Submitted by: Submitted by halo123
Views: 158
Words: 1056
Pages: 5
Category: Business and Industry
Date Submitted: 11/20/2013 08:06 AM
Exercise 1
You are the finance director of CR7, a US based manufacturer of luxury products.
The CEO has just signed a large contract with ‘Hotel de Paris’ from Monaco for a
large delivery of accessories, worth € 1 million. Both delivery and payment are
due in 7 months from now. At the current exchange rate of about 1.25 $ per €, this
contract is worth about $ 1.25 million.
a. Represent graphically the cash flow (in $) of CR7 in six months on a figure as a function of the $/€ exchange rate, supposing that CR7 remains long in €, i.e. if it does not hedge.
b. The current US interest rate is 3%, the euro area interest rate is 1%. Calculate the arbitrage-free 7-month forward price for the $/€ exchange rate. Show how this currency forward contract can be replicated by buying / lending $ and/or €’s.
The formula to calculate arbitrage-free 7-month forward price is: F = S0*e^(r$ – r €)t. With S0= spot price of exchange rate, r$ = US $ interest rate, r € = euro € interest rate, t= time in years.
F = 1,25 * e(0,03 – 0,01)*(7/12)
F = 1,2647 $/€
To receive at t=1: $ 1.264.668,735
Replicating strategy:
Buy: € 1.000.000 * e-0,01*(7/12). The cost in $ is then equal to €1.000.000 * e-0,01*(7/12) * $1,25/€.
This is $1.242.729,559.
Borrow: PV(F) = €1.000.000 * F * e-0,038(7/12) = €1.242.729,559
Calculate F in such a way that this portfolio has zero cost:
€1.000.000 * F * e-0.03*(7/12) = 1.25 * e-0.01*(7/12)
€1.000.000 * F * e-0.03*(7/12) = 1.242.729,559
€1.000.000 * e-0.03*(7/12) = 982.652,236
F = 1.242.729,559/982.652,236 = 1,2647
Result of the replicating strategy:
Buy: St*e-RfT = 1.25 * e-0,01*(7/12) = 1.242.729,559
Borrowing: F*e-RhT = F * e-0,03*(7/12) = 1.242.729,559
Net cash flow: = 0
Cash flow at time T:
Foreign deposit ST =1.250.000
Repay domestic loan F = 1.264.668,735
c. Describe the position in this forward contract if management of CR7 would decide to fully eliminate exchange rate...