How to Make a Geographical Arbitrage - Assignment Example

International Financial Management xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Lecturer xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Question 1 Arbitrage Delbaen & Schachermayer (2006) defines arbitrage as the opportunity to buy a currency, asset or financial instrument at a low price and then selling it immediately at higher prices at different markets. The corporate treasury is in a position to make geographical arbitrage profits from the difference in currencies of the two banks. Arbitrage profit Westpac Sydney A$1.1840-60/€ Barclays London A$1.1830-50/€ A$1,000,000/1.1830 = €845308.5376 €845308.5376 x A$1.1860 = A$1,002,535.9256 Arbitrage profit = A$1,002,535.9256- A$1,000,000 = A$2,535.9256 By acting fast, the corporate treasury will make a geographical arbitrage of A$2,535.9256. To get this the firm will convert A$1,000,000 to euro by dividing it by A$1.1830/€ to become €845308.5376. These are Euros as offered by the Barclays London. Then multiply €845308.5376 by A$1.1860/€ to get A$1,002,535.9256 in Australian dollar. The corporate treasury will as a result make A$1,002,535.9256 - A$1,000,000 = A$2,535.9256 from the arbitrage process. The firm, using one million Australian dollar, buy the euro at the lowest quoted price A$1.1830/€ as quoted by Barclays London. From the resultant amount, in form of euro, sell it in to Australian dollar at the highest quoted price A$1.1860/€ by Westpac Sydney. This will give the company an arbitrage profit. To get the maximum arbitrage profit the corporate treasury must act very fast as this prices are subject to change very fast. It must operate speedily to exploit on the currency difference. Question 2 Covered interest rate arbitrage entails investing in a foreign currency, for a short term that is covered by forward contract for the purpose of selling the currency upon the maturity of the investment as Björk (2004) explains. This arbitrage is credible when the interest rates differences are not reflected by the forward premium between the two countries as indicated by the formula for interest rate parity. The interest rate parity provides that the forward premium should indicate the interest rate differences between the two countries (Japan and Australia). 180 - Day interest rate differential = 3% - 1.8% = 2.2% Since 2.2% is higher than 0.36% (110.20 – 109.80)/110.20)) 180 – day forward rate, the covered interest arbitrage is worth Given that forward (A$/¥) = (1 – 0.03) = 0.97(A$/¥) spot rate. The base currency is Australian dollar that is in forward premium meaning that the number of Japanese yen being paid per 1 Australian dollar on the forward is 3% less than the spot rate. Initial investment = A$2,000,000 1 buys at cheap Australia interest rates = A$2,000,000 x 1.03 = A$2,060,000 2 then sell the A$ and buy yen at spot market = A$2,000,000 x 110.20 ¥/A$ = ¥220,400,000 3 sell in Tokyo = ¥220,400,000 x 1.018¥/A$ = ¥224,367,200 4 covering the amount = A$2,060,000 x 109.80¥/A$ = ¥226,188,000 Profit /loss = ¥224,367,200 - ¥226,188,000 = (¥1,820,800) Question 3 a) Charge = RM1050/ day 30 days = 1050 x 30 = RM 31500 = 31500/3.75 = A$8,400/30 = A$280 per day Dollars needed one year for the 30 day vacation = A$8400 x 1.01% = A$8484 The Malaysian ringgit will inflate as RM31500 x 1.04 = RM32760 Assuming inflation will be even throughout the year Dollars needed = A$8400 X (1/12) % = A$8407 = RM31500 X (3/12) % = RM31578.75 = RM31578.75/3.75 = A$8421 are needed for the 30 day vacation in the island b) Percentage change in dollar cost Change = A$8421 - A$8400 = A$21 Percentage change = (A$21/ A$8400) x 100 = 0.25% The dollar cost have gone up by 0.25% Question 4 A call option presents Katya Berezovsky a right but not necessarily a requirement to buy the currency at a prearranged strike price before the expiry of the call option. She will buy the call option with hopes that the underlying currency rates will rise significantly well higher than the strike price for her to exercise the call option. A put option gives her the right, and again not necessarily a requirement, to sell the currency at a prearranged strike price way before the expiry of the put option. At exercising this option, she will hope that the underlying currency exchange rate will be low than the strike price so that she can make some profits. Since it’s a right and not a requirement, she may decide to exercise the right or not. a) Katya Berezovsky should buy a put on yen option; this will present her with the best value for the currency. Since she expects the dollar to rise significantly against the Japanese yen, put option will be low than the strike price and hence will make higher profits. If the dollar rises, the yen will lower in value than the current spot rate and therefore exercise the option. b) The breakeven price of the put option Breakeven price = put option exercise price – premium and transactional costs = ¥140.00 There are no premium costs, transactions and commission costs. This makes the ¥140.00 to be the breakeven price of the put option. The breakeven price is the strike price plus money received on exercise of the option. As per the question, the premiums and costs are not provided. c) Gross profit and net profit There will be no gross profit as there are no costs involved in the exercise of this rights, this maximizes the net profit that Katya will receive after selling the right. Net profit = ¥140.00/US$ - ¥120.00/US$ = ¥20.00/US$ Question 5 a) The exchange rate after devaluation Rate of devaluation = 20% Spot exchange rate before devaluation = TL68, 000/USD Devaluation value = 20% x TL68, 000 = TL 13,600 Exchange rate after devaluation = TL68, 000 + TL13, 600 = TL81, 600/USD b) Percentage change after fall = TL100, 000/USD Fall value = TL100, 000/USD - TL81, 600/USD = TL18, 400/USD Percentage change = (TL19, 000/USD/ TL81, 600/USD) x 100% = 0.2255 x 100% = 22.55% The devaluation of the Turkish lira will encourage exports and discourage imports. The costs of exports will be favorable while the costs of import will be very high. Devaluation will also take the excess cash flow that is in possession of individuals and business in order to restore the economic crisis. The prices of commodities, particularly the farm products, will rise up thereby reducing the purchasing and bargaining power in the country. This as well reduces available cash flow for disposal. Devaluation of the lira will make foreign currencies to be cheap in respect to lira; this favors foreign persons coming to turkey. Question 6 Calculation of weighted average cost of capital WACC = (weight of equity x cost of equity) + (weight of debt x cost of debt) Cost of equity = (risk free rate + beta) x market risk premium Cost of equity = Rf + (Rm – Rf)β Company A 2.50 + (5.5% - 2.50%) 0.86 = 5.08% Company B 2.50 + (5.5% - 2.50%) 0.78 =4.84% Cargill 2.50 + (5.5% - 2.50%) = 5.5% Company A Company B Cargill Market value of equity 2.97 billion 15.34 billion 36 billion Market value of debt 1.53 billion 10.66 billion 14 billion Total market value of debt and equity 4.5 billion 26 billion 50 billion Weight of equity 66% 59% 72% Weight of debt 34% 41% 28% Cost of equity 2.50 + (5.5% - 2.50%)0.86 = 5.08% 2.50 + (5.5% - 2.50%)0.78 =4.84% 2.50 + (5.5% - 2.50%) = 5.5% Cost of debt 6.885% 7.125% 6.820% WACC (66% x 5.08%) + (34% x 6.885%) (59% x 4.84%) + (41% x 7.125%) (72% x 5.5%) + (28% x 6.820%) = 0.033528 + 0.02309 = 0.05694 = 5.694% = 0.028556 + 0.0292125 = 0.05777 = 5.777% = 0.0396 + 0.019096 = 0.058696 = 5.8696% The other two companies (A and B) provide a good WACC for comparison to that of Cargill. Although Cargill is well established in the market and makes substantial sales compared to them, the WACCs of these companies are relatively. The WACC of these companies are comparable. The sales proportion has been sued to calculate the weight of equity and debt. This is because no additional data has been provided for calculation of the same. Cargill is in a good financial base. This is an indication of good company management. The impressive sales the company has been making (over $50 billion) in the last five years indicate that the company’s stocks and capital budgeting are prudent. This WACC, Brealey et al., (2006) point, will help the company to make capital expenditure plans and amount of funds that it needs for financing investments. The company will have easy access of funds because of good financial management as indicated by the weighted average cost of capital, Caselli & Feyrer (2007). It has maintained a good balance between equity financing and debt financing. The WACC also indicate that the company will get additional cash flows from investments and therefore increase the net present value of its assets and stocks. Comparing Cargill performance with companies A and B, it is better placed not only for accessing external funds but also market performance of its investments. This is positive for management as they will focus attention on diversifying the investments so as to spread risks accordingly. References Arbitrage Risk and Post‐Earnings‐Announcement Drift, The Journal of Business, 77(4), 875-894. Björk, T. (2004), Arbitrage theory in continuous time, Oxford university press. Mendenhall, R. R. (2004). Brealey, R. A., Myers, S. C., & Allen, F., (2006), Corporate finance Boston et al.: McGraw-Hill/Irwin. Caselli, F., & Feyrer, J., (2007), The marginal product of capital, The Quarterly Journal of Economics, 122(2), 535-568 Delbaen, F., & Schachermayer, W., (2006), The mathematics of arbitrage Berlin: Springer. Read More