Arbitrage/Hedging Problem

The purpose of this research is to analyze a foreign currency exchange arbitrage/hedging problem. The problem involves a US$60 million payment which must be made by Nestle US to its Swiss parent corporation in Swiss francs in approximately three weeks. Alternatives considered are (1) the use of a forward contract, (2) the purchase of Swiss franc futures, and (3) the purchase of a calloption contract.

The term arbitrage refers to purchases in one market, and sales in another market which, together, have the effect of maintaining the price relationship between comparable items traded in the affected markets, within the limits defined by the cost of buying the items in one market and selling them in another. Thus, it can be seen, at once, that the use of arbitrage is a method of limiting riskof establishing the boundaries, so to speak, of risk.

Arbitrage transactions, by definition, are either simul taneous, or nearly so; thus, the conduct of arbitrage activi ties tends to maintain prices in different markets for similar items within a reasonable alignmentwithin the arbitrage limits. Although the principal effect of arbitrage

1 2transactions is to bring about a relation among prices of similar items according to the cost of converting the items from one to the other (between markets), there need not be certainty about the outcome.

The concept of arbitrage, especially in application, is close

Related Essays

Foreign Currencies in Thailand & Hedging .... The problem lies in the occurrence of dramatic changes in international economic .... as a concept, it must be differentiated from both arbitrage and hedging. .... (6398 26 )

Hedging Principle Situtation .... application of the hedging principle to the problem facing the .... In practical applications, the concept of hedging works much like the concept of arbitrage. .... (1681 7 )

Foreign Currencies in Thailand .... The problem lies in the occurrence of dramatic changes in international economic .... as a concept, it must be differentiated from both arbitrage and hedging. .... (6388 26 )

APPLYING ECONOMIC MODELS TO INTERPRET THE EXCHANGE RATE MOVEMENT .... Historical Evaluation of the Yen/Dollar Relationship Hedging and arbitrage to achieve .... Ramirez and Khan (1999) address this problem in their cointegration .... (1392 6 )

Manufacturing Offshore Constanti .... Ohmae suggested that the solution to the problem facing contemporary Japanese .... requires an understanding of the relationship between arbitrage and hedging. .... (9642 39 )

t of the multinational business organization, potential foreign exchange losses depend on a company's exposureon its vulnerability to foreign exchange loss. In a general sense, there are two main types of such exposurecommer cial exposure and translation exposure. Commercial exposure arises when a company has an obligation to make or to receive payment in a foreign currency, such as the payment for imported goods, or the collection for exported products. In the case of imports, losses could occur, if the value of the foreign currency were to rise in relation to the home country currency of the importer. In the case of exports, losses could occur, if the value of the foreign currency were to be devalued in relation to the home currency of the exporter. In such instances, the multinational business organization may enter a forward market for foreign currencies, and apply the concept of arbitrage to limit the risks associated with such commercial transactions. 4 The Forward Contract Alternative The first solution alternative considered is to obtain a Swiss franc forward contract, to lock in an exchange rate. The US$60 million payment due in Swiss francs would be paid at an exchange rate of SF1.2702/US$1, if the

Category: Economics - A