Problem:
The treasurer of a middle market, import-export Company has approached you for advice on how to best invest some of the firm's short-term cash balances. The company, which has been a client of the bank that employs you for a few years, has $250,000 that is able to commit for a one year holding period. The treasurer is currently considering two alternatives: (1) invest all the funds in a one year U.S treasury bill offering a bond equivalent yield of 4.25%, and (2) invest all the funds in a Swiss government security over the same horizon, locking in the spot and forward currency exchanges in the FX market. A quick call to the bank's FX desk gives you the following two currency exchange quotes. Swiss francs U.S Dollar per U.S Dollar Swiss Franc (CHF) Spot 1.5035 0.6651 1-year CHF futures - 0.6586
Required:
Question 1: Calculate the one year bond equivalent yield for the Swiss government security that would support the interest rate parity condition.
Question 2: Assuming the actual yield on a one year Swiss government bond is 5.50%, which strategy would leave the treasurer with the greatest return after one year?
Question 3: Describe the transactions that an arbitrageur could use to take advantage of this apparent mispricing, and calculate what profit would be for a $250, 000 transactions.
Please explain in detail and show all workings.