You are the CEO of Fruity Computers Products, and hold 100B EUR of as-yet untaxed profits in Europe. Today Congress announced (after market close) that in 20 days, they would open a one month window for US firms to repatriate cash and "invest in America." As a reward, the tax rate will be halved. You are obviously worried about exchange risk, so you decide to hedge the exchange risk with a forward. Assume that the 30 day US interest is 0.25%, the Euro 30 day interest rate is 0.35%, and the EURUSD spot rate is 1.3200.

A.What is the lowest forward rate (out to four digits, round at the last calculation) you expect/are willing to pay? At that rate, how many (pre-tax) dollars will you have?

B.What is the forward premium/discount implied by CIRP? (In percentages, out to four digits.)

Question 10 (2p):

Continuing from the last question. Your firm also has 100,000 ZZZ. ZZZ is a unique currency in that the FOREX markets can provide spot and forward rates between USD and ZZZ - the weird thing is that FOREX markets are comfortable doing this despite the ZZ government not being able to issue risk free, or even low-risk bonds.

You aren't going to repatriate this money because you have an amazing investment opportunity which requires you to have ZZZ in 15 days. You don't trust the local banks to protect your money, so you fabricate a risk free bond in ZZZ. What is the rate of return on this bond?

A.Under the conditions: A USD bond with 15 days to maturity yields 0.2%, the forward USDZZZ rate is 100, and the spot USDZZZ rate is 97. (In percentages, out to four digits.)

B.Under the conditions: There are transaction costs. Lending a US bond with 15 days to maturity yields 0.1%, borrowing costs 0.12%. The best forward USDZZZ quote is 100.00/70. The best spot USDZZZ quote is 97.75/99.85. What is the highest or lowest interest rate consistent with CIRP? (In percentages, out to four digits.) Hint: be careful to identify the correct rate.

Question 11 (1.5p):

Continuing from question 9. At 6am the next morning, your CFO reports to you all of the new market rates. The EURUSD spot rate has surged to 1.35, and the USD and EUR interest rates are both now 0.2%. Your CFO reports that the forward rate should be 1.35 as well, but is currently being quoted at 1.39!!!

A.What is the profit ratio on this arbitrage opportunity?

B.If the US interest rate went to ___________% and nothing else changed, the arbitrage would disappear.

C.Why is this higher/lower than the current rate of 0.2%?

D.If the Euro interest rate went to ___________% and nothing else changed, the arbitrage would disappear.

E.If the spot rate went to __________ and nothing else changed, the arbitrage would disappear.