Stock Options and Credit Default Swaps in Risk Management | Assignment

Running head: QUESTION AND ANSWERS
Question and Answer
Name of the Student:
Name of the University:
Author Note:

QUESTION AND ANSWERS1
Answer to Question 1:
Part 1:
The interest rate parity means the forward rate should be equal to the interest rate
differential between the two countries multiplied by the spot rate. Thus the interest rate parity
highlights that the difference between the forward rate and the spot rate should be equal to the
difference between the interest rate between the two countries. This has an immense role to
play in the forex markets as if the interest rate parity does not hold good then investors can
earn arbitrage profits by taking relevant position in the currency.
Thus as per the question, the spot rate and the forward rates have been provided with
the bid ask rate. The bid rate is the rate at which the investor can sell to the bank and the ask
rate is the rate at which the investor can purchase from the bank. Thus for simplicity of
calculating interest rate parity mid rates are taken for the same.
Mid Spot Rate = 1.2575
Mid Forward Rate = 1.2375
Forward discount Premium = ((1.2375-1.2575)/1.2575)*100 = 1.59%
Interest rate US 3% UK 5%,
Hence interest rate differential = (5-3) % = 2%
Hence arbitrage is possible since the interest rate differential is not equal to the
currency differential. Thus the formula for IRP is given by,
Forward Rate/ spot Rate = (1+US)^N/(1+UK)^N
Forward Rate = 1.2575*((1+0.03)^3/12/(1+0.05)^3/12)

QUESTION AND ANSWERS2
Forward Rate = 1.251
The Forward parity rate is the rate which should be the exchange rate after the time
period which is equal to the interest rate differential of the two countries multiplied by the
spot rate. If the rate is not equal to the forward rate, then the investor has an opportunity to
generate arbitrage profits. The mid rates from the spot and the forward rates for both the
currency is calculated, which is used in the parity equation. Thus the interest rate for the both
the country is taken and used in the parity equation, which provides the forward rate of $
1.251 per euro. Thus the forward rates of the currency is not equal to the parity forward rate
which is calculated.
Part 2:
The interest rate arbitrage can be defined as borrowing in low yielding currency and
investing in high yielding currency. The arbitrage profit is earned when the interest rate parity
does not hold good and the investor makes more money than it was supposed to from the
investment. Thus the interest rate arbitrage is highlighted in the following steps.
Step 1: The amount which needs to be invest is pound 100000.
Step 2: convert the pound into spot dollars at the exchange rate of 1.255 which is the bid rate.
The dollar which is received is 125500.
Step 3: Invest the dollar which has been converted for 3 months at the US interest rate which
is 3%. Thus the amount after 3 months is 126430.84 dollars.
Step 4: This amount which is received in dollars is converted in pound at ask forward rate of
1.245. Thus the pound which is received is 101550.
Step 5: If the pound 100000 would had been invested at 5% UK rate the pound amount would
had been 101227.22.

QUESTION AND ANSWERS3
Step 6: Thus arbitrage profit from the transaction is pound 323.65.
Thus since the transaction was covered the effective exchange rate which was locked
by the company from the above transaction is 126430.84/101227.22 = 1.249.
Thus as per the money market mechanism the parity forward rate for the currency pair
is $1.2489. Thus this is not equal to the parity forward rate calculated from the parity
equation. The forward rate as per the money market mechanism implies that if the position in
the foreign currency is left open and not covered the rate which should be present should be
equal to the forward rate of the currency. Thus, it is the effective exchange rate at which the
company can convert its currency, ignoring taxes and transaction cost.
Part 3:
The parity equation takes into account the spot rates, the interest rates for both the
countries when the forward rate is calculated. In the money market mechanism, the forward
rate is calculated by dividing a set amount invested in one currency by the same amount
invested in other currency (Du, Tepper and Verdelhan 2018). The difference which is of
$0.02 is on account of the fact of the effect of the spot rate. In uncovered IRP the spot rate is
the rate for conversion, and gives a specific set of amount which is invested in the market rate
for a specific time period. Thus the amount which earned is not covered and is exchanged on
the day of the investment horizon ends (Han 2018). Thus the difference between the interest
rates and the exchange rates should be equal to avoid arbitrage. However, since the difference
is not equal it gives rise to arbitrage opportunity which is exploited by the investors (Lothian
2016).