Problem Set 1 of FINA 3404 Instructor: Dr.

Du Du

Select the best answers for questions (2 points each for questions 1-8) 1. Of the following exchange rates, which are quoted in European terms? (Answer: D)
i) ii) iii) iv) 2 USD for one British pound; 0.75 euro for one USD; 7.8 HKD for one USD; 100 yen for one USD

A) only i) B) only ii) C) iii) and iv) D) ii), iii) and iv)

2. Which of the following statements about forward rate/forward contract is FALSE? (Answer: D) A) the forward rate is determined when both the long side and the short side enter into the forward contract B) The forward rate will not be executed until the forward contract expires
C) The forward rate represents the market prediction of the future spot rate D) The forward rate is determined when the forward contract is about to expire 3. A WSJ (wall street journal) article reports that: the euro was at $1.3653 up from $1.3674 at Mondays close, while the dollar was at 115.09 yen from 116.08 yen (answer: A) That means the dollar_________against euro, and the yen_____________against dollar

A) appreciated; appreciated B) appreciated; depreciated C) depreciated; depreciated D) depreciated; appreciated 4. The AUD/$ spot exchange rate is AUD1.60/$ and the SF/$ exchange rate is

SF1.25/$. The AUD/SF cross exchange rate is thus: (Answer: C) A) 0.7813 B) 2.0000 C) 1.2800 D) 0.3500

5. If IRP fails to hold, (Answer: D) A) Pressure from arbitrageurs should bring exchange rates and interest rates back into line B) It may fail to hold due to transactions costs
C) It may be due to the government-imposed capital controls

D) All of the above 6. Suppose the current exchange rate is $1.6 for 1, and the expected inflation rate in the U.S. and in the U.K. are 2% and 4%, respectively, in the coming year. According to the relative PPP, (Answer: A)
A) $ is expected to appreciate against in one year B) $ is expected to depreciate against in one year C) the $/ exchange rate is expected to remain unchanged in the coming year

D) none of the above 7. Consider the two quotations about Japanese yen against the U.S. dollar: The

spot rate is 108/$; whereas the 90 day forward rate is 110/$. Applying what youve learned from interest rate parity (IRP), which of the following is correct? (Answer: A) A) yen is expected to depreciate against dollar, and according to IRP, interest rate prevailing in Japan should be higher than that prevailing in the U.S. B) yen is expected to appreciate against dollar, and according to IRP, interest rate prevailing in Japan should be higher than that prevailing in the U.S. C) yen is expected to depreciate against dollar, and according to IRP, interest rate prevailing in Japan should be lower than that prevailing in the U.S.
D) yen is expected to appreciate against dollar, and according to IRP, interest rate prevailing

in Japan should be lower than that prevailing in the U.S.

8. According to Fisher effect, when interest rate in country A is higher than interest rate in country B, the inflation rate in country A is expected to be _________ the inflation rate in country B. (Answer: B)
A) lower than B) higher than

C) the same as
D) no enough information to tell

9. Suppose a U.S. investor bought 100 shares of Toyota Corporation in year 2001. At that time each share of Toyota Corporation cost 10,000 yen, and the prevailing spot exchange rate was 120 yen/dollar. Suppose one year later, the price of Toyota Corporation increased to 11,000 yen share. a) (2 points) Compute the investors one year net return (in percentage) from this investment in terms of yen b) (3 points) if the spot exchange rate one year later was 110 yen/dollar, compute the investors net return (in percentage) in terms of dollar c) (3 points) if the spot exchange rate one year later was instead 140 yen/dollar, repeat the computation in b) d) (4 points) what do you learn from the computations in a)-c)? Answer: a) one year net return in terms of yen is: (11,000*10-10,000*10)/(10,000*10)*100%=10% b) initial dollar investment: 10,000*100/120=$8333.33 dollar payoff one year later: 11,000*100/110=$10,000 Hence, one year net return in terms of dollar is: (10,000-8333.33)/8333.33*100%=20% c) initial dollar investment: 10,000*100/120=$8333.33 dollar payoff one year later: 11,000*100/140=$7857.14

Hence, one year net return in dollar is: (7857.14-8333.33)/8333.33*100%=-5.7% d) For a U.S. investor who considers doing international investment, he faces the so called foreign exchange risk. That is, even though he earns profits in a foreign currency (such as yen in this question), it is not necessary that the same investment will bring him profits in dollar terms. In particular, foreign currency profits may evaporate due to the depreciation of the foreign currency, and the investor may even lose money in dollar terms, as the computation in c) shows. On the other hand, the investor may earn higher profits in dollar terms than in the foreign currency if the U.S. dollar appreciates against the foreign currency. 10. Using the following table, calculate a) (3 points) spot cross exchange rate between Argentina Peso and British pound (peso price of pound) on Friday; b) (3 points) six-month forward cross exchange rate between Canadian and British pound (price of pound denominated in CAD) on Thursday. Please list the formulas that you use, and then report the numerical results. USD equiv Country Friday Argentina (Peso) 0.3309 Australia (Dollar) 0.7830 Brazil (Real) 0.3735 Britain (Pound) 1.9077 1 Month Forward1.9044 3 Months Forward1.8983 6 Months Forward1.8904 Canada (Dollar) 0.8037 1 Month Forward0.8037 3 Months Forward0.8043 6 Months Forward0.8057 USD equiv Thursday 0.3292 0.7836 0.3791 1.9135 1.9101 1.9038 1.8959 0.8068 0.8069 0.8074 0.8088 Currency per USD Friday 3.0221 1.2771 2.6774 0.5242 0.5251 0.5268 0.5290 1.2442 1.2442 1.2433 1.2412 Currency per USD Thursday 3.0377 1.2762 2.6378 0.5226 0.5235 0.5253 0.5275 1.2395 1.2393 1.2385 1.2364

Answer: a) S(peso/)=S(peso/USD)*S(USD/) =3.0221*1.9077= peso 5.7653/ b) F180 (CAD/)= F180 (CAD/USD)* F180 (USD/) =1.2364*1.8959= CAD2.3441/ 11. Using the same table for question 10 to calculate the one-, three-, and six-month

(annualized) forward premium or discount for the Canadian dollar versus the U.S. dollar on Friday using American term quotations. (2 points each) For simplicity, assume each month has 30 days. What is the interpretation of your results? (2 points)
Answer: The formula we want to use is: fN,CD = [(FN(USD/CAD) - S(USD /CAD)/S(USD /CAD)] * 360/N f1,CD = [(.8037 - .8037)/.8037] *360/30 = .0000 f3,CD = [(.8043 - .8037)/.8037] *360/90 = .0030 f6,CD = [(.8057 - .8037)/.8037] *360/180 = .0050 The pattern of forward premiums indicates that the Canadian dollar is trading at an increasing premium versus the U.S. dollar. That is, it becomes more expensive (in both absolute and percentage terms) to buy a Canadian dollar forward for U.S. dollars the further into the future

12. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal, you notice that Dresdner Bank is quoting 0.7627/$1.00 and Credit Suisse is offering SF1.1806/$1.00. You learn that UBS is making a direct market between the Swiss franc and the euro, with a current /SF quote of 0.6395. Suppose you start with $5,000,000. Calculate the profit/loss for the following trading strategy: first sell $ to Dresdner Bank for ; then sell to UBS for SF; finally sell SF to Credit Suisse for $. (6pts) Answer: The trade of selling $5,000,000 to Dresdner Bank at 0.7627/$1.00 would yield 3,813,500 = $5,000,000 x0 .7627. (1.5pts) The trade of selling 3,813,500 to UBS at 0.6395/SF1.00 would yield SF5,963,253 = 3,813,500/.6395. (1.5pts) The trade of selling SF5,963,253 to Credit Suisse would yield $5,051,036 = SF5,963,253/1.1806 (1.5pts) Hence, a (triangular arbitrage) profit of $51,036. (1.5pts) 13. Currently, the spot exchange rate is $1.50/ and the three-month forward exchange rate is $1.52/. The three-month interest rate is 8.0% per annum in the

U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or 1,000,000. a) (3 points) Determine whether the interest rate parity holds or not b) (8 points) If the IRP does not hold, how would you carry out covered interest arbitrage? Show all the steps and determine the maximum arbitrage profit. c) (5 points) Explain how the IRP will be restored as a result of covered arbitrage activities. Answer: Lets first summarize the information that is given: S = $1.5/; F = $1.52/; I$ = 2.0%; I = 1.45% Credit = $1,500,000 or 1,000,000. a) (1+I$) = 1.02 (1+I)(F/S) = (1.0145)(1.52/1.50) = 1.0280 Thus, IRP is not holding exactly. b) (1) Borrow the maximum amount of $1,500,000; repayment will be $1,530,000. (2) Buy 1,000,000 spot using $1,500,000. (3) Invest 1,000,000 at the pound interest rate of 1.45%; maturity value will be 1,014,500. (4) Sell 1,014,500 forward for $1,542,040 Arbitrage profit will be $12,040 c) Following the arbitrage transactions described above, The dollar interest rate will rise; The pound interest rate will fall; The spot exchange rate will rise; The forward exchange rate will fall. These adjustments will continue until IRP holds.