Suppose the spot exchange rate TODAY for exchanging South African rand (ZAR) versus US dollars (USD) is 15.49 / 15.50 (bid/ask). In other words, it takes 15.49 / 15.50 rand to make up one USD, 15.49 if you are buying rand and 15.50 if you are selling rand. Also, suppose the 1-year forward rate that trades in the market is 16.10/16.20 (bid/ask), and the 1-year US Libor interest rate is 0.20%.

1. Assuming the 1-year US Libor interest rate is 0.20% (this is the interbank interest rate that determines derivative pricing), what is the equivalent 1-year interbank interest rate in South Africa TODAY according to the arbitrage-free pricing model for currency forwards? When answering the question, assume you are buyer of USD on the forward contract.

2. Suppose the CIO of a capital-rich South Africa-based pension fund is evaluated on the performance return of investments in South African terms (in other words, she is focused on bottom line returns in rand not dollars). Suppose TODAY she invests $1 million in a 1-year zero-coupon bond issued by a US corporation that promises to pay a 3.00% return denominated in USD after 1 year (for the avoidance of doubt, after 1 year the principal is returned plus 3.00% return in USD).

(a) Assuming the US corporation does not default, what will the return be in South African rand terms if spot is unchanged over the 1-year period. You must express this return as percentage gain/loss on original rand-denominated capital for full credit.

(b) If the spot exchange rate at the end of the 1-year investment period is 17.99/18.00 (bid/ask), and assuming the US corporation does not default, what will the return be in South African rand terms. You must express this return as percentage gain/loss on original rand-denominated capital for full credit.

(c) If the spot exchange rate at the end of the 1-year investment period is 11.99/12.00 (bid/ask), and assuming the US corporation does not default, what will the return be in South African rand terms. You must express this return as percentage gain/loss on original rand-denominated capital for full credit.

3. The CIO in the previous question is not a currency expert and has no idea where exchange rates are going. Thus, she decides to execute the 1-year forward mentioned above to hedge *half* of the currency risk in the investment.

(a) State the 5 critical terms of this contract.

(b) If the spot exchange rate at the end of the 1-year investment period is 17.99/18.00 (bid/ask), and assuming the US corporation does not default, what will the return be in South African rand terms under the hedged scenario? You must express this return as percentage gain/loss on original rand-denominated capital for full credit.

(c) If the spot exchange rate at the end of the 1-year investment period is 11.99/12.00 (bid/ask), and assuming the US corporation does not default, what will the return be in South African rand terms under the hedged scenario? You must express this return as percentage gain/loss on original rand-denominated capital for full credit.

4) Suppose a South African company with a similar credit risk pays a yield of 5.0% in rand terms for a 1-year term. Should the pension fund a) buy this bond instead, b) buy the US bond discussed above and *hedge 100%* of the currency risk, or c) impossible to know without knowing where the spot rate will end up?