Problem 7.

1 Amber McClain

Amber McClain, the currency speculator we met earlier in the chapter,sells eight June futures contracts for
500,000 pesos at the closing price quoted in Exhibit 8.1.

a. What is the value of her position at maturity if the ending spot rate is $0.12000/Ps?
b. What is the value of her position at maturity if the ending spot rate is $0.09800/Ps?
c. What is the value of her position at maturity if the ending spot rate is $0.11000/Ps?

a. b. c.
Assumptions Values Values Values
Number of pesos per futures contract 500,000 500,000 500,000
Number of contracts 8.00 8.00 8.00
Buy or sell the peso futures? Sell Sell Sell

Ending spot rate ($/peso) $0.12000 $0.09800 $0.11000

June futures settle price from Exh8.1 ($/peso) $0.10773 $0.10773 $0.10773
Spot - Futures $0.01227 ($0.00973) $0.00227

Value of total position at maturity (US$) ($49,080.00) $38,920.00 ($9,080.00)

Value = - Notional x (Spot - Futures) x 8

Interpretation
Amber buys at the spot price and sells at the futures price.
If the futures price is greater than the ending spot price, she makes a profit.
Problem 7.2 Peleh's Puts

Peleh writes a put option on the Australian dollar (A$) with a strike price of $0.9100/A$ at a premium of $0.0245/A$ and with an expiration date six months from now. The option is
for A$100,000. What is Peleh’s profit or loss at maturity if the ending spot rates are $0.8500/A$, $0.8800/A$, $0.9100/A$, $0.9400/A$, and $0.9700/A$?

a) b) c) d) e)
Assumptions Values Values Values Values Values
Notional principal (AUD) 100,000 100,000 100,000 100,000 100,000
Maturity (days) 180 180 180 180 180
Strike price (USD/AUD) $0.910000 $0.910000 $0.910000 $0.910000 $0.910000
Premium (USD/AUD) $0.024500 $0.024500 $0.024500 $0.024500 $0.024500

Ending spot rate (USD/AUD) 0.85 0.88 0.91 0.94 0.97

in USD/AUD

Option premium (USD) 2450.00 2450.00### 2450.00### 2450.00### 2450.00

Less put payoff (USD) $6,000.00 $3,000.00 $0.00 $0.00 $0.00
Net profit/loss (USD) -3550.00 -550.00 2450.00 2450.00 2450.00

$0.00
Problem 7.3 Ventosa Investments

Jamie Rodriguez, a currency trader for Chicago-based Ventosa Investments, uses the following futures quotes on the British pound (£) to speculate on the value of
the pound.

British Pound Futures, US$/pound (CME) Contract = 62,500 pounds

Open
Maturity Open High Low Settle Change High Interest
March 1.4246 1.4268 1.4214 1.4228 0.0032 1.4700 25,605
June 1.4164 1.4188 1.4146 1.4162 0.0030 1.4550 809

a. If Jaime buys 5 June pound futures, and the spot rate at maturity is $1.3980/£, what is the value of her position?
b. If Jamie sells 12 March pound futures, and the spot rate at maturity is $1.4560/£, what is the value of her position?
c. If Jamie buys 3 March pound futures, and the spot rate at maturity is $1.4560/£, what is the value of her position?
d. If Jamie sells 12 June pound futures, and the spot rate at maturity is $1.3980/£, what is the value of her position?

a) b) c) d)
Assumptions Values Values Values Values
Pounds (₤) per futures contract £62,500 £62,500 £62,500 £62,500
Maturity month June March March June
Number of contracts 5 12 3 12
Did she buy or sell the futures? buys sells buys sells

Ending spot rate ($/₤) $1.3980 $1.4560 $1.4560 $1.3980

Pound futures contract, settle price ($/ $1.4162 $1.4228 $1.4228 $1.4162
Spot - Futures ($0.0182) $0.0332 $0.0332 ($0.0182)

Value of position at maturity ($) ($5,687.50) ($24,900.00) $6,225.00 $13,650.00

buys: Notional x (Spot - Futures) x contracts
sells: - Notional x (Spot - Futures) x contracts

Interpretation
Buys a futures: Jamie buys at the futures price and sells at the ending spot price. She therefore profits when the futures price is
less than the ending spot price.
Sells a future: Jamie buys at the ending spot price and sells at the futures price. She therefore profits when the futures price is
greater than the ending spot price.
Problem 7.4 Sallie Schnudel

Sallie Schnudel trades currencies for Keystone Funds in Jakarta. She focuses nearly all of her time and attention on the U.S.
dollar/Singapore dollar ($/S$) cross-rate. The current spot rate is $0.6000/S$. After considerable study, she has concluded that the
Singapore dollar will appreciate versus the U.S. dollar in the coming 90 days, probably to about $0.7000/S$. She has the following options
on the Singapore dollar to choose from:

Option Strike Price Premium

Put on Sing $ $0.6500/S$ $0.00003/S$
Call on Sing $ $0.6500/S$ $0.00046/S$

a. Should Sallie buy a put on Singapore dollars or a call on Singapore dollars?

b. What is Sallie's breakeven price on the option purchased in part (a)?
c. Using your answer from part (a), what is Sallie's gross profit and net profit (including premium) if the spot rate at the end of 90 days is
indeed $0.7000/S$?
d. Using your answer from part (a), what is Sallie's gross profit and net profit (including premium) if the spot rate at the end of 90 days is
$0.8000/S$?

Option choices on the Singapore dollar: Call on S$ Put on S$

Strike price (US$/Singapore dollar) $0.6500 $0.6500
Premium (US$/Singapore dollar) $0.00046 $0.00003

Assumptions Values
Current spot rate (US$/Singapore dollar) $0.6000
Days to maturity 90
Expected spot rate in 90 days (US$/Singapore dollar) $0.7000

a. Should Sallie buy a put on Singapore dollars or a call on Singapore dollars?

Since Sallie expects the Singapore dollar to appreciate versus the US dollar, she should buy a call on Singapore dollars. This gives her the
right to BUY Singapore dollars at a future date at $0.65 each, and then immediately resell them in the open market at $0.70 each for a
profit. (If her expectation of the future spot rate proves correct.)

b. What is Sallie's breakeven price on the option purchased in part a)?

Per S$
Strike price $0.65000
Note this does not include any interest cost on the premium. Plus premium $0.00046
Breakeven $0.65046

c. What is Sallie's gross profit and net profit (including premium) if the ending spot rate is $0.70/S$?

Gross profit Net profit

(US$/S$) (US$/S$)
Spot rate $0.70000 $0.70000
Less strike price ($0.6500) ($0.6500)
Less premium ($0.00046)
Profit $0.05000 $0.04954

d. What is Sallie's gross profit and net profit (including premium) if the ending spot rate is $0.80/S$?

Gross profit Net profit

(US$/S$) (US$/S$)
Spot rate $0.80000 $0.80000
Less strike price ($0.6500) ($0.6500)
Less premium ($0.00046)
Profit 0.15000 $0.14954
Problem 7.5 Blade Capital (A)

Christoph Hoffeman trades currency for Blade Capital of Geneva. Christoph has $10 million to begin with, and he must state all
profits at the end of any speculation in U.S. dollars. The spot rate on the euro is $1.3358/€, while the 30-day forward rate is
$1.3350/€.

a. If Christoph believes the euro will continue to rise in value against the U.S. dollar, so that he expects the spot rate to be
$1.3600/€ at the end of 30 days, what should he do?

b. If Christoph believes the euro will depreciate in value against the U.S. dollar, so that he expects the spot rate to be $1.2800/€
at the end of 30 days, what should he do?

a. b.
Assumptions Values Values
Initial investment (funds available) $10,000,000 $10,000,000
Current spot rate (US$/€) $1.3358 $1.3358
30-day forward rate (US$/€) $1.3350 $1.3350
Expected spot rate in 30 days (US$/€) $1.3600 $1.2800

Strategy for Part a):

One of the more interesting dimensions of speculating in the forward market, is that if the speculator has access to the forward
market (bank lines or relationships when working on behalf of an established firm), many forward speculation strategies require
no actual cash flow position up-front. In this case, Christoph believes the dollar will be trading at $1.36/€ in the open market at
the end of 30 days, but he has the ability to buy or sell dollars at a forward rate of $1.3350/€. He should therefore buy euros
forward 30 days (requires no actual cash flow up-front), and at the end of 30 days take delivery of those euros and sell in the spot
market at the higher dollar rate for profit.

Initial investment principle

30 day forward rate (US$/€)
Euros bought forward (Investment / forward rate)
Spot rate in open market at end of 30 days (US$/€)
US$ proceeds (euros bought forward exchanged to US$ spot)
Profit in US$

Strategy for Part b):

Again, a profitable strategy can be executed without any actual cash flow changing hands at the beginning of the period. Since
Christoph believes that the dollar will strengthen to $1.28 in 30 days, he should sell euros forward now at the higher dollar rate,
wait 30 days and buy the euros needed on the open market at $1.28, and immediately then use those euros to fulfill his forward
contract to sell euros for dollars at $1.3350. For a profit.

Investment funds needed in 30 days

Spot rate in open market at end of 30 days
Euros bought in open market in 30 days (Investment / spot rate)

Stefan had sold these euros forward at the start of the 30 day period.
30 day forward rate (US$/€)
US$ proceeds (euros sold forward into US$)
Profit in US$
Problem 7.6 Blade Capital (B)

Christoph Hoffeman of Blade Capital now believes the Swiss franc will appreciate versus the U.S. dollar in the
coming three-month period. He has $100,000 to invest. The current spot rate is $0.5820/SF, the three-month
forward rate is $0.5640/SF, and he expects the spot rates to reach $0.6250/SF in three months.

a. Calculate Christoph's expected profit assuming a pure spot market speculation strategy.
b. Calculate Christoph's expected profit assuming he buys or sells SF three months forward.

a. b.
Assumptions Values Values
Initial investment (funds available) $100,000 $100,000
Current spot rate (US$/Swiss franc) $0.5820 $0.5820
Six-month forward rate (US$/Swiss franc) $0.5640 $0.5640
Expected spot rate in six months (US$/Swiss franc) $0.6250 $0.6250

Strategy for Part a:

1. Use the $100,000 today to buy SF at spot rate SFr. 171,821.31 $ 171,821.31
2. Hold the SF indefinitely.
3. At the end of six months, convert SF at expected rate $0.6250 $0.6250
4. Yielding expected dollar revenues of $107,388.32 107,388.3162
5. Realize profit (revenues less $100,000 initial invest) $7,388.32 7,388.3162

Strategy for Part b:

1. Buy SF forward six months (no cash outlay required)
2. Fulfill the six months forward in six months $ 177,304.96 SFr. 177,304.96
cost in US$ $ (100,000.00) ($100,000.00)
3. Convert the SF into US$ at expected spot rate $110,815.60
4. Realize profit $10,815.60
Problem 7.7 Chavez S.A.

Chavez S.A., a Venezuelan company, wishes to borrow $10,000,000 for 18 weeks.

Potential lenders in New York, Switzerland, and London using, respectively,
international, Swiss (Eurobond), and British definitions of interest (day count
conventions) quote rates, respectively, 8.25%, 8.30%, and 8.35% per annum. From
which source should Chavez borrow?

Assumptions Values
Quantum of loan 10,000,000
Tenure of loan (weeks) 18

Country U.S. Switzerland U.K.

Practice International Swiss British
Day in period Actual 30 Actual
Days in year 360 360 365
Interest rate 8.25% 8.30% 8.35%

Days used 126 126 126

Interest payment 288,750.00 290,500.00 288,246.58

Chavez should borrow from the London lender.

Problem 7.8 Botany Bay Corporation
The Botany Bay Corporation of Australia seeks to borrow US$50,000,000 in the eurodollar market. Funding is needed for two years.
Investigation leads to three possibilities. Compare the alternatives and make a recommendation. Assume that LIBOR is currently
5.00% for all maturities.

#1. 1. Botany Bay could borrow the US$50,000,000 for two years at a fixed 5.50% rate of interest.

#2. Botany Bay could borrow the US$50,000,000 at LIBOR + 0.50%, and the rate would be reset every six months.
#3. Botany Bay could borrow the US$50,000,000 for one year only at 5.25%. At the end of the first year Botany Bay Corporation
would have to negotiate for a new 1-year loan.

Assumptions Values
Quantum of loan 50,000,000.00
Tenure of loan (years) 2.0
Current LIBOR for all maturities 5.00%

Fixed rate, 2 years 5.50%

Floating rate, reset every six-month LIBOR + Spread
Spread 0.50%
Fixed rate, 1 year, then re-fund 5.25%

Now First 6-months Second 6-months Third 6-months Fourth 6-months

#1: Fixed rate, 2 years
Loan payment (interest & principal) 2,500,000.00 52,500,000.00
Certainty over access to capital Certain Certain Certain Certain
Certainty over cost of capital Certain Certain Certain Certain
PV of loan payments $50,000,000.00

#2: Floating rate, six-month LIBOR + spread

Interest payment 1,375,000.00 ??? ??? 50,000,000 + ???
Certainty over access to capital Certain Certain Certain Certain
Certainty over cost of capital Certain Uncertain Uncertain Uncertain
PV of loan payments $50,470,246.78

#3: Fixed rate, 1 year, then re-fund

Interest payment 1,350,000.00 ??? ???
Certainty over access to capital Certain Certain Uncertain Uncertain
Certainty over cost of capital Certain Certain Uncertain Uncertain
PV of loan payments Depends on re-fund terms

Only alternative #1 has a certain access and cost of capital for the full 2 year period.
Alternative #2 has certain access to capital for both years, but the interest costs is uncertain except for the first period.
Alternatvie #3, possessing a lower interest cost in year 1, has no guaranteed access to capital in the second year.

Depending on the firm's business needs and tolerance for interest rate risk, it could choose between #1 and #2.
If the firm based its decision on the present value of loan payaments, it would choose #1.
Problem 7.9 Vatic Capital

Cachita Haynes works as a currency speculator for Vatic Capital of Los Angeles. Her latest speculative position is to profit from her
expectation that the U.S. dollar will rise significantly against the Japanese yen. The current spot rate is ¥120.00/$. She must choose between
the following 90-day options on the Japanese yen:

Option Strike Price Premium

Put on yen ¥125/$ $0.00003/¥
Call on yen ¥125/$ $0.00046/¥

a. Should Cachita buy a put on yen or a call on yen?

b. What is Cachita's breakeven price on the option purchased in part (a)?
c. Using your answer from part (a), what is Cachita's gross profit and net profit (including premium) if the spot rate at the end of 90 days is
¥140/$?

Assumptions Values
Current spot rate (Japanese yen/US$) 120.00
in US$/yen $0.00833
Maturity of option (days) 90
Expected ending spot rate in 90 days (yen/$) 140.00
in US$/yen $0.00714

Call on yen Put on yen

Strike price (yen/US$) 125.00 125.00
in US$/yen $0.00800 $0.00800
Premium (US$/yen) $0.00046 $0.00003

a. Should she buy a call on yen or a put on yen?

Cachita should buy a put on yen to profit from the rise of the dollar (the fall of the yen).

b. What is Cachita's break even price on her option of choice in part a)?
Cachita buys a put on yen. Pays premium today.
In 90 days, exercises the put, receiving US$.
KORISTEME GI INFORMACIITE OD PUT ON YEN in yen/$
Strike price $0.00800 125.00
Less premium -$0.00003
Breakeven $0.00797 125.47

c. What is Cachita's gross profit and net profit if the end spot rate is 140 yen/$?

Gross profit Net profit

(US$/yen) (US$/yen)
Strike price $0.00800 $0.00800
Less spot rate -$0.00714 -$0.00714
Less premium -$0.00003
Profit $0.00086 $0.00083
Net profit for the industry 0.00089 -0.00717
Problem 7.10 Calling All Profits

Consider an American call option on New Zealand dollars (NZ$) with a strike price of $0.8100/NZ$ traded at a premium of $0.0192 per NZ$ and with an expiration date three months from now. The
option is for NZ$100,000.
a. Suppose that you have bought such a call option. Plot your profit or loss on a graph should you exercise before maturity at a time when the NZ$ is traded spot at between $0.7000/NZ$ and
$0.9200/NZ$. Find the break-even exchange rate.
b. Repeat (a) if you have sold such a call option.

Assumptions Values
Notional principal (NZD) NZD 100,000
Strike price (USD/NZD) USD 0.8100
Premium (USD/NZD) USD 0.019200

(a) Break-even rate

Spot rate (USD/NZD) 0.7000 0.8100 0.8292 0.9200

Call payoff (USD) 0.00 0.00 1,920.00 11,000.00

Less option premium (USD) 1,920.00 1,920.00 1,920.00 1,920.00
Net profit/loss (USD) -1,920.00 -1,920.00 0.00 9,080.00

Net profit/loss (USD) for call buyer

10000

8000

6000

4000

2000

0
0.7 0.75 0.8 0.85 0.9
-2000

(b) Break-even rate

Spot rate (USD/NZD) 0.7000 0.8100 0.8292 0.9200

Option premium (USD) 1,920.00 1,920.00 1,920.00 1,920.00

Less call payoff (USD) 0.00 0.00 1,920.00 11,000.00
Net profit/loss (USD) 1,920.00 1,920.00 0.00 -9,080.00

Net profit/loss (USD) for call writter

2000

0
0.7 0.75 0.8 0.85 0.9
-2000

-4000

-6000

-8000

-10000
Problem 7.11 Mystery at Baker Street

Arthur Doyle is a currency trader for Baker Street, a private investment house in London. Baker Street’s clients are a collection of
wealthy private investors who, with a minimum stake of £250,000 each, wish to speculate on the movement of currencies. The investors
expect annual returns in excess of 25%. Although officed in London, all accounts and expectations are based in U.S. dollars.
Arthur is convinced that the British pound will slide significantly -- possibly to $1.3200/£ -- in the coming 30 to 60 days. The current
spot rate is $1.4260/£. Arthur wishes to buy a put on pounds which will yield the 25% return expected by his investors. Which of the
following put options would you recommend he purchase. Prove your choice is the preferable combination of strike price, maturity, and
up-front premium expense.

Strike Price Maturity Premium

$1.36/£ 30 days $0.00081/£
$1.34/£ 30 days $0.00021/£
$1.32/£ 30 days $0.00004/£
$1.36/£ 60 days $0.00333/£
$1.34/£ 60 days $0.00150/£
$1.32/£ 60 days $0.00060/£

Assumptions Values
Current spot rate (US$/£) $1.4260
Expected endings spot rate in 30 to 60 days (US$/£) $1.3200
Potential investment principal per person (£) £250,000.00

Put options on pounds Put #1 Put #2 Put #3

Strike price (US$/£) $1.36 $1.34 $1.32
Maturity (days) 30 30 30
Premium (US$/£) $0.0008 $0.0002 $0.0000

Put options on pounds Put #4 Put #5 Put #6

Strike price (US$/£) $1.36 $1.34 $1.32
Maturity (days) 60 60 60
Premium (US$/£) $0.0033 $0.0015 $0.0006

Issues for Sydney to consider:

1. Because his expectation is for "30 to 60 days" he should confine his choices to the 60 day options to be sure and capture
the timing of the exchange rate change. (We have no explicit idea of why he believes this specific timing.)

2. The choice of which strike price is an interesting debate.

* The lower the strike price (1.34 or 1.32), the cheaper the option price.
* The reason they are cheaper is that, statistically speaking, they are increasingly less likely to end up in the money.
* The choice, given that all the options are relatively "cheap," is to pick the strike price which will yield the required return.
* The $1.32 strike price is too far 'down,' given that Sydney only expects the pound to fall to about $1.32.

Put #4 Put #5 Put #6

Net profit Net profit Net profit
Strike price $1.36000 $1.34000 $1.32000
Less expected spot rate (1.32000) (1.32000) (1.32000)
Less premium (0.00333) (0.00150) (0.00060)
Profit $0.03667 $0.01850 ($0.00060)

If Sydney invested an individual's principal purely

in this specific option, they would purchase an
option of the following notional principal (£): £75,075,075.08 £166,666,666.67 £416,666,666.67

Expected profit, in total (profit rate x notional): $2,753,003.00 $3,083,333.33 -$250,000.00

Initial investment at current spot rate $356,500.00 $356,500.00 $356,500.00
Return on Investment (ROI) 772% 865% -70%
Risk: They could lose it all (full premium)
Problem 7.12 Contrarious Calandra

Calandra Panagakos works for CIBC Currency Funds in Toronto. Calandra is something of a contrarian -- as opposed to
most of the forecasts, she believes the Canadian dollar (C$) will appreciate versus the U.S. dollar over the coming 90
days. The current spot rate is $0.6750/C$. Calandra may choose between the following options on the Canadian dollar:

Option Strike Price Premium

Put on C$ $0.7000 $0.00003/S$
Call on C$ $0.7000 $0.00049/S$

a. Should Calandra buy a put on Canadian dollars or a call on Canadian dollars?

b. What is Calandra's breakeven price on the option purchased in part (a)?
c. Using your answer from part (a), what is Calandra's gross profit and net profit (including premium) if the spot rate at
the end of 90 days is indeed $0.7600?
d. Using your answer from part (a), what is Calandra's gross profit and net profit (including premium) if the spot rate at
the end of 90 days is $0.8250?

Assumptions Values
Current spot rate (US$/Canadian dollar) $0.6750
Days to maturity 90

Option choices on the Canadian dollar: Call option Put option

Strike price (US$/Canadian dollar) $0.7000 $0.7000
Premium (US$/Canadian dollar) $0.00049 $0.0003

a) Which option should Giri buy?

Since Giri expects the Canadian dollar to appreciate versus the US dollar, he should buy a call on Canadian dollars.

b) What is Giri's breakeven price on the option purchased in part a)?

Strike price $0.7000

Plus premium 0.00049
Breakeven $0.7005

c) What is Giri's gross profit and net profit (including premium) if he ending spot rate is $0.7600/C$?

Gross profit Net profit

(US$/C$) (US$/C$)
Spot rate $0.7600 $0.7600
Less strike price (0.7000) (0.7000)
Less premium (0.00049)
Profit $0.0600 $0.05951

d) What is Giri's gross profit and net profit (including premium) if the ending spot rate is $0.8250/C$?

Gross profit Net profit

(US$/C$) (US$/C$)
Spot rate $0.8250 $0.8250
Less strike price (0.7000) (0.7000)
Less premium (0.00049)
Profit $0.1250 $0.12451
Problem 7.13 Raid Gauloises

Raid Gauloises is a rapidly growing French sporting goods and adventure racing outfitter. The company has decided to borrow €20,000,000 via a
euro-euro floating rate loan for four years. Raid must decide between two competing loan offerings from two of its banks.

Banque de Paris has offered the four-year debt at euro-LIBOR + 2.00% with an up-front initiation fee of 1.8%. Banque de Sorbonne, however, has
offered euro-LIBOR + 2.5%, a higher spread, but with no loan initiation fees up-front, for the same term and principal. Both banks reset the interest
rate at the end of each year.

Euro-LIBOR is currently 4.00%. Raid’s economist forecasts that LIBOR will rise by 0.5 percentage points each year. Banque de Sorbonne,
however, officially forecasts euro-LIBOR to begin trending upward at the rate of 0.25 percentage points per year. Raid Gauloises’s cost of capital is
11%. Which loan proposal do you recommend for Raid Gauloises?

Expected Chg
Assumptions Values in LIBOR
Principal borrowing need € 20,000,000
Maturity needed, in years 4.00
Current euro-LIBOR 4.000%
Banque de Paris' spread & expectation 2.000% 0.500%
Banque de Paris' initiation fee 1.800%
Banque de Sorbonne's spread & expectation 2.500% 0.250%
Banque de Sorbonne's initiation fee 0.000%

Raid Gauloises must evaluate both loan proposals under both potential interest rate scenarios.

Banque de Paris Loan Proposal Year 0 Year 1 Year 2 Year 3 Year 4

Expected interest rates & payments:
Expected euro-LIBOR 4.000% 4.500% 5.000% 5.500% 6.000%
Bank spread 2.000% 2.000% 2.000% 2.000% 2.000%
Interest rate 6.000% 6.500% 7.000% 7.500% 8.000%

Funds raised, net of fees € 19,640,000

Expected interest costs -€ 1,300,000 -€ 1,400,000 -€ 1,500,000 -€ 1,600,000
Repayment of principal -€ 20,000,000
Total cash flows € 19,640,000 -€ 1,300,000 -€ 1,400,000 -€ 1,500,000 -€ 21,600,000

All-in-cost of funds if:

euro-LIBOR rises 0.500% per year 7.7438%
euro-LIBOR rises 0.250% per year 7.1365% Found by plugging in .250% in expectations above.

Banque de Sorbonne Loan Proposal Year 0 Year 1 Year 2 Year 3 Year 4

Expected interest rates & payments:
Expected euro-LIBOR 4.000% 4.250% 4.500% 4.750% 5.000%
Bank spread 2.500% 2.500% 2.500% 2.500% 2.500%
Interest rate 6.500% 6.750% 7.000% 7.250% 7.500%

Funds raised, net of fees € 20,000,000

Expected interest costs -€ 1,350,000 -€ 1,400,000 -€ 1,450,000 -€ 1,500,000
Repayment of principal -€ 20,000,000
Total cash flows € 20,000,000 -€ 1,350,000 -€ 1,400,000 -€ 1,450,000 -€ 21,500,000

All-in-cost of funds if:

euro-LIBOR rises 0.500% per year 7.0370% Found by plugging in .500% in expectations above.
euro-LIBOR rises 0.250% per year 7.1036%

The Banque de Sorbonne loan proposal is actually lower all-in-cost under either interest rate scenario.
Problem 7.14 Schifano Motors

Schifano Motors of Italy recently took out a 4-year €5 million loan on a floating rate basis. It is now worried, however, about rising interest
costs. Although it had initially believed interest rates in the Euro-zone would be trending downward when taking out the loan, recent
economic indicators show growing inflationary pressures. Analysts are predicting that the European Central Bank will slow monetary
growth driving interest rates up.

Schifano is now considering whether to seek some protection against a rise in euro-LIBOR, and is considering a Forward Rate
Agreement (FRA) with an insurance company. According to the agreement, Schifano would pay to the insurance company at the end of
each year the difference between its initial interest cost at LIBOR + 2.50% (6.50%) and any fall in interest cost due to a fall in LIBOR.
Conversely, the insurance company would pay to Schifano 70% of the difference between Schifano’s initial interest cost and any increase
in interest costs caused by a rise in LIBOR.

Purchase of the floating Rate Agreement will cost €100,000, paid at the time of the initial loan. What are Schifano’s annual financing
costs now if LIBOR rises and if LIBOR falls.? Schifano uses 12% as its weighted average cost of capital. Do you recommend that
Schifano purchase the FRA?

Assumptions Values
Principal borrowing need € 5,000,000
Maturity needed, in years 4.00
Current LIBOR 4.000%
Felini's bank spread 2.500%
Proportion of differential paid by FRA 70%
Cost of FRA € 100,000

If LIBOR Falls 50 Basis Pts Per Year Year 0 Year 1 Year 2 Year 3 Year 4

Expected annual change in LIBOR -0.500%

LIBOR 4.000% 3.500% 3.000% 2.500% 2.000%

Bank spread 2.500% 2.500% 2.500% 2.500% 2.500%
Interest rate 6.500% 6.000% 5.500% 5.000% 4.500%

Funds raised, net of fees € 5,000,000

Expected interest (interest rate x principal) -€ 300,000 -€ 275,000 -€ 250,000 -€ 225,000
Forward Rate Agreement -€ 100,000 -€ 25,000 -€ 50,000 -€ 75,000 -€ 100,000
Repayment of principal -€ 5,000,000
Total cash flows € 4,900,000 -€ 325,000 -€ 325,000 -€ 325,000 -€ 5,325,000

All-in-cost of funds (IRR) 7.092%

If LIBOR Rises 50 Basis Pts Per Year Year 0 Year 1 Year 2 Year 3 Year 4

Expected annual change in LIBOR 0.500%

LIBOR 4.000% 4.500% 5.000% 5.500% 6.000%

Bank spread 2.500% 2.500% 2.500% 2.500% 2.500%
Interest rate 6.500% 7.000% 7.500% 8.000% 8.500%

Funds raised, net of fees € 5,000,000

Expected interest (interest rate x principal) -€ 350,000 -€ 375,000 -€ 400,000 -€ 425,000
Forward Rate Agreement -€ 100,000 € 17,500 € 35,000 € 52,500 € 70,000
Repayment of principal -€ 5,000,000
Total cash flows € 4,900,000 -€ 332,500 -€ 340,000 -€ 347,500 -€ 5,355,000

All-in-cost of funds (IRR) 7.458%

This rather unusual forward rate agreement is somewhat one-sided in the favor of the insurance company. When Schifano is correct,
Schifano pays the full difference in rates to the insurance company. But when interest rates move against Schifano, the insurance company
pays Schifano only 70% of the difference in rates. And all of that is after Schifano paid €100,000 up-front for the agreement regardless of
outcome. Not a very good deal.

A final note of significance is that since Schifano receives only 70% of the difference in rates, its total cost of funds is not effectively
"capped"; they could in fact rise with no limit over the period as interest rates rose.
Problem 7.15 Chrysler LLC

Chrysler LLC, the now privately held company sold off by DaimlerChrysler, must pay floating rate interest three
months from now. It wants to lock in these interest payments using interest rate futures contracts. Interest rate futures
for three months from now settled at 96.77, for a yield of 3.23% per annum.

a. IfShould
b. Chrysler
the floating buy or
interest sell
rate the months
three interest from
rate futures
now iscontract?
either 3.00% or 3.50%, what did Chrysler gain or lose in each
case?

Assumptions Values
Future price 96.77
Yield 3.23%
Notional principal $1,000,000

(a) Chrysler should sell the interest rate futures contract.

(b)
Interest rate three months later 3.00% 3.50%
Future price 97.00 96.50
Gain/loss per contract -57,500.00 67,500.00
Problem 7.16 CB Solutions

Heather O'Reilly, the treasurer of CB Solutions, believes interest rates are going to rise, so she wants to swap her future floating
rate interest payments for fixed rates. At present she is paying LIBOR + 2% per annum on $5,000,000 of debt for the next two
years, with payments due semiannually. LIBOR is currently 4.00% per annum. Ms. O'Reilly has just made an interest payment
today, so the next payment is due six months from today.

Ms. O'Reilly finds that she can swap her current floating rate payments for fixed payments of 7.00% per annum. (CB
Solution’s weighted average cost of capital is 12%, which Ms. O'Reilly calculates to be 6% per six month period, compounded
semiannually).

a. If LIBOR rises at the rate of 50 basis points per six month period, starting tomorrow, how much does Ms. O'Reilly save or
cost her company by making this swap?

b. If LIBOR falls at the rate of 25 basis points per six month period, starting tomorrow, how much does Ms. O'Reilly save or
cost her company by making this swap?

Assumptions Values
Notional principal $ 5,000,000
LIBOR, per annum 4.000%
Spread paid over LIBOR, per annum 2.000%
Swap rate, to pay fixed, per annum 7.000%

First Second Third Fourth

Interest & Swap Payments 6-months 6-months 6-months 6-months

a. LIBOR increases 50 basis pts/6 months 0.500%

Expected LIBOR 4.500% 5.000% 5.500% 6.000%

Current loan agreement:

Expected LIBOR (for 6 months) -2.250% -2.500% -2.750% -3.000%
Spread (for 6 months) -1.000% -1.000% -1.000% -1.000%
Expected interest payment -3.250% -3.500% -3.750% -4.000%

Swap Agreement:
Pay fixed (for 6-months) -3.500% -3.500% -3.500% -3.500%
Receive floating (LIBOR for 6 months) 2.250% 2.500% 2.750% 3.000%

Net interest (loan + swap) -4.500% -4.500% -4.500% -4.500%

Swap savings?
Net interest after swap $ (225,000) $ (225,000) $ (225,000) $ (225,000)
Loan agreement interest (162,500) (175,000) (187,500) (200,000)
Swap savings (swap cost) $ (62,500) $ (50,000) $ (37,500) $ (25,000)

b. LIBOR decreases 25 basis pts/6 months -0.250%

Expected LIBOR 3.750% 3.500% 3.250% 3.000%

Current loan agreement:

Expected LIBOR (for 6 months) -1.875% -1.750% -1.625% -1.500%
Spread (for 6 months) -1.000% -1.000% -1.000% -1.000%
Expected interest payment -2.875% -2.750% -2.625% -2.500%

Swap Agreement:
Pay fixed (for 6-months) -3.500% -3.500% -3.500% -3.500%
Receive floating (LIBOR for 6 months) 1.875% 1.750% 1.625% 1.500%

Net interest (loan + swap) -4.500% -4.500% -4.500% -4.500%

Swap savings?
Net interest after swap $ (225,000) $ (225,000) $ (225,000) $ (225,000)
Loan agreement interest (143,750) (137,500) (131,250) (125,000)
Swap savings (swap cost) $ (81,250) $ (87,500) $ (93,750) $ (100,000)

In both cases CB Solutions is suffering higher total interest costs as a result of the swap.
Problem 7.17 Lluvia and Paraguas

Lluvia Manufacturing and Paraguas Products both seek funding at the lowest possible cost. Lluvia
would prefer the flexibility of floating rate borrowing, while Paraguas wants the security of fixed rate
borrowing. Lluvia is the more credit-worthy company. They face the following rate structure. Lluvia,
with the better credit rating, has lower borrowing costs in both types of borrowing.

Lluvia wants floating rate debt, so it could borrow at LIBOR+1%. However it could borrow fixed at
8% and swap for floating rate debt. Paraguas wants fixed rate, so it could borrow fixed at 12%. However
it could borrow floating at LIBOR+2% and swap for fixed rate debt. What should they do?

Assumptions Xavier Zulu

Credit rating AAA BBB
Prefers to borrow Floating Fixed
Fixed-rate cost of borrowing 8.000% 12.000%
Floating-rate cost of borrowing:
LIBOR (value is unimportant) 5.000% 5.000%
Spread 1.000% 2.000%
Total floating-rate 6.000% 7.000%

Comparative Advantage in Borrowing Values

Lluvia's absolute advantage:
in fixed rate borrowering 4.000%
in floating-rate borrowing 1.000%
Comparative advantage in fixed rate 3.000%

One Possibility Xavier Zulu

Lluvia borrows fixed -8.000% ---
Paraguas borrows floating --- -7.000%
Lluvia pays Paraguas floating (LIBOR) -5.000% 5.000%
Paraguas pays Lluvia fixed 8.500% -8.500%
Net interest after swap -4.500% -10.500%

Savings (own borrowing versus net swap):

If Lluvia borrowed floating 6.000%
If Lluvia borrows fixed & swaps with Paraguas 4.500%
1.500%

If Paraguas borrowes fixed 12.000%

If Paraguas borrows floating & swaps with Lluvia 10.500%
1.500%

The 3.0% comparative advantage enjoyed by Lluvia represents the opportunity set for improvement for
both parties. This could be a 1.5% savings for each (as in the example shown) or any other combination
which distributes the 3.0% between the two parties.
Problem 7.18 Trident's Cross Currency Swap: SFr for US$

Trident Corporation entered into a three-year cross currency interest rate swap to receive U.S. dollars and pay Swiss francs. Trident, however, decided to
unwind the swap after one year – thereby having two years left on the settlement costs of unwinding the swap after one year. Repeat the calculations for
unwinding, but assume that the following rates now apply:

Assumptions Values Swap Rates 3- year bid 3-year ask

Notional principal $ 10,000,000 Original: US dollar 5.56% 5.59%
Original spot exchange rate, SFr./$ 1.5000 Original: Swiss franc 1.93% 2.01%
New (1-year later) spot exchange rate, SFr./$ 1.5560
New fixed US dollar interest 5.20%
New fixed Swiss franc interest 2.20%

a. Interest & Swap Payments Year 0 Year 1 Year 2 Year 3

Receive fixed rate dollars at this rate: 5.56% 5.56% 5.56%

On a notional principal of: $ 10,000,000
Trident will receive cash flows: → ### → ### → ###
↑
Exchange rate, time of swap (SFr./$) 1.5000
↓
Trident will pay cash flows: → SFr. 301,500 → SFr. 301,500 → SFr. 15,301,500
On a notional principal of: SFr. 15,000,000
Pay fixed rate Swiss francs at this rate: 2.01% 2.01% 2.01%

b. Unwinding the swap after one-year Year 1 Year 2 Year 3

Remaining dollar cash inflows $ 556,000 $ 10,556,000

PV factor at now current fixed $ interest 5.20% 0.9506 0.9036
PV of remaining dollar cash inflows $ 528,517 $ 9,538,232
Cumulative PV of dollar cash infllows $ 10,066,750

Remaining Swiss franc cash outflows SFr. 301,500 SFr. 15,301,500

PV factor at now current fixed SF interest 2.20% 0.9785 0.9574
PV of remaining SF cash outflows SFr. 295,010 SFr. 14,649,818
Cumulative PV of SF cash outflows SFr. 14,944,827
New current spot rate, SFr./$ 1.5560
Cumulative PF of SF cash outflows in $ $ 9,604,645

Settlement:
Cash inflow $ 10,066,750
Cash outflow (9,604,645)
Net cash settlement of unwinding $ 462,105 This is a cash receipt by Trident from the swap dealer.
Problem 7.19 Trident's Cross Currency Swap: Yen for Euros

Using the table of swap rates in the chapter (Exhibit 8.13), and assume Trident enters into a swap agreement to receive euros and pay Japanese yen,
on a notional principal of €5,000,000. The spot exchange rate at the time of the swap is ¥104/€.

a. Calculate all principal and interest payments, in both euros and Swiss francs, for the life of the swap agreement.

b. Assume that one year into the swap agreement Trident decides it wishes to unwind the swap agreement and settle it in euros. Assuming that a
two-year fixed rate of interest on the Japanese yen is now 0.80%, and a two-year fixed rate of interest on the euro is now 3.60%, and the spot rate of
exchange is now ¥114/€, what is the net present value of the swap agreement? Who pays whom what?

Assumptions Values Swap Rates 3- year bid 3-year ask

Notional principal € 5,000,000 Euros -- € 3.24% 3.28%
Spot exchange rate, Yen/euro 104.00 Japanese yen 0.56% 0.59%

a) Interest & Swap Payments Year 0 Year 1 Year 2 Year 3

Receive fixed rate euros at this rate: 3.24% 3.24% 3.24%

On a notional principal of: € 5,000,000
Trident will receive cash flows: → ### → ### → ###
↑
Exchange rate, time of swap (¥/€) 104.00
↓
Trident will pay cash flows: → 3,068,000 → 3,068,000 → 523,068,000
On a notional principal of (yen): 520,000,000
Pay fixed rate Japanese yen at this rate: 0.59% 0.59% 0.59%

b) Unwinding the swap after one-year Year 1 Year 2 Year 3

Remaining euro cash inflows € 162,000 € 5,162,000

PV factor at now current fixed € interest 3.60% 0.9653 0.9317
PV of remaining € cash inflows € 156,371 € 4,809,484
Cumulative PV of € cash infllows € 4,965,855

Remaining ¥ cash outflows SFr. 3,068,000 SFr. 523,068,000

PV factor at now current fixed ¥ interest 0.80% 0.9921 0.9842
PV of remaining ¥ cash outflows SFr. 3,043,651 SFr. 514,798,280
Cumulative PV of ¥ cash outflows 517,841,931
New current spot rate, ¥/€ 114.00
Cumulative PV of ¥ cash outflows in € € 4,542,473

Settlement:
Cash inflow € 4,965,855
Cash outflow (4,542,473)
Net cash settlement of unwinding € 423,382 This is a cash receipt by Trident from the swap dealer.
Problem 7.20 Falcor

Falcor is the U.S.-based automotive parts supplier which was spun-off from General Motors in 2000. With annual sales of over $26 billion, the company has expanded its
markets far beyond the traditional automobile manufacturers in the pursuit of a more diversified sales base. As part of the general diversification effort, the company wishes to
diversify the currency of denomination of its debt portfolio as well. Assume Falcor enters into a $50 million 7-year cross currency interest rate swap to do just that – pay euro and
receive dollars. Using the data in Exhibit 8.13,

a. Calculate all principal and interest payments in both currencies for the life of the swap.

b. Assume that three years later Falcor decides to unwind the swap agreement. If 4-year fixed rates of interest in euros have now risen to 5.35% and 4-year fixed rate dollars have
fallen to 4.40%, and the current spot exchange rate of $1.02/€, what is the net present value of the swap agreement? Who pays who what?

Assumptions Values Swap Rates 7- year bid 7-year ask

Notional principal $ 50,000,000 US dollar 5.86% 5.89%
Spot exchange rate, $/€ 1.16 Euros 4.01% 4.05%

a. Interest & Swap Payments Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Receive fixed rate dollars at rate: 5.86%

Notional principal of: $ 50,000,000
Receive cash inflows of: $ 2,930,000 $ 2,930,000 $ 2,930,000 $ 2,930,000 $ 2,930,000 $ 2,930,000 $ 52,930,000
↑
Spot exchange rate, $/€ 1.16
↓
Pay cash outflows of: € 1,745,690 € 1,745,690 € 1,745,690 € 1,745,690 € 1,745,690 € 1,745,690 € 44,849,138
Notional principal of: € 43,103,448
Pay fixed rate euros at rate: 4.05%

b. Unwindingthe Swap Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

If the swap is unwound three years later, there are four years of cash flows remaining:

Remaining dollar cash inflows $ 2,930,000 $ 2,930,000 $ 2,930,000 $ 52,930,000

PV factor at now current fixed $ interest 4.40% 0.9579 0.9175 0.8788 0.8418
PV of remaining dollar cash inflows $ 2,806,513 $ 2,688,231 $ 2,574,934 $ 44,555,354
Cumulative PV of $ cash infllows $ 52,625,033

Remaining euro cash outflows € 1,745,690 € 1,745,690 € 1,745,690 € 44,849,138

PV factor at now current fixed € interest 5.35% 0.9492 0.9010 0.8553 0.8118
PV of remaining euro cash outflows € 1,657,038 € 1,572,889 € 1,493,012 € 36,409,603
Cumulative PV of € cash outflows € 41,132,542
Spot exchange rate at unwinding ($/€) 1.02
Cumulative PV of € cash outflows, $ $ 41,955,193

Settlement:
Cash inflow $ 52,625,033
Cash outflow (41,955,193)
Net cash settlement of unwinding $ 10,669,840 This is a net cash payment to Falcor from the swap dealer.
Problem 7.21 U.S. dollar/Euro

Pricing Currency Options on the Euro

A U.S.-based firm wishing to buy A European firm wishing to buy

or sell euros (the foreign currency) or sell dollars (the foreign currency)

Variable Value Variable Value

Spot rate (domestic/foreign) S0 $1.2480 S0 € 0.8013
Strike rate (domestic/foreign) X $1.2500 X € 0.8000
Domestic interest rate (% p.a.) rd 1.453% rd 2.187%
Foreign interest rate (% p.a.) rf 2.187% rf 1.453%
Time (years, 365 days) T 1.000 T 1.000
Days equivalent 365.00 365.00
Volatility (% p.a.) s 12.000% s 12.000%

Call option premium (per unit fc) c $0.0534 c € 0.0412

Put option premium (per unit fc) p $0.0643 p € 0.0342
(European pricing)

Call option premium (%) c 4.28% c 5.15%

Put option premium (%) p 5.15% p 4.27%

When the volatility is increased to 12.000% from 10.500%, the premium on the call option on euros rises to $0.0412/€, or 5.15%.
Problem 7.22 U.S. Dollar/Japanese Yen

Pricing Currency Options on the Japanese yen

A Japanese firm wishing to buy A U.S.-based firm wishing to buy
or sell dollars (the foreign currency) or sell yen (the foreign currency)

Variable Value Variable Value

Spot rate (domestic/foreign) S0 JPY 105.64 S0 $0.0095
Strike rate (domestic/foreign) X JPY 100.00 X $0.0100
Domestic interest rate (% p.a.) rd 0.089% rd 1.453%
Foreign interest rate (% p.a.) rf 1.453% rf 0.089%
Time (years, 365 days) T 1.000 T 1.000
Days equivalent 365.00 365.00
Volatility (% p.a.) s 12.000% s 12.000%

Call option premium (per unit fc) c JPY 7.27 c $0.0003

Put option premium (per unit fc) p JPY 3.06 p $0.0007
(European pricing)

Call option premium (%) c 6.88% c 3.06%

Put option premium (%) p 2.90% p 7.27%

A Japanese firm wishing to sell U.S. dollars would need to purchase a put on dollars. The put option premium listed above is JPY3.06/$.

Put option premium (JPY/US$) JPY 3.06

Notional principal (US$) $750,000
Total cost (JPY) JPY 2,297,243
Problem 7.23 Euro/Japanese Yen

Pricing Currency Options on the Euro/Yen Crossrate

A Japanese firm wishing to buy A European firm wishing to buy
or sell euros (the foreign currency) or sell yen (the foreign currency)

Variable Value Variable Value

Spot rate (domestic/foreign) S0 JPY 133.89 S0 € 0.0072
Strike rate (domestic/foreign) X JPY 136.00 X € 0.0074
Domestic interest rate (% p.a.) rd 0.088% rd 2.187%
Foreign interest rate (% p.a.) rf 2.187% rf 0.088%
Time (years, 365 days) T 0.247 T 0.247
Days equivalent 90.00 90.00
Volatility (% p.a.) s 10.000% s 10.000%

Call option premium (per unit fc) c JPY 1.50 c € 0.0001

Put option premium (per unit fc) p JPY 4.30 p € 0.0002
(European pricing)

Call option premium (%) c 1.12% c 1.30%

Put option premium (%) p 3.21% p 2.90%

A European-based firm like Legrand (France) would need to purchase a put option on the Japanese yen. The company wishes a strike rate of 0.0072 euro
for each yen sold (the strike rate) and a 90-day maturity. Note that the "Time" must be entered as the fraction of a 365 day year, in this case, 90/365 = 0.247.

Put option premium (euro/JPY) € 0.0002

Notional principal (JPY) JPY 10,400,000
Total cost (euro) € 2,167.90
Problem 7.24 U.S. Dollar/British Pound

Pricing Currency Options on the British pound

A U.S.-based firm wishing to buy A British firm wishing to buy

or sell pounds (the foreign currency) or sell dollars (the foreign currency)

Variable Value Variable Value

Spot rate (domestic/foreign) S0 $1.8674 S0 £0.5355
Strike rate (domestic/foreign) X $1.8000 X £0.5556
Domestic interest rate (% p.a.) rd 1.453% rd 4.525%
Foreign interest rate (% p.a.) rf 4.525% rf 1.453%
Time (years, 365 days) T 0.493 T 0.493
Days equivalent 180.00 180.00
Volatility (% p.a.) s 9.400% s 9.400%

Call option premium (per unit fc) c $0.0696 c £0.0091

Put option premium (per unit fc) p $0.0306 p £0.0207
(European pricing)

Call option premium (%) c 3.73% c 1.70%

Put option premium (%) p 1.64% p 3.87%

Call option premiums for a U.S.-based firm buying call options on the British pound:

180-day maturity ($/pound) $0.0696

90-day maturity ($/pound) $0.0669
Difference ($/pound) $0.0027

The maturity doubled while the option premium rose only about 4%.
Problem 7.25 Euro/British Pound

Pricing Currency Options on the British pound/Euro Crossrate

A European firm wishing to buy A British firm wishing to buy

or sell pounds (the foreign currency) or sell euros (the foreign currency)

Variable Value Variable Value

Spot rate (domestic/foreign) S0 € 1.4730 S0 £0.6789
Strike rate (domestic/foreign) X € 1.5000 X £0.6667
Domestic interest rate (% p.a.) rd 4.000% rd 4.160%
Foreign interest rate (% p.a.) rf 4.160% rf 4.000%
Time (years, 365 days) T 0.247 T 0.247
Days equivalent 90.00 90.00
Volatility (% p.a.) s 11.400% s 11.400%

Call option premium (per unit fc) c € 0.0213 c £0.0220

Put option premium (per unit fc) p € 0.0487 p £0.0097
(European pricing)

Call option premium (%) c 1.45% c 3.24%

Put option premium (%) p 3.30% p 1.42%

When the euro's interest rate rises from 2.072% to 4.000%, the call option premium on British pounds rises:

Call option on pounds when euro interest is 4.000% € 0.0213

Call option on pounds when euro interest is 2.072% € 0.0189
Change, an increase in the premium € 0.0213