Math/Physic/Economic/Statistic Problem
Math/Physic/Economic/Statistic Problem
Calculate the forward premium on the South African Rand and explain
Every investor aims to make a profit. However, this is not always the case since it depends on the type of investment done. When investing in foreign exchange, one can only make money after investing in the right side of the trade. To determine if you will make money after making your investment, you should be able to determine the future price of the given currency. The difference between the current currency price with its future price is referred to as the forward premium.
The forward premium of the South African land is the difference between its spot rate as compared to its future rate. When calculating the forward premium, it is assumed that the future rate for Rand will be higher than its current rate. In the given question, the spot rate of south African Rand valued against the Euro is 12.4125 and a six-month forward rate of 12.8825. The forward premium for the Rand will be given by (12.8825 – 12.4125) / 12.4125 = 0.0378 which is equal to 3.78%
A positive value of forward premium means that the quote currency is strong than the base currency. In our case, the value is +3.78%, meaning that the South African Rand is stronger than the Japanese yen. The Yen will be trading at a discount.
Is there an opportunity for covered interest arbitrage (CIA)?
Covered interest arbitrage is a type of trading where the investors make use of the difference between the interest rates of two given countries to eliminate the risk associated with the exchange rates. In such cases, the investors use a forward contract to earn a profit with no risk of losing their money, when investors identify such chances, they capitalize in it by investing a lot of money since they will have nothing to lose from it.
In the question, the amount of money available is 2,000,000 EUR. An investor who will do a domestic investment using euros will not earn the same amount of money as the one who will use the covered interest arbitrage. By first converting the Euros to South African Rand and then invest them for the six months, and later convert them back to Euros, the profit will be higher. By investing domestically, the 2,000,000 EUR will earn an interest of 0.025% per month, meaning that by the end of the six months, the investor will be having a profit of 300000 EUR. However, by converting the 2,000,000 EUR to ZAR at the spot rate, the investor will get 2,000,000 EUR 12.4125 = 24825000 ZAR. Then the investor will invest this amount at a rate of 0.55% per month, meaning by the end of six months, a profit of 81922500 ZAR will be realized. Then converting ZAR back to Euro at the forward premium rate of 12.8825, the investor will get 6359208.2 EURO as profit. The two methods of investment have a different of 6359208.2 EUR – 300000 EUR =6059208.2 EUR as the extra profit realized from using the covered risk.
If the spot rate in six months’ time were 12.6700 ZAR per EUR, what uncovered interest arbitrage profit could be made?
If the spot rate in six months’ time were 12.6700 ZAR per EUR, the profit that would be made would be slightly higher. This is because the realized profit of 8192500 ZAR would be converted back to Euro using a relatively lower rate of 12.6700, giving 6465464.24 EUR. Then the realized covered profit will be given by 6465464.24 EUR. Minus 300000 EUR. = 6165864.2, which is higher than 6059208.2 EUR.
Evaluate the company’s hedging options-explain.
The general aim of buyers is to buy a product at the lowest price possible. This is because it helps them in saving some money and earning a higher profit if they resale the product. When dealing with a foreign product, the buyer has to consider the costs they will be incurred due to the interest rates and chose the best option that they will spend the minimal possible amount of money from the given transaction. Minimizing the risk associated with foreign exchange transactions is called hedging.
After buying the product worth ¥200 million from Japan, the US company has several options that they can choose when paying for the product. The aim of the company should be to reduce the amount of money that they will spend buying the product. Given that the company’s cost of capital is 12%, the company has to make more than 12% of ¥200 million so that they can earn some profit. This will only be achievable if they spend as little as possible when paying the product.
Unhedged
The first option the company has is to pay for the product immediately. By so doing, they will have to buy the ¥200 million at the current conversion rate of 94.000, implying that they will be required to pay ¥200 000000 94.0040 = 2127569.57 us dollars. By spending this amount of money, they will have paid for the product immediately after buying it.
Forward rate
It is not a must that they pay for the product immediately since the product is payable withing in the first four months. This means that the company can consider paying after for months. Before making this consideration, it would be wise for them to consider the USD/JPY 4-month forward rate. They have to consider which of the two currencies will stronger than the other after the four months. The forward rates are given as 86.1000 and 89.7000 for the bid and ask price, respectively, meaning that the Japanese yen will be relatively stronger than us dollar as compared to the current spot price. If they pay after the four months, they will be supposed to pay a total of ¥200 000000 86.1000 = 2322880.37 us dollars. This amount is higher than when they would have paid for the product immediately after buying it.
Option market
The company may also decide to use the strike price. This is the price at which the option trader can buy or sell the options depending on either the call or put option. These prices are only given for a specific period of time, of which they become invalid after their expiration dates. The company may decide to use the strike price, meaning that they will be required to pay ¥200 000000 divided by the stated strike price, which is 92, which is equal to 2173913.0437 us dollars. This will be relatively cheaper than waiting for the four months and then pay at the forward premium rate, but it is expensive than paying for the product at the current spot rate.
Money markets
The company may also take advantage of the different interest rates. This is by converting all their dollars into Japanese yen, then invest with the Japanese yen. Their money will attract an interest rate for the four months at the given Japanese yen interest rates. Then after the four months, they will use ¥200 million to pay for the product and then convert back the interest that will have been earned back to US dollars. Investing the 2127569.57dollars in their domestic currency, the company will get an interest equal to (2127569.570.1/12) 4 =70918. But they convert their money into Japanese yen and the invest with the foreign currency, and they will have (200000000 0.4./12)26666666.67 which they can convert back to us dollars at the future rate of 86.1000 to get 309717.32USD as savings.
The money market method will be the best method that the company should use. This is because they will have after the four months they will pay the 200 million JPY, but they will have invested the money for the four months.