Question: 1

i. C
ii. A
iii. C
iv. B
v. A
vi. B
vii. C
viii. B
ix. B
x. B

Question: 3

a.
i. Interest Rate Parity hold when: FTZS/US$ = STZS/US$*(1 + iTZS)/( 1 + iUS$)
= 1,500*(1.02)/( 1.0145)
= TZS1,508/US$
Compare with market forward rate TZS.1,520/US$
Interest rate parity does not hold so covered arbitrage exists.
ii. Comparing the theoretical rate TZS1,508/US$ and the market rate
TZS.1,520 per US$ we find that the US$ is OVERVALUED. So, borrow in
Tanzania shillings and invest in US dollars market

 Borrow TZS.3,000,000 2% for three months repayment will be

TZS.3,060,000
 Sell TZS.3,000,000 at spot rate TZS.1,500/US$ you obtain US$2,000
 Invest at the US interest rate 1.45% for three months, will be US$2,029
 Sell US$2,029 forward for TZS.1,520/US$, will be TZS.3,084,080
 Profit will be: TZS.3,084,080 - TZS.3,060,000 = TZS.24,080
iii. Following the arbitrage: The Tanzania interest rate will rise, US interest
rate will fall, the spot rate will rise and forward rate will fall. These
adjustment will continue until the IRP holds

b.
TZS.
Sales revenue
In 3 months £130,000 × TZS.2,423/£ 314,990,000

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 In 6 months £410,000 × TZS.2,420/£ 992,200,000
Less: Purchase cost
In 3 months £100,000 × TZS.2,465/£ 246,500,000
In 6 months £400,000 × TZS.2,462/£ 984,800,000
Net receipts 75,890,000

Workings
Bid Ask
Spot rate (TZS per £) 2,410 2,450
Add: discounts 13 15
3 month forward rate 2,423 2,465

Bid Ask
Spot rate (TZS per £) 2,410 2,450
Add: discounts 10 12
6 month forward rate 2,420 2,462

Question: 4

a.
i. It gives only the right and not obligation to the holder to buy or sell
currencies at a later date at agreed date. The holder of option has a choice
to exercise or leave the option.
ii. It can obtained over –the-counter or at an organized exchange, so easier to
access the option
iii. Some of can be exercised at any date before maturity, so giving flexibility,
iv. The maximum amount that can be lost due to buying an option is the
premium.
v. The currency option allows the holder to participate in market if the current
exchange rates are favorable.

b.
i. The company is due to receive US$1,522,800 so it will sell US$1,522,800
and buy €1,080,000 (1,522,800/1.4100), it needs to buy euro futures.
Number of contracts is 10 (€1,080,000/€108,000).
Hedge is “the Germany company will buy 10 September euro future at
future price US$1.4100/€ with contract size of €108,000”.

In August US$1,522,800 will be sold at spot rate US$1.4170/€.

The result (1,522,800/1.4170) is €1,074,664.7848
Target income (1,522,800/1.4090) is €1,080,766.5011.
The loss made = €1,080,766.5011 - €1,074,664.7848

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 = €6,101.7163
In August the futures contract will be closed
Sell at 1.4150 - Buy at 1.4100 = Gain US$0.0050/€
Total gain = 10 contracts × €108,000 × US$0.0050/€ = US$5,400
The gain will be sold at spot rate 5,400/1.4170 = €3,810.8680.
Hedge efficiency = Gain/Loss
= €3,810.8680/€6,101.7163 = 62.46%

Question: 5
Only the transactions resulting in cash flows between Kenduri Plc and Lakama
Plc are considered for hedging. Other transactions are not considered.
Net flow in US$: US$4·5m (payable) – US$2·1m (receivable) = US$2·4m
(payable).
Hedge the US$ exposure using the forward market, the money market and
options.

i. Forward market
US$ hedge: 2,400,000/1·5996 = £1,500,375 payment
ii. Money market US$ hedge
Invest in US$: 2,400,000/(1 + 0·031/4) = US$2,381,543
Convert into £ at spot: US$2,381,543/1·5938 = £1,494,255
Borrow in £: £1,494,255 x (1 + 0·040/4) = £1,509,198
iii. Options
Kenduri Plc would purchase Sterling three-month put options to protect itself
against a strengthening US$ to £.
Exercise price: $1·60/£1
£ payment = 2,400,000/1·60 = 1,500,000
Contracts = 24 (1,500,000/62,500) contracts 24 put options purchased
Premium payable = 24 x 0·0208 x 62,500 = US$31,200
Premium in £ = 31,200/1·5938 = £19,576
Total payments = £1,500,000 + £19,576 = £1,519,576

QUESTION SIX
a.
1. a
2. d
3. b
4. d
5. c
6. b
7. a

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 8. a
9. c
10. a

b.
i. Premium
ii. Discount
iii. Premium
iv. Discount

QUESTION EIGHT
a. Currency futures hedge position set up
Transaction exposure for Accounts receivable of £875,000
Contract size: £62,500
Contract numbers = £875,000/£62,500 = 14 contracts.
Expiry date: December
Sell 14 December sterling futures contracts at US$1.3900/£

b. In November the value of the dollar has strengthened to US$1.3800/£

and the December futures market price is US$1.3700/£.
When the sterling income is received, the supplier will close the futures
position by buying December contracts at US$1.3700/£.
Bought at US$1.3700
Sold at US$1.3900
Gain per contract US$0.0200
The total gain is (£62,500 × US$0.0200 per £1 × 14 = US$17,500

In November when £875,000 is sold at spot rate US$1.3800/£

Income from spot £875,000 × US$1.3800/£ US$1,207,500
Gain futures position US$ 17,500

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 Total income US$1,225,000

The effective rate exchange rate secured by trading in futures is

(US$1,225,000/£875,000) = US$1.4000/£, which is equal to the target
spot rate in September.

c. In November the value of the dollar has weakened to US$1.4300/£ and

the December futures market price is US$1.4200/£.
When the sterling income is received, the supplier will close the futures
position by buying December contracts at US$1.4200/£.
Bought at US$1.4200
Sold at US$1.3900
Loss per contract US$0.0300

The total loss is (£62,500 × US$0.0300 per £1 × 14 = US$26,250

In November when £875,000 received is sold at spot rate US$1.4300/£
Income from spot £875,000 × US$1.4300/£ US$1,251,250
Loss futures position US$ (26,250)
Total income US$1,225,000

The effective rate exchange rate secured by trading in futures is

(US$1,225,000/£875,000) = US$1.4000/£, which is equal to the target
spot rate in September.

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QUESTION NINE
a.
i. Exchange rate implied by the Law of One Price (Purchasing Power
Parity Theory) can be used to check on opportunities for commodity
arbitrage.
The exchange rate implied by the Law of One Price is:
TZS 1,200,000/Yuan50,000 = TZS 24/Yuan.
This rate differs from the actual market rate of TZS 52/Yuan.
Hence, opportunities for commodity arbitrage exist.

ii. The Yuan is overvalued and TZS is undervalued

The product is therefore expensive in China and cheaper in Tanzania. To
benefit from the possible commodity arbitrage XYZ Ltd. should take the
following steps:
Purchase 100 tons of super rice in Tanzania at TZS1,200,000 per ton.
Total purchase cost will be TZS1,200,000 x 100 = TZS120,000,000.
(Purchases costs)

Ship the 100 tons to Beijing at US$90 per ton

Total shipping costs US$90 x 100 = US$9,000.
At TZS1,560/US$ the shipping costs will amount to
TZS1,560/US$ x US$9,000 = TZS14,040,000.
(Shipping costs)

The 100 tons can be sold for Yuan50,000 per ton realizing Yuan50,000
per ton x 100 tons = Yuan5,000,000.
The Yuan5,000,000 will then be converted into TZS at TZS 52/Yuan to
Yuan5,000,000 x TZS 52/Yuan = TZS260,000,000.
(Sales revenue)

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 Thus, we have:
Sales Revenue……………………………………………… TZS 260,000,000
Less: Purchase Costs……………TZS 120,000,000
Shipping Costs…………..TZS 14,040,000 TZS 134,040,000
Net Profit…………………………….........………………… TZS 125,960,000
Commodity arbitrage profit is TZS 125,960,000 (03 marks)

b. Actions expected profit by the speculator

(i) If Suma believe the sport exchange rate will be TZS 1520/US$ in six
months, she should buy $ 10,000,000 forward for TZS 1500/US$.

(ii) The expected profit will be

US$ 10,000,000 x (TZS1520– TZS 1500)/US$= TZS 200,000,000/=
(i) If the spot exchange rate turns out to be TZS 1460/US$ in three
months, Suma will get a loss amounting to
US$ 10,000,000 x (TZS 1460 – TZS 1500)/US$ = TZS 400,000,000/=

QUESTION TEN
The dealer has two alternatives either booking a forward contract or implement
a money market hedge as suggested by the banker.
Forward contract hedge: Accounts receivable = € 6,150,000
Spot exchange rate (¥/€) 160 175
6-m swap points (¥/€) -5 -4
Outright forward rate (¥/€) 155 171
The exporter can sell his receivable at outright forward bid rate of 155.00
The amount realized in ¥ under forward contract is
¥ 155/€ x € 6,150,000 = ¥ 953,250,000

Money market hedge: Accounts receivable = € 6,150,000

If the dealer borrows € now and converts them spot to ¥
The interest rates prevailing are:
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 For ¥ 2% for € 5%
Borrow € X amount at 5%
X * (1 + 5%/2) = € 6,150,000
X = € 6,150,000 / 1.025 = € 6,000,000
Convert €6,000,000 to ¥ at spot bid rate
¥160/€ x € 6,000,000 = ¥ 960,000,000
Invest ¥ 960,000,000 at 2%
¥ 960,000,000 (1 + 2%/2) = ¥ 960,000,000 (1 + 0 01) = ¥ 969,600,000

Now 06 months
Forward Market ¥ 953,250,000
Money Market ¥ 960,000,000 ¥ 969,600,000

Money market hedge gives higher amount than the forward market hedge
The dealer therefore must follow the advice of the banker and borrow euro to
have yen now.
QUESTION ELEVEN:
i. B
ii. A
iii. A
iv. B
v. A
vi. B
vii. A
viii. B
ix. A
x. E

QUESTION TWELVE
i. COVERED INTEREST ARBITRAGE

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Checking on opportunities for covered interest arbitrage we compare the
interest rate differential with one year forward discount/premium on the $
Interest rate differential= one year forward discount/premium on the $
10%- 15 %=( fwd rate- spot rate)/spot rate *12/n*100%
-5%= (1680-1750)/1750*12/12*100
-5%≠ -4%
Therefore arbitrage opportunity exists (5 marks)
ii. To determine covered interest differential in favor of New York or Dar es
Salaam.
Covered yield on the TZS= interest on the TZS + forward premium
Covered yield on the TZS= 10%+ 4%
Covered yield on the TZS= 14%
Covered yield on the $= interest on the $ - forward discount
Covered yield on the $= 15%-4%
Covered yield on the $= 11%
The covered yield on the $ is greater than the interest rate on the TZS.
Therefore covered interest differential in favour of NEW YORK ($). There
will be movement of funds from Dar es Salaam to New York. (5 marks)
iii. profit associated with covered interest arbitrage
 borrow tzs 1,000,000 with an interest of 10%
one year will accumulate to 1,000,000(1+10%)= 1,100,000
 convert the borrowed amount to $ at spot rate
1,000,000/1750= $571.43
 invest the $571.43 for one year with interest rate of 15%
$571.43(1+15%)= $657.14
 convert the amount invested in $ to TZS at forward rate of 1680
$657.14*1680= TZS 1,103,995.20
 pay the loan amount of TZS 1,100,000
 arbitrage profit 1,103,995.20-1,100,000= TZS 3,995.20 (10 marks)

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QUESTION THIRTEEN
Suggested Solution
Only the transactions resulting in cash flows between KenduriPlc and
LakamaPlc are considered for hedging. Other transactions are not considered.
Net flow in US$: US$4·5m (payable) – US$2·1m (receivable) = US$2·4m
(payable). (4 marks)
Hedge the US$ exposure using the forward market, the money market and
options.

iv. Forward market

US$ hedge: 2,400,000/1·5996 = £1,500,375 payment(2 marks)
v. Money market US$ hedge
Invest in US$: 2,400,000/(1 + 0·031/4) = US$2,381,543
Convert into £ at spot: US$2,381,543/1·5938 = £1,494,255
Borrow in £: £1,494,255 x (1 + 0·040/4) = £1,509,198(4 marks)
vi. Options
KenduriPlc would purchase Sterling three-month put options to protect itself
against a strengthening US$ to £.
Exercise price: $1·60/£1
£ payment = 2,400,000/1·60 = 1,500,000
Contracts = 24 (1,500,000/62,500) contracts 24 put options purchased
Premium payable = 24 x 0·0208 x 62,500 = US$31,200
Premium in £ = 31,200/1·5938 = £19,576
Total payments = £1,500,000 + £19,576 = £1,519,576(8 marks)

Conclusion
The forward market minimizes the payment and is therefore recommended over
the money market and the option.(2 marks)

QUESTION FIFTEEN
Money market
i. Borrow in foreign currency present value of receivable.

X (1+5%) = $ 300,000
1.05x = $ 300,000
Amount to borrow at US will be $ 285,714.29
ii. Convert the foreign currency borrowing into home currency.

TZS 2,300 = $1
TZS? = $ 285,714.29
The amount will be TZS 657,142,857.14
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 i. Investing TZS shillings for 180 days
657,142,857(1+4.5%)
After 180 days will receive TZS 686,714,285.71
The foreign currency receivable repays the foreign currency borrowing.
After three month the USA Company will pay the amount of $ 300,000 to
JEDRILYON plc. and simultaneously the company will pay the foreign debt.
Forward market
TZS 2350= $ 1
TZS? = $ 300,000
The amount will be TZS 705,000,000
As the financial analyst I will advise the director to hedge by using forward
market since it has higher returns compare to money market.
TZS 705,000,000- 686,714,285.71= TZS 18,285,714.29

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