will give a ton of points to anyone who can really explain the answers to this q
ID: 2790441 • Letter: W
Question
will give a ton of points to anyone who can really explain the answers to this question. :)
1) Suppose that the CFO of the Vatican on Jan. 1, 2017 had 10 million Euros to invest with a time horizon of 1 year until major renovations to St. Peter's Basilica and the papal residence were planned to begin. Suppose further that the interest rate at that time on 1 year $ Libor deposits in the London interbank was 1.7%, while the rate on 1 year Euro Libor deposits in the London market was (-09). Finally, assume at that time 1 Euro was worth $1.04 in the FX market. A) Based on the interest rate parity condition, what must the FX market have expected about the (S/euro) exchange rate by Jan 1, 2018? (An exact answer is required for full credit. Partial credit can be earned by identifying the direction of change in the $ cost of a Euro.) 4pts B) Currently despite three 25 basis point increases in the US Fed Funds target rate range during 2017 and no increases in the ECB's overnight interbank rate the $is now trading at 1.16 dollars per Euro. Assuming that this exchange rate does not change over the next 6 weeks what rate of return would the CFO of a US based company earn if she invested 10 million $ in 12 month Euro Libor deposits at the rate in part A?4pts C) How can you explain the difference between the breakeven rate in the $ to Euro FX rate based on the IRP condition and the actual change in that exchange rate over this year? 2ptsExplanation / Answer
(A)
Case A (convert to USD and deposit in LIBOR)
On 1st Jan 2017, Convert 1 Euro = 1.04*1= 1.04 USD
Invest $1.04 in LIBOR deposit at the rate of 1.7% for 12 months.
On 1st Jan, 2018 the invested amount will result = $1.04*(1+.017) =$1.05768
Case B (Deposit 1 euro in EURO-LIBOR)
On 1st Jan 2017, depositing 1 Euro in Euro-Libor at the rate (-.09), after 1-year value of the investment will be = 1*(1-.09) = .91 Euro
Let say on 1st Jan 2018, the exchange rate is $X per Euro.
So, the value of the .91 Euro will be on 1st Jan 2018 = .91*X= $.91X
As per the interest rate parity condition, this two-investments value should be same.
.91X = 1.05768
or, X= 1.05768/.91 = 1.16242 USD per Euro (Ans)
(B)
US based company CFO invested $10 million on 1st Jan 2017 at the rate of 1.04 USD per Euro.
So, 10 million USD = 10/1.04= 9.61538 million EURO
Investing 9.61538 million EURO in the Euro-Libor deposit for 1 year would result
= 9.61538 * (1-.09) = 8.75 million euro.
On 1st Jan 2018, the euro-dollar rate = $1.16 per euro.
So, 8.75 million euro = 8.75*1.16 = 10.15 million USD.
The return of the CFO = (10.15/10)-1 = 15% (Ans)
(C)
Without considering FED rate hike, as per IRP condition, the breakeven rate was $1.16242 per EURO. If we consider the rate hike of FED by (.25*3) =.75% then as per IRP condition USD should further depreciate and the rate must have been high.
But the rate on 1st Jan 2018 is 1.16. Reason behind this is that due rate hike by FED attract more investment in USD which increase the demand of USD. That’s why the USD didn’t depreciate to the level IRP suggested.
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.