1. (Hedging exercise) You as a real estate investor are considering adding additional studio apartments, currently being built, to your investment portfolio. You are going to invest into 6 apartments with the total value of 1.4 million euros. You have reserved the apartments but the purchase price should be paid only in 9 month from now. Currently you have sufficient funds deposited in Cayman Islands (in US dollars). The annual interest rate on bank deposit is 2.10%. Another option would be to convert a certain amount of dollars into euros and deposit in a Latvian bank that offers 1.20%. The spot exchange rate is 1.2000 EUR/USD and the 9m forward rate is currently quoted with premium equal to +60 basis points.

So you have two possibilities to pay for the investment with exchange rate risk mitigated

a) Buy forward contract to sell dollars and buy euros in 9 months (and continue to deposit dollars)

b) Invest enough euros into Latvian bank to meet the future obligation.

Questions:

* Try to show with calculations, which option has the lowest present value cost for you in dollars?

* Compute the correct forward rate implied by the interest rates.