1. (27 points) 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 CHF1.1806/$1.00. You learn that UBS is making a direct market between the

Swiss franc (CHF) and the euro, with a current €/CHF quote of 0.6395. Assume you have

$5,000,000 with which to conduct the arbitrage.

(a) Show how you can make a triangular arbitrage profit by trading at these prices. Please list

your strategies and determine the triangular arbitrage profit. (Ignore bid-ask spreads for this

problem.) (12%)

(b) What happens if you initially sell dollars for Swiss francs? (10%)

(c) What €/CHF price will eliminate triangular arbitrage? (5%)

2. (8 points) An investor believes that the price of a stock, say IBM’s shares, will increase in the

next 60 days. If the investor is correct, which combination of the following investment

strategies will show a profit in all the choices? List all investment strategies that will generate

positive returns and explain why.

(i) – buy the stock and hold it for 60 days

(ii) – buy a put option

(iii) – sell (write) a call option

(iv) – buy a call option

(v) – sell (write) a put option

3. (16 points) A U.S. company has issued floating-rate notes with a maturity of 10 years, an

interest rate of (6-month LIBOR+ 0.25%), and total face value of $10 million. The company

now believes that interest rates will rise and wishes to protect itself against this by entering

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into an interest rate swap. A dealer provides a quote on a 10-year swap whereby the company

will pay a fixed rate 5 percent and receive 6-month LIBOR. Interest is paid semiannually.

Assume the current LIBOR rate is 4%. Indicate how the company can use a swap to convert

the debt to a fixed rate. Calculate the first net payment and indicate which party makes the

payment. Also, what is the dealer’s first net payment (or profit)? Assume that all payments

are semiannual and made on the basis of 180/360.

4. (16 points) A Japanese EXPORTER has a €1,000,000 receivable due in one year.

Listed Options

Strike Puts Calls

Euro

€62,500

$1.25 = €1.00 $0.0075 per € $0.02 per €

Yen

¥12,500,000

$1.00 = ¥100 $0.0075 per ¥100 $0.02 per ¥100

(a) Detail the hedging strategy with options.

(b) Estimate the cost today of an options strategy that will eliminate exchange rate risk.

5. (16 points) Today’s settlement price on a Chicago Mercantile Exchange (CME) Yen

futures contract is $0.8011/¥100. Your margin account currently has a balance of

$1,800. The next three days’ settlement prices are $0.8057/¥100, $0.7996/¥100, and

$0.7985/¥100. (The contractual size of one CME Yen contract is ¥12,500,000). You

have a short position in one futures contract.

(a) Calculate the changes in the margin account from daily marking-to-market and the

balance of the margin account after the third day.

(b) Do the problem again assuming you have a long position in the futures contract.

6. (17 points) Suppose that on Jan. 1, GE was awarded a contract to supply turbine blades to

Luthansa. On Dec. 31, GE would receive payment of Euro10 million for these blades. The

money market interest rates and foreign exchange rates are given as follows:

U.S. interest rate Euro interest rate Spot exchange rate Forward exchange rate |
10% per annum 15% per annum $1/Euro $0.957/Euro (one-year maturity) |

(a) Explain the strategy and calculate the hedged value of GE’s cash flow using a forward

market hedge.

(b) Explain the strategy and calculate the hedged value of GE’s cash flow using a money

market hedge