International Finance 725
Practice Midterm summer 2010
Solutions
Solutions for questions 1 – 11 are not included. They can be found the notes or lecture slides.
12. You have dollar denominated quotes and are selling Pounds. Since the transaction is though a
hedge fund (not a bank), you sell Pounds at the bid, which is the reciprocal of the dollar
denominated ask quote.
$/£
(0.53 $/£)(£ 500,000) = $263,157.89
13. To fill in the table you take the reciprocal of the bid (ask) quote to get the ask (bid) quote
Bid Ask
S(€/$) .765 1/1.25 = .8
S($/€) 1.25 1/.765 = 1.3072
S(MP/€) 14.75 14.92
S(€/MP) 1/14.92 = .067 1/14.75 = .0678
14. The bid ask cross rates can be calculated as a standard cross rate but just using the bid quotes or
the ask quotes.
SBid(Yuan/$) = 6.32
SAsk(Yuan/$) = 6.50
SBid(RR/$) = 30.32
SAsk(RR/$) = 31.30
15. Triangular arbitrage
a. The calculated rate is 113.7572 ¥/€ the traded rate is 104.75 ¥/€ since the traded rate is
less than the calculated rate there is an arbitrage opportunity. We want to sell € for Yen at
the calculated rate and buy € with Yen at the market rate.
b. Conversion triangle
c. Arbitrage table:
Borrow € +1 €
Convert € to $ -1 € + 1.1561 $
Convert $ to ¥ - 1.1561 $ + 113.7572 ¥
Convert ¥ to € - 113.7572 ¥ 1.086 €
Repay loan -1 €
0.086 €
16. Interest rate Parity: Think of two possible trading strategies (i) an investor can invest $1 for 3
months in the dollar risk free rate. (ii) The investor can convert that dollar to yen and invest at the
yen risk free rate for 3 months. If IRP holds each trading strategy should yield the cash flow at in
3 months.
After converting Yen back to dollars in 3 months we end up with a value exactly equal to the
dollar investment
17. Strict Purchasing Power Parity the idea begins from the law of one price, which states that in
efficient markets identical assets must have the same price. Therefore, one should be able to take
the price of a basket of goods in one currency convert to any other currency and purchase the
same basket of goods with no residual cash flow. Hence, under strict PPP, the exchange rate
between the currencies of any two countries is equal to the ratio of prices (of a standard basket of
goods) in those two countries.
18. Purchasing Power Parity:
2005 2006
Canada Mexico Canada Mexico
Inflation 2% 4.3% 1.5% 4%
Exchange rates 13.2 MP/CD 12.3 MP/CD
a. No, relative PPP does not hold. For relative PPP to hold, the percent change in the
exchange rate must equal the percent change in the exchange rate implied by inflation.
%∆ exchange rate
%∆ from inflation
b. The real exchange rate is:
The real exchange rate is greater than one, indicating that the exchange rate MP/CD
increased in real (inflation adjusted) terms. Therefore, prices in Mexico increased more
than prices in Canada, which would increase Canada’s competitive advantage relative to
Mexico in the global market.
19. Forward Arbitrage:
a. The market traded price is 11.5 MP/$ and the calculated price is 12.48. Therefore, the
market price is less than the calculated (synthetic forward price)
b.
c. Arbitrage Table:
t=0 t = 0.25
Borrow $ + 0.995 $ -1$
Convert $ to MP - 0.995 $ +12.4377 MP
Lend MP - 12.4377 MP + 12.4844 MP
Long Forward +1$ - 11.5 MP
Total Profit 0$ 0 MP 0$ 0.9844 MP
20. To calculate the value of the contract you must first calculate the forward price:
F(€/$) = .877e(.023-.034)140/365 = 0.8733076
v(short) = (.793 - 0.873) e(-.023)140/365 = 0.0796022 €/$
21. The cash flow that can occur at maturity is:
t=0 t = 0.4932
Borrow $ + 0.9931 $ -1$
Convert $ to ¥ - 0.9931 $ + 94.8429 ¥
Lend ¥ - 94.8429 ¥ + 95.3118 ¥
Forward (long) +1$ - 98.34 ¥
Total Cash Flows 0 0 0 -3.0282 ¥
The cash flow that can occur today is:
t=0 t=0
Borrow $ + 0.9931 $ -1$
Convert $ to ¥ - 0.9931 $ + 94.8429 ¥
Lend ¥ - 97.8562 ¥ + 98.34 ¥
Forward (long) +1$ - 98.34 ¥
Total Cash Flows 0$ -3.0133 ¥ 0$ 0$
22. The total account balance on each day is shown below
day T-t S(Yuan/$) ryuan r$ F(Yuan/$)
0 90 6.5 0.023 0.012 6.5176541
1 89 6.2 0.021 0.011 6.2151363
2 88 6.3 0.02 0.013 6.3106413
3 87 6.5 0.022 0.01 6.5186184
F(Yuan/$) ∆ Contract Value ∆ Position Value Account Balance
6.5176541 3000
6.2151363 0.304070843 7356.552659 10356.55266
6.3106413 -0.095966681 -2284.920972 8071.631687
6.5186184 -0.209070551 -4824.705031 3246.926655
23. Hedging with Forwards and Futures:
a. Your company is exposed to FX risk because the company is set to deliver € 750,000 in 6
months. The company you work for realizes profits and losses in US dollars. Therefore,
the company is exposed to FX risk because the dollar price of a € in 6 months is
uncertain. If the dollar cost of a € increase, it will cost the company more $ to buy their
light bulbs.
b. The hedge is : the forward price is 0.891768 €/$
t=0 t = 6m
Economic Position - 750,000 €
Short Forward
($ in the denominator ) + 750,000 € - 841,026.10 $
total cost 0 - 841,026.10 $
c. Hedging in the money market gives:
t=0 t = 6m
Economic Position - 750,000 €
Borrow $ + 832,657.80 $ - 841,026.10 $
Convert $ to € - 832,657.80 $ + 744,396 €
Lend € - 744,396 € + 750,000 €
total cost 0 0 0 - 841,026.10 $