Question 3 You are a foreign exchange trader for Bank of America in New York. You have authority to borrow 1,000,000 U.S. dollars (USD) or 850,000 euros (EUR) for a short term investment. There are two investment strategies: A and B. In strategy A, you make a covered interest arbitrage investment in EUR. In strategy B, you borrow EUR and invest in USD for three months, and hedge your foreign exchange rate risk. You face the following quotes: Exchange Rate (a) (b) (c) Bid Ask Spot rate for EUR USD 1.1763 USD 1.1767 Three-month forward rate for EUR USD 1.1806 USD 1.1811 Interest Rate Bid Ask Three-month interest rate for EUR 0.25% 0.50% Three-month interest rate for USD 2.30% 2.50% What is the USD profit/loss of investment strategy A? Provide a detailed explanation of the steps you take to execute strategy A, and identify the sources of the gains and losses. (10 marks) What is the USD profit/loss of investment strategy B? Would you recommend investment strategy A or B? Why? (10 marks) Suppose call and put options on EUR with exercise price USD 1.1808 are available for some low premiums. Would you recommend options to be use for hedging purpose in the investment strategy B? If yes, what are the benefits of using options, and would you use call or put options? If no, what are the disadvantages of using options? (5 marks) (TOTAL: 25 marks)