Risk Exposure

Question 1

Use the table below to answer the following questions:

	American Terms		European Terms
Bank A’s Quotations	Bid		Ask		Bid		Ask
British pounds	$	1.9712			$	1.9717			£	0.5072			£	0.5073
Euros	$	1.4738			$	1.4742			€	0.6783			€	0.6785

1. What is ?

• What is ?
• Suppose Bank B provides a quote of GBP 0.7462-68 for the EUR. Demonstrate whether and how an arbitrage profit can be made.

Question 2

You are a U.S.-based treasurer with $1,000,000 to invest. The dollar-euro exchange rate is quoted as $1.50 = €1.00 and the dollar-pound exchange rate is quoted at $2.00 = £1.00. If a bank quotes you a cross rate of £1.00 = €1.25, is there an arbitrage opportunity? If so, how much money would you make? Show all workings.

Question 3

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

            SFr/$ = 1.5958–70

            A$/$ = 1.7249–58

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

Question 4

Explain the differences between a long forward position and a short forward position. In your answer, illustrate the pay-off functions of these positions with graphs. Fully label your graphs. (note: you are welcome to draw them by hand, take a photo and attach it here)

Question 5

Suppose IBM has a liability of £1,000,000, payable in three months. The company wants to hedge foreign exchange risk using forward contracts. The current spot rate for the £ is $1.2415/£, and the three-month forward rate is $1.2492/£.

1. What forward position should IBM enter into?
2. Suppose the spot exchange rate in three months’ time is either $1.2342/£ or $1.2547/£. Using this example, demonstrate how the forward contract in part i helps IBM eliminates foreign exchange risk exposure.