Foreign Exchange Market Harvard Case Solution & Analysis

1. Is there any arbitrage opportunities among cross currencies?

There is no arbitrage opportunity assessed in other currencies pairs as well due to such a high transaction cost the risk-free profit that can be earned using arbitrage turns into loss.

2. Using Triangular Arbitrage

Triangular Arbitrage is taking advantage of arbitrage opportunity due to pricing discrepancy among different currency pairs. A triangular arbitrage opportunity strategy involves discrepancy among three different currencies.

In triangular arbitrage strategy, it involves converting initial currency into another pair then converting second pair to third and back to initial currency at cross exchange rates, thus involving currency trade in three pairs.

Profit and loss data is summarized in Exhibit 2. By assuming there is no transaction cost then the use$10 million of investment which is converted in different currencies and again converted at cross exchange rate. There is arbitrage opportunity available in Canadian Dollar pair that could generate US$199 profit and Pound pair in which US$ of 454 can be earned and Euro pair in which US$ 958 can be earned.

By using same approach, if 12.314 Million Canadian Dollars are converted into different currency then there is arbitrage opportunity available in all pairs expect in UK Pound and Dollar pair.$1053 profit can be earned by converting USD in CAD and CAD into CHF.

3. Forward Currency Table

For 1 Swiss Franc = SPOT 3 month 12 months
European Euro 1.03665 -22.905 -102.875
British Pound 1.46435 -61.54 -278.08
Japanese Yen 0.7747 -18.3585 -73.42
US Dollar 0.95055 -33.5 -166.75

4. Carry Trade

Detail calculation depicts that in a country where there are high-interest rates currency of that country will depreciate more quickly. In EU, the current interest rate is 0.75%$, which is highest among other peer countries such as UK, Japan and USA. As CHF pair is compared with other major currencies, expected exchange rate using interest rate parity is as follows;

Interest Rates
Switzerland 0.25%
EU 0.75%
UK 0.50%
Japan 0.10%
USA 0.25%
Foreign Currency Rates Based on Interest Rates Parity
  Spot After 1 Year
For 1 Swiss Franc =
European Euro 1.04 1.0470
British Pound 1.46            1.4753
Japanese Yen 0.77            0.7774
US Dollar 0.95            0.9539
Portfolio CHF 10,000,000
  Exchanged at Spot Exchanged After 1 Year Profit/Loss(CHF)
For 10 Million Swiss Franc =
European Euros             9,646,457                              9,550,948            (91,220.61)
British Pounds             6,828,968                              6,778,132            (34,457.31)
Japanese Yens           12,908,223                           12,863,201            (57,911.68)
US Dollars           10,520,225                           10,483,533            (38,466.56)

All the currencieswill decrease against Swiss Franc. If CHF is converted into different currencies and then again converted into CHF at rate calculated using interest rate parity then all the currencies will appreciate against CHF, which means they will require more CHF and thus,it will lead to a loss.

Foreign Exchange Market Case Solution

5. Speculator

If George Soros expects that Euro will depreciate by 7%, then this means dollar will appreciate although it will not be in the same percentage. If this news flows to currency market, then spot rate will change immediately and Euro/USD will depreciate.

On the other hand,it will also have impact on the forward market as there will be change in forward market as well. Forward market takes into account spot rate. In each case profit and loss would be as follows;

At Spot
Portfolio $10,000,000
Spot Euro 6% Depreciated
EUR/USD 1.0978                            1.03193
Investment                9,109,127 €                     9,690,561 €  $  290,561
At Forward
Portfolio $10,000,000
12 Month Forward Euro 6% Depreciated
EUR/USD 1.108778 1.04225
Investment                9,018,938 €                     9,594,615 €  $  194,615

If $10 Million are invested at spot rate and exchange rate is depreciated by 6%, then a profit of $290,561 will be generated. On the other hand,if same amount is invested in forward then an amount of $194,615 will be earned.

Other factor will include liquidity and movement in the pair. It is not necessary that spot rate or forward price will move same as estimated amount the exchange rate moves in rage throughout the time period. Spot market is more liquid than forward market spot market. Also, transaction cost should also be considered..............

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