# International Financial Management

Eun & Resnick, “International Financial Management,” 7e

Ch. 05, “The Market for Foreign Exchange”

End-of-Chapter Problems and Solutions

Exhibit 5.4:

1. Using the American term quotes from Exhibit 5.4, calculate a cross-rate matrix for the euro, Swiss franc, Japanese yen, and the British pound so that the resulting triangular matrix is similar to the portion above the diagonal in Exhibit 5.6.

Solution:  The cross-rate formula we want to use is:

S(j/k) = S(\$/k)/S(\$/j).

The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.

 ¥ SF £ \$ Euro 129.70 1.2335 .8499 1.3092 Japan (100) .9510 .6552 1.0094 Switzerland .6890 1.0614 U.K 1.5405

1. Using the American term quotes from Exhibit 5.4, calculate the one-, three-, and six-month forward cross-exchange rates between the Australian dollar and the Swiss franc. State the forward cross-rates in “Australian” terms.

Solution:  The formulas we want to use are:

or

We will use the top formula that uses American term forward exchange rates.

1. A foreign exchange trader with a U.S. bank took a short position of £5,000,000 when the \$/£ exchange rate was 1.55. Subsequently, the exchange rate has changed to 1.61.  Is this movement in the exchange rate good from the point of view of the position taken by the trader?  By how much has the bank’s liability changed because of the change in the exchange rate?

Solution:

The increase in the \$/£ exchange rate implies that the pound has appreciated with respect to the dollar.  This is unfavorable to the trader since the trader has a short position in pounds.

Bank’s liability in dollars initially was 5,000,000 x 1.55 = \$7,750,000

Bank’s liability in dollars now is 5,000,000 x 1.61 = \$8,050,000

1. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in forward points.

Spot                            1.3431-1.3436

One-Month                1.3432-1.3442

Three-Month             1.3448-1.3463

Six-Month                  1.3488-1.3508

Solution:

One-Month                  01-06

Three-Month               17-27

Six-Month                   57-72

1. Using the spot and outright forward quotes in problem 4, determine the corresponding bid-ask spreads in points.

Solution:

Spot                             5

One-Month                  10

Three-Month               15

Six-Month                   20

1. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the Japanese yen versus the U.S. dollar using American term quotations. For simplicity, assume each month has 30 days.  What is the interpretation of your results?

Solution:  The formula we want to use is:

fN,CD    = [(FN(\$/¥) - S(\$/¥/\$)/S(\$/¥)] x 360/N

f1,CD   = [(.010095 - .010094)/.010094] x 360/30   = .0012

f3,CD   = [(.010099 - .010094)/.010094] x 360/90   = .0020

f6,CD  = [(.010106 - .010094)/.010094] x 360/180  = .0024

The pattern of forward premiums indicates that the Japanese yen is trading at a premium versus the U.S. dollar.  That is, it becomes more expensive to buy a Japanese yen forward for U.S. dollars (in absolute and percentage terms) the further into the future one contracts.

1. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the U.S. dollar versus the British pound using European term quotations. For simplicity, assume each month has 30 days.  What is the interpretation of your results?

Solution:  The formula we want to use is:

fN,\$    = [(FN (£/\$) - S(£/\$))/S(£/\$)] x 360/N

f1,\$   = [(.6493 - .6491)/.6491] x 360/30   = .0037

f3,\$   = [(.6494 - .6491)/.6491] x 360/90   = .0018

f6,\$   = [(.6498 - .6491)/.6491] x 360/180  = .0022

The pattern of forward premiums indicates that the dollar is trading at a premium versus the British pound.  The one-month premium is larger than the either the three-month or six-month premium in percentage but not absolute terms.

1. A bank is quoting the following exchange rates against the dollar for the Swiss franc and the Australian dollar:

SFr/\$ = 1.5960--70

A\$/\$ = 1.7225--35

An Australian firm asks the bank for an A\$/SFr quote.  What cross-rate would the bank quote?

Solution:

The SFr/A\$ quotation is obtained as follows.  In obtaining this quotation, we keep in mind that SFr/A\$ = SFr/\$/A\$/\$, and that the price (bid or ask) for each transaction is the one that is more advantageous to the bank.

The SFr/A\$ bid price is the number of SFr the bank is willing to pay to buy one A\$.  This transaction (buy A\$—sell SFr) is equivalent to selling SFr to buy dollars (at the bid rate of 1.5960 and the selling those dollars to buy A\$ (at an ask rate of 1.7235).  Mathematically, the transaction is as follows:

bid SFr/A\$ = (bid SFr/\$)/(ask A\$/\$) = 1.5960/1.7235 = 0.9260

The SFr/A\$ ask price is the number of SFr the bank is asking for one A\$.  This transaction (sell A\$—buy SFr) is equivalent to buying SFr with dollars (at the ask rate of 1.5970 and then simultaneously purchasing these dollars against A\$ (at a bid rate of 1.7225).  This may be expressed as follows:

The resulting quotation by the bank is

SFr/A\$ = 0.9260—0.9271

1. Given the following information, what are the NZD/SGD currency against currency bid-ask quotations?

American Terms       European Terms

New Zealand dollar       .7265  .7272              1.3751 1.3765

Singapore dollar                        .6135  .6140              1.6287 1.6300

Solution:  Equation 5.12 from the text implies Sb(NZD/SGD) = Sb(\$/SGD) x Sb(NZD/\$) = .6135 x 1.3751 = .8436.  The reciprocal, 1/Sb(NZD/SGD) = Sa(SGD/NZD) = 1.1854.  Analogously, it is implied that Sa(NZD/SGD) = Sa(\$/SGD) x Sa(NZD/\$) = .6140 x 1.3765 = .8452.  The reciprocal, 1/Sa(NZD/SGD) = Sb(SGD/NZD) = 1.1832.  Thus, the NZD/SGD bid-ask spread is NZD0.8436-NZD0.8452 and the SGD/NZD spread is SGD1.1832-SGD1.1854.

1. Doug Bernard specializes in cross-rate arbitrage. He notices the following quotes:

Swiss franc/dollar = SFr1.5971/\$

Australian dollar/U.S. dollar = A\$1.8215/\$

Australian dollar/Swiss franc = A\$1.1440/SFr

Ignoring transaction costs, does Doug Bernard have an arbitrage opportunity based on these quotes?  If there is an arbitrage opportunity, what steps would he take to make an arbitrage profit, and how would he profit if he has \$1,000,000 available for this purpose.

Solution:

1. The implicit cross-rate between Australian dollars and Swiss franc is A\$/SFr = A\$/\$ x \$/SFr = (A\$/\$)/(SFr/\$) = 1.8215/1.5971 = 1.1405. However, the quoted cross-rate is higher at A\$1.1.1440/SFr.  So, triangular arbitrage is possible.
2. In the quoted cross-rate of A\$1.1440/SFr, one Swiss franc is worth A\$1.1440, whereas the cross-rate based on the direct rates implies that one Swiss franc is worth A\$1.1405. Thus, the Swiss franc is overvalued relative to the A\$ in the quoted cross-rate, and Doug Bernard’s strategy for triangular arbitrage should be based on selling Swiss francs to buy A\$ as per the quoted cross-rate.  Accordingly, the steps Doug Bernard would take for an arbitrage profit is as follows:
3. Sell dollars to get Swiss francs: Sell \$1,000,000 to get \$1,000,000 x SFr1.5971/\$ = SFr1,597,100.
4. Sell Swiss francs to buy Australian dollars: Sell SFr1,597,100 to buy SFr1,597,100 x A\$1.1440/SFr = A\$1,827,082.40.
• Sell Australian dollars for dollars: Sell A\$1,827,082.40 for A\$1,827,082.40/A\$1.8215/\$ = \$1,003,064.73.

Thus, your arbitrage profit is \$1,003,064.73 - \$1,000,000 = \$3,064.73.

1. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal, you notice that Dresdner Bank is quoting €0.7627/\$1.00 and Credit Suisse is offering SF1.1806/\$1.00.  You learn that UBS is making a direct market between the Swiss franc and the euro, with a current €/SF quote of .6395.  Show how you can make a triangular arbitrage profit by trading at these prices.  (Ignore bid-ask spreads for this problem.)  Assume you have \$5,000,000 with which to conduct the arbitrage.  What happens if you initially sell dollars for Swiss francs?  What €/SF price will eliminate triangular arbitrage?

Solution:  To make a triangular arbitrage profit the Deutsche Bank trader would sell \$5,000,000 to Dresdner Bank at €0.7627/\$1.00.  This trade would yield €3,813,500= \$5,000,000 x .7627.  The Deutsche Bank trader would then sell the euros for Swiss francs to Union Bank of Switzerland at a price of €0.6395/SF1.00, yielding SF5,963,253 = €3,813,500/.6395.  The Deutsche Bank trader will resell the Swiss francs to Credit Suisse for \$5,051,036 = SF5,963,253/1.1806, yielding a triangular arbitrage profit of \$51,036.

If the Deutsche Bank trader initially sold \$5,000,000 for Swiss francs, instead of euros, the trade would yield SF5,903,000 = \$5,000,000 x 1.1806.  The Swiss francs would in turn be traded for euros to UBS for €3,774,969= SF5,903,000 x .6395.  The euros would be resold to Dresdner Bank for \$4,949,481 = €3,774,969/.7627, or a loss of \$50,519.  Thus, it is necessary to conduct the triangular arbitrage in the correct order.

The S(/SF) cross exchange rate should be .7627/1.1806 = .6460.  This is an equilibrium rate at which a triangular arbitrage profit will not exist.  (The student can determine this for himself.)  A profit results from the triangular arbitrage when dollars are first sold for euros because Swiss francs are purchased for euros at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss francs are purchased for only €0.6395/SF1.00 instead of the no-arbitrage rate of €0.6460/SF1.00.  Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs are sold for euros at too low a rate, resulting in too few euros.  That is, each Swiss franc is sold for €0.6395/SF1.00 instead of the higher no-arbitrage rate of €0.6460/SF1.00.

1. The current spot exchange rate is \$1.95/£ and the three-month forward rate is \$1.90/£. Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be \$1.92/£ in three months. Assume that you would like to buy or sell £1,000,000.
2. What actions do you need to take to speculate in the forward market? What is the expected dollar profit from speculation?
3. What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be \$1.86/£.

Solution:

1. If you believe the spot exchange rate will be \$1.92/£ in three months, you should buy £1,000,000 forward for \$1.90/£. Your expected profit will be:

\$20,000 = £1,000,000 x (\$1.92 -\$1.90).

1. If the spot exchange rate actually turns out to be \$1.86/£ in three months, your loss from the long position will be:

-\$40,000 = £1,000,000 x (\$1.86 -\$1.90).

1. Omni Advisors, an international pension fund manager, plans to sell equities denominated in Swiss Francs (CHF) and purchase an equivalent amount of equities denominated in South African rands (ZAR).

Omni will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate the risk that the ZAR will appreciate relative to the CHF during this 30-day period.  The following exhibit shows current exchange rates between the ZAR, CHF, and the U.S. dollar (USD).

Currency Exchange Rates

 ZAR/USD ZAR/USD CHF/USD CHF/USD Maturity Bid Ask Bid Ask Spot 6.2681 6.2789 1.5282 1.5343 30-day 6.2538 6.2641 1.5226 1.5285 90-day 6.2104 6.2200 1.5058 1.5115
1. Describe the currency transaction that Omni should undertake to eliminate currency risk over the 30-day period.
2. Calculate the following:
• The CHF/ZAR cross-currency rate Omni would use in valuing the Swiss equity portfolio.
• The current value of Omni’s Swiss equity portfolio in ZAR.
• The annualized forward premium or discount at which the ZAR is trading versus the CHF.

Solution:

1. To eliminate the currency risk arising from the possibility that ZAR will appreciate against the CHF over the next 30-day period, Omni should sell 30-day forward CHF against 30-day forward ZAR delivery (sell 30-day forward CHF against USD and buy 30-day forward ZAR against USD).
1. The calculations are as follows:
• Using the currency cross rates of two forward foreign currencies and three currencies (CHF, ZAR, USD), the exchange would be as follows:

--30 day forward CHF are sold for USD.  Dollars are bought at the forward selling price of CHF1.5285 = \$1 (done at ask side because going from currency into dollars)

--30 day forward ZAR are purchased for USD.  Dollars are simultaneously sold to purchase ZAR at the rate of 6.2538 = \$1 (done at the bid side because going from dollars into currency)

--For every 1.5285 CHF held, 6.2538 ZAR are received; thus the cross currency rate is 1.5285 CHF/6.2538 ZAR = 0.244411398.

• At the time of execution of the forward contracts, the value of the 3 million CHF equity portfolio would be 3,000,000 CHF/0.244411398 = 12,274,386.65 ZAR.
• To calculate the annualized premium or discount of the ZAR against the CHF requires comparison of the spot selling exchange rate to the forward selling price of CHF for ZAR.

Spot rate = 1.5343 CHF/6.2681 ZAR = 0.244779120

30 day forward ask rate 1.5285 CHF/6.2538 ZAR = 0.244411398

[(forward rate – spot rate) / spot rate] x (360 / # day contract) =

[(0.244411398 – 0.24477912) / 0.24477912] x (360 / 30) =

-1.8027126 % = -1.80% discount ZAR to CHF

MINI CASE:  SHREWSBURY HERBAL PRODUCTS, LTD.

Shrewsbury Herbal Products, located in central England close to the Welsh border, is an old-line producer of herbal teas, seasonings, and medicines.  Its products are marketed all over the United Kingdom and in many parts of continental Europe as well.

Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign customers in order to guard against adverse exchange rate changes.  Nevertheless, it has just received an order from a large wholesaler in central France for £320,000 of its products, conditional upon delivery being made in three months’ time and the order invoiced in euros.

Shrewsbury’s controller, Elton Peters, is concerned with whether the pound will appreciate versus the euro over the next three months, thus eliminating all or most of the profit when the euro receivable is paid.  He thinks this is an unlikely possibility, but he decides to contact the firm’s banker for suggestions about hedging the exchange rate exposure.

Mr. Peters learns from the banker that the current spot exchange rate is €/£ is €1.4537, thus the invoice amount should be €465,184.  Mr. Peters also learns that the three-month forward rates for the pound and the euro versus the U.S. dollar are \$1.8990/£1.00 and \$1.3154/€1.00, respectively.  The banker offers to set up a forward hedge for selling the euro receivable for pound sterling based on the €/£ forward cross-exchange rate implicit in the forward rates against the dollar.

What would you do if you were Mr. Peters?

Suggested Solution to Shrewsbury Herbal Products, Ltd.

Suppose Shrewsbury sells at a twenty percent markup.  Thus the cost to the firm of the £320,000 order is £256,000.  Thus, the pound could appreciate to €465,184/£256,000 = €1.8171/1.00 before all profit was eliminated.  This seems rather unlikely.  Nevertheless, a ten percent appreciation of the pound (€1.4537 x 1.10) to €1.5991/£1.00 would only yield a profit of £34,904 (= €465,184/1.5991 - £256,000).  Shrewsbury can hedge the exposure by selling the euros forward for British pounds at F3(€/£) =  F3(\$/£) ÷ F3(\$/€) = 1.8990 ÷ 1.3154 = 1.4437.  At this forward exchange rate, Shrewsbury can “lock-in” a price of £322,217 (= €465,184/1.4437) for the sale.  The forward exchange rate indicates that the euro is trading at a premium to the British pound in the forward market.  Thus, the forward hedge allows Shrewsbury to lock-in a greater amount (£2,217) than if the euro receivable was converted into pounds at the current spot

If the euro was trading at a forward discount, Shrewsbury would end up locking-in an amount less than £320,000.  Whether that would lead to a loss for the company would depend upon the extent of the discount and the amount of profit built into the price of £320,000.  Only if the forward exchange rate is even with the spot rate will Shrewsbury receive exactly £320,000.

Obviously, Shrewsbury could ensure that it receives exactly £320,000 at the end of three-month accounts receivable period if it could invoice in £.  That, however, is not acceptable to the French wholesaler.  When invoicing in euros, Shrewsbury could establish the euro invoice amount by use of the forward exchange rate instead of the current spot rate.  The invoice amount in that case would be €461,984 = £320,000 x 1.4437.  Shrewsbury can now lock-in a receipt of £320,000 if it simultaneously hedges its euro exposure by selling €461,984 at the forward rate of 1.4437.  That is, £320,000 = €461,984/1.4437.

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