Back in 1990, East Germany Was in the Process of Merging

question 12

Essay

Back in 1990, East Germany was in the process of merging into West Germany. Its national currency was to be replaced by the Deutsche mark (DM). A U.S. dollar-based investor has a portfolio worth DM 100 million in German bonds. The current spot exchange rate is 2 DM/$. The current one-year market interest rates are 6% in DM and 10% in dollars. One-year currency options are quoted in Chicago with a strike price of 50 U.S. cents per DM; a call DM is quoted at 1 U.S. cent and a put
DM is quoted at 1.2 U.S. cents; these option prices are for one DM.
You are worried that the integration of East and West Germany will cause inflation in Germany and a drop in the DM. So, you consider using forward contracts or options to hedge the currency risk.
a. What is the one-year forward exchange rate DM/$?
b. Simulate the dollar value of your portfolio assuming that its DM value stays at DM 100 million; use DM/$ spot exchange rates equal in one year to: 1.6, 1.8, 2, 2.2, and 2.4. First consider a currency forward hedge, then a currency-option insurance.
c. What could make your forward hedge imperfect?

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