EXERCICES AND PROBLEMS IN FOREIGN EXCHANGE

1. Using the quotes listed below for August 26, 199X, calculate a cross-rate matrix for the French
franc, German mark, Japanese yen, and the British pound.
Country

U.S.$ equivalent

Currency per U.S.$

1.5578
1.5571
1.5576
1.5577
.7294
.7302
.7318
.7341
.1980
.1983
.1988
.1996
.6760
.6772
.6799
.6843
.009281
.009320
.009399
.009524
.8379
.8401
.8446
.8519

.6419
.6422
.6420
.6420
1.3710
1.3695
1.3665
1.3623
5.0515
5.0440
5.0305
5.0088
1.4793
1.4766
1.4709
1.4614
107.75
107.29
106.39
105.00
1.1935
1.1904
1.1840
1.1739

Britain (Pound)
30-day Forward
90-day Forward
180-day Forward
Canada (Dollar)
30-day Forward
90-day Forward
180-day Forward
France (Franc)
30-day Forward
90-day Forward
180-day Forward
Germany (Mark)
30-day Forward
90-day Forward
180-day Forward
Japan (Yen)
30-day Forward
90-day Forward
180-day Forward
Switzerland (Franc)
30-day Forward
90-day Forward
180-day Forward
Solution:
FRF
DEM
JPY
GBP

FRF
0.2929
21.33
0.1271

DEM
3.4141
72.83
0.4339

JPY
0.0469
0.0137
0.0060

GBP
7.8681
2.3045
167.8564
-

2. Using the same quotes, calculate the 30-, 90-, and 180-day forward cross exchange rates between
the German mark and the Swiss franc using the most current quotations.
Solution:
F(DEM/CHF)30 = F(DEM/$)30 F($/CHF)30 = 1.4766 0.8401 = 1.2405
F(DEM/CHF)90 = 1.2423; F(DEM/CHF)180 = 1.2450
3. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in
forward points.
Spot
One-Month
Three-Month
Six-Month
Solution:
One-Month
Three-Month
Six-Month

1.3431-1.3436
1.3432-1.3442
1.3448-1.3463
1.3488-1.3508
01-06
17-27
57-72

4. Using the spot and outright forward quotes in problem 3, determine the corresponding bid-ask
spreads in points.

Solution:
Spot
One-Month
Three-Month
Six-Month

5
10
15
20

5. Using the quotes listed at problem 1, calculate the 30-, 90-, and 180-day forward premium or
discount for the British pound using quotations in American terms.
Solution:
fN,v$
f30,v$
f90,v$
f180,v$

= [(FN($/) - S($/))/S($/] x 360/N 100

= [(1.5571 - 1.5578)/1.5578] x 360/30 100 = -0.5392%
= [(1.5576 - 1.5578)/1.5578] x 360/90 100 = -0.0514%
= [(1.5577 - 1.5578)/1.5578] x 360/180 100 = -0.0128%

6. Using the quotes listed at problem 1, calculate the 30-, 90-, and 180-day forward premium or
discount for the Canadian dollar using quotations in European terms.
Solution:
The formula we want to use is:
fN,CAD/$ = [(S(CAD/$) - FN(CAD/$))/FN(CAD/$)] x 360/N 100
f30,CAD/$ = [(1.3710 - 1.3695)/1.3695] x 360/30 100 = +1.3143%
f90,CAD/$ = [(1.3710 - 1.3665)/1.3665] x 360/90 100 = +1.3172%
f180,CAD/$ = [(1.3710 - 1.3623)/1.3623] x 360/180 100 = +1.2773%
7. Given the following information, what are the DM/S$ currency against currency bid-ask
quotations?
Bank Quotations
Deutsche Marks
Singapore Dollar

American Terms
Bid
Ask
0.6784 0.6789
0.6999 0.7002

European Terms
Bid
Ask
1.4730 1.4741
1.4282 1.4288

Solution:
We know that S(DM/S$b) = S($/S$b) x S(DM/$b) = .6999 x 1.4730 = 1.0310. The reciprocal, 1/S(DM/S$b) =
S(S$/DMa) = .9699. Analogously, it is implied that S(DM/S$a) = S($/S$a) x S(DM/$a) = .7002 x 1.4741 =
1.0322. The reciprocal, 1/S(DM/S$a) = S(S$/DMb) = .9688. Thus, the DM/S$ bid-ask spread is DM1.0310DM1.0322 and the S$/DM spread is S$0.9688-S$0.9699.
8. A foreign exchange dealer in London normally quotes spot, one month, three months, and six
months. When you ask over the telephone for current quotations for the Finnish markka (FIM)
against the U.S. dollar, you hear:
4.2040 to 200, 120 to 110, 350 to 312, 680 to 620
a. What would you receive in dollars if you sold FIM 1,000,000 spot?
b. What would you receive in FIM if you sold 10,000,000 dollars forward three months?
What would it cost you to purchase FIM 15,000,000 forward six months with dollars? When would
you make payment?
Solution:
The quotes above should be read as follows:
Spot
4.2040-4.2200 FIM/USD
F1m
4.1920-4.2090
F3m
4.1690-4.1880
F6m
4.1360-4.1580
a) Sell FIM spot & buy $ at 4.2200 FIM/$ you receive 1,000,000 FIM/4.2200 = 236,967$
b) Sell $ F3m & Buy FIM at 4.1690 FIM/$ you receive 10,000,000$ 4,1690 = 41,690,000 FIM
c) Buy FIM F6m & Sell $ at 4.1360 FIM/$ you pay 15,000,000 FIM/ 4.1360 = 3,626,692$. You would
make payment in 6 months plus 2 business days.

9. The Malaysian ringgit and the Czech koruna change in value relative to the dollar as indicated.
Calculate the after-change exchange rate in local currency units per dollar.
Currency
Malaysian ringgit
Czech koruna

Initial exchange rate

MR 2.5400/$
CK 236.2100/$

Change relative to U.S. dollar

Depreciates 20%
Appreciates 5%

Solution:
For MR -0,20 = (2,5400 S1)/S1 S1 = 3,1750 MR/$
For CK +0,05 = (236,2100 S1)/S1 S1 = 224,961 CK/$
10. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal,
you notice that Dresdner Bank is quoting DM1.6230/$1.00 and Credit Suisse is offering
SF1.4260/$1.00. You learn that UBS is making a direct market between the Swiss franc and the mark,
with a current DM/SF quote of 1.1250.
a) Show how you can make a triangular arbitrage profit by trading at these prices. (Ignore bidask spreads for this problem). Assume you have $5,000,000 with which to conduct the
arbitrage.
b) What happens if you initially sell dollars for Swiss francs?
c) What DM/SF price will eliminate triangular arbitrage?
Solution:
a) To make a triangular arbitrage profit the Deutsche Bank trader would sell $5,000,000 to Dresdner
Bank at DM1.6230/$1.00. This trade would yield DM8,115,000 = $5,000,000 x 1.6230. The
Deutsche Bank trader would then sell the deutsche marks for Swiss francs to Union Bank of
Switzerland at a price of DM1.1250/SF1.00, yielding SF7,213,333 = DM8,115,000/1.1250. The
Dresdner trader will resell the Swiss francs to Credit Suisse for $5,058,438 =SF7,213,333/1.4260,
yielding a triangular arbitrage profit of $58,438.
b) If the Deutsche Bank trader initially sold $5,000,000 for Swiss francs, instead of deutsche marks, the
trade would yield SF7,130,000 = $5,000,000 x 1.4260. The Swiss francs would in turn be traded for
deutsche marks to UBS for DM8,021,250 = SF7,130,000 x 1.1250. The marks would be resold to
Dresdner Bank for $4,942,237 =DM8,021,250/1.6230, or a loss of $57,763. Thus, it is necessary to
conduct the triangular arbitrage in the correct order.
c) The S(DM/SF) cross exchange rate should be 1.6230/1.4260 = 1.1381. This is an equilibrium rate at
which a triangular arbitrage profit will not exist. (The student can determine this for himself.) A profit
results from the triangular arbitrage when dollars are first sold for marks, because Swiss francs are
purchased for marks at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss francs
are purchased for only DM1.1250/SF1.00 instead of the no-arbitrage rate of DM1.1381/SF1.00.
Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs
are sold for marks at too low a rate, resulting in too few marks, i.e. each Swiss franc is sold for DM
1.1250/SF1.00 instead of the higher no-arbitrage rate of DM1.1381/SF1.00.
11. The following quotations are available to you. (You may either buy or sell at the stated rates.)
Hong Kong Shanghai Bank, French franc quote for U.S. dollars
Dresdner Bank, Deutschemark quote for U.S. dollars
Banque Nationale de Paris, French franc quote for Deutschemarks

FF4.8600/$
DM 1.4200/$
FF 3.4400/DM

Assume that you have an initial $ 1,000,000. Is triangular arbitrage possible? If so, explain the steps
and compute your profit.
Solution:
Calculated FRF/DEM = 4,8600 (1/1,4200) = 3,4225 FRF/DEM < 3,4400 FRF/DEM in the market, DEM
is more expensive in FRF terms sell DEM and buy FRF at 3,4400 FRF/DEM. Arbitrage steps:
1. Sell 1m $ and buy DEM at 1,4200 DEM/$ 1m$ 1,4200 = 1,42m DEM
2. Sell 1,42m DEM and buy FRF at 3,4400 FRF/DEM 4,8848m FRF
3. Sell 4,8848m FRF and buy $ at 4,86 FRF/$ 1,0051m $
Profit = 1,0051m $ - 1m $ = 5100 $

12. Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for six
months. The six-month interest rate is 8% per annum in the U.S. and 6% per annum in Germany.
Currently, the spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate is
DM1.56 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should
he/she invest to maximize the return?
Solution:
The market conditions are summarized as follows:
I$ = 4%; iDM = 3%; S = DM1.60/$; F = DM1.56/$.
If $1,000,000 is invested in the U.S., the maturity value in six months will be
$1,040,000 = $1,000,000 (1 + .04).
Alternatively, $1,000,000 can be converted into DM and invested at the German interest rate, with the DM
maturity value sold forward. In this case the dollar maturity value will be
$1,056,410 = ($1,000,000 x 1.60)(1 + .03)(1/1.56)
Clearly, it is better to invest $1,000,000 in Germany with exchange risk hedging.
13. Currently, the spot exchange rate is $1.50/ and the three-month forward exchange rate is $1.52/.
The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume
that you can borrow as much as $1,500,000 or 1,000,000.
a. Determine whether the interest rate parity is currently holding.
b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps
and determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of covered arbitrage activities.
Solution:
Lets summarize the given data first: S = $1.5/; F = $1.52/; I $ = 2.0%; I = 1.45%; Credit = $1,500,000 or
1,000,000.
a. (1+I$) = 1.02
(1+I)(F/S) = (1.0145)(1.52/1.50) = 1.0280
Thus, IRP is not holding exactly.
b. (1) Borrow $1,500,000; repayment will be $1,530,000.
(2) Buy 1,000,000 spot using $1,500,000.
(3) Invest 1,000,000 at the pound interest rate of 1.45%;
maturity value will be 1,014,500.
(4) Sell 1,014,500 forward for $1,542,040
Arbitrage profit will be $12,040
c. Following the arbitrage transactions described above: The dollar interest rate will rise; The pound interest
rate will fall; The spot exchange rate will rise; The forward exchange rate will fall.
These adjustments will continue until IRP holds.
14. You plan to spend one month at the luxurious Nusa Dua hotel in Bali, Indonesia, a year from now.
The present charge for a suitable suite plus meals is Rps 28,800 per night, or $800 at the present
exchange rate of Rps 36/$. The Nusa Dua Hotel tells you that next years charges will increase with
Indonesian inflation, which you expect to be 16%. U.S. inflation is currently 4% per annum. You
believe implicitly in the theory of purchasing power parity. How many U.S. dollars will you need one
year hence to pay for your 30-day vacation?
Solution:
1. Calculate expected hotel charges 1 year hence in Indonesia by first inflating the currency one night
expense in Rps: Rps 28,800 1.16 = Rps33,408. Then multiplying by 30 days the total vacation cost in local
currency Rps33,408 30 = Rps1,002,240.
2. Forecast next year's exchange rate according to PPP S1 = Rps36 (1.16/1.04) = Rps40.15
3. Calculate next year's rupee price in dollars: Rps1,002,240/40.15 = $24,962.39
15. The United States and France both produce Cabernet sauvignon wine. A bottle of Cabernet
Sauvignon sells in the United States for $18. An equivalent bottle sells in France for FRF100.
a. According to purchasing power parity, what should be the U.S. dollar / French franc spot rate
of exchange?
b. Suppose the price of Cabernet Sauvignon in the U.S. is expected to rise to $20 over the next
year, while the price of comparable bottle of French wine is expected to rise to FRF118. What
should be the one-year forward U.S. dollar / French franc exchange rate?

c. Given your answers to (a) and (b) above, and given that the current interest rate in the United
States is 6% for notes of a one-year maturity, what would you expect current French interest
rates to be?
Solution:
a) SPPP = FRF100/$18 = FRF5.5556/$
b) SPPP = FRF118/$20 = FRF5.9000/$
c) According to International Fisher Effect, the percentage change in the dollar value in FRF will be
equal to the interest differential iFRF -iUSD, We compute first the change in $value, as (5.9 5.5556)/5.5556 = +6.1992%. Consequently, i FRF -iUSD = 6.1992% iFRF = 6.1992% + 6% iFRF =
12.1992% (approximately)
16. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and
invoiced DM 10 million payable in six months. Currently, the six-month forward exchange rate is
$1.50/DM and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be
$1.43 in six months.
(a) What is the expected gain/loss from the forward hedging?
(b) If you were the financial manager of Cray Research, would you recommend hedging this DM
receivable? Why or why not?
(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as
the forward exchange rate quoted today. Would you recommend hedging in this case? Why
or why not?
Solution:
(a) (a) Expected gain ($) = 10,000,000(1/1.50-1/1.43) = 10,000,000(.6667-.6993) = -$326,000.
(b) There is no easy answer here. Hedging is expected to reduce the dollar receipt by $326,000. If I
were willing to sacrifice $326,000 or more to eliminate exchange risk, I would hedge. Otherwise, I
would not. It depends on the degree of my risk aversion.
(c) Since I eliminate risk without sacrificing dollar receipt, I would be more likely to hedge.