Q.2 Futures markets and currency risk (30pts)

1. Define and explain the concept of conditional expectation and variance;
2. Could you use the GARCH model to make an exchange rate forecast? If so, define and explain each of the formulas, also giving an example;
3. Either the following information

• Spot rate $1.54/;
• Standard deviation of the spot rate is: 4.14%;
• An appreciation of this spot rate is anticipated in 90 days: 2.13%

• Compute the expectation and the conditional variance;
• What is the probability that the pound () appreciates in 90 days to $1.63/E?

(d) Explain how a foreign exchange swap for an amount of $100,000 can be set up between an American firm (MSN) and a Japanese bank (Nomura), by applying swap points 23/18 knowing that the Bid is _ 104.33/S and Ask is 104.37/S.

Using interest rate parity theory, justify why this trade might be valid for Nomura.