rate, )ith the euro maturit% value sol" for)ar". In this case the "ollar maturit% value )ill be $106,6*0,*0* 1 8$100,000,000 x 1.01:81 9 .056:81-0.**: &learl%, it is better to invest $100,000,000 in $erman% )ith exchan'e ris+ he"'in'. ,hile %ou )ere visitin' 56,000 for)ar". 8b: 8b: Bu% a certain poun" amount spot to"a% an" invest the amount in the !.B. for three months so that the maturit% value becomes eCual to >56,000. 8c: Dvaluate each pa%ment metho". ,hich metho" )oul" %ou prefer/ ,h%/ The problem situation is summari.e" as follo)s0 ;-P 1 >56,000 pa%able in three months i@? 1 0.563-month, compoun"in' monthl% i4 7 1 $1.20->. Fption a0 ,hen %ou bu% >56,000 for)ar", %ou )ill nee" $2*,000 in three months to fulGll the for)ar" contract. The present value of $2*,000 is compute" as follo)s0 $2*,000-81.0056:5 1 $2,2*. Thus, the cost of =a'uar as of to"a% is $2,2*. Fption b0 The present value of >56,000 is >52,512 1 >56,000-81.0A:. To bu% >52,512 to"a%, it )ill cost $2*,#66 1 52,512x1.26. Thus the cost of =a'uar as of to"a% is $2*,#66. ?ou shoul" "eGnitel% choose to use Hoption aI, an" save $1,AJJ, )hich is the "iKerence bet)een $2*,#66 an" $22*. &urrentl%, the spot exchan'e rate is $1.60-> an" the three-month for)ar" exchan'e rate is $1.6A->. The three-month interest rate is .03 per annum in the !.S. an" 6.3 per annum in the !.B. ;ssume that %ou can borro) as much as $1,600,000 or >1,000,000. a. Eetermine )hether the interest rate parit% is currentl% hol"in'.b. If the ILP is not hol"in', ho) )oul" %ou carr% out covere" interest arbitra'e/ Sho) all the steps an" "etermine the arbitra'e proGt. c. Dxplain ho) the ILP )ill be restore" as a result of covere" arbitra'e activities. S 1 $1.6->4 7 1 $1.6A->4 I$ 1 A.034 I> 1 1.263 &re"it 1 $1,600,000 or >1,000,000. a. 819I$: 1 1.0A819I>:87-S: 1 81.0126:81.6A-1.60: 1 1.0A0 Thus, ILP is not hol"in' exactl%. Since 819I$: 1 1.0A is cheaper, borro) !SE "irectl%.b. 81: Borro) $1,600,0004 repa%ment )ill be $1,650,000. 8A: Bu% >1,000,000 spot usin' $1,600,000. 85: Invest >1,000,000 at the poun" interest rate of 1.2634 maturit% value )ill be >1,012,600. 82: Sell >1,012,600 for)ar" for $1,62A,020 ;rbitra'e proGt )ill be $1A,020 7ollo)in' the arbitra'e transactions "escribe" above,The "ollar interest rate )ill rise4The poun" interest rate )ill fall4The spot exchan'e rate )ill rise4The for)ar" exchan'e rate )ill fall.These a"Mustments )ill continue until ILP hol"s. Suppose that the current spot exchan'e rate is (0.0-$ an" the three-month for)ar" exchan'e rate is (0.#15-$. The three-month interest rate is 6.J percent per annum in the !nite" States an" 6.20 percent per annum in 7rance. ;ssume that %ou can borro) up to $1,000,000 or (00,000. a. Sho) ho) to reali.e a certain proGt via covere" interest arbitra'e, assumin' that %ou )ant to reali.e proGt in terms of !.S. "ollars. ;lso "etermine the si.e of %our arbitra'e proGt. b. ;ssume that %ou )ant to reali.e proGt in terms of euros. Sho) the covere" arbitra'e process an" "etermine the arbitra'e proGt in euros.In the issue of Fctober A5, 1***, the Dconomist reports that the interest rate per annum is 6.*53 in the !nite" States an" #0.03 in Tur+e%. ,h% "o %ou thin+ the interest rate is so hi'h in Tur+e%/ Base" on the reporte" interest rates, ho) )oul" %ou pre"ict the chan'e of the exchan'e rate bet)een the !.S. "ollar an" the Tur+ish lira/; hi'h Tur+ish interest rate must reNect a hi'h expecte" inNation in Tur+e%. ;ccor"in' to international 7isher eKect 8I7D:, )e have D8e: 1 i$ - i.a. ,hat is Lolls-Lo%ceUs "ollar transaction exposure in "ollar terms/ In poun" terms/Suppose the poun" appreciates to $1.#J2A->. ,hat is Lolls-Lo%ceUs 'ain or loss, in poun" terms, on its "ollar transaction exposure/Lolls-Lo%ce has $1J0 million in "ollar transaction exposure 8$1.6 billion - $#20 million - $J00 million:. In poun" terms, its transaction exposure eCuals >106.#J million 81J0,000,000-1.61A:.Translate" at the ne) exchan'e rate, the value of its transaction exposure is no) >*0.J* million. &ompare" to the former value of its transaction exposure, the result is a loss of >16.0# million 8>*0.J* million - >106.#J million:.&ompan% V is a hi'h ris+ Grm )ho )ants a Gxe" rate, lon' term loan. Its borro)in' rate is 11.60 3 in the Gxe" rate mar+et. It is presentl% borro)in' at a Noatin' rate of prime plus A.00 3. &ompan% ? prefers a Noatin' rate loan, )here it can borro) at prime plus 0.60 3, %et it is currentl% pa%in' a rate of *.#6 3 in the Gxe" rate mar+et. ?ou are the mana'er of a s)ap "es+ for a maMor ban+. ,or+ out a s)ap )hich )oul" 'enerate a 6 basis point proGt to the ban+, an" split the rest eCuall% bet)een both counter parties 8companies V an" ?:.Era) up all the s)ap transactions7ixe" 7loatin'V 11.6 P9A.00? *.#6 P9.6EiK 1.#6 1.6EiK 1 A6 bp, split as 6 bp to ban+, 10 to each V-?V eKective 11.24 ban+ pa%s P9A ? eKectiveP9.24 ban+ pa%s ? *.#634 Eell &omputers )oul" li+e to borro) poun"s, an" Wir'in ;irlines )ants to borro) "ollars. Because Eell is better +no)n in the !nite" States, it can borro) on its o)n "ollars at # percent an" poun"s at * percent, )hereas Wir'in can on its o)n borro) "ollars atpercent an" poun"s at .63 Suppose Eell )ants to borro) >10 million for t)o %ears, Wir'in )ants to borro) $1J million for t)o %ears, an" the currentexchan'e rate is $1.J0. ,hat s)ap transaction )oul" accomplish this obMective/ ;ssume the counterparties )oul" exchan'e principal an" interest pa%ments )ith no rate a"Mustments. ,hat savin's are reali.e" b% Eell an" Wir'in/ XSE is 1.6 0 here, no Grm has absolute a"vanta'e4 both have onl% relative a"vanta'e Wir'in )oul" borro) >10 million for t)o %ears an" Eell )oul" borro) $1J million for t)o %ears. The t)o companies )oul" then s)ap their procee"s an" pa%ment streams. ;ssumin' no interest rate a"Mustments, Eell )oul" pa% .63 on the >10 million an" Wir'in )oul" pa% #3 on its $1J million. $iven that its alternative )as to borro) poun"s at *3, Eell )oul" save 0.63 on its borro)in's, or an annual savin's of >60,000. Similarl%, Wir'in )in"s up pa%in' an interest rate of #3 instea" of 3 on its "ollar borro)in's, savin' it 13 or $1J0,000 annuall%. Dollar PoundEell # *Wir'in.6Eell Wir'in$ive 1J !SE, 'et 10 $BP4 'et #3 int4 'et bac+ 1J !SE $ive 10 $BP, 'et.63 $BP4 int4 'et bac+ 10 $BP XSE A.A64 "ell has absolute a"v Suppose, in fact, that Eell can borro) "ollars at # percent an" poun"s at * percent, )hereas Wir'in can borro) "ollars at .#6 percent an" poun"s at *.6 percent. ,hat ran'e of interest rates )oul" ma+e this s)ap attractive to both parties/ I'norin' cre"it ris+ "iKerences, Wir'in )oul" have to provi"e Eell )ith a poun" rate of less than *3. $iven that Wir'in has to borro) the poun"s at *.63, it )oul" have to save at least 0.63 on its "ollar borro)in' from Eell to ma+e the s)ap )orth)hile. If Eell borro)s poun"s from Wir'in at *3 - x. then Wir'in )oul" have to borro) "ollars from Eell at .#63 - 80.63 9 x: to cover the 0.63 9 x "iKerence bet)een the interest rate at )hich it )as borro)in' poun"s an" the interest rate at )hich it )as len"in' those poun"s to Eell. Therefore max that vir'in can pa% for its "ollars is .A6Dollar PoundEell # *Wir'in .#6 *.6 Base" on the scenario in part 8c:, suppose Eell borro)s "ollars at # percent an" Wir'in borro)s poun"s at *.6 percent. If the parties s)ap their current procee"s, )ith Eell pa%in' .#6 percent to Wir'in for poun"s an" Wir'in pa%in' #.#6 percent to Eell for "ollars, )hat are the cost savin's to each part%/ !n"er this scenario, Eell saves 0.A63 on its poun" borro)in's an" earns 0.#63 on the "ollars it s)aps )ith Wir'in, for a total beneGt of 13 annuall%. Wir'in loses 0.#63 on the poun"s it s)aps )ith Eell an" saves 13 on the "ollars it receives from Eell, for a net savin's of 0.A63 annuall%. Is there an% component of exchan'e rate ris+/ ;