Hedging/Arbitrage the 3-Month Forward Rate

Hedging/Arbitrage

The 3-month forward rate equals the spot rate less the discount. Therefore:

RF =.8200 * (.99375) =.814875 b)

Therefore, interest rate parity does not hold.

A c) to take advantage of the arbitrage opportunity I would borrow USD, lend CAD, and sell the CAD on the forward contract. I will receive Canadian interest of 500,000 * (.085/4) = $10,625. I will pay American interest of (410,000) * (.065/4) = $6,662.50. The CAD will be converted back to USD in 3 months to pay the debt at a rate of.814875. Therefore the proceeds from the CAD side will be (10,625)(.814875) = $8,658.05. The profit from the arbitrage will be these proceeds less the cost of the borrowed USD, so:

$6,662.50 = $1,995.55 d) for interest rate parity to hold, the Canadian interest rate would have to be:

1/.82)(1 + Rc (.25))(.8148) = 1.01625

1.2195127(1 + Rc (.25) = 1.01625 / .8148

Rc = 1.2472385 /

Rc =.0227351

Rc = 4 (.0227351)

Rc = 9.09%

a) the spot rate bid/ask is 6.4685-6.4782. The 1-month forward bid/ask is 6.465-6.498. The 3-month forward is 6.435-6.522. The 6-month forward is 6.430-6.561.

A b) the annualized percentage discount from the six-month bid rate is:

(R/2) =.1555209 / .1545953

R/2 =.0059872 c) the ask price for dollars in three months is 1 / 6.435 =.1554001; therefore for FFR 1,000,000 you will receive $155,400.10 d) the bid price for francs in six months is 1 / 6.430 =.1555209; therefore it will cost $77, 760.45 for the FFR 500,000.

3. The bid from the Paris dealer would be.03/.2 =.15.

The ask from the Paris dealer would be.0335 / .202 =.1658415

4. The DEM is undervalued as of December 31, 1999. The PPP calculations for the DEM as follows:

5225 (1.05/1.025) =.5352438;.5252438 (1.045 / 1.02) =.5483624;.5483624 (1.055 / 1.035) =.5589587 should have been the value of the DEM on December 31, 1999.