Quiz 5/6

The current spot exchange rate is $1.55/€1.00 and the three-month forward rate is $1.60/€1.00. Consider a three-month American put option on €25,000 with a strike price of $1.50/€1.00. If you pay an option premium of $1,200 to buy this option, at what exchange rate will you break-even?

$1.452/€1.00

suppose you observe a spot exchange rate of $1.50/euro1. if interest rates are 5% APR in the US and 3% APR in the euro zone what is the no-arbritage 1-year forward rate

$1.5291/euro1

The current spot exchange rate is $1.55/€1.00 and the three-month forward rate is $1.60/€1.00. Consider a three-month American call option on €62,500 with a strike price of $1.50/€1.00. If you pay an option premium of $5,000 to buy this call, at what exchange rate will you break-even?

$1.58/€1.00

The current spot exchange rate is $1.55/€1 and the three-month forward rate is $1.50/€. You enter into a long position on €1,000. At maturity, the spot exchange rate is $1.60/€. How much have you made or lost?

$100

Assume you have good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$ = 3% and in the euro zone the one-year interest rate is i€ = 2%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.24 = €1.00. How much profits can you make by entering into a coverage interest arbitrage?

$18,160.00

(Interest rate swap problem #1, 2 of 4) Company X wants to borrow $10,000,000 floating for 5 years; Company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are shown below: Credit Rating Fixed-Rate Borrowing Cost Floating Rate Borrowing Cost Company X AA 10.5% LIBOR Company Y A 12.0% LIBOR+1% Assume a swap bank is quoting five-year dollar interest rate swaps at 10.7-10.8 percent against LIBOR flat. Therefore, the QSD in this swap is _______

.5% .50% 0.5 50 basis points 50 bp 0.5%

(Interest swap problem #2, 1 of 4) Use the following information to calculate the quality spread differential (QSD). Fixed-rate borrowing cost Floating-rate borrowing cost Company X 10% LIBOR Company Y 12% LIBOR+1.5%

0.50 %

(Interest rate swap problem #1, 4 of 4) Company X wants to borrow $10,000,000 floating for 5 years; Company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are shown below: Credit Rating Fixed-Rate Borrowing Cost Floating Rate Borrowing Cost Company X AA 10.5% LIBOR Company Y A 12.0% LIBOR+1% Assume a swap bank is quoting five-year dollar interest rate swaps at 10.7-10.8 percent against LIBOR flat, the swap bank would have made a profit of ___________.

10,000

(Interest rate swap problem #1, 3 of 4) Company X wants to borrow $10,000,000 floating for 5 years; Company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are shown below: Credit Rating Fixed-Rate Borrowing Cost Floating Rate Borrowing Cost Company X AA 10.5% LIBOR Company Y A 12.0% LIBOR+1% Assume a swap bank is quoting five-year dollar interest rate swaps at 10.7-10.8 percent against LIBOR flat. If Firm Y enters into this swap, what is the borrow cost of Firm Y?

11.8%

Which of the following statements regarding forward contracts is CORRECT? A. Both buyers and sellers of forward contracts face non-trivial counterparty risk. B. Buyers or sellers of forward contracts need to post margin at time zero (i.e., when they enter into the contract). C. In forwards market, a clearinghouse serves as a third party to all transactions. D. Forward contracts are mark-to-market daily. E. Forward contracts represent a right but not a contractual obligation to complete the transaction in the future.

A. Both buyers and sellers of forward contracts face non-trivial counterparty risk.

(Interest rate swap problem #1, 1 of 4) Company X wants to borrow $10,000,000 floating for 5 years; Company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are shown below: Credit Rating Fixed-Rate Borrowing Cost Floating Rate Borrowing Cost Company X AA 10.5% LIBOR Company Y A 12.0% LIBOR+1% Please match borrowers to their respective absolute and relative competitive advantages.

Absolute advantage = firm x Comparative advantage in borrowing at a floating interest rate = firm y Comparative advantage in borrowing at a fixed interest rate = firm x

Which of the following is FALSE?

At the inception of an interest-only interest rate swap, the equivalent principal amounts are exchanged at the spot rate.

Which of the following statements regarding futures contracts is CORRECT? A. Futures contracts are tailor made in terms of contract size and delivery date by an international bank for its clients. B. A futures contract is a standardized contract between two parities to buy or sell an asset at a specified price on a future date. C. More than 90 percent of the futures contracts result in the actual delivery of the underlying asset. D. Compared to forwards, futures are less liquid and are traded on OTC rather than on exchanges. E. Futures face higher counterpart risk than forwards.

B. A futures contract is a standardized contract between two parities to buy or sell an asset at a specified price on a future date.

Which of the following statements if FALSE? A. Currency futures are often sold by speculators who expect that the spot rate of a currency will be less than the rate at which they would be obligated to sell it. B. Currency futures is a non-binding contract that locks in for a future trade in FX at a specified exchange rate. C. Most currency futures contracts are closed out before the settlement date. D. Sellers (buyers) of currency futures can close out their positions by buying (selling) identical futures contracts prior to settlement. E. The price of currency futures will be similar to the forward rate.

B. Currency futures is a non-binding contract that locks in for a future trade in FX at a specified exchange rate.

Which of the following statements is FALSE? A. For American options, the intrinsic value is the difference between the time value and the market value. B. American call and put premiums should be at least as large as their intrinsic value. C. In-the-money options are more expensive, the less in-the-money they are. D. Speculators who expect a currency to appreciate should purchase call options on that currency. E. A put option on $15,000 with a strike price of €10,000 is the same thing as a call option on €10,000 with a strike price of $15,000.

C. In-the-money options are more expensive, the less in-the-money they are.

Which of the following statement is INCORRECT? A. Derivatives are so named because their values are derived from underlying assets. B. Stock can be viewed as an option with zero exercise price. C. The buyer of an option is referred to as the writer of the option. D. Put options give the holder the right, but not the obligation, to sell a given quantity of an asset at some time in the future at a price agreed upon today.

C. The buyer of an option is referred to as the writer of the option.

Company X and Company Y have mirror-image financing needs (they both want to borrow equivalent amounts for the same amount of time). Company X has a AAA credit rating, but company Y's credit standing is considerably lower.

Company X should more readily agree to a swap involving Company Y if there is a swap bank providing credit risk intermediation.

(Interest swap problem #2, 2 of 4) Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are given below. A swap bank proposes the following interest only swap: X will pay the swap bank annual payments on $10,000,000 with the coupon rate of LIBOR - 0.15%; in exchange the swap bank will pay to company X interest payments on $10,000,000 at a fixed rate of 9.90%. What is the value of this swap to company X? Fixed-rate borrowing cost Floating-rate borrowing cost Company X 10% LIBOR Company Y 12% LIBOR+1.5%

Company X will save 5 basis points per year on $10,000,000 = $5,000 per year.

(Interest swap problem #2, 3 of 4) Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are given below. A swap bank proposes the following interest only swap: Y will pay the swap bank annual payments on $10,000,000 with a fixed rate of rate of 9.90% in exchange the swap bank will pay to company Y interest payments on $10,000,000 at LIBOR - 0.15%. What is the value of this swap to company Y? Fixed-rate borrowing cost Floating-rate borrowing cost Company X 10% LIBOR Company Y 12% LIBOR+1.5%

Company Y will save 45 basis points per year on $10,000,000 = $45,000 per year.

A European option is different from an American option in that _____________.

European options can only be exercised at maturity; American options can be exercised prior to maturity

Which of the following graph is the payoff profile of a call option?

Graph A

A swap bank has identified two companies with mirror-image financing needs (they both want to borrow equivalent amounts for the same amount of time.) Company X has agreed to one leg of the swap but company Y is "playing hard to get."

If the swap bank has already contracted one leg of the swap, they should be anxious to offer better terms to company Y to just get the deal done.

Which of the following is the payoff profile of the buyer of a forward contract?

Line A

Which of the following is the payoff profile of the buyer of a futures contract?

Line A

Which of the following is the payoff profile of the seller of a forward contract?

Line B

Which of the following is the payoff profile of the seller of a futures contract?

Line B

Assume you are the buyer of a put option on €10,000. The option premium is $0.25 per €. The exercise price is $1.125 per €. Should you exercise the put option if the current market price is $1.50 per €?

No

Assume a spot price of 112.01, which of the following American call options is in of the money? Exercise price Call premium Option 1 111 1.83 Option 2 113 0.76

Option 1

Assume a spot price of 112.01, which of the following American put options is out of the money? Exercise price Put premium Option 1 111 0.66 Option 2 113 1.57

Option 1

Assume a spot price of 112.01, which of the following American call options is out of the money? Exercise price Call premium Option 1 111 1.83 Option 2 113 0.76

Option 2

__________ is a trade with the objective to profit by trading on expectations about prices in the future, which is in contrast with ________ whose objective is to reduce risks.

Speculation, hedging

A swap bank quotes 5-year swaps for AAA-rated firms at 7.0—7.2 percent in Euro against dollar LIBOR flat. This means ________________________.

The bank stands ready to pay €7.0% against receiving dollar LIBOR on 5-year loans

Which of the following statements is FALSE?

The favored currencies for cross-currency basis-swaps are the U.S. dollar, Chinese RMB, and Korean won.

(Interest swap problem #2, 4 of 4) Company X wants to borrow $10,000,000 floating for 5 years; company Y wants to borrow $10,000,000 fixed for 5 years. Their external borrowing opportunities are given below. A swap bank proposes the following interest only swap: X will pay the swap bank annual payments on $10,000,000 with the coupon rate of LIBOR - 0.15%; in exchange the swap bank will pay to company X interest payments on $10,000,000 at a fixed rate of 9.90%. Y will pay the swap bank interest payments on $10,000,000 at a fixed rate of 10.30% and the swap bank will pay Y annual payments on $10,000,000 with the coupon rate of LIBOR - 0.15%. What is the value of this swap to the swap bank?

The swap bank will earn 40 basis points per year on $10,000,000 = $40,000 per year.

Assume you are the holder of a call option on €10,000. The option premium is $0.25 per €. The exercise price is $1.125 per €. Should you exercise the call option if the current market price is $1.50 per €?

Yes

Consider the dollar- and euro-based borrowing opportunities of Firm A and B. Firm A is a U.S.-based MNC with AAA credit. Firm A can borrow in Italy at 7% or in the US at 8%. Firm B is an Italian firm with AAA credit. Firm B can borrow in Italy at 6% or in the US at 9%. Firm A wants to borrow €1,000,000 for one year and B wants to borrow $2,000,000 for one year. The spot exchange rate is $2.00 = €1.00 and the one-year forward rate is given by IRP as $2.0377/€1 given that the interest rate in the U.S. is 8% and the interest rate in Italy is 6% ($2.00*1.08/€1.00*1.06 = $2.0377/€1). Suppose they agree to the swap shown below. Is this mutually beneficial swap equally fair to both parties?

Yes, A can be better off by 1% on €1 million; B by 1% on $2 million

Consider the dollar- and euro-based borrowing opportunities of companies A and B. A is a U.S.-based MNC with AAA credit; B is an Italian firm with AAA credit. Firm A wants to borrow €1,000,000 for one year and B wants to borrow $2,000,000 for one year. The spot exchange rate is $2.00 = €1.00 and the one-year forward rate is given by IRP as $2.0377/€1. Is there a mutually beneficial swap? Euro borrowingUSD borrowingCompany A€7%$8%Company B€6%$9%

Yes, QSD = 2% = (7% - 6%) - (8% - 9%) = 1% - (-1%)

A call option to buy £10,000 at a strike price of $1.80 = £1.00 is equivalent to ___________________________ .

a put option to sell $18,000 at a strike price of $1.80 = £1.00

Basis risk in a swap refers to ______________________ .

a situation in which the floating rates of the two counterparties are not pegged to the same index

one unit of currency has same purchasing power globally

absolute ppp

In a currency swap, ________________________________ .

all statements are correct

ppp is the manifestation of the law of one price applied to a standard commodity basket it will hold only if

all the statements are correct

the foreign currency would have to ___________ over the investment horizon by aproximately 1.6%(2.8%-1.2%=1.6%)

appreciate

A __________ is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency

currency swap

suppose the inflation rate is japan is expected to be 1% in the next year and 8% in mexico, then the relative purchasing power purity predicts mexican peso to __________ by __________ during the next year

depreciate; 7%

countries with higher inflation rates have higher nominal interest rates

fisher effecr

Which of the following is false?

for interest rate parity to hold, a country with a higher interest rate should expect to see its currency appreciate in the future.

which of the following statement is correct

forward parity states that any forward premuim or discount is equal to the expected change in the exchange rate

some commodities never enter into international trade. examples include

haircut

Suppose the quote for a five-year swap with semiannual payments is 8.50—8.60 percent in dollar against dollar LIBOR (London Interbank Offered Rate) flat. It means ________________________ .

if the swap bank is successful in getting counterparties to both legs of the swap at these prices, the bank will have an annual profit of ten basis points

fisher effect states that an ______ is the expected inflation rate in a country will cause a proportionate _______ in the nominal interest rate in the country

increase; increase

the forward exchange rate premium equals the interst rate differentiality

interest rate parity

spot exchange rates adjust to the nominal interest rate differential between two countries

international fisher effect

Assume you have good credit and can borrow either $1,000,000 or €800,000 for one year. The one-year interest rate in the U.S. is i$ = 3% and in the euro zone the one-year interest rate is i€ = 2%. The spot exchange rate is $1.25 = €1.00 and the one-year forward exchange rate is $1.24 = €1.00. If you determine that there is an arbitrage opportunity, to execute the coverage interest arbitrage you should _______ and ________ forward.

lend in the US; buy eruo

Assume a FX trader agreed to sell £1,000,000 30-day forward@$1.118/£. Further assume S0 = $1.112/£ and S30-day = $1.120/£. The trader ___________ .

lost $2,000 by engaging in this FX trade

A currency carry trade is a trading strategy that involves borrowing a currency at a ______ interest rate and investing in a currency that provides a _______ rate of return

lower; higher

The international fisher effect is an economic theory stating that the expected disparity between the exchange rate of the two currencies is approximately equal to their countries

nominal interest rate

the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation

relative ppp

which of the following is false

relative purchasing power parity suggests that countries with lower rates of inflation will have a devalued currency

Which of the following statement is correct

the absolute purchasing power parity predicts that the price levels will the same across countries

Suppose the quote for a five-year swap with semiannual payments is 2.11—2.22 percent in dollars and 3.60—4.80 percent in euro against six-month dollar LIBOR. The means _______________________.

the both statements are correct

A major risk faced by a swap dealer is mismatch risk. This is ____________________.

the difficulty in finding a second counterparty for a swap that the bank has agreed to take with another party

With regard to a swap bank acting as a dealer in swap transactions, interest rate risk refers to ___________________.

the risk that interest rates changing unfavorably before the swap bank can lay off to an opposing counterparty on the other side of an interest rate swap entered into with the first counterparty

Suppose the quote for a five-year swap with semiannual payments is 8.50—8.60 percent in dollars and 6.60—6.80 percent in euro against six-month dollar LIBOR. The means _______________________.

the swap bank will enter into a currency swap in which it would pay semiannual fixed-rate dollar payments of 8.50 percent against receiving semiannual fixed-rate euro payments of 6.80

Suppose the quote for a five-year swap with semiannual payments is 2.50—2.60 percent in dollars against six-month dollar LIBOR. This means ___________________.

the swap bank will pay semiannual fixed-rate dollar payments of 2.50 percent against receiving six-month dollar LIBOR

When interest rate parity does not hold,

there are opportunities for covered interest arbitrage

For an American call option, B and A in the graph are ________________, respectively.

time value and intrinsic value

Because of their _______, American call and put premium should be at least at large as their _______________ .

time value, intrinsic value

generally unfavorable evidence on purchasing power parity suggests that

transportation costs can make it difficult to directly compare commodity prices

which of the following currencies is like to be the funding currency in a carry trade

us dollars when the interest rate in the united states is low

For the same maturity, we should have __________.

value of in-the-money options > value of at-the-money options > value of out-of-money options

With any hedge ___________________________________________.

your losses on one side should about equal your gains on the other side