Derivatives and Risk Management

Home assignment 1

Spring 2021

Students:
Calvin Duarte
Guillem Bogunya
Maria Pagano


Problem 1

1.

The relevant formula to compute annual interest rates is:

(1 + 𝑟𝑠𝑒𝑚𝑖𝑎𝑛𝑛𝑢𝑎𝑙 )2 − 1

Therefore, the risk-free annual interest rates are:

𝑟𝑈𝑆 = (1 + 0.022)2 − 1 = 4.4484%

𝑟𝐷𝐾𝐾 = (1 + 0.004)2 − 1 = 0.8016%

In order for the covered interest parity to hold,

𝐹 = 𝑆𝑡 𝑒 (𝑟𝐷𝐾𝐾−𝑟𝑈𝑆 )(𝑇−𝑡) ⇒

𝐹 = 𝑆0 𝑒 (𝑟𝐷𝐾𝐾 −𝑟𝑈𝑆)0.5 = 6.09𝑒 (0.008016−0.044484)0.5 ≈ 5.97996

Thus, the theoretically correct forward price is 𝐹 ≈ 5.97996 𝐷𝐾𝐾/𝑈𝑆𝐷

2.

If the current forward price is 𝐹0 = 6.09 𝐷𝐾𝐾/𝑈𝑆𝐷, then 𝐹0 > 𝑆0 𝑒 (𝑟𝐷𝐾𝐾 −𝑟𝑈𝑆)0.5 since 6.09 >

5.97996. This means that covered interest parity does not hold anymore, thus we have

arbitrage. To obtain a risk-free arbitrage gain we “short the expensive” and “long the cheap”.

In this case, we short the forward 𝐹0 and go long in 𝑆0 𝑒 (𝑟𝐷𝐾𝐾 −𝑟𝑈𝑆)0.5 . The following table

summarizes the strategy.

Today (t=0) Delivery Day (T=0.5)

Buy PV(1 USD) in US −1𝑈𝑆𝐷 ∗ 𝑒 −𝑟𝑈𝑆∗𝑇 1𝑈𝑆𝐷

today

Borrow PV(1 USD) in 𝑆0 𝐷𝐾𝐾 ∗ 𝑒 −𝑟𝑈𝑆∗𝑇 −𝑆0 𝐷𝐾𝐾 ∗ 𝑒 (𝑟𝐷𝐾𝐾 −𝑟𝑈𝑆)∗𝑇

DKK, repay at T

Short USD forward 0 𝐹0 − 1𝑈𝑆𝐷

Net 0 𝐹0 −𝑆0 𝐷𝐾𝐾 ∗ 𝑒 (𝑟𝐷𝐾𝐾 −𝑟𝑈𝑆)∗𝑇

Cashflow in DKK in 6 months from now:

𝐹0 −𝑆0 𝐷𝐾𝐾 ∗ 𝑒 (𝑟𝐷𝐾𝐾 −𝑟𝑈𝑆)∗𝑇 ⟺ 6.09 − 6.09 ∗ 𝑒 (0.8016−4.4484)∗0.5 ⟺ 5.1066 > 0