FINAN 4550 Quiz 2

How can you determine if CIA is profitable?

Basically if the Forward rate will differ from spot rate by an amount different to the interest rate difference between two countries. They will not be the same amount of difference and will not be aligned to the IRP line. If the differential interest rates and the forward premium/discount are the same, then CIA is not possible.

In the Money, At the Money, and Out of the Money

Call: if s > x = in the money If x = x, At the money If s < x, out of the money Put: If s > x, out of the money If s < x, in the money If s = x, at the money

covered interest arbitrage

Capitalize on interest rate differential between two countries while "covering" exchange rate risk with a forward contract. Ability to guarantee a return on your funds > the domestic rateOnce forward rate has a discount = interest rate advantage, realignment happens in minutes because forward market is less liquid than spot market, its mores sensitive to supply and demand, realignment usually happens in F market Ensures Forward rates are set separately

What mechanism results in change in the foreign currency value?

Change in foreign currency value come from a mix of change in inflation b/w home and foreign currency, change in interest rate differential b/w home and foreign, change in differential b/w home and foreign income level, change in government controls, and change in expectations of future exchange rates

What are the Exchange Rate Regimes. What are the advantages and disadvantages of each?

Fixed, Floating, Managed Float and Pegged. Fixed: Currencies can fluctuate within a narrow boundary of +/-1%. Need a central bank to intervene and maintain currency within the narrow boundaries. Banks can devalue or reduce the value of its currency against others or they can revalue its currency against other currencies. Pros: Provide security and stability to help economic growth Cons: A country can determine that at any time its currency will not hold that value and the government will devalue it. Negatively affects countries using that currency. Floating: Exchange rates are determined and adjust on a continual basis in response to Supply and demand without government intervention. Also affected by the market. Allows for complete flexibility. Pros: A country is more insulated from inflation/unemployment of other countries. Changing exchange rates act as a buffer to keep unemployment and inflation from spreading to other countries. Usually those problems stay domestic and are dealt with by the government. A central bank is not needed to maintain rates and currency values. Cons: insulation can be a problem for the country that initially experienced the economic problems. (If there is high inflation, imports will seem more expensive to the US. Then US products that use imports will be more expensive. The weaker dollar will make foreign products seem more expensive as well. However, instead of domestic products becoming cheaper than foreign goods, domestic producers will feel like they can raise prices because foreign products are more expensive. If they do that, inflation won't go down). Can adversely affect a country that has high unemployment (if the US has high unemployment, they will purchase less foreign items. Purchasing less foreign goods will strengthen the dollar. This will then make people want to buy foreign goods, because they will seem cheaper. Since they are not buying domestic products, unemployment will still be low). A country's economic problems can sometimes be com- pounded by freely floating exchange rates. Managed Float: Governments can and sometimes do intervene to prevent their currencies from moving too far in a certain direction. Pros: Governments can intervene if their currency is moving too much in one direction. They can also change currency values to stimulate the economic. Cons: allows a government to manipulate exchange rates in order to benefit its own country at the expense of others. Tends to be criticized when governments intervene. A government may attempt to weaken its currency to stimulate a stagnant economy. Their prices will seem cheaper and they will become more competitive. Other countries may lose sales. Pegged: The home currency's value is pegged to one foreign currency or to an index of currencies. Although, the home currency's value is fixed in terms of the foreign currency which it is pegged, it moves in line with that currency against other currencies. Smaller countries will pegged to a larger, more developed country. When the country is using a pegged system they use a currency board instead of a central bank Pros: Historically developing countries have used this to stabilize. Pegging to a more stable currency will make the pegged currency more stable. Cons: you have to keep interest rates similar to the country you're pegging to. Weak economic or political conditions can cause firms and investors to question whether a peg will hold. If the peg is broken, and if the exchange rate is dictated by market forces, then the local currency's value could immediately decline by 20 % or more.

Difference between revaluation and appreciation

Revaluation refers to an upward adjustment of the exchange rate by the central bank. Appreciation refers to the increase in a currency's value that is allowed to fluctuate in response to market conditions. Appreciate is more commonly used when discussing currencies that are not subject to a fixed exchange rate system.

IFE International Fisher Effect

use interest rates instead of inflation rates. Increased interest rates => increase demand for currency (investment) and a increase in currency value. Central banks use rates to increase or decrease value of currency.

According to PPP, high inflation should ____________ the value of the foreign currency

decrease. If the inflation is happening in the foreign currency's home country, then it makes the value of the currency decrease. If high inflation happens in the US, the foreign currency's value will increase.

Ch.8 #33 You believe that interest rate parity and the international Fisher effect hold. Assume that the U.S. interest rate is presently much higher than the New Zealand interest rate. You have receivables of 1 million New Zealand dollars that you will receive in 1 year. You could hedge the receivables with the 1-year forward contract. Or, you could decide to not hedge. Is your expected U.S. dollar amount of the receivables in 1 year from hedging higher, lower, or the same as your expected U.S. dollar amount of the receivables without hedging? Explain.

he expected amount is the same, because the forward rate reflects the interest rate differential, and the expected spot rate (if you do not hedge) according to IFE reflects the interest rate differential.

Triangular Arbitrage

if "quoted" cross rate does not equal the "calculated" cross rate, then triangular arbitrage is possible Conducted in spot market, usually at 3 different banks Ensures cross rates are properly set.

How does IRP relate to covered interest arbitrage (CIA).

if they are equal investors in different countries they will earn the same return (cannot use covered interest arbitrage to achieve increased returns meaning those available in home country)

Where do you buy/sell currency options?

in the currency options market

Ch. 5 #4 Compute the forward discount or premium for the Mexican peso whose 90-day forward rate is $.102 and the spot rate is $.10. State whether your answer is a discount or premium.

($0.102/0.10)-1 = 0.02 0.02(360/90) = 0.08 = 8% premium

Ch. 8 #19 Assume that the spot exchange rate of the Singapore dollar is $.70. The 1-year interest rate is 11 percent in the United States and 7 percent in Singapore. What will the spot rate be in 1 year according to the IFE? What is the force that causes the spot rate to change according to the IFE?

(1.11/1.07)-1= 3.738% interest rate differential (1+3.738%)(0.70) = $0.72617 = spot rate in 1 year The force that causes this expected effect on the spot rate is the inflation differential. The anticipated inflation differential can be derived from interest rate differential.

Bid/Ask Spread

(ask - bid)/ask

Equation to calculate the % change in the foreign currency

(new rate - old rate)/old rate

What is a long straddle and a short straddle. When are they used.

A long straddle combination of buying a put option and a call option. A Short straddle is a combination of selling a call and put option. In both cases the exercise prices are not the same. With straddles, speculators anticipate having gains that more that offset loses. People use a long straddle in very high volatile currencies. A speculator may anticipate a currency being substantially affected by some economic event. But the person might not know what direction the currency will go. In this case they do a long straddle. A short straddle is used when a speculator anticipates low volatility. The person thinks there will be very small changes in the currency and may not be sure if it will depreciate or appreciate. In this case, they will earn the premium on one option and lose only a little on the other.

Difference between absolute and relative PPP

Absolute Form of PPP: without international barriers, consumers shift their demand to wherever prices are lower. Prices of the same basket of products in two different countries should be equal when measured in common currency. Assumes perfect markets, so it doesn't hold well Relative form of PPP: Different factors (market imperfections) like taxes, quotas, tariffs, transportation costs, the prices of a product in two different markets are not the same but the rate of change in the price should be the same when measured in a common currency

Describe Bretton Woods and Smithsonian Agreements

Bretton Woods: From 1944 - 1971 where most exchange rates were fixed according to this agreement. Each currency was valued in terms of gold so their values with respect to each other were fixed. Governments intervened in the foreign exchange markets to ensure that exchange rates drifted no more than 1% above or below the initially set rates. Smithsonian: In December of 1971 a conference of reps from various countries concluded with this agreement which called for a devaluation of the US dollar by about 8% against other currencies. Currency values were expanded to within 2.25% above or below. The imbalances in international payments continued and in February 1973 the US dollar was devalued again. By March of 1973 countries were no longer attempting to maintain their home currency values within the boundaries established by this agreement.

Equations for put and call options

Buy Call: IV = s - x Profit = s - x - p Sell Call: IV = -(s-x) Profit = -(s-x) + p But Put: IV = x - s Profit = x - s - p Sell put: IV = -(x-s) Profit = -(x-s) + p s = spot rate x = strike price p = premium

Locational Arbitrage

Buy at lower price, sell at higher price. Prices then adjust to parity. Ensures exchange rates are similar.

Ch.5 #18 Assume that a March futures contract on Mexican pesos was available in January for $.09 per unit. Also assume that forward contracts were available for the same settlement date at a price of $.092 per peso. How could speculators capitalize on this situation, assuming zero transaction costs? How would such speculative activity affect the difference between the forward contract price and the futures price?

Buy futures contract in January at $0.09 per peso. I would sell forward contracts at $0.092. When the pesos are received (as a result of the futures position) on the settlement date, the speculators would sell the pesos to fulfill their forward contract obligation. This strategy results in a $.002 per unit profit. As many speculators capitalize on the strategy described above, they would place upward pressure on futures prices and downward pressure on forward prices. Thus, the difference between the forward contract price and futures price would be reduced or eliminated.

Ch.5 #20 Auburn Co. has purchased Canadian dollar put options for speculative purposes. Each option was purchased for a premium of $.02 per unit, with an exercise price of $.86 per unit. Auburn Co. will purchase the Canadian dollars just before it exercises the options (if it is feasible to exercise the options). It plans to wait until the expiration date before deciding whether to exercise the options. In the following table, fill in the net profit (or loss) per unit to Auburn Co. based on the listed possible spot rates of the Canadian dollar on the expiration date. Spot Rates: $.76 .79 .84 .87 .89 .91

Buy put option: Profit: X - S - P 0.86 - .76 - 0.02 = 0.08 0.86 - .79 - 0.02 = 0.05 0.86 - .84 - 0.02 = 0 0.86 - .87 - 0.02 = -0.02 0.86 - .89 - 0.02 = -0.02 0.86 - .91 - 0.02 = -0.02

Difference between devaluation and depreciation of a currency

Devaluation is a central banks actions to devalue a currency in a fixed exchange rate system. Basically when a government intervenes and changes the value of the currency. Depreciation refers to the decrease in a currency's value that is allowed to fluctuate in response to market conditions. The term depreciation is more commonly used when describing the decrease in values of currencies that are not subject to a fixed exchange rate system.

Ch. 6 #3 How can a central bank use direct intervention to change the value of a currency? Explain why a central bank may desire to smooth exchange rate movements of its currency.

Direct intervention: buy dollars when it wants the dollar to strengthen. Upward pressure on dollar will change exchange rates. Sell dollars when it wants the dollar to weaken. Downward pressure on dollar will change exchange rates. Central banks want smooth exchange rate movements so that economies using the dollar won't fluctuate a lot. They want to stabilize the economy and financial markets.

Difference between Direct and Indirect intervention. Difference between sterilized and non-sterilized.

Direct: Central bank would enter the currency market and buy or sell its own currency. To force the dollar to weaken, the fed can intervene directly by selling dollars. If the Fed wants to strengthen the dollar, they will buy dollars to put upward pressure on the dollar. Indirect: Government doesn't buy or sell its currencies. Other government controls and interest rates are used. They alter supply and demand of currencies. They can also control the amount of currency that can leave their country Sterilized: no change in the money supply. The fed interacts with investments in the treasury market. Offset lowering the value of the dollar from selling dollar by selling treasury stock for USD. If they want to offset the rise in the value of the dollar they caused by buying USD, they buy US treasuries for dollars, which increases supply of dollars in the market. Non-Sterilized: Allow money supply to change. The fed doesn't buy treasury stocks.

What is dollarization and currency board?

Dollarization: Is the replacement of foreign currency with US dollars. This process is a step beyond a currency board because it forces local currency to be replaced by the US dollar. Although dollarization and a currency board attempt to peg the local currency's value, the currency board does not replace the local currency with dollars. Currency Board: System for pegging the value of local currency to some other specified currency. The board must maintain currency reserves for all the currency that it has printed. This large amount of reserves may increase the ability of a country's central bank to maintain its pegged currency.Only effective if investors believe that it will last. IF investors expect that market forces will prevent a government from maintaining the local currency's exchange rate, then they will attempt to move their funds to countries in which the local currency is expected to be stronger. By withdrawing their funds from a country and cover the funds into a different currency, foreign investors put downward pressure on the local currency's exchange rate. If the supply of the currency for sale continues to exceed demand, the government willl be forced to devalue its currency.

Do tests support PPP?

Empirical tests do not support PPP? Inflation by itself is not a strong indicator of predicting how exchange rates will change. Another reason that PPP might not hold is that there are not substitutes for traded goods. Certain goods don't have competition. There might not be a substitute in a different market. The price wouldn't change without competition, there wouldn't be a comparison to make. If substitute goods are not available domestically, consumers may not stop buying imported goods.

Do tests support IRP?

Empirical tests do support IRP. Differential interest rates are and do explain the reason there are differences between forward and spot rates. Explains premium and discount of forward

European option v. American option

European options must be exercised on the expiration date if they are to be exercised at all. These offer less flexibility although that is not relevant in some situations. Example: For example, firms that purchase options to hedge future foreign currency cash flows will probably have no desire to exercise their options before the expiration date. If European-style options are available for the same expiration date as American- style options and can be purchased for a slightly lower premium, then some corporations may prefer them for hedging.

How to calculate the forward rate, spot rate, and premium

F= S (1+p) P = (F/S) -1 or (F-S)/S S= F/(1+p) F = forward rate P = premium S = spot rate

Difference between a forward and a futures contract

Forward: Agreement between a corporation and financial institution (commercial bank). Right to sell or buy a currency @ a specified rate/time/amount. Exchange the amount at the "forward rate." Private, customizable agreements between two parties. Possibility of default, mostly used by hedgers. Traded over-the-counter. Settle at the end of the agreement. Businesses prefer forwards k. There is counter party risk Futures: Standardized terms, mostly used by speculators. Traded on exchange. Prices settled on a daily basis until end of contract.

According to IFE, high interest rates lead to ________ foreign currency values.

High interest rates in the US should lead foreign currency value to increase. High interest rates in the foreign country should cause the foreign currency value to decrease.

Interest Rate Parity

IRP: Equilibrium state. Focused discount = interest rate differential between two countries.

Ch.6 #8 Why would the Fed's indirect intervention have a stronger impact on some currencies than others? Why would a central bank's indirect intervention have a stronger impact than its direct intervention?

Increasing or decreasing interest rates can affect currencies with less active markets from smaller countries. Smaller countries are less liquid, and so they will respond to changes in interest rates and other changes in regulation more than bigger, developed countries with active markets. Indirect is stronger than direct intervention because interest rates strongly affect the equilibrium of exchange rates. It also affects supply and demand for the currency. Direct intervention is superficially changing supply and demand. Usually, market forces can overwhelm direct intervention.

Ch 6. #4 How can a central bank use indirect intervention to change the value of a currency?

Indirect intervention uses interest rates or government control to change value of a currency. High interest rates causes more investors to want to invest in the dollar. It attracts a foreign demand for the home currency to buy high-yield securities. This strengthens the dollar and causes it to appreciate. Low interest rates makes investors want to invest in other currencies instead of the dollar. This puts downward pressure on the dollar and causes it to depreciate because there is reduced demand for the home currency by foreign investors.

IRP Formulas for interest rate differentials and forward premium/discount

Interest rate differential: either ih - if or [(1 + ih)/(1 + if)] - 1 Forward premium/discount: (F - S)/S

What are the conclusions between IRP, PPP, and IFE

Interest rate parity (IRP) focuses on the why the forward rate differs from the spot rate (x-axis) and on the degree of difference that should exist. It relates to a specific point in time (change in interest rates y-axis). Purchasing Power Parity (PPP) suggests that the spot rate will change (x-axis) in accordance with inflation differentials (y-axis). International Fisher Effect (IFE) suggests that the spot rate (x-axis) will change in accordance with interest rate differentials (y-axis).

Equation for using Fisher Effect to estimate inflation

Nominal rates - real rates = inflation

***ask professor which types of currencies are mostly affected** What is NDF and which types of currencies are most affected?

Non-deliverable forward contract. It is an agreement regarding a position in a specified amount of a specified currency, a specified exchange rate and a specified future settlement date (similar to a futures contract). But it does NOT result in actual exchange of the currencies at the future date' that is, there is NO delivery. Instead one party to the agreement makes a payment to the other party based on the exchange rate at the future date. It mostly affects emerging market currencies. Example: US company has an NDF with a local Chilean bank for pesos. Current value of the peso is $0.002. The US company will need 100 million Pesos. At current rate it will be $200,000 USD. If in 90-days (end of NDF) the value of peso grows to $0.0023, the cost will be $230,000 USD. Since it's $30,000 more than when the NDF started, the bank will pay the US company $30,000. If the value of the peso went down instead of up, then the US company would pay that difference to the bank.

Ch.5 #41 Assume that 1 year ago, the spot rate of the British pound was $1.70. One year ago, the 1-year futures contract of the British pound exhibited a discount of 6 percent. At that time, you sold futures contracts on pounds, representing a total of £1,000,000. From 1 year ago to today, the pound's value depreciated against the dollar by 4 percent. Determine the total dollar amount of your profit or loss from your futures contract.

S (a year ago) = $1.70 Discount (a year ago) = -6% -6% = (F/$1.70) - 1 0.94 = F/1.70 F (a year ago) = $1.598 Current S = $1.70 * (1-0.04) = $1.632 Profit: (£1 million x $1.598) - (£1 million x $1.632) = -$34,000 loss

Pros & Cons of strong currencies and weak currencies.

Strong currency: Benefit : increased imports => decrease prices at home => decreased inflation Cost: increased unemployment because people are importing more. Weak currency: Benefit : Increase exports => Increase jobs => increase economic growth. This is good for a poor economy. Cost: might lead to inflation. Fewer imports because they seem too expensive => less competition => domestic prices may rise => inflation.

Do tests support IFE?

Tests support IFE in emerging markets. IFE is not supported in developed markets. IFE has a limitation where it says real rates are stable and constant throughout countries. This is not realistic.

Ch.5 #39 This morning, a Canadian dollar call option contract has a $.71 strike price, a premium of $.02, and an expiration date of 1 month from now. This afternoon, news about international economic conditions increased the level of uncertainty surrounding the Canadian dollar. However, the spot rate of the Canadian dollar was still $.71. Would the premium of the call option contract be higher than, lower than, or equal to $.02 this afternoon? Explain.

The premium will be higher than $.02. The call option premium is positively related to expected volatility and when uncertainty surrounding the exchange rate increases, the expected volatility increases.

Ch.5 #23 A U.S. professional football team plans to play an exhibition game in the United Kingdom next year. Assume that all expenses will be paid by the British government, and that the team will receive a check for 1 million pounds. The team anticipates that the pound will depreciate substantially by the scheduled date of the game. In addition, the National Football League must approve the deal, and approval (or disapproval) will not occur for 3 months. How can the team hedge its position? What is there to lose by waiting 3 months to see if the exhibition game is approved before hedging?

The team could purchase put options on pounds in order to lock in the amount at which it could convert the 1 million pounds to dollars. The expiration date of the put option should correspond to the date in which the team would receive the 1 million pounds. If the deal is not approved, the team could let the put options expire. If the team waits three months, option prices will have changed by then. If the pound has depreciated over this three-month period, put options with the same exercise price would command higher premiums. Therefore, the team may wish to purchase put options immediately. The team could also consider selling futures contracts on pounds, but it would be obligated to exchange pounds for dollars in the future, even if the deal is not approved.

Define put and call options

They are the right to purchase or sell currencies at specified prices, which are done in the currency options market. A currency call option grants the right to buy a specific currency at a designated price within a specific period of time. The owner of a currency put option has the right to sell a currency at a specified price (the strike price) within a specified period of time.

What did countries that joined the Euro Single Currency give up in order to join?

They gave up their monetary policy - having control of the supply of their currency.

Would you purchase or sell a futures contract to hedge a payable? A Receivable?

To hedge a payable, I would purchase a futures contract. Buying a futures contract will benefit us if the currency rises. When value of the currency rises, the value of the contract rises. The increase in the value of the contract will offset how much it will cost to cover the payable. To hedge a receivable, I would sell a futures contract. Value of contract goes up as the value of the currency goes down. Our contract offsets what we lose from receivables.

Ch 6. #5 Assume there is concern that the United States may experience a recession. How should the Federal Reserve influence the dollar to prevent a recession? How might U.S. exporters react to this policy (favorably or unfavorably)? What about U.S. importing firms?

To prevent a recession, Fed Reserve may lower interest rates to stimulate the economy. This will cause upward pressure on economic growth and inflation. This will weaken the dollar. This causes U.S. goods to seem cheaper to foreign countries. Exporters will like this. Importers will not like this because foreign goods will seem more expensive to U.S. imports.

What are mitigating factors for IRP?

Transaction costs (Might eat away at profit), political risk (A crisis in the foreign country could cause its government to restrict any exchange of the local currency for other currencies. This can lower profit), differential tax laws (Covered interest arbitrage might be feasible when considering before-tax returns but not necessarily when considering after-tax returns. Pre plan for tax impact so that you're still profitable).

Ch.8 #38 The United States and the country of Rueland have the same real interest rate of 3 percent. The expected inflation over the next year is 6 percent in the United States versus 21 percent in Rueland. Interest rate parity exists. The 1-year currency futures contract on Rueland's currency (called the ru) is priced at $.40 per ru. What is the spot rate of the ru?

US interest rate = 3+6= 9% Rueland interest rate = 3 + 21 = 24% (1.09/1.24) - 1 = -12.097% interest rate differential = forward premium % -12.097% = (F/S) - 1 0.87903 = ($0.4/S) S = $0.45505

Ch.6 #6 What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal?

Weak home currency: This can help the economy grow because exporting since domestic products will seem cheaper than foreign products. This will create more jobs. However, it can cause inflation in the long run because local producers can raise prices since there is hardly any foreign competition. Strong home currency: More imports than exports because foreign goods will seem cheaper than domestic ones. This will increase unemployment because people are not exporting items. Domestic prices will also be low since they are trying to compete with cheap, foreign goods. This can reduce inflation.

Purpose of a forward or futures contract.

When MNCs anticipate a future need for or the future receipt of some foreign currency, they can set up forward contracts to lock in the rate at which they can purchase or sell that currency. Currency futures contracts are purchased to lock in the amount of dollars needed to obtain a specified amount of a particular foreign currency; they are sold to lock in the amount of dollars to be received from selling a specified amount of a particular foreign currency Agreement between two parties who want to protect themselves from future movements of interest rates. Parties lock in an interest rate for a stated of period time starting on a specific date, based on the notional principal amount.

In parity, will the CIA return = the domestic return on investment?

Yes. In parity, the return will be the same as the investor's home rates.

PPP equation

[(1 + Ih)/(1 + If)] - 1 = inflation differential I = inflation or Ih - If (inflation differential)(current spot rate) = future spot rate x-axis is the percentage change in the foreign currency's spot rate.

Ch.8 #20 As of today, assume the following information is available: U.S. Real interest rate: 2% Mex Real interest rate: 2% US Nominal interest rate: 11% Mex Nominal interest rate: 15% Mex Spot rate: $0.20 Mex forward rate: $0.19 a) Use the forward rate to forecast the percentage change in the Mexican peso over the next year. b) Use the differential in expected inflation to forecast the percentage change in the Mexican peso over the next year. c) Use the spot rate to forecast the percentage change in the Mexican peso over the next year

a) (0.19/0.2)-1 = -5% b) US = 11-2 = 9% Mex = 15-2= 13% (1.09/1.13)-1= -3.54% c) 0% change

Ch.8 #24 Beth Miller does not believe that the international Fisher effect (IFE) holds. Current 1-year interest rates in Europe are 5 percent, while 1-year interest rates in the United States are 3 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate of the euro is $1.10. a) According to the IFE, what should the spot rate of the euro in 1 year be? b) If the spot rate of the euro in 1 year is $1.00, what is Beth's percentage return from her strategy? c) If the spot rate of the euro in 1 year is $1.08, what is Beth's percentage return from her strategy? d) What must the spot rate of the euro be in 1 year for Beth's strategy to be successful?

a) (1.03/1.05)-1= -1.905% (-1.905%+1)($1.10) = $1.07905 b) $100,000 x 1/$1.10 = 90,909.09E 90,909.09E(1.05)=95,454.55E 95,454.55E($1)= $95,454.55 ($95,454.55-$100,000)/100,000= -4.545% Return c) $100,000 x 1/$1.10 = 90,909.09E 90,909.09E(1.05)=95,454.55E 95,454.55E($1.08) = $103,090.914 ($103,090.914-100,000)/100,000 = 3.091% d) [(95,454.55E(spot rate))-100,000]/100,000 = 3%-> this is US return 3,000 = (95,454.55E(spot rate))-100,000 103,000 = 95,454.55E(spot rate) spot rate > $1.07905

Ch.8 #25 Assume the following information is available for the United States and Europe: U.S. Nominal interest rate: 4% EU Nominal interest rate: 6% US expected inflation: 2% EU expected inflation: 5% EU Spot rate: $1.13 EU 1-year forward rate: $1.10 a) Does IRP hold? b) According to PPP, what is the expected spot rate of the euro in 1 year? c) According to the IFE, what is the expected spot rate of the euro in 1 year? d) Reconcile your answers to parts (a) and (c).

a) (1.04/1.06)-1 = -1.887% interest rate differential. In IRP, IR differential = Forward premium/discount. -1.887% = (F/S) - 1 (F/1.13) - 1 = -1.887% F = $1.10868 IRP does not hold because the forward rate should be $1.10868, but it is $1.10 b) PPP uses inflation differential. (1.02/1.05)-1 = -2.857% inflation differential (1+ -2.857% )($1.13) = $1.09771 c) IFE uses interest rate differential (1.04/1.06)-1 = -1.887% (-1.887%+1)($1.13) = $1.10868 d) Parts a and c combined say that the forward rate premium or discount is exactly equal to the expected percentage appreciation or depreciation of the euro.

Ch.8 #34 The U.S. 3-month interest rate (unannualized) is 1 percent. The Canadian 3-month interest rate (unannualized) is 4 percent. Interest rate parity exists. The expected inflation over this period is 5 percent in the United States and 2 percent in Canada. A call option with a 3-month expiration date on Canadian dollars is available for a premium of $.02 and a strike price of $.64. The spot rate of the Canadian dollar is $.65. Assume that you believe in purchasing power parity. a) Determine the dollar amount of your profit or loss from buying a call option contract specifying C$100,000. b) Determine the dollar amount of your profit or loss from buying a futures contract specifying C$100,000.

a) (1.05/1.02)-1 = 2.942% inflation differential. Future spot rate = (2.942% +1)($0.65)= $0.66912 Profit: $0.66912 - 0.64 (strike) - 0.02 (premium) = 0.00912 $0.00912(CAN$100,000) = $912 b) (1.01/1.04)-1 = -0.02885% interest rate differential -0.02885% = premium = (F/S)-1 (F/$0.65) = 0.97115 F = $0.63125 (future spot rate x $100,000) - ($100,000 x forward rate) ($0.66912*$100,000)-($100,000*$0.63125) = $3,787 profit

Ch.8 #21 The opening of Russia's market has resulted in a highly volatile Russian currency (the ruble). Russia's inflation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inflation rate in Russia. a) Explain why the high Russian inflation has put severe pressure on the value of the Russian ruble. b) Does the effect of Russian inflation on the decline in the ruble's value support the PPP theory? How might the relationship be distorted by political conditions in Russia? c) Does it appear that the prices of Russian goods will be equal to the prices of U.S. goods from the perspective of Russian consumers (after considering exchange rates)? Explain. d) Will the effects of the high Russian inflation and the decline in the ruble offset each other for U.S. importers? That is, how will U.S. importers of Russian goods be affected by the conditions?

a) As Russian prices were increasing, the purchasing power of Russian consumers was declining. This would encourage them to purchase goods in the U.S. and elsewhere, which results in a large supply of rubles for sale. Given the high Russian inflation, foreign demand for rubles to purchase Russian goods would be low. Thus, the ruble's value should depreciate against the dollar, and against other currencies. b) The general relationship suggested by PPP is supported, but the ruble's value will not normally move exactly as specified by PPP. The political conditions that could restrict trade or currency convertibility can prevent Russian consumers from shifting to foreign goods. Thus, the ruble may not decline by the full degree to offset the inflation differential between Russia and the U.S. Furthermore, the government may not allow the ruble to float freely to its proper equilibrium level. c) Russian prices might be higher than U.S. prices, even after considering exchange rates, because the ruble might not depreciate enough to fully offset the Russian inflation. The exchange rate cannot fully adjust if there are barriers on trade or currency convertibility. d) U.S. importers will likely experience higher prices, because the Russian inflation may not be completely offset by the decline in the ruble's value. This may cause a reduction in the U.S. demand for Russian goods.

Ch.5 #17 Assume that on November 1, the spot rate of the British pound was $1.58 and the price on a December futures contract was $1.59. Assume that the pound depreciated during November so that by November 30 it was worth $1.51. a) What do you think happened to the futures price over the month of November? Why? b) If you had known that this would occur, would you have purchased or sold a December futures contract in pounds on November 1? Explain.

a) The December futures price would have decreased, because it reflects expectations of the future spot rate as of the settlement date. If the existing spot rate is $1.51, the spot rate expected on the December futures settlement date is likely to be near $1.51 as well. b) You would have sold futures at the existing futures price of $1.59. Then as the spot rate of the pound declined, the futures price would decline and you could close out your futures position by purchasing a futures contract at a lower price. Alternatively, you could wait until the settlement date, purchase the pounds in the spot market, and fulfill the futures obligation by delivering pounds at the price of $1.59 per pound.

Ch.5 #30 Maggie Hawthorne is a currency speculator. She has noticed that recently the euro has appreciated substantially against the U.S. dollar. The current exchange rate of the euro is $1.15. After reading a variety of articles on the subject, she believes that the euro will continue to fluctuate substantially in the months to come. Although most forecasters believe that the euro will depreciate against the dollar in the near future, Maggie thinks that there is also a good possibility of further appreciation. Currently, a call option on euros is available with an exercise price of $1.17 and a premium of $.04. A euro put option with an exercise price of $1.17 and a premium of $.03 is also available. (See Appendix B in this chapter.) a) Describe how Maggie could use straddles to speculate on the euro's value. b) At option expiration, the value of the euro is $1.30. What is Maggie's total profit or loss from a long straddle position? c) What is Maggie's total profit or loss from a long straddle position if the value of the euro is $1.05 at option expiration? d) What is Maggie's total profit or loss from a long straddle position if the value of the euro at option expiration is still $1.15? e) Given your answers to the questions above, when is it advantageous for a speculator to engage in a long straddle? When is it advantageous to engage in a short straddle?

a) straddles can be used to speculate a currency if an investor thinks it will either appreciate or depreciate substantially. b) Call profit: $1.30 - 1.17 - 0.04 = $0.09 Put profit: $1.17 - 1.30 - 0.03 = -0.03 Total profit = $0.09-0.03 = $0.06 c) Call profit: $1.05 - 1.17 - 0.04 = -$0.04 Put profit: $1.17 - 1.05 - 0.03 = $0.09 Total profit = $0.09-$0.04= $0.05 d) Call profit: $1.15 - 1.17 - 0.04 = -$0.04 Put profit: $1.17 - 1.15 - 0.03 = -$0.01 Total profit =-$0.04-$0.01 = -$0.05 e) It is advantageous for a speculator to engage in a long straddle if the currency will fluctuate in either direction a lot. This is because the advantage of benefiting from either an appreciation or depreciation is offset by the cost of two option premiums. It is better to do a short straddle when the currency won't fluctuate a lot in either direction. In that case, the speculator would collect both premiums, and the loss associated with either the call or the put option is minimal.