Notes econ 462 Essay

Interest Rate Arbitrage 462 10/14/2013

Exchange rate risk and int. business
1. Overseas operations
a. Country a – sales and profits
b. Country b – sales and profits
c. Country c – sales and profits
Consolidated financials would have to take into consideration the exchange rate of each country at a given time. If exchange rates are unfavorable then the consolidated profits will be hurt.
If a US business buys from a foreign business exchange rate must be accounted for. If an on delivery contract is created between the two there are ways to eliminate exchange rate risk. Exchange US dollars for foreign immediately and avoid future exchange rates. Lock in the exchange rate into the contract from the beginning. Doing nothing until the time of delivery/payment leaves you susceptible to exchange rate risk (however if the foreign currency becomes weaker than it saves the US company money).
Hedging – Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

1 (a).
1 b . interest rate arbitrage Ius = 2% for one year T-bills Iuk = 3.5%
If invested in the US treasury bill you will receive $1.02 (no exchange rate risk).
Case: invest your money in UK bonds.
Transactions involved:
1. Sell US $ for British pounds.
2. Use the pounds to purchase British bonds
3. Options
a. Do Nothing – you will receive £1/St (1 + Iuk). You will need to convert the amount of £ you have after a year back into US $ to realize the actual rate of return. There is an exchange rate risk.
b. Hedge away the exchange rate risk – 3 transactions simultaneously. Buy British £. Use

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