Arbitrage Contract Evaluation

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Introduction

Arbitrage is simply an action by investors which involve buying a security in one market

and at the same time selling it in another market in a bid to take advantage of higher pricing. The

investors, in such cases usually profit by taking advantage of the temporary price differences in

the market. For example, traders may choose to buy stock on a foreign exchange in a murky

where the prices are not a dusted at a constant fluctuating rate. In such a case the price of stock is

undervalued and there is a higher chance of him earning profit. Drawing from Vermont cases an

arbitrage contract was reached between Para’s, Sullivan and Credit Suisse bank which amounted

to SFr 37.5 million. The two investor first took a loan with the bank which was later converted

into securities which were worth 21.5 million dollars issued in favor of the credit bank to secure

the loan but was held in trust by Chemical Bank.

Identifying the problem

The arbitrage contract can be defined as value adding though it was against the Swiss law

which at the time prohibited use of securities such as bonds as collateral for getting loans. For

one the arbitrages contact was to earn profits in two ways simultaneously. The first way through

which profits were to be earned was by taking advantage of the interest difference between the

8% interest earned on the UDS bonds and the 4% interest that was to be earned on the loan with

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Credit Suisse Bank. The second way of earning profits would be to trade the money against the

Swiss Franc exchange rate. Piras predicted that the dollar would strengthen in a matter of six

years which would result in bond proceedings that were more than the 21. 5 dollar as translating

to more than SFr 37.5 needed to pay up the loan. This meant that if the market favored the

arbitrage contract then it was definitely value adding for Piras and he would be able to earn profit

from the proceeds of the contract

Assumptions and Analysis

In valuing the arbitrage contract the assumption of certainty is held. This means that

there are no uncertainties in the market and thus theirs is a proper feedback of the dollar gaining

strength and culmination into profits that can be split between the two banks. Another

assumption is that the Swiss bank will get paid first on its loan and also all other loans have

claim on the arbitrage contract. That is after the loan on Credit Suisse bank gets paid then the

American loans and the bank will split the profit. The calculations are detailed as follows. The

Swiss Loan at the time amounted at SFr 37.5 at the time. Currently one SFr is exchanging at a

rate of 1.01 dollars. Converting the loan would mean that currently it is valued at 37. 875 million

dollars meaning the value of the loan has appreciated with time.

At the same time the 21.5 million dollars which were converted to bonds yielded 8 % interest

every year

21.5×0.08×8= 13.75 million, dollars on the bond earnings. This means that the total value of the

bond investment is calculated by taking the initial investment plus the profit which amounts to

21.5+13.75=35.26 million dollars at the time. The arbitrage contracts on bonds are valued at

35.26. This meant that the arbitrage value had appreciated with time.

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The value of the arbitrage contract is increasing with an increase in the interest rates at annual

interest rates. The higher the interest rate the higher the financial gain on the contract. The loan

by Credit Suisse loan in regard with current exchange rate has appreciated meaning the loan has

more value and is to be paid at a higher value which stands at 37. 875.

Alternatives

Richard should consider using forward contracts as an option of mitigating the risks. A forward

contract involves an agreement between two parties to buy or sell assets on a specific future date

at a specific price. This mean that despite any changes in the market the asset will value at the

same price. The benefit of hedging is that the asset will not depreciate in value thus it reduces the

risk of making losses on the asset. Richard should consider hedging the current against the

0% 8%

value of the loans

value of the loans against the exchange rate

Arbitrage contract

credit suise loan

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market exchange rates at a future date depending on the behavior in the exchange rate market.

However before hedging he should make a determination whether the currency is weakening or

strengthening in value. A currency that is strengthening in value is the best option when

considering hedging for a future date.

Conclusion

However it is good to note the value from the arbitrage contract would only depend on

the ability of the market favoring the contract. This means that the value differences must have

existed if the American loan and the Swiss bank were looking to benefit from the surplus of the

arbitrage contract.

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