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problem 1: Below is information about the spot and forward rates for three currencies against the US dollar (USD):

Currency (exchange rate)             Spot Rate             Six-month forward rate

Euro (EUR) (EUR/USD)                   0.84                    0.81
Japanese Yen (JPY) (JPY/USD)       122.10                 118.80
British Pound (GBP) (USD/GBP)        1.47                    1.49
a) Critically discuss the interest rate parity and covered interest arbitrage theories.

b) Discuss the conditions for interest rate parity theory to hold.
c) Use the spot exchange rates to check if interest rate parity holds or not, given the following six-month interest rates:

United States   5.60 per cent
Euro area         3.40 per cent
Japan              1.00 per cent
Britain             5.25 per cent

problem 2: You have been provided with the following information on a fixed-fixed USD-GBP currency swap, the spot exchange rate between USD and GBP, and the USD and GBP yield curves:

  • Five-year swap 5.5 per cent fixed coupon USD for 6.125 per cent fixed coupon GBP
  • Notional principal of USD 15,000,000
  • Spot exchange rate GBP 1 = USD 1.35
  • Current discount yield curves USD 2.35 per cent flat, GBP 2.00 per cent flat.

a) You wish to value the swap. What assumptions must you make to use the information that has been provided to you?

b) What is the time zero value of the swap to the GBP receiver?

c) What settlement payment will ensure fair value against the swap to both parties, and to whom must it be paid?

d) What is the implied exchange rate between USD and GBP for the interest payments made under the swap? Should you expect this rate to match the current value of the exchange rate? describe.

problem 3: You have the following limited information upon which to base your decision as to which is the better of two alternative funding arrangements: 

i) Alternative 1 is to arrange funding by using 3.25% YTM, five-year USD Eurocurrency loan with USD 10,000,000 principal value.

ii) Alternative 2 is to arrange funding by using a 1.65% YTM, five-year zero-coupon currency option bond with principal repaid in USD or AUD at USD/AUD 1.05. The premium on a five-year currency call option with strike of USD/AUD 1.05 is 0.0375 USD per AUD

a) Do Alternatives 1 and 2 provide the same value of payment at maturity? Assume that the exchange rate is
USD/AUD 1.0225 at maturity.

b) Is it better to issue USD LIBOR or to issue the currency-option bond hedged with a call option on AUD?

problem 4:

You have the following information about rates in London for Eurocurrency loans of one-year duration, the exchange rate between the USD and euros, the currency in which you want financing, and the level of financing required:
•  Eurodollar rates 2.15%
•  Euroeuro rates 3.75%
•  Exchange rate USD 1 = EUR 0.7035
•  The volatility (standard deviation) of the above exchange rate is 15.45% p.a.
•  You require a total of Euro 250,000,000 to fund capital investments, which is to be repaid at maturity of the loan.
a) Discuss the pros and cons of financing in unhedged Eurodollars instead of via Euroeuros. As you do this you must give consideration to the foreign exchange risks associated with financing in Eurodollars.

b) Provide a simple numerical ex demonstrating the potential risk from financing in Eurodollars based on the above information.

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