Forex

Question 1

(This is Forward Case)
We purchased $ at spot rate of Rs. 165 per $.
We entered into a forward contract to sell $ at Rs. 175 per $ after 3 months.
PKR borrowing rate is 10% per annum.
What is the net arbitrage gain (per $ or in Rs.)?
(Assume USD interest rate is zero / not given, use only given data)

Answer 1

Confirmed receipt
175
less: bought at spot (cost) (165)
less: finance cost of buying at spot
(16510%3/12) (4.125)

Net gain (arbitrage gain)
= 5.875

Question 2

What is Interest Rate Parity (IRP) in forex?

Answer 2

IRP is a no-arbitrage theory that states:
The difference in interest rates between two countries equals the difference between the spot and forward exchange rates (premium or discount).
It prevents risk-free profit from covered interest arbitrage.

Question 3

Why do we use Interest Rate Parity?

Answer 3

To find the theoretical (fair) forward rate

Question 4

What is the formula to calculate theoretical forward rate using IRP?

Answer 4

Forward rate (F)
= Spot rate (S) × (1 + i_domestic × t) / (1 + i_foreign × t)
Where:

S = spot rate
i_domestic = home/base currency interest rate (annual)
i_foreign = foreign currency interest rate (annual)
t = time in years (e.g., 3 months = 3/12 = 0.25)

Question 5

Spot: 1 USD = 280 PKR
i_PKR = 10% p.a., i_USD = 4% p.a.
Time: 6 months
Calculate theoretical forward rate.

Answer 5

t = 6/12 = 0.5
F = 280 × (1 + 0.10 × 0.5) / (1 + 0.04 × 0.5)
= 280 × (1.05) / (1.02)
= 280 × 1.02941176
≈ 288.24 PKR per USD

Question 6

In hedging, what does “right to buy” strategy mean? Which option is used?

Answer 6

“Right to buy” = Hedger wants protection against price increase (e.g., buyer hedging future purchase cost).

→ Use call option (buy call / long call).
This gives the right (not obligation) to buy the underlying at strike price later.

Question 7

In call option hedging, where do we add the premium?

Answer 7

We add premium to the strike price to find:
Effective level / Breakeven =
Strike Price + Premium Paid

Question 8

Why do we add premium to strike in call option hedging?

Answer 8

Premium is the cost you pay upfront for the protection/right.
→To recover this cost and break even:
Underlying price at expiry must be strike + premium higher.
→ Adds to your effective cost
→ worst-case hedged price becomes Strike + Premium.

Question 9

How is premium treated differently in put option hedging?

Answer 9

Put option (right to sell / protect against price fall):
Premium paid → cost
But subtract from strike: Breakeven / Effective min selling price = Strike – Premium Paid