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Dear sir, today I was trying to solve a past exam question (Dec 12 Adapted). However, I got stuck in one part and I need your help. It is a long question but I will only type below the part where I need your help. The question states that:
Lignum Co regularly trades with companies based in Zuhait, a small country in South
America whose currency is the Zupesos (ZP). It recently sold machinery for ZP140 million,
which it is about to deliver to a company based there. It is expecting full payment for the
machinery in four months. Although there are no exchange traded derivative products
available for the Zupesos, Medes Bank has offered Lignum Co a choice of two over-the-
counter derivative products.
The first derivative product is an over-the-counter forward rate determined on the basis of
the Zuhait base rate of 8.5% plus 25 basis points and the French base rate of 2.2% less 30
basis points.In solution for the above derivative. they have done like this:
Using forward rate
Forward rate = 142 × (1 + (0.085 + 0.0025)/3)/(1 + (0.022 – 0.0030)/3) = 145.23
Income in Euro fixed at ZP145.23 = ZP140,000,000/145.23 = €963,988I want to know that why they have divided the above figures by 3 in Forward rate calculation? It seems that they have used a formula S1= So((1+hc)/1+hb)). I want to know how this is relevant here. Thank you for your assistance.
As I explain in my free lectures, forward rates are always determined by the respective interest rates and the formula is the interest rate parity formula that is given in the exam. (The formula you quote is the purchasing power parity formula which is used to forecast future spot rates.)
Dear sir, thank you for your response. I have checked but I am still not getting the point. The interest rate parity formula is Fo = So (1+ic)/(1+ib). I want to know that why they are dividing interest rate by 3?
The question also mentions that after previous part that:
Alternatively, with the second derivative product Lignum Co can purchase either Euro call
or put options from Medes Bank at an exercise price equivalent to the current spot
exchange rate of ZP142 per €1. The option premiums offered are: ZP7 per €1 for the call
option or ZP5 per €1 for the put option.
The premium cost is payable in full at the commencement of the option contract. Lignum
Co can borrow money at the base rate plus 150 basis points and invest money at the base
rate minus 100 basis points in France.
Using OTC options
Purchase call options to cover for the ZP rate depreciating
Gross income from option = ZP140,000,000/142 = €985,915
Cost
€985,915 × ZP7 = ZP6,901,405
In € = ZP6,901,405/142 = €48,601
€48,601 × (1 + 0.037/3) = €49,200
(Use borrowing rate on the assumption that extra funds to pay costs need to
borrowed initially; investing rate can be used if that is the stated preference)They have again divided the interest rate by 3. I want to know the reason. Thanks for your support.
The transaction is in 4 months time, which is 1/3 of a year.
Interest rates are always given as yearly rates, so for four months it is 1/3 of the yearly rate.
Have you watched my free lectures on this?
Thank you very much for your kind support. Yes, I did watch your lectures. They have helped me a lot in preparing for AFM syllabus. May God bless you. Actually, there was a bit confusion
which you have now cleared to me. Thanks.
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