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IBF301_Final Essay_2022
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No Arbitrage Forward rate = Spot Rate * (1 + RD)/ (1 + RF)
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Question 10 of 40
With regard to operational hedging versus financial hedging,
A. financial hedging, when instituted on a rollover basis, is a superior long-term approach to operational hedging.
B. none of the above
C. since they both have the same goal, stabilizing the firm's cash flows in domestic currency, they are fungible in use.
D. operational hedging provides a more stable long-term approach than does financial hedging.
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where RD is the interest rate in the domestic country, in this case United States
RF is the interest rate in the foreign country, in this case Germany
Thus, using this formula, the no arbitrage forward rate should be LOW.COM 1.6*(1+2%)/(1+4%) = 1.6 * 1.02/1.04 = $1.57 approximately
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However, the actual forward rate = $1.58/€
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Hence, there is an arbitrage opportunity.
Suppose an arbitrager borrows 1,000,000 in the United States at 2%.
Thus, after one year, he has to pay back 1,000,000 * (1 + 2%) = $1,020,000
He converts 1,000,000 into Euros at the spot exchage rate of $1.60/€.
Thus he gets 1,000,000/1.6 = €625,000
The arbitrager now invests this money in Germany at 4%.
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At the same time, he enters into a forward contract to convert the money that he will get US Dollars at a forward rate of $1.58/€
After 1 year, he gets 625,000 *(1+4%) = €650,000
He converts this money into USD at the exchange rate of $1.58/€ (at which he entered th
Thus he gets 650,000 * 1.58 = $1,027,000
Amount he has to pay back = $1,000,000 * (1 + 2%) = $1,020,000
Net cash flow for the year through this arbitrage = $1,027,000 - $1,020,000 = $7,000
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8:43 AM
11/9/2022
