Jeanne Chan works as a trader at Brownstone, LLC, a hedge fund based in Greenwich, CT. She is convinced that the value of the Brazilian currency, the Real (BRL), will appreciate against the US dollar (USD) in the very short term. Therefore, she sees a good profit opportunity in being long Reals (BRL) and, at the same time, short dollars (USD), especially since, in addition, BRL interest rates are substantially higher than USD interest rates. Obviously, there is no guarantee that this will happen, making the trade highly speculative. Brownstone has a margin account opened at a large NY bank, Bank of New York (BNY) with a current deposit amount of USD 1 million. This means that Brownstone can take a trading position equal to an amount up to 10 times the size of its deposit (in this case USD 10 million). All of Brownstones trades will be done with BNY as counterparty. For BNY, Brownstones USD 1 million deposit serves as collateral for the trade. This means that BNY will monitor Brownstones open trading position and, if it sees that Brownstone is losing an amount that reaches 50% of the value of its collateral (margin deposit), it will force Brownstone to close its position. With this in mind, Chan decides first to go short USD 10 Million dollars. To do that, it borrows USD 9 million from BNY for 1 week at a 2% interest rate (remember that market interest rates are always quoted as annual interest rates). Then, adding these borrowed funds to the USD 1 million it has in deposit, it decides to sell the USD 10 Million to BNY on the foreign exchange market and buy BRL instead. So, Chan contacts BNYs foreign exchange (FX) trading desk and asks them for a FX quote for the equivalent in BRL of USD 10 million. The BNY FX desk, not knowing Chans intention (whether she is a seller or a buyer of BRL), gives her 2 quotes: a bid price of 1.54 BRL/USD (1.54 BRL per 1 USD) and an ask price of 1.64 BRL/USD (1.64 BRL per 1 USD). To clarify, the bid price is the BRL amount per unit of USD at which BNY is willing and able to buy 10 million USD from Chan, while the ask price is the BRL amount per unit of USD at which BNY is willing and able to sell 10 million USD to Chan. Chan thus buys, based on the above quote, the BRLs with its USD 10 million and decides to deposit the purchased BRLs for 1 week on a BRL account. That BRL account receives an interest rate of 6% (1-week rate).

Questions:

1) At which of the bid or the ask rates above will Chan trade at to open her position? Briefly explain your choice.

2) Assume that, at the end of the week, Chan closes her position based on the bid/ask FX rate of 1.45 BRL/USD (bid) / 1.50 BRL/USD (ask). At which of these 2 rates will Chan trade to close her position? What will be her net profit or loss (in USD amount, 2 decimals) on that trade? What will be Brownstones ROE on this particular trade (not annualized)?

3) What would be the BRL/USD FX rate at which BNY will force Chan to close her position? Assume that the position would be closed right at the 1-week maturity. Please include all costs and revenues generated by this trade. Your FX rate must have 4 decimals. (Note: Questions 2 and 3 are independent from each other. Assume a 360-day year).