Level II Economics item sets

Amara Osei is a senior consultant at Kestrel Treasury Advisers, a firm that advises mid-sized European companies on foreign-exchange risk. Her largest client is Harlow Engineering, a German maker of industrial pumps that buys components priced in US dollars and sells a growing share of its output to customers in Japan. Harlow Engineering's functional currency is the euro, and its treasury team is small, so it relies on Kestrel Treasury Advisers to check dealer quotes and explain the economics of its hedges.

All quotes in this case use the convention A/B, which is the price of one unit of currency B expressed in units of currency A. For example, a USD/EUR quote of 1.0850 means that one euro costs 1.0850 US dollars. Exhibit 1 shows the spot quotes that Harlow Engineering's bank sent on the morning of Osei's review. The bank does not quote a JPY/EUR rate directly to Harlow Engineering, so any euro–yen transaction would have to go through the US dollar.

Harlow Engineering's treasurer wants to buy yen with euros next week to pay a Japanese logistics supplier. Before speaking to the bank, she asks Osei what cross rate the bank would effectively charge if the trade were executed through the dollar quotes in Exhibit 1. Osei reminds her that a client always buys the base currency at the dealer's offer and sells it at the dealer's bid, and that the same rule applies to each leg of a cross trade.

Next, the treasurer asks about one-year forward rates. Osei uses the mid-market spot USD/EUR rate together with the one-year interest rates in Exhibit 2 and explains that, if covered interest rate parity holds, the forward rate is set so that a dollar deposit and a hedged euro deposit earn the same return. She adds that the forward premium or discount reflects the interest rate differential and is not a forecast of where the spot rate will be in a year.

Six months ago, Harlow Engineering entered into a one-year forward contract to sell EUR 10,000,000 against US dollars at a forward rate of 1.0900 USD/EUR, to lock in the dollar value of a planned investment in a US subsidiary. The investment plan has since been cancelled, and the treasurer wants to know what the contract is worth today if Harlow Engineering closes it out by entering into an offsetting forward contract for the remaining six months. Osei obtains the six-month forward quote and the six-month dollar interest rate shown in Exhibit 3. The contract has exactly 180 days to run, and dollar money-market rates are quoted on an actual/360 basis.

Finally, a board member at Harlow Engineering has read about the carry trade and asks whether the company could earn extra return by borrowing euros, converting them into dollars and investing the dollars for one year. Osei explains that the strategy profits only if the higher-yielding currency does not depreciate by more than the interest rate differential, which is what uncovered interest rate parity would predict. To illustrate, she uses the one-year rates in Exhibit 2, the mid-market spot rate today, and an assumed spot rate of 1.1000 USD/EUR in one year. She ignores bid–offer spreads and transaction costs for this illustration.

Osei also notes that, in practice, carry trades tend to earn small positive returns in calm markets and suffer sharp losses when risk aversion rises and funding currencies appreciate quickly. She recommends that Harlow Engineering's board treat the carry trade as a speculative position rather than a treasury activity.

Before the meeting ends, the treasurer asks Osei to put all of the figures in a short memo, so that the board can see the cross rate, the forward rate, the value of the cancelled hedge and the carry trade illustration side by side.