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FINC3014 Solutions - Topic 10:

Arbitrage and Hedging Transaction


Question 1
What is index arbitrage?
A strategy designed to profit from temporary discrepancies between the prices of
the underlying assets comprising an index and the price of a futures contract on
that index. By buying either the underlying assets or the futures contract and
selling the other, an investor can sometimes exploit market inefficiency for a
profit. Like all arbitrage opportunities, index arbitrage opportunities disappear
rapidly once the opportunity becomes well-known and many investors act on it.
Index arbitrage can involve large transaction costs because of the need to
simultaneously buy and sell many different underlying assets and futures, and so
only large money managers, banking institutions and so on, are usually able to
profit from index arbitrage. In addition, sophisticated computer programs are
needed to keep track of the large number of underlying assets and futures
involved, which makes this a very difficult trading strategy for individuals.

Question 2
Consider a stock, currently trading at $80 (assuming no dividend). The interest
rate is 1% per month.

(a) What should be the price of a 3 month future on this stock?

The price of the three month future is F0,3 = S0(1+r)3 = $80 x 1.013 = $82.42

(b) If a 6 month future is trading at $90, can you make arbitrage profit? How?
The fair value of a 6 month future should be F0,6 = S0(1+r)6 = 80 x 1.016 =
$84.92. Given the trading price of $90, we know that it is overvalued. Hence,
to make an arbitrage profit, we want to short (sell) the future.
At t=0, we short one unit of the future; borrow $80 to buy one unit of stock
at spot market. The net cash flow is zero.
At t=6, we deliver the unit to the buyer, receive payment of $90 on the
future, and repay the bank loan $80 x 1.016 = $84.92. The net cash flow or
arbitrage profit is $90 - $84.92 = $5.08.

(c) If a 1 year future is trading at $90, can you make arbitrage profit? How?
The fair value of a 1 year future should be F0,12 = S0(1+r)12 = 80 x 1.0112 =
$90.146. Given the trading price of $90, we know that it is undervalued.
Hence, to make an arbitrage profit, we want to long (buy) the future.
At t=0, we long one unit of the future; borrow and short one unit of stock at
spot market and save the $80 proceeds from the sale of the stock in the
bank. The net cash flow is zero.

At t=12, we acquire one unit of the stock from the seller of the future and
return the stock to the lender. We have to pay $90 according to the future
contract. On the other hand we withdraw from the bank $80 x 1.0112 =
$90.146. The net cash flow or arbitrage profit is $90.146 - $90 = $0.146.

Question 3
What is triangular arbitrage? What is a condition that will give rise to a triangular
arbitrage opportunity?
Triangular arbitrage is the process of trading out of one currency into a second
currency, then trading it for a third currency, which is in turn traded for back into
the original currency. The purpose is to earn an arbitrage profit via trading from
the second to the third currency when the direct exchange between the two is not
in alignment with the cross exchange rate.
As a simple example, one might trade out of AUD and into NZD. Then they may
trade from NZD into USD. Then they may trade from USD back into AUD. If the
three exchange rates are out of alignment this would generate a risk free profit,
they would be back in their original currency with a higher principal value.
Most, but not all, currency transactions go through the dollar. Certain banks
specialize in making a direct market between non-dollar currencies, pricing at a
narrower bid-ask spread than the cross-rate spread.
Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the
non-dollar market makers. If their direct quotes are not consistent with the cross
exchange rates, a triangular arbitrage profit is possible.

Question 4
A foreign exchange trader with a U.S. bank took a short position of 5,000,000
when the GBP/USD exchange rate was 1.55. Subsequently, the exchange rate
has changed to 1.61. Is this movement in the exchange rate profitable from the
point of view of the position taken by the trader? By how much has the banks
liability changed because of the change in the exchange rate?
The increase in the GBPUSD exchange rate implies that the pound has
appreciated with respect to the dollar. This is unfavourable to the trader since the
trader has a short position in pounds.
Banks liability in dollars initially was 5,000,000 GBP x 1.55 = $7,750,000 USD.
Banks liability in dollars now is 5,000,000 GBP x 1.61 = $8,050,000 USD.
The liability has increased by $300,000 USD.

Question 5
Assume you are a trader with Deutsche Bank. You note that EUR/USD is trading
at 1.28 (one EUR is worth 1.28 USD). USD/JPY is trading at 106 (one USD is
worth 106 JPY). A cross rate on EUR/JPY is being quoted by UBS at 134. What
trades might you use to generate a risk free profit? (Assume no transaction
If one Euro is worth 1.28 USD, and one USD is worth 106 JPY, then one Euro
should be worth 1.28*106, so 135.7 JPY. Since EURJPY is trading at 134 the EUR
is under-priced (it should buy more JPY than it does).
Say you had $1,000 USD.

You convert it into JPY, so $1,000 * USDJPY = (1,000) * 106 = 106,000 JPY.
You then buy EUR with this money, so: (106,000) / EURJPY = 106,000 / 134 =
791.04 EUR.
You then use these EUR to buy back into USD: (791.04) * EURUSD = (791.04) *
1.28 = $1,012.53
You have made a risk free profit of $12.53.

Question 6
The current spot exchange rate is GBP/USD 1.95 and the three-month forward
rate is GBP/USD 1.9. Based on your analysis of the exchange rate, you are pretty
confident that the spot exchange rate will be GBP/USD 1.92 in three months.
Assume that you would like to buy or sell 1,000,000.
a) What actions do you need to take to speculate in the forward market? What
is the expected dollar profit from speculation?
If you believe the spot exchange rate will be $1.92/ in three months, you
should buy 1,000,000 forward for $1.90/. Your expected profit will be:
$20,000 = 1,000,000 x ($1.92 -$1.90).
b) What would be your speculative profit in dollar terms if the spot exchange
rate actually turns out to be GBP/USD 1.86.
If the spot exchange rate actually turns out to be $1.86/ in three months,
your loss from the long position will be:
-$40,000 = 1,000,000 x ($1.86 -$1.90).

Question 7
Kit Kat Research sold a super computer to the Max Planck Institute in Germany
on credit and invoiced 10 million payable in six months. Currently, the six-
month forward exchange rate is EUR/USD 1.1 and the foreign exchange advisor
for Kit Kat Research predicts that the spot rate is likely to be EUR/USD 1.05 in six
a) What is the expected gain/loss from the forward hedging?
Expected gain ($) = 10,000,000(1.10 1.05) = 10,000,000(.05) =

b) If you were the financial manager of Kit Kat Research, would you recommend
hedging this euro receivable? Why or why not?
I would recommend hedging because Kit Kat Research can increase its
expected US-dollar receipt by $500,000 while also eliminating its exchange
rate risk.

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?
Since I eliminate risk without sacrificing dollar receipts, I would still
recommend hedging.

Question 8
WOWEE Financial Services is rumored to be considering launching a takeover bid
for WOAH International Consulting Group. A local hedge fund (DPGM), believing
that this will eventuate decides to employ a pairs merger arbitrage strategy to
profit from their information.
a) What sort of arbitrage is this, and why? Discuss what risks remain for the
hedge fund.
This is a speculative arbitrage with a high level of market exposure. Going
long the acquired and short the acquirer is the standard merger arbitrage
strategy, and although this removes some market wide, and even industry
specific exposure, the hedge fund will still be exposed to relative performance
of the two stocks. In addition, if the takeover bid is unsuccessful, then you
would expect the share price of the acquirer to rise, and the rumoured target
to fall.

b) DPGM decides they will have an equal investment in each firm (one short one
long), and they will hedge their net beta using ASX200 Futures Contracts.
WOWEE has a beta of 1.3, WOAH has a beta of 3.6. They intend to invest
$10M in each. The ASX contracts have a beta of 1. What position should
DPGM hold in each of the three securities (in dollar terms)?
They will be buying the target firm, WOAH, and selling the acquirer, WOWEE.
The dollar portfolio beta will be $10m * 3.6 - $10m * 1.3 = $23m.
The futures position must have a dollar value of -$23m to counteract this by
removing market risk.
The final portfolio is thus long $10m WOAH, short $10m WOWEE, and short
$23m in ASX futures.

c) DPGM disagrees with the beta estimate of 3.6 for WOAH. They task their best
intern with estimating the beta, based on a covariance to the market of 12%,
a variance of the market of 2% and a variance of WOAH of 21%. The analyst
also discovers that WOWEE has a correlation to the market of 0.7 and a
standard deviation of 42%. How should he adjust his hedge?

Beta = Covariance (Asset, Market) / Variance (Market)

For WOAH, Beta = 12%/2% = 6.

Covariance = Correlation * Standard Deviation (Asset) * Standard Deviation

and: Standard Deviation (Market) = Sqrt (Variance (Market))
Covariance for WOWEE = 0.7 * 42% * Sqrt (2%) = 4.16%.
For WOWEE, Beta = 4.16%/2% = 2.08.

Portfolio beta is now ($10m * 6) + (-$10m * 2.08) = $39.2m. They must

short an additional ($39.2m - $23m), i.e. a further $16.2m of futures