Financial Engineering – IC302
Autumn Term 2020/1
Seminar 1: Introduction to Financial Engineering Questions
1. Suppose that the spot EURUSD exchange rate is 1.50, the one-year USD interest rate is 3%, and the one-year EUR interest rate is 5%. For the purpose of this question, you may ignore any day-count conventions specific to interest rates in these currencies.
(a) Calculate the fair-value one-year EURUSD forward exchange rate consistent with covered interest arbitrage.
(b) Suppose that the market forward exchange rate is 1.50. Use replication arguments to construct an arbitrage portfolio and calculate the arbitrage profit.
(c) Suppose that the market forward exchange rate is 1.45. Use replication arguments to construct an arbitrage portfolio and calculate the arbitrage profit.
2. Use the contractual equation for an EURUSD FX forward to explain how we might create a synthetic loan in which we borrow USD.
3. How does the synthetic USD loan created in the previous question compare to synthetic borrowing of USD using an FX swap, as described in the lecture?
4. The Refinitiv Eikon screen image below reports spot and forward exchange rates for USDJPY on 28 September 2020. If covered interest parity holds for this currency pair, what do the forward points and outright forward exchange rates shown here imply about the relative level of money market interest rates in the United States and Japan?
Source: Refinitiv Eikon