Full project
FIN 440 International Economics and Finance Spring 2020 Group Project Due on Friday, April 24th Currency Risk Management & Assessment of Potential Arbitrage Opportunities Your term project is composed of a set of questions related to Currency Risk Management & Assessment of Potential Arbitrage Opportunities. Potential contribution of this assignment to your overall grade is 20%. Please note that this is a group project (two students in each team). To insure proper credit, you need to show all your work and explain/present your work clearly. Your grade will be based on not only how correctly you address and answer the questions, but also on the clarity and organization of the written report. Please note that your typed report should include a cover page with group members’ names and the title of the assignment on it. You should turn in your assignment by noon on Friday, April 24th. Late assignments will not be accepted for grading. I. Country’s Best Services, (CBS, Inc.), a US based company, will receive 2,610,000 Canadian dollars in three months for the services rendered to a Canadian corporation. The current exchange-rate on May 16, 1995 was 1US$=C$1.3594. The CEO of CBS, Mr. Safeguard was concerned that the Canadian dollar might depreciate against the US$ during the next 90 days --before or at the time of the payment made by the Canadian corporation. Mr. Safeguard had called his account manager at the bank, Judy Edge, to ask for her advice regarding various alternatives to hedge the foreign currency risk. Ms. Edge, after evaluating macroeconomic fundamentals and determining what her bank's lending rates were likely to be based on this outlook, was now ready to advise Mr. Safeguard of the various alternatives to hedge the foreign currency risk. She prepared the following list of alternatives for Mr. Safeguard. Your task is to analyze/evaluate each of the three hedging alternatives available for CBS. Specifically, you need to calculate total $US proceeds three months from May 16th under each alternative. a. Forward contract: As of May 16th, the bank quoted the three-month forward rate as 1US$=C$1.3653. b. Foreign currency option: At the time, the 90-day currency put-option premium written on Canadian dollar with a strike of 1C$=US$ .7200 was: put premium=US$ 0.0225 per C$. c. Money Market Hedge (or Foreign Currency Loan): As an alternative Ms. Edge was ready to offer a Canadian dollar loan to CBS at 2.25% above the present Canadian prime rate of 10.25% with a zero arrangement fee due to their long-term relationships. She explained to Mr. Safeguard that he could borrow in Canadian dollars against the Canadian dollars to be received in 3 months and convert immediately into US dollars. This way, she suggested CBS would eliminate any exchange rate risk associated with the transaction. At the time of this conversation, the US interest rate was around 11%. II. In addition to Canada, CBS also provides services to customers in Thailand. Mr. Safeguard, therefore, closely follows the current economic conditions and exchange rate quotes in this country both for hedging purposes and arbitrage opportunities. Based on current market information, he has identified three possible arbitrage opportunities associated with foreign currency transactions and would like to know which one is the most profitable: a. The first arbitrage opportunity relates to locational arbitrage. Safeguard has obtained spot rate quotations from two banks in Thailand, Minzu Bank and Sobat Bank, both located in Bangkok. The bid and ask prices of Thai baht for each bank are displayed in the table below: Minzu Bank Sobat Bank Bid $0.0224 $0.0228 Ask $0.0227 $0.0229 Determine whether the foreign exchange quotations are appropriate. If they are not, determine the profit Mr. Safeguard could generate by using $100,000 and engaging in arbitrage before the rates are adjusted. b. Mr. Safeguard has obtained several forward contract quotations for the Thai baht to determine whether covered interest arbitrage may be possible. He was quoted a forward rate of $0.0225 per Thai baht for a 90-day forward contract. The current spot rate is $0.0227. Ninety-day interest rates available to CBS in the U.S. are 2 percent, while 90-day interest rates in Thailand are 3.75 percent (these rates are not annualized). Holt is aware that covered interest arbitrage, unlike locational and triangular arbitrage, requires an investment of funds. Thus, he would like to be able to estimate the dollar profit resulting from arbitrage over and above the dollar amount available on a 90-day U.S. deposit. Determine whether the forward rate is priced appropriately. If it is not priced appropriately, determine the profit you could generate for CBS by using $100,000 and engaging in covered interest arbitrage. Measure the profit as the excess amount above what you could generate by investing in the U.S. money market. c. Assume that besides the two potential arbitrage opportunities listed above, Mr. Safeguard is exposed to following exchange rates (ignoring transaction costs, i.e. bid-ask spreads) quoted by Sonzu Bank among three currencies: US dollar, Japanese Yen, and Thai Baht. Determine whether the cross exchange rate between the Thai baht and Japanese yen based on Sonzu Bank quotations is appropriate. If it is not appropriate, determine the profit you could generate for CBS by using $100,000 and engaging in triangular arbitrage before the rates are adjusted. Sonzu Bank Quotations S($/TB) $0.0227 S($/JY) $0.0085 S(JY/TB) ¥2.6900