You own a US company with borrowings from Switzerland. Over the next few months,
ID: 1136104 • Letter: Y
Question
You own a US company with borrowings from Switzerland. Over the next few months, your loan repayment of CHF 50 million is due. Given the foreign exchange market movements, you would like to minimise the impact on your cash outflow. Based on the following data, devise a suitable strategy. Evaluate your chosen strategy against suitable alternatives for a range of expected future spot rates.(using the information given, consider the relationship between them ) using the infromtion to explain and give the specific formula for every stepts.
Spot rate = 0.9888 CHF/USD
3 month forward rate = 3 month future rate = 0.9796 CHF/USD
Option Premia: Strike Price
Call Option
Put Option
0.9850
0.0108
0.0146
0.9900
0.0087
0.0175
Each option contract has a size of 125,000 Swiss Francs.
Option Premia: Strike Price
Call Option
Put Option
0.9850
0.0108
0.0146
0.9900
0.0087
0.0175
Explanation / Answer
1. From base price levels of 100 in 1987, West German and U.S. price levels in 1988 stood at 102 and 106, respectively. If the 1987 $/DM exchange rate was $0.54, what should the exchange rate be in 1988? In fact, the exchange rate in 1988 was DM 1 = $0.56. What might account for the discrepancy? (Price levels were measured using the consumer price index.)
Answer. If e1981 is the dollar value of the German mark in 1988, then according to purchasing power parity e1988/.54 = 106/102 or e1988 = $.5612. The discrepancy between the predicted rate of $.5612 and the actual rate of $.56 is insignificant and hence needs no explaining. Historically, however, discrepancies betweenthe PPP rate and the actual rate have frequently occurred. These discrepancies could be due to mismeasurement of the relevant price indices. Estimates based on narrower price indices reflecting only traded goods prices would probably be closer to the mark, so to speak. Alternatively, it could be due to a switch in investors' preferences from dollar to nondollar assets.
3. In early 1996, the short-term interest rate in France was 3.7%, and forecast French inflation was 1.8%. At the same time, the short-term German interest rate was 2.6% and forecast German inflation was 1.6%.
a. Based on these figures, what were the real interest rates in France and Germany?
Answer. The French real interest rate was 1.037/1.018 - 1 = 1.87%. The corresponding real rate in Germany was 1.026/1.016 - 1 = 0.98%.
b. To what would you attribute any discrepancy in real rates between France and Germany?
Answer. The most likely reason for the discrepancy is the inclusion of a higher inflation risk component in the French real interest rate than in the German real rate. Other possibilities are the effects of currency risk or transactions costs precluding this seeming arbitrage opportunity.
4. In July, the oneyear interest rate is 12% on British pounds and 9% on U.S. dollars.
a. If the current exchange rate is $1.63:1, what is the expected future exchange rate in one year?
Answer. According to the international Fisher effect, the spot exchange rate expected in one year equals 1.63 x 1.09/1.12 = $1.5863.
b.Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate?
Answer. If rus is the unknown U.S. interest rate, and assuming that the British interest rate stayed at 12% (because there has been no change in expectations of British inflation), then according to the IFE, 1.52/1.63 = (1+rus)/1.12 or rus = 4.44%.
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