CHAPTER19

FUTURES,FORWARDSANDSWAPMARKETS

1. Thereislittlehedgingorspeculativedemandforcementfutures,sincecementprices
arefairlystableandpredictable.Thetradingactivitynecessarytosupportthefutures
marketwouldnotmaterialize.
2. Theabilitytobuyonmarginisoneadvantageoffutures.Anotheristheeaseof
alteringonesholdingsoftheasset.Thisisespeciallyimportantifoneisdealingin
commodities,forwhichthefuturesmarketisfarmoreliquidthanthespotmarket.
3. Shortsellingresultsinanimmediatecashinflow,whereastheshortfuturesposition
doesnot:
Action
InitialCF
FinalCF
ShortSale
+P0
PT
ShortFutures

0
F0PT
4. a. TakeashortpositioninTbondfutures,tooffsetinterestraterisk.Ifrates
increase,thelossonthebondwillbeoffsettosomeextentbygainsonthe
futures.

b. Again,ashortpositioninTbondfutureswilloffsettheinterestraterisk.

c. Youwishtoprotectyourcashoutlaywhenthebondispurchased.Ifbondprices
increase,youwillneedextracashtopurchasethebond.Thus,youwanttotakea
longfuturespositionthatwillgenerateaprofitifpricesincrease.

5.

a.
Action
LongfutureswithT1maturity
ShortfutureswithT2maturity
AtT1buyasset.SellatT2
AtT1,borrowF(T1)

CashFlows
T1
P1F(T1)
0
P1
F(T1)

Total

191

T2
0
F(T2)P2
+P2
F(T1)(1+r)

(T2T1)

F(T2)F(T1)(1+r)

(T2T1)

b. SincetheT2cashflowisrisklessandnonetinvestmentwasmade,anyprofits
wouldrepresentanarbitrageopportunity.
c. Thezeroprofitnoarbitragerestrictionimpliesthat
F(T2)=F(T1)(1+r)

6.

(T2T1)

Theputcallparityrelationstatesthat
P=CS0+X/(1+rf)T
IfF=X,thenP=CS0+F/(1+rf)T
ButspotfuturesparitytellsusthatF=S0(1+rf)T.Substituting,wefindthat
P=CS0+[S0(1+rf)T]/(1+rf)T=CS0+S0,whichimpliesthatP=C.

7.

8.

Thebeforetaxprofitis$.40perbushel.Becauseeachcontractcallsfordelivery
of5,000bushels,andtheinvestorpurchases3contracts,thepretaxprofitis
$.40x5,000x3=$6,000,whichprovidesaftertaxprofitsof$3,000,orof$4,500,
dependingonwhetheryourfuturesincomeistaxedasordinaryincomeorcapital
gains,inthelattercase,only50%ofthegainsaretaxed.
a. F=S0(1+r)=150(1.06)=159
b. F=S0(1+r)3=150(1.06)3=178.65

c. F=150(1.08)3=188.96

9.

AsSincreases,sowillF.Youshouldbuythefutures.Alongpositioninfuturesis
betterthanbuyingthestocksinceyougettheadvantageofbuyingonmargin.

10. F=S0(l+rd)=800(1+.05.02)=824.
11. Accordingtotheparityrelation,theproperpriceforDecemberfuturesis:

192

FDec=FJune(l+rf)l/2=546.30(1.05)1/2=559.79.
TheactualfuturespriceforDecemberistoolowrelativetotheJuneprice.You
shouldlongtheDecembercontractandtakeashortpositionintheJunecontract.

193

12. a. 120(1.06)=$127.20
b. Thestockpricefallsto120(1.03)=$116.40
Thefuturespricefallsto116.4(1.06)=$123.384
Theinvestorloses(127.20123.384)1000=$3,816
c. Thepercentagelossis3,816/12,000=.318=31.8%
13. a. TheinitialfuturespriceisF0=1300(1+.005.002)12=1347.58
Inonemonth,thefuturespricewillbeF0=1320(1+.005.002)11=1364.22
Theincreaseinthefuturespriceis16.64,sothecashflowwillbe16.64$250=
$4,160
b. Theholdingperiodreturnis$4160./$13,000=.32=32%
14. a. Thecalloptionisdistinguishedbyitsasymmetricpayoff.IftheSwissfrancrises
invalue,thefirmcanbuyfrancsforagivennumberofdollarstoserviceitsdebt,
andtherebyputacaponthedollarcostofitsfinancing.Ifthefrancfalls,the
firmwillbenefitfromthechangeintheexchangerate.
Thefuturesandforwardcontractshavesymmetricpayoffs.Thedollarcostofthe
financingislockedinregardlessofwhetherthefrancappreciatesordepreciates.The
majordifferencefromthefirm'sperspectiveinfuturesvs.forwardsisinthemarkto
marketfeatureoffutures,whichmeansthatthefirmmustbereadyforthecash
managementissuessurroundingcashinflowsoroutflowsasthecurrencyvaluesand
futurespricesfluctuate.
b. Thecalloptiongivesthefirmtheabilitytobenefitfromdepreciationinthefranc,but
atacostequaltotheoptionpremium.Unlessthefirmhassomespecialexpertisein
currencyspeculation,itseemsthatthefuturesorforwardstrategy,whichlocksina
dollarcostoffinancingwithoutanoptionpremium,maybethebetterstrategy.
15.

Thetreasurerwouldliketobuythebondstoday,butcannot.Asa
proxyforthispurchase,Tbondfuturescontractscanbepurchased.Ifratesdoin
factfall,thetreasurerwillhavetobuybackthebondsforthesinkingfundat
priceshigherthanthepricesatwhichtheycouldbepurchasedtoday.However,
thegainsonthefuturescontractswilloffsetthishighercosttosomeextent.

16.

Theimportantdistinctionbetweenafuturescontractandanoptionscontractisthatthe
futurescontractisanobligation.Whenaninvestorpurchasesorsellsafutures
contract,theinvestorhasanobligationtoeitheracceptordeliver,respectively,the
194

underlyingcommodityontheexpirationdate.Incontrast,thebuyerofanoption
contractisnotobligatedtoacceptordelivertheunderlyingcommoditybutinsteadhas
theright,orchoice,toacceptdelivery(forcallholders)ormakedelivery(forput
holders)oftheunderlyingcommodityanytimeduringthelifeofthecontract.
Futuresandoptionsmodifyaportfoliosriskindifferentways.Buyingorsellinga
futurescontractaffectsaportfoliosupsideriskanddownsideriskbyasimilar
magnitude.Thisiscommonlyreferredtoassymmetricalimpact.Ontheotherhand,
theadditionofacallorputoptiontoaportfoliodoesnotaffectaportfoliosupside
riskanddownsiderisktoasimilarmagnitude.Unlikefuturescontracts,theimpactof
optionsontheriskprofileofaportfolioisasymmetric.
17.a. The investor should sell the forward contract to protect the value of the bond against
rising interest rates during the holding period. Because the investor intends to take a
long position in the underlying asset, the hedge requires a short position in the
derivative instrument.
b. Thevalueoftheforwardcontractonexpirationdateisequaltothespotpriceofthe
underlyingassetonexpirationdateminustheforwardpriceofthecontract:
$978.40$1,024.70=$46.30
Thecontracthasanegativevalue.Thisisthevaluetotheholderofalongpositionin
theforwardcontract.Inthisexample,theinvestorshouldbeshorttheforward
contract,sothatthevaluetothisinvestorwouldbe+$46.30sincethisisthecashflow
theinvestorexpectstoreceive.
c.

Thevalueofthecombinedportfolioattheendofthesixmonthholdingperiodis:
$978.40+$46.30=$1,024.70
Thechangeinthevalueofthecombinedportfolioduringthissixmonthperiodis:
$24.70
Thevalueofthecombinedportfolioisthesumofthemarketvalueofthebond
andthevalueoftheshortpositionintheforwardcontract.Atthestartofthesix
monthholdingperiod,thebondisworth$1,000andtheforwardcontracthasa
valueofzero(becausethisisnotanoffmarketforwardcontract,nomoney
changeshandsatinitiation).Sixmonthslater,thebondvalueis$978.40andthe
valueoftheshortpositionintheforwardcontractis$46.30,ascalculatedinpart
(b).
Thefactthatthecombinedvalueofthelongpositioninthebondandtheshort
positionintheforwardcontractattheforwardcontractsmaturitydateisequalto
theforwardpriceontheforwardcontractatitsinitiationdateisnotacoincidence.
Bytakingalongpositionintheunderlyingassetandashortpositioninthe
forwardcontract,theinvestorhascreatedafullyhedged(andhenceriskfree)
position,andshouldearntheriskfreerateofreturn.Thesixmonthriskfreerate
195

ofreturnis5.00%(annualized),whichproducesareturnof$24.70overasix
monthperiod:
($1,0001.05(1/2))$1,000=$24.70
TheseresultssupportVanHusensstatementthatsellingaforwardcontracton
theunderlyingbondprotectstheportfolioduringaperiodofrisinginterestrates.
Thelossinthevalueoftheunderlyingbondduringthesixmonthholdingperiod
isoffsetbythecashpaymentmadeatexpirationdatetoholderoftheshort
positionintheforwardcontract;thatis,ashortpositionintheforwardcontract
protects(hedges)thelongpositionintheunderlyingasset.
18.

19.

a.

Accurate.Futurescontractsaremarkedtothemarketdaily.Holdingashort
positiononabondfuturescontractduringaperiodofrisinginterestrates
(decliningbondprices)generatespositivecashinflowfromthedailymarkto
market.Ifaninvestorinafuturescontracthasalongpositionwhenthepriceof
theunderlyingassetincreases,thenthedailymarktomarketgeneratesapositive
cashinflowthatcanbereinvested.Forwardcontractssettleonlyatexpiration
dateanddonotgenerateanycashflowpriortoexpiration.

b.

Inaccurate.Accordingtothecostofcarrymodel,thefuturescontractpriceis
adjustedupwardbythecostofcarryfortheunderlyingasset.Bonds(andother
financialinstruments),however,donothaveanysignificantstoragecosts.
Moreover,thecostofcarryisreducedbyanycouponpaymentspaidtothe
bondholderduringthelifeofthefuturescontract.Anyconvenienceyieldfrom
holdingtheunderlyingbondalsoreducesthecostofcarry.Asaresult,thecost
ofcarryforabondislikelytobenegative.

a.

Futures prices are determined from the spreadsheet as follows:

Spot price
Income yield (%)
Interest rate (%)
Today's date
Maturity date 1
Maturity date 2
Maturity date 3
Time to maturity 1
Time to maturity 2
Time to maturity 3

Spot Futures Parity and Time Spreads

1,500
1.5 Futures prices versus maturity
3.0
1/1/2008 Spot price
1,500.00
2/14/2008 Futures 1
1,502.67
5/21/2008 Futures 2
1,508.71
11/18/2008 Futures 3
1,519.79
0.12
0.39
0.88
LEGEND:
Enter data
Value calculated
See comment

196

b.

The spreadsheet demonstrates that the futures prices now decrease with
increased income yield:
Spot price
Income yield (%)
Interest rate (%)
Today's date
Maturity date 1
Maturity date 2
Maturity date 3

Spot Futures Parity and Time Spreads

1,500
4.0 Futures prices versus maturity
3.0
1/1/2008 Spot price
1,500.00
2/14/2008 Futures 1
1,498.20
5/21/2008 Futures 2
1,494.15
11/18/2008 Futures 3
1,486.78

Time to maturity 1
Time to maturity 2
Time to maturity 3

0.12
0.39
0.88
LEGEND:
Enter data
Value calculated
See comment

20.

The current yield for Treasury bonds (coupon divided by price) plays the role of
the dividend yield.
b. When the yield curve is upward sloping, the current yield exceeds the short rate.
Hence, T-bond futures prices on more distant contracts are lower than those on
near-term contracts.

21.

a. The strategy that would take advantage of the arbitrage opportunity is a reverse cash
and carry. A reverse cash and carry opportunity results when the following
relationship does not hold true:

a.

F0 S0 (1+ C)
If the futures price is less than the spot price plus the cost of carrying the goods to the
futures delivery date, then an arbitrage opportunity exists. A trader would be able to sell
the asset short, use the proceeds to lend at the prevailing interest rate, and then buy the
asset for future delivery. At the future delivery, the trader would then collect the
proceeds of the loan with interest, accept delivery of the asset, and cover the short
position in the commodity.
b.
Cash Flows
Action

Now

Sell the spot commodity short

+$120.00

197

One year from now

$125.00

Buy the commodity futures expiring in 1 year

Contract to lend $120 at 8% for 1 year

$0.00
$120.00

Total cash flow

$0.00

$0.00
+$129.60
+$4.60

22. a. S0(1+rf)D=1,425(1.06)15=1495.5
b. S0(1+rf)D=1,425(1.03)15=1452.75
c. Thefuturespriceistoolow.Buyfutures,shorttheindex,andinvestthe
proceedsoftheshortsaleinTbills.
Buyfutures
Shortindex
Buybills
TOTAL

CFNow

CFin6months
0
ST1,422
1,425
ST15
1425
1467.75
0
30.75

Thearbitrageprofitequalsthemispricingofthecontract.

23.

a.

Thevalueoftheunderlyingstockis:
$2501,350=$337,500
25/$337,500=0.000074=0.0074%ofthevalueofthestock

b. $400.000074=$0.0030(lessthanhalfofonecent)
c.

$0.20/$0.0030=67
Thetransactioncostinthestockmarketis67timesthetransactioncostinthe
futuresmarket.

24. a. Fromparity,F0=800(1+.03)10=814.ActualF0is812,sothefutures
priceis2belowthe"proper"level.
b. Buytherelativelycheapfuturesandselltherelativelyexpensivestock.
Sellshares

CFNow

CFin6months
+800
(ST+10)

198

Buyfutures
Lend$800
TOTAL

0
800
0

ST812
+824
2

c. Ifyoudonotreceiveinterestontheproceedsoftheshortsales,thenthe$800you
receivewillnotbeinvestedbutwillsimplybereturnedtoyou.Theproceedsfrom
thestrategyinpart(b)arenownegative:anarbitrageopportunitynolongerexists.
Sellshares
Buyfutures
Place$800inmarginaccount
TOTAL

+800
0
800
0

(ST+10)
ST812
+800
22

d. IfwecalltheoriginalfuturespriceF0,thentheproceedsfromthelongfutures,
shortstockstrategyare:
Sellshares
Buyfutures
Place$800inmarginaccount
TOTAL

+800
0
800
0

(ST+10)
STF0
+800
790F0

Therefore,F0canbeaslowas790withoutgivingrisetoanarbitrage
opportunity.Ontheotherhand,ifF0ishigherthantheparityvalue,814,an
arbitrageopportunity(buystocks,sellfutures)willopenup.Thereisnoshort
sellingcostinthiscase.Therefore,thenoarbitragebandis790F0814.
25.

a.

Callpthefractionofproceedsfromtheshortsaletowhichwehaveaccess.
Ignoringtransactioncosts,thelowerboundonthefuturespricethatprecludes
arbitrageisthefollowingusualparityvalue(exceptforthefactorp):
S0(l+rfp)D
Thedividend(D)equals:0.0121,350=$16.20
Thefactorparisesbecauseonlythisfractionoftheproceedsfromtheshort
salecanbeinvestedintheriskfreeasset.Wecansolveforpasfollows:
1,350(1+0.022p)16.20=1,351p=0.579

b.

Withp=0.9,thenoarbitragelowerboundonthefuturespriceis:
1,350[1+(0.0220.9)]16.20=1,360.53
Theactualfuturespriceis1,351.Thedeparturefromtheboundistherefore
9.53.Thisdeparturealsoequalsthepotentialprofitfromanarbitragestrategy.
Thestrategyistoshortthestock,whichcurrentlysellsat1,350.Theinvestor
199

receives90%oftheproceeds(1,215)andtheremainder(135)remainsinthe
marginaccountuntiltheshortpositioniscoveredin6months.Theinvestor
buysfuturesandlends1,215:
Buyfutures
Sellshares
Lend
Total

CFNow
0
1350135
1,215

CFin6months
ST1,351
135ST16.20
1,2151.022=1,241.73

9.53

Theprofitis:9.53$250percontract=$2,382.50

26.

a.

Delsingshouldsellstockindexfuturescontractsandbuybondfutures
contracts.Thisstrategyisjustifiedbecausebuyingthebondfuturesand
sellingthestockindexfuturesprovidesthesameexposureasbuyingthe
bondsandsellingthestocks.Thisstrategyassumeshighcorrelationsbetween
themovementsofthebondfuturesandbondportfolioaswellasthestock
indexfuturesandthestockportfolio.

b.

Thecorrectnumberofcontractsineachcaseis:
i.

5$200,000,0000.0001=$100,000
$100,000/97.85=1,022contracts

ii.
27.

$200,000,000/($1,378250)=581contracts

Thefuturespriceistheagreeduponpricefordeferreddeliveryoftheasset.Ifthat
priceisfair,thenthevalueoftheagreementoughttobezero;thatis,thecontract
willbeazeroNPVagreementforeachtrader.

28. F0 =S0(l+r)T=1050(1.04)=1092
IfF=1100,youcouldearnarbitrageprofitsasfollows:
Buygold
Shortfutures
Borrow

CFNow
1050
0
1050
0

1910

CFin1year
ST
1100ST
1092
8

Theforwardpricemustbe1092inorderforthisarbitragestrategytoyieldno
profits.
29. Ifabadharvestthisyearmeansaworsethanaverageharvestinfutureyears,then
thefuturespriceswillriseinresponsetothisyearsharvest,althoughpresumablythe
twoyearpricewillchangebylessthantheoneyearprice.Thesamereasoning
holdsifwheatisstoredacrosstheharvest.Nextyearspriceisdeterminedbythe
availablesupplyatharvesttime,whichistheactualharvestplusthestoredwheat.A
smallerharvestnowmeanslessstoredwheatfornextyearwhichcanleadtohigher
prices.
Supposefirstthatwheatisneverstoredacrossaharvest,andsecondthatthequality
ofaharvesthasnothingtodowiththequalityofpastharvests.Underthese
circumstances,thereisnolinkbetweenthecurrentpriceofwheatandtheexpected
futurepriceofwheat.Thequantityofwheatstoredwillfalltozerobeforethenext
harvest,andthusthequantityofwheatandthepriceinayearwilldependsolelyon
thequantityofnextyearsharvest,whichhasnothingtodowiththisyearsharvest.
30. Therequiredrateofreturnonanassetwiththesameriskascornis1%+.5(1.8%
1%)=1.4%permonth.Thus,intheabsenceofstoragecosts,threemonthsfrom
nowcornwouldhavetosellfor$2.75(1.014)3=$2.867.Thefuturevalueofthe3
month'sstoragecostsis$.03FA(1%,3)=$.091,whereFAstandsforthefuture
valuefactorofalevelannuitywithagiveninterestrateandnumberofpayments.
Thus,theexpectedpricewouldhavetobe$2.867+$.091=$2.958toinduce
storage.Becausetheexpectedspotpriceisonly$2.94,dontstoreit.
31. SituationA.Themarketvalueoftheportfoliotobehedgedis$20million.Themarket
valueofthebondscontrolledbyonefuturescontractis$63,330.Ifweweretoequate
themarketvaluesoftheportfolioandthefuturescontract,wewouldsell
20,000,000/63,330=315.806contracts.However,wemustadjustthisnaivehedge
forthepricevolatilityofthebondportfoliorelativetothefuturescontract.Price
volatilitiesdifferaccordingtoboththedurationandtheyieldvolatilityofthebonds.
Inthiscase,theyieldvolatilitiesmaybeassumedequal,becauseanyyieldspread
betweentheTreasuryportfolioandtheTreasurybondunderlyingthefuturescontract
islikelytobestable.However,thedurationoftheTreasuryportfolioislowerthan
thatofthefuturescontract.Adjustingthenaivehedgeforrelativedurationand
relativeyieldvolatility,weobtaintheadjustedhedgeposition:
315.806(7.6/8)1.0=300contracts

1911

SituationB.Hereweneedtohedgethepurchasepriceofthebonds,andrequirealong
hedge.Themarketvalueofthebondstobepurchasedis$20million.93=$18.6
million.Thedurationratiois7.2/8.0,andtherelativeyieldvolatilityis1.25.Therefore,
thehedgerequiresthetreasurertogolonginthefollowingnumberofcontracts:
(18,600,000/63,330)(7.2/8)1.25=330contracts

32.

a.

1 rJapan
From parity: F0 E0

1 rUS

0.5

1.0010
124.30

1.0380

0.5

122.06453

b.
Action Now

CF in $

Borrow $1,000,000 in U.S.

$1,000,000

Sell forward $1,008,637.446

at F0 = 123.2605

Action at periodRepay loan

Unwind forward

Convert borrowed dollars to yen;

lend 124,300,000 in Japan

$1,000,000
Total
0

CF in
($1,000,000 1.0350.25 ) =
$1,008,637.446
(1,008,637.446 123.2605) =
124,325,155.9127

Collect repayment
in yen
Total

124,300,000 1.0050.25 =
124,455,084.5187
129,928.61

The arbitrage profit is: 129,928.61

33.

a.

Byspotfuturesparity:
F0=S0(l+rf)=185[1+(0.06/2)]=190.55

b.

Thelowerboundisbasedonthereversecashandcarrystrategy.

ActionNow
BuyoneTOBECindex
futurescontract
SellspotTOBECindex
Lend$18,500
Total

CFin$
0
+$18,500
$18,500
0

Actionatperiodend
SelloneTOBECindex
futurescontract
BuyspotTOBECindex
Collectloanrepayment
Paytransactioncosts
Total

CFin$
$100(F1F0)
$100S1
$18,5001.03=+$19,055
$15.00
$100F0+$19,040

(NotethatF1=S1atexpiration.)
ThelowerboundforF0is:19,040/100=190.40
34.

a.

Youshouldbeshorttheindexfuturescontracts.Ifthestockvaluefalls,you
needfuturesprofitstooffsettheloss.

1912

b.

Eachcontractisfor$250timestheindex,currentlyvaluedat1,350.
Therefore,eachcontractcontrolsstockworth:$2501,350=$337,500
Inordertohedgea$13.5millionportfolio,youneed:
$13,500,000
40 contracts
$337,500

c.

Now,yourstockswingsonly0.6asmuchasthemarketindex.Hence,you
need0.6asmanycontractsasin(b):0.640=24contracts

a.

ThestrategywouldbetosellJapanesestockindexfuturestohedgethemarket
riskofJapanesestocks,andtosellyenfuturestohedgethecurrencyexposure.

b.

Somepossiblepracticaldifficultieswiththisstrategyinclude:

35.

Contractsizeonfuturesmaynotmatchsizeofportfolio.
Stockportfoliomaynotcloselytrackindexportfoliosonwhichfuturestrade.
Cashflowmanagementissuesfrommarkingtomarket.
Potentialmispricingoffuturescontracts(violationsofparity).

36. Thedollarisdepreciatingrelativetotheeuro.Toinduceinvestorstoinvestinthe
U.S.,theU.S.interestratemustbehigher.

37.

1 rUS
1.04
1.60
1.541
1 rUK
1.08

a.

Fromparity: F0 E 0

b.

SupposethatF0=$1.58/.Thendollarsarerelativelytoocheapinthe
forwardmarket,orequivalently,poundsaretooexpensive.Therefore,you
shouldborrowthepresentvalueof1,usetheproceedstobuypound
denominatedbillsinthespotmarket,andsell1forward:

ActionNow
Sell1forwardfor$1.58
Buy1/1.08inspotmarket;
investattheBritishriskfreerate
Borrow$1.481
Total

CFin$
0

Actionatperiodend
Collect$1.58,
deliver1

1.60/1.08=$1.481 Exchange1for$E1
$1.481
0

38. a.LendintheU.K.
1913

Repayloan;
U.S.interestrate=4%
Total

CFin$
$1.58$E1
$E1
$1.540
$0.04

b.BorrowintheU.S.
c.BorrowingintheU.S.offersa4%rateofreturn.BorrowingintheU.K.and
coveringinterestrateriskwithfuturesorforwardsoffersarateofreturnof:

F
1.58

rUS (1 rUK ) 0 1 1.07

1 0.0566 5.66%
E0
1.60

ItappearsadvantageoustoborrowintheU.S.,whereratesarelower,andto
lendintheU.K.Anarbitragestrategyinvolvessimultaneouslendingand
borrowingwiththecoveringofinterestraterisk:
ActionNow
CFin$
Borrow$1.60inU.S.
$1.60
Convertborroweddollarsto
$1.60
pounds;lend1poundinU.K.
Sellforward1.07atF0=$1.58 0
Total
0
39.

a.

Actionatperiodend
CFin$
Repayloan
1.601.04
Collectrepayment;exchange
1.07E1
proceedsfordollars
Unwindforward
1.07(1.58E1)
Total
$0.0266

Thehedgedinvestmentinvolvesconvertingthe$1milliontoforeign
currency,investinginthatcountry,andsellingforwardtheforeigncurrencyin
ordertolockinthedollarvalueoftheinvestment.Becausetheinterestrates
arefor90dayperiods,weassumetheyarequotedasbondequivalentyields,
annualizedusingsimpleinterest.Therefore,toexpressratesonaperquarter
basis,wedividetheseratesby4:
Convert $1 million
to local currency
Invest in local currency
for 90 days
Convert to $ at
90-day forward rate

Japanese government
$1,000,000 133.05 =
133,050,000

Switzerland government
$1,000,000 1.5260 =
DM1,526,000

133,050,000 [1 + (0.076/4)] =
135,577,950

SF1,526,000 [1 + (0.086/4)] =
SF1,558,809

135,577,950/133.47 =
$1,015,793

1,558,809/1.5348 =
$1,015,643

b.

Theresultsinthetwocurrenciesarenearlyidentical.Thisnearequalityreflectsthe
interestrateparitytheorem.Thistheoryassertsthatthepricingrelationships
betweeninterestratesandspotandforwardexchangeratesmustmakecovered(that
is,fullyhedgedandriskless)investmentsinanycurrencyequallyattractive.

c.

The90dayreturninJapanis1.5793%,whichrepresentsabondequivalentyieldof
1.5793%365/90=6.405%.The90dayreturninGermanyis1.5643%,which
representsabondequivalentyieldof1.5643%365/90=6.344%.Theestimatefor
the90dayriskfreeU.S.governmentmoneymarketyieldisinthisrange.

1914

40. Iftheexchangeofcurrencieswerestructuredasthreeseparateforwardcontracts,the
forwardpriceswouldbedeterminedasfollows:
Forwardexchangerate$1millioneuros=dollarstobedelivered
Year1: 1.20(1.05/1.04)$1millioneuros=$1.2115million
Year2: 1.20(1.05/1.04)2$1millioneuros=$1.2232million
Year3: 1.20(1.05/1.04)3$1millioneuros=$1.2349million
Instead,wedeliverthesamenumberofdollars(F*)eachyear.ThevalueofF*is
determinedbyfirstcomputingthepresentvalueofthisobligation:
F*
F*
F*
1.2115 1.2232 1.2349

3.3300
1
2
3
1.05 1.05
1.05
1.051
1.05 2
1.05 3

F*equals$1.2228millionperyear.

41.

a.

The swap rate moved in favor of firm ABC. ABC should have received 1%
more per year than it could receive in the current swap market. Based on
notional principal of $10 million, the loss is:
0.01 x $10 million = $100,000 per year.

b.

The market value of the fixed annual loss is obtained by discounting at the
current 7% rate on 3-year swaps. The loss is:
$100,000 x Annuity factor (7%, 3) = $262,432

c.

If ABC had become insolvent, XYZ would not be harmed. XYZ would be
happy to see the swap agreement cancelled. However, the swap agreement
ought to be treated as an asset of ABC when the firm is reorganized.

42. If one buys the cap and writes a floor, one reproduces a conventional swap, which is
costless to enter. Therefore, the proceeds from writing the floor must be the same as
from buying the cap, $0.30 per dollar of notional principal.
43.

Thefirmreceivesafixedratethatis2%higherthanthemarketrate.Theextra
paymentof(0.02$10million)haspresentvalueequalto:
$200,000Annuityfactor(8%,5)=$798,542

1915