fin exam

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.

Assume that the interest rate on a one-year insured home country bank deposit is 2.8%, and the interest rate on a 1-year insured foreign bank deposit is 1.2%. For the actual returns of these two investments to be similar from the perspective of investors in the home country, the foreign currency would have to _____________ over the investment horizon by approximately 1.6% (2.8%-1.2%=1.6%).

appreciate

Currency carry trade involves ________ a currency that has a higher rate of interest and funding the trade by ________ in a currency with a low rate of interest, without any hedging.

buying; borrowing

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

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

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/€1. If interest rates are 5% APR in the U.S. and 3% APR in the euro zone, what is the no-arbitrage 1-year forward rate?

$1.5291/€1

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

(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

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

(Step 3 of CIA) 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

Which of the following statements regarding futures contracts is CORRECT?

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

Which of the following statement in CORRECT?

***Forward parity states that any forward premium or discount is equal to the expected change in the exchange rate.*** The interest rate parity is said to be covered when the no-arbitrage condition could be satisfied through the use of swap contracts in an attempt to hedge against foreign exchange risk. The International Fisher Effect (IFE) states that the currency of the country with a lower nominal interest rate is expected to depreciate against the currency of the country with the lower nominal interest rate. Parity conditions are equilibrium conditions and hold in both short-term and long-term time periods. Interest Rate Parity (IRP) is best defined as when the central bank of a country brings its domestic interest rate in line with its major trading partners.

Which of the following statement is FALSE?

***Funding currency in a carry trade is frequently a volatile currency e.g., Saudi riyal that is sensitive to oil price movements.*** One hallmark pattern of carry trade is steady rise in small profits and then sudden crash. Carry trade has paid off on average because historically interest rate differences haven't reflected actual subsequent exchange rate movements. Currency risk in a carry trade is seldom hedged because hedging would either impose an additional cost or negate the positive interest rate differential if currency forwards are used. The carry trade is profitable as long as the interest rate differential is greater than the appreciation of the currency with a low interest rate against the currency with a high interest rate.

(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 _______

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%

(Step 1 of CIA) 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. What is the intrinsic interest rate in the United States?

1.18%

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

(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%

One unit of currency has same purchasing power globally

Absolute PPP

(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?

As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. All types of debt instruments are not regularly available for all borrowers. Swaps assist in tailoring financing to the type desired by a particular borrower. The primary reason for a counterparty to use a currency swap is to obtain debt financing in the swapped currency at an interest cost reduction brought about through comparative advantages each counterparty has in its national capital market. ***At the inception of an interest-only interest rate swap, the equivalent principal amounts are exchanged at the spot rate.*** The swap market offers price discovery to market participants.

Which of the following statements regarding forward contracts is CORRECT?

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

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.

Which of the following statements is CORRECT?

Currency risk in carry trades is typically hedged. The Big-Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their "correct" level. It is based on the relative purchasing-power parity. An appreciation of high-yielding currencies is the main risk in carry trade. ***The absolute purchasing power parity predicts that price levels will the same across countries.***

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

Countries with higher inflation rates have higher nominal interest rate

Fisher Effect

Which of the following statements is FALSE?

In-the-money options are more expensive, the less in-the-money they are. For American options, the intrinsic value is the difference between the time value and the market value. 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. American call and put premiums should be at least as large as their intrinsic value. Speculators who expect a currency to appreciate should purchase call options on that currency.

The forward exchange rate premium equals (approximately) the interest rate differential

Interest Rate Parity

Which of the following statements is FALSE?

Interest rate parity (IRP) is a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate. The interest rate parity is said to be covered when the no-arbitrage condition could be satisfied through the use of forward contracts in an attempt to hedge against foreign exchange risk. ***For interest rate parity (IRP) to hold, a country with a higher interest rate should expect to see its currency appreciate in the future.*** The basic premise of interest rate parity (IRP) is that hedged returns from investing in different currencies should be the same, regardless of the level of their interest rates. The interest rate parity (IRP) is the fundamental equation that governs the relationship between interest rates and currency exchange rates.

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

International Fisher Effect

Which of the following is a likely benefit of have a weak currency?

Lower foreign debt service costs Potential for increasing international reserve Weaker inflationary pressure ***Potential to increase export***

Which of the following statements is FALSE?

Monetary policies (e.g., cutting interest rates) have less simulative effect on the economy when interest rates are close to zero (i.e., zero-bound interest rate) because it is difficult for financial institutions to pass on negative interest rates to consumers. ***The favored currencies for cross-currency basis-swaps are the U.S. dollar, Chinese RMB, and Korean won.*** Inverted yield curves occur when short-term debt instruments have a higher interest rate than long-term debt instruments. When two firms both have better name recognition in their home countries than in the other's country where they are trying to raise funds, they may utilize a currency swap to take advantage of their comparative advantage. Japanese Yen as a haven asset will depreciate if global economic indicators are strong and investors are optimistic about the capital markets.

Which of the following statements if FALSE?

Most currency futures contracts are closed out before the settlement date. The price of currency futures will be similar to the forward rate. ***Currency futures is a non-binding contract that locks in for a future trade in FX at a specified exchange rate.*** 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. Sellers (buyers) of currency futures can close out their positions by buying (selling) identical futures contracts prior to settlement.

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

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 statement in FALSE?

Relative Purchasing Power Parity is an extension of the traditional Purchasing Power Parity theory to include changes in inflation over time. While frequently failing to hold true in practice, purchasing power parity is still a useful economic theory because it helps predict where FX is eventually heading . An arbitrage is best defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making guaranteed profits. ***Relative Purchasing Power Parity suggests that countries with lower rates of inflation will have a devalued currency.*** Purchasing power is the power of money expressed by the number of goods or services that one unit can buy, and which can be reduced by inflation.

__________ 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

Which of the following statement is INCORRECT?

Stock can be viewed as an option with zero exercise price. ***The buyer of an option is referred to as the writer of the option. The buyer of an option is referred to as the holder of the option.*** 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. Derivatives are so named because their values are derived from underlying assets. Speculation is a trade with the objective to profit by trading on expectations about prices in the future.

Which of the following statement is FALSE?

The Fisher Effect suggests that nominal interest rates of two countries differ because of the difference in expected inflation between the two countries. The International Fisher Effect (IFE) states that the difference between the nominal interest rates in two countries is directly proportional to the changes in the exchange rate of their currencies at any given time. The International Fisher Effect (IFE) theory suggests that currencies with high interest rates will have high expected inflation (due to the Fisher effect) and the relatively high inflation will cause the currencies to depreciate (due to the relative PPP effect). Other country characteristics besides inflation (e.g., income levels, government controls) can affect exchange rate movements. Even if the expected inflation derived from the Fisher Effect properly reflects the actual inflation rate over the period, relying solely on inflation to forecast the future exchange rate is subject to errors. ***The International Fisher Effect (IFE) theory suggests that foreign investors who attempt to capitalize on relatively high U.S. interest rates will be adversely affected by USD appreciation.***

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 benefit to forecasting exchange rates accrues to, and are a vital concern for, MNCs formulating international sourcing, production, financing and marketing strategies If the forward rate is unbiased, then it should reflect the expected future spot rate. If international capital markets are fully integrated, real interest rates should be the same across countries. Covered Interest Arbitrage (CIA) activities results in restoring equilibrium prices quickly. ***If a foreign country experiences a hyperinflation, its currency should appreciate against stable currencies.***

(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.

Which of the following currencies is like to be the funding currency in a carry trade: Australian dollars when the interest rate in Australia is high Mexican Peso during a presidential election US dollars when the interest rate in the United States is low

US dollar

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 borrowing USD borrowing Company A €7% $8% Company B €6% $9%

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

Suppose the inflation rate in Japan is expected to be 1% in the next year and 8% in Mexico, then the Relative Purchasing Power Parity predicts Mexican peso to ________ by _______ during the next year.

depreciate; 7%

Some commodities never enter into international trade. Examples include ____________.

haircut

Which of the following conditions tend to generate profits for carry trades? i. When the funding currency is converted to a currency, which is then invested at a much higher interest rate than the interest rate for borrowing in the funding currency. ii. Buying the investment currency drives up the yields of debts denominated in the investment currency iii. The investment currency appreciates against the funding currency

i and iii

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 __________ in the expected inflation rate in a country will cause a proportionate ____________ in the nominal interest rate in the country.

increase; increase

In a currency swap, ________________________________ .

it may be the case that firms have a comparative advantage in borrowing in their domestic markets it may be the possible that each firm enjoys a lower cost of funding it may be the case that two counterparties have equivalent credit ratings ***All of the statements are correct***

(Step 2 of CIA) 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 United States; buy euro

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 (IFE) is an economic theory stating that the expected disparity between the exchange rate of two currencies is approximately equal to their countries' __________.

nominal interest rates

PPP is the manifestation of the law of one price applied to a standard commodity basket. It will hold only if _______________.

the composition of the consumption basket is the same across countries the prices of the constituent commodities are equalized across countries in a given currency There is no international barrier and consumers can freely and costly shift their demand to wherever prices are lower. ***All the 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

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 swap bank will enter into a currency swap in which it would pay semiannual fixed-rate euro payments of 3.60 percent against receiving semiannual fixed-rate dollar payments of 2.22 the swap bank will enter into a currency swap in which it would pay semiannual fixed-rate dollar payments of 2.11 percent against receiving semiannual fixed-rate euro payments of 4.80. ***that both statements are correct***

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 (IRP) does not hold, ____________________ .

there are opportunities for covered interest arbitrage

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 (PPP) suggests that _______________.

transportation costs can make it difficult to directly compare commodity prices

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