International Finance Midterm #1

Who is Shinzo Abe? What is the inflation goal of Abenomics? What effect will Abenomics have on the value of the Yen against the USD according to theory? Explain using a diagram. Compare and contrast the theoretical effects of Abenomics on the value of the Yen with the real-world experience of Abenomics on the value of the Yen against the U.S. dollar after Abe's election in December 2012.

"Abenomics is the name given to a suite of measures introduced by Japanese prime minister Shinzo Abe after his December 2012 re-election to the post he last held in 2007. His aim was to revive the sluggish economy with "three arrows": a massive fiscal stimulus, more aggressive monetary easing from the Bank of Japan" to increase expected and targeted inflation to 2%, "and structural reforms to boost Japan's competitiveness." Source: http://lexicon.ft.com/Term?term=abenomics Japanese Prime Minister Abe designed Abenomics to increase expected inflation to 2% in Japan, which historically has had very low inflation rates. If inflation increases in Japan, this will increase the supply of yen and reduce the demand for yen by foreigners who will want to buy less denominated in ¥, given Japan's higher prices. The theoretical effect of Abenomincs is shown in the supply and demand diagram for the market for ¥ (in terms of USD). Theoretically, the increase in the ¥ money supply from higher inflation and the reduction in demand for ¥ will both depreciate the yen. This is indeed what has happened since Abenomics was announced, the Yen fell from 0.0130 to 0.097 in 2012 to 2013.

Assume Poland's currency (the zloty) is worth $.17 and the Japanese yen is worth $.008. What is the cross rate of the zloty with respect to yen? That is, how many yen equal a zloty?

$.17/$.008 = 21.25 1 zloty = 21.25 yen

Utah Bank's bid price for Canadian dollars is $.7938 and its ask price is $.81. What is the bid/ask percentage spread?

($.81 - $.7938)/$.81 = .02 or 2%

Assume the spot rate of the British pound is $1.73. The expected spot rate one year from now is assumed to be $1.66. What percentage depreciation does this reflect?

($1.66 - $1.73)/$1.73 = -4.05% Expected depreciation of 4.05% percent

LEHMAN SISTERS Bank believes the Polish Zloty will depreciate over the next year from $0.33 to $0.30. The following annual interest rates apply: Currency Lending Rate Borrowing Rate US Dollars (USD) 2.8% 3.2% Polish Zloty (PLZ) 4.0% 4.2% LEHMAN SISTERS Bank has the capacity to borrow 30 million PLZ or US $10 million for one year. If LEHMAN SISTERS Bank's forecast is correct, what will its dollar profit be from speculation over the next year. Show all steps clearly.

1. Borrow 30 million PLZ. 2. Convert the 30 million PLZ to 30,000,000 $0.33 = $9,900,000 at the spot exchange rate of $0.33. 3. Invest the $9,900,000 at an annual rate of 2.8% for one year. $9,900,000 [1 + 2.8% ] = $9,900,000*1.028=$10,177,200 4. Determine Zloties owed: 30,000,000 PLZ [1 + 4.2% ] = 31,260,000 PLZ. 5. Determine dollars needed to repay Zloty loan: PLZ 31,260,000 $0.30 = $9,378,000 at the $0.30 exchange rate after one year. 6. The dollar profit is $10,177,200 $9,378,000 = $799,200

Assume all the preceding information with this exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy.

1. Borrow $10 million 2. Convert the $10 million to pesos (MXP): $10,000,000/$.15 = MXP66,666,667 3. Lend the pesos through the interbank market at 8.5% annualized over a 30‑day period. The amount accumulated in 30 days is: MXP66,666,667 × [1 + (8.5% × 30/360)] = 66,666,667 × [1.007083] = MXP67,138,889 Repay the dollar loan. The repayment amount on the dollar loan is: $10,000,000 × [1 + (8.3% × 30/360)] = $10,000,000 × [1.006917] = $10,069,170 5. Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30 days (based on the expected spot rate of $.17) is: MXP67,138,889 × $.17 = $11,413,611 6. The profits are determined by estimating the dollars available after repaying the loan: $11,413,611 - $10,069,170 = $1,344,441

Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist: Lending Rate Borrowing Rate U.S. dollar 8.0% 8.3% Mexican peso 8.5% 8.7% Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peos in the interbank market, depending on which currency it wants to borrow. a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy.

1. Borrow MXP70 million 2. Convert the MXP70 million to dollars: MXP70,000,000 × $.15 = $10,500,000 3. Lend the dollars through the interbank market at 8.0% annualized over a 10‑day period. The amount accumulated in 10 days is: $10,500,000 × [1 + (8% × 10/360)] = $10,500,000 × [1.002222] = $10,523,333 4. Repay the peso loan. The repayment amount on the peso loan is: MXP70,000,000 × [1 + (8.7% × 10/360)] = 70,000,000 × [1.002417]=MXP70,169,167 5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is: MXP70,169,167 × $.14 = $9,823,683 6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of: $10,523,333 - $9,823,683 = $699,650

If the direct exchange rate of the euro is worth $1.25, what is the indirect rate of the euro? That is, what is the value of a dollar in euros?

1/1.25 = .8 euros.

12. Suppose that both the US and Europe are following a gold standard. The price of gold in the US is pegged at $1300/oz while the price of gold in Europe is pegged at E 1000. Calculate the implied EUR/USD exchange rate.

1300 / $1000 = $1.30 per Euro Suppose that large US trade deficits cause the Euro to appreciate to a price of $1.35 per Euro. In which direction will gold flow? What will happen to prices of goods and services in the United States? In Europe? ANSWER: With the current exchange rate, the Euro is overvalued relative to the implied rate based on gold prices. A strategy that involves selling Euro and buying dollars will be profitable. For example: 1) Borrow 1000 Euro 2) Sell the 1000 Euro for 1350 ($1.35(1000)) and use the dollars to buy 1.03846oz. of Gold in the US (1350/1300) 3) Ship the gold to Europe and sell the gold at E1000 per ounce to get EUR 1038.46 (1.03846 oz * 1000 EUR/oz) - a 3.846% return! Note that gold will flow out of the US and into Europe causing a contraction of the US money supply and an expansion of the European money supply. In response, prices in the US should fall while prices in Europe rise. The price changes should correct the trade imbalance.

3W is a Wisconsin firm that recently established a European subsidiary with a major Wurst production facility in Munich. The subsidiary was designed to make the wonderful 3W Wurst in Germany to export to America. 3W will sell this Wurst throughout Wisconsin. The subsidiary pays its local employees in Euros. The subsidiary has all of its expenses denominated in Euros. If the Euro strengthens over the next four years, will the value of 3W be favorably affected, unfavorably affect, or not affected? Briefly explain.

3W has large net cash outflows in Euros because the large amount of expenses of paying the employees at the Munich production facility in Euros. Since 3W has large net cash outflows in Euros from its Munich production facility, the strengthening of the Euro will unfavorably affect the value of 3W. It will pay more dollars for the Euros to pay its employees and run its Munich production facility in the stronger €.

If 3W finances its Munich production facility by borrowing in Euros from BNP Bank how will its exchange rate exposure change? Why?

3W will have to pay back the loan to BNP Bank in Euros. So the size of its net cash inflows in €s will be increased reduced. It will now will add the € salaries to its local Munich employees and the € denominated loan to BNP Bank. This increases 3W's net exposure to the stronger €.

Consider the following balance of payments data. (in billions of dollars) Merchandise Exports $100 Merchandise Imports $125 Service Imports $90 Service Exports $80 Income received from abroad $110 Income payments to foreigners $150 Increase in US ownership of private assets abroad $160 Increase in foreign ownership of private US assets $200 Increase in home official reserve assets $30 Increase in foreign official assets in US $35 Assuming that unilateral transfers are zero, find the trade balance on goods and services, the current account balance, the Balance of Payments, and the statistical discrepancy.

: Trade Balance = Sum of first 4 lines = -$35 Current Account = Sum of first 6 lines = -$75 Balance of Payments = Sum of all 10 Lines = -$30 Statistical Discrepancy = -(BOP) = $30.

What are the advantages and disadvantages to a U.S. corporation that uses currency options on euros rather than a forward contract on euros to hedge its exposure in euros? Explain why an MNC use forward contracts to hedge committed transactions and use currency options to hedge contracts that are anticipated but not committed. Why might forward contracts be advantageous for committed transactions, and currency options be advantageous for anticipated transactions?

A currency option on euros allows more flexibility since it does not commit one to purchase or sell euros (as is the case with a euro futures or forward contract). Yet, it does allow the option holder to purchase or sell euros at a locked‑in price. The disadvantage of a euro option is that the option itself is not free. One must pay a premium for the call option, which is above and beyond the exercise price specified in the contract at which the euro could be purchased. An MNC may use forward contracts to hedge committed transactions because it would be cheaper to use a forward contract (a premium would be paid on an option contract that has an exercise price equal to the forward rate). The MNC may use currency options contracts to hedge anticipated transactions because it has more flexibility to let the contract go unexercised if the transaction does not occur.

a. Do you think the acquisition of a foreign firm or licensing will result in greater growth for an MNC? Which alternative is likely to have more risk?

An acquisition will typically result in greater growth, but it is more risky because it normally requires a larger investment and the decision cannot be easily reversed once the acquisition is made.

Asheville Co. has a subsidiary in Mexico that develops software for its parent. It rents a large facility in Mexico and hires many people in Mexico to work in the facility. Ashville Co. has no other international business. All operations are presently funded by Asheville's parent. All the software is sold to U.S. firms by Asheville's parent and invoiced in U.S. dollars. a. If the Mexican peso appreciates against the dollar, does this have a favorable effect, unfavorable effect, or no effect on Asheville's value?

Appreciation of the peso has an unfavorable effect because it results in higher dollar expenses to Asheville Co.

Diamond Bank expects that the Singapore dollar will depreciate against the dollar from its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist: Lending Rate Borrowing Rate U.S. dollar 7.0% 7.2% Singapore dollar 22.0% 24.0% Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in dollars for 60 days. Estimate the profits (or losses) that could be earned from this strategy. Should Diamond Bank pursue this strategy?

Borrow S$10,000,000 and convert to U.S. $: S$10,000,000 × $.43 = $4,300,000 Invest funds for 60 days. The rate earned in the U.S. for 60 days is: 7% × (60/360) = 1.17% Total amount accumulated in 60 days: $4,300,000 × (1 + .0117) = $4,350,310 Convert U.S. $ back to S$ in 60 days: $4,350,310/$.42 = S$10,357,881 The rate to be paid on loan is: .24 × (60/360) = .04 Amount owed on S$ loan is: S$10,000,000 × (1 + .04) = S$10,400,000 This strategy results in a loss: S$10,357,881 - S$10,400,000 = -S$42,119 Diamond Bank should not pursue this strategy.

Asheville Co. plans to borrow funds to support its expansion in the U.S. The Mexican interest rates are presently lower than U.S. interest rates, so Asheville obtains a loan denominated in Mexican pesos in order to support its expansion in the U.S. Will the borrowing of pesos increase, decrease, or have no effect on its exposure to exchange rate risk? Briefly explain.

Borrowing pesos will increase Asheville's exposure because it will increase the amount of dollar cash outflows that are needed to cover expenses.

Explain why MNCs such as Coca Cola and PepsiCo, Inc., still have numerous opportunities for international expansion.

Coca Cola and PepsiCo still have new international opportunities because countries are at various stages of development. Some countries have just recently opened their borders to MNCs. Many of these countries do not offer sufficient food or drink products to their consumers.

You just came back from Canada, where the Canadian dollar was worth $.70. You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 1,300 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain.

Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange desk, the cross-rate is $.60/$10 = 6. Thus, the C$200 would be exchanged for 1,200 pesos (computed as 200 × 6). If you exchange Canadian dollars for pesos with the tourist, you will receive 1,300 pesos.

Today, the stock price of Genevo Company (based in Switzerland) is priced at SF80 per share. The spot rate of the Swiss franc (SF) is $.70. During the next year, you expect that the stock price of Genevo Company will decline by 3%. You also expect that the Swiss franc will depreciate against the U.S. dollar by 8% during the next year. You own American depository receipts (ADRs) that represent Genevo stock. Each share that you own represents one share of the stock traded on the Swiss stock exchange. What is the estimated value of the ADR per share in one year?

Expected value of Swiss stock in 1 year = SF80 x (1 - .03) = SF77.6. Expected value of Swiss franc in 1 year = $.70 (1 - .08) = $.644 Expected value of ADR in 1 year = SF77.6 x ($.644 per franc) = $49.97.

Why do you think international trade volume has increased over time? In general, how are inefficient firms affected by the reduction in trade restrictions among countries and the continuous increase in international trade?

International trade volume has increased because of the reduction in trade restrictions over time. It may have also increased for many other reasons, such as increased information flow (via Internet etc.) between firms in different countries. Inefficient firms are adversely affected if they have to face tougher competition from foreign firms as a result of a reduction in trade restrictions.

Because of the low labor costs in Thailand, Melnick Co. (based in the United States) recently established a major research and development subsidiary there that it owns. The subsidiary was created to improve new products that the parent of Melnick can sell in the United States (denominated in dollars) to U.S. customers. The subsidiary pays its local employees in baht (the Thai currency). The subsidiary has a small amount of sales denominated in baht, but its expenses are much larger than its revenue. It has just obtained a large loan denominated in baht that will be used to expand its subsidiary. The business that the parent of Melnick Co. conducts in the United States is not exposed to exchange rate risk. If the Thai baht weakens over the next 3 years, will the value of Melnick Co. be favorably affected, unfavorably affected, or not affected? Briefly explain.

It will be favorably affected since it needs fewer dollars over time to cover its loan payments and its baht expenses. Its revenue are mostly in dollars and therefore will not be significantly affected by a depreciation of the baht. Currency Joke: I wish I could pay back my student loans in Confederate dollars. They depreciated as the North won the Civil War and the Confederacy ended. I really, really wish my debt was in a depreciated (or depreciating) currency.

Suppose that a BMW costs E 45,000 in Germany and that the current USD/EUR exchange rate is .7624. Calculate the dollar price of the BMW.

Note that the exchange rate is in terms of Euros per dollar (E/$). Therefore, to get the dollar price, divide by the exchange rate. 45,000 / .7624 = $59,024. Notice the units.....(E/BMW)/(E/$) = (1/BMW)/(1/$) = ($/BMW)

Explain why political risk may discourage international business.

Political risk increases the rate of return required to invest in foreign projects. Some foreign projects would have been feasible if there was no political risk, but will not be feasible because of political risk.

Bama Corp. has sold British pound call options for speculative purposes. The option premium was $.06 per unit, and the exercise price was $1.58. Bama will purchase the pounds on the day the options are exercised (if the options are exercised) in order to fulfill its obligation. In the following table, fill in the net profit (or loss) to Bama Corp. if the listed spot rate exists at the time the purchaser of the call options considers exercising them.

Possible Spot Rate at the Net Profit (Loss) per Time Purchaser of Call Option Unit to Bama Corporation Considers Exercising Them if Spot Rate Occurs $1.53 $.06 1.55 .06 1.57 .06 1.60 .04 1.62 .02 1.64 .00 1.68 -.04

Bulldog, Inc., has sold Australian dollar put options at a premium of $.01 per unit, and an exercise price of $.76 per unit. It has forecasted the Australian dollar's lowest level over the period of concern as shown in the following table. Determine the net profit (or loss) per unit to Bulldog, Inc., if each level occurs and the put options are exercised at that time.

Possible Value Net Profit (Loss) to of Australian Dollar Bulldog, Inc. if Value Occurs $.72 -$.03 .73 -.02 .74 -.01 .75 .00 .76 .01

Randy Rudecki purchased a call option on British pounds for $.02 per unit. The strike price was $1.45 and the spot rate at the time the option was exercised was $1.46. Assume there are 31,250 units in a British pound option. What was Randy's net profit on this option?

Profit per unit on exercising the option = $.01 Premium paid per unit = $.02 Net profit per unit = -$.01 Net profit per option = 31,250 units × (-$.01) = -$312.50

. Alice Duever purchased a put option on British pounds for $.04 per unit. The strike price was $1.80 and the spot rate at the time the pound option was exercised was $1.59. Assume there are 31,250 units in a British pound option. What was Alice's net profit on the option?

Profit per unit on exercising the option = $.21 Premium paid per unit = $.04 Net profit per unit = $.17 Net profit for one option = 31,250 units × $.17 = $5,312.50

Randy Marsh purchased a call option on British pounds for $.04 per unit. The strike price was $1.30 and the spot rate at the time the option was exercised was $1.36. Assume there are 31,250 units in a British pound option. What was Randy's net profit on this option?

Randy can buy pounds for $1.30 using the call option, when the spot price for pounds is higher at $1.36. $1.36 - $1.30 - $0.04 = $0.02 for 31,250 pounds $0.02*31,250 = $625 net profit for Randy

Ubiflex Technology expects to receive 25,000,000 Japanese yen 90 days from now. Ubiflex decides to hedge its position by selling Japanese yen forward. The current spot rate of the yen is $.0079, while the forward rate is $.0085. Ubiflex expects the spot rate in 90 days to be $.0080. How many dollars will Ubiflex receive for the 25,000,000 yen 90 days from now? Show all steps clearly.

Since Ubiflex sold 25,000,000 yen forward at the $.0085 forward rate, they will receive: 25,000,000 yen * $.0085 / 1 yen = $212,500.

Describe a scenario in which the size of a corporation is not affected by access to international opportunities.

Some firms may avoid opportunities because they lack knowledge about foreign markets or expect that the risks are excessive. Thus, the size of these firms is not affected by the opportunities.

a. What was Bretton Woods Agreement? When was Bretton Woods Agreement in effect? How did it affect exchange rates?

The Bretton Woods Agreement was the agreement between the United States and the other victorious Allies of World War 2 negotiated at the Bretton Woods, New Hampshire retreat in 1944 by British John Maynard Keynes, U.S. Treasury Secretary Harry Dexter White, and other Allied representatives to create an international financial system of fixed exchange rates, the International Monetary Fund, and the World Bank. The Bretton Woods Agreement, that lasted until President Nixon closed the gold window in 1971, tied the value of on ounce of gold to $35 (USD). Then other countries' currency was tied to the value of the USD, such as 360 Japanese Yen equaling one U.S. dollar, or 119 French Francs equaling one USD. Counties could periodically adjusted their fixed exchange rates by devaluing or raising the value of their currency against the benchmark U.S. dollar.

What is the "J-curve" effect?

The J-curve effect on the home country's balance of trade from a depreciation (weaker home currency) is the initial deterioration of the balance of trade (while pre-existing contracts to import and export are carried out with a weaker home currency) followed by an improvement in the home county's balance of trade (as home county importers and exporters and their foreign counterparts respond to the reduce purchasing power of the depreciated home currency.) Note the J-curve refers to the graph of time versus the home country after a devaluation which looks like a J.

a. What is the approximate position of the U.S. capital and financial account?

The U.S. has a large capital and financial account surplus. Forgeiners are investing more into the U.S. to buy USD denominated assets than we are investing in assets abroad.

a. What is the approximate position of the U.S. trade balance on goods and services?

The U.S. has a trade deficit on goods and services of around $500B annually because we import more goods and services than we export.

a. What is the approximate position of the U.S. trade balance on services?

The U.S. has a trade surplus on services that is around $200B to $250B annually because we export more services than we import.

Assume a simple world in which the U.S. exports soft drinks and beer to France and imports wine from France. If the U.S. imposes large tariffs on the French wine, explain the likely impact on the values of the U.S. beverage firms, U.S. wine producers, the French beverage firms, and the French wine producers.

The U.S. wine producers benefit from the U.S. tariffs, while the French wine producers are adversely affected. The French government would likely retaliate by imposing tariffs on the U.S. beverage firms, which would adversely affect their value. The French beverage firms would benefit.

A U.S. investor buys 500 shares of CEMEX (CEMEXCPO.MX ) on the Bolsa Mexicana de Valores (Mexican Stock Exchange) for 6.8 MXN per share in 2009. The price of CEMEX increases to 13 MXN per share in 2010 when this U.S. investor sells. The USD was worth 12.05 MXN when the investor bought CEMEX in 2009. The USD appreciated to 13.7 MXN when the investor sold CEMEX in 2010. What is the U.S. dollar return of this investment to the investor? Show all steps clearly.

The USD was worth 12.05 MXN when the investor bought 500 shares of CEMEX for 6.8 MXN per share in 2009, so 500 shares cost 500*6.8 MXN * ($1/ 12.05 MXN)=$282. When the investor sold 500 shares in 2010 for 12.05 MXN, the USD was worth 13.7 MXN, so the sale produced 500*13*($1/13.7 MXN) = $474.5. The dollar denominated return was $474.5-$282= $192.29 in dollars, or $192.29/$282 = 68% return in percentage terms.

Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized countries? How does this affect a U.S. firm that does substantial business in Mexico?

The bid/ask spread is wider because the banks that provide foreign exchange services are subject to more risk when they maintain currencies such as the peso that could decline abruptly at any time. A wider bid/ask spread adversely affects the U.S. firm that does business in Mexico because it increases the transactions costs associated with conversion of dollars to pesos, or pesos to dollars.

a. What is definition of the capital and financial account?

The capital and financial accounts are a summary of the flow of funds between one specified country and all other countries due to purchases of assets, direct foreign investments, portfolio investments, and other capital investment or cash flows from income-producing financial assets.

a. What is definition of the current account?

The current account balance is composed of (1) the balance of trade, (2) the net amount of payments of interest to foreign investors and from foreign investment, (3) payments from international tourism, and (4) private gifts and grants.

Mexico tends to have much higher inflation than the United States and also much higher interest rates than the United States. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries. a. Identify the most obvious economic reason for the persistent depreciation of the peso.

The high inflation in Mexico places continual downward pressure on the value of the peso.

High interest rates are commonly expected to strengthen a country's currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the peso's value has declined against the dollar over most years even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico's securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico?

The high interest rates in Mexico result from expectations of high inflation. That is, the real interest rate in Mexico may not be any higher than the U.S. real interest rate. Given the high inflationary expectations, U.S. investors recognize the potential weakness of the peso, which could more than offset the high interest rate (when they convert the pesos back to dollars at the end of the investment period). Therefore, the high Mexican interest rates do not encourage U.S. investment in Mexican securities, and do not help to strengthen the value of the peso.

8. . List the factors that affect currency call option premiums and briefly explain the relationship that exists for each. Do you think an at-the-money call option in euros has a higher or lower premium than an at-the-money call option in Mexican pesos (assuming the expiration date and the total dollar value represented by each option are the same for both options)?

The higher the existing spot rate relative to the strike price, the greater is the call option value, other things equal. The longer the period prior to the expiration date, the greater is the call option value, other things equal. The greater the variability of the currency, the greater is the call option value, other things equal. The at-the-money call option in euros should have a lower premium because the euro should have less volatility than the peso (assuming that the expected volatility of the euro is lower than that of the peso).

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 three months. How can the team hedge its position? What is there to lose by waiting three 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.

a. What was the Gold Standard? How did it affect exchange rates?

Until 1913, exchange rates were fixed by the gold standard. Each currency was convertible to good at a specified rate. Thus, the exchange rate between two currencies was determined by their relative convertibility rates per ounce of good. When every country fixed the value of their paper money (gold notes) to gold, then the world has a system of fixed exchange rates.

Suppose that a Richard Mille RM27-03 watch costs €777,000 in Germany and that the current EUR/USD exchange rate is $1.20. One Canadian dollar is worth $0.82 USDs. Calculate the Canadian dollar price of a Richard Mille RM27-03 watch. Show all steps clearly.

Value of one Euro is $1.20 $1.20 --------------------------------- = ---------- Value of one $C is $0.82 $0.82 = One Euro is C$1.463415 The Canadian cost of a a Richard Mille RM27-03 watch is E777,000 * C$1.463415 = C$1,137,073.

Wendy Testaberger purchased a put option on British pounds for $.03 per unit. The strike price was $1.50 and the spot rate at the time the pound option was exercised was $1.36. Assume there are 31,250 units in a British pound option. What was Wendy's net profit on the option?

Wendy can sell £s for $1.50 when the spot price was $1.36. So she can buy each of the 31,250 pounds for $1.36 and sell for $1.50. The $0.14 profit is reduced by the $0.03 put option premium to $0.11. $0.11* 31,250=$3,437.50 net profit for Wendy

You go to Wu Tang Financial and are given these foreign exchange quotes You can buy a euro for 18 pesos. The bank will pay you 17.5 pesos for a euro. You can buy a U.S. dollar for 0.9 euros. The bank will pay you 0.85 Euros for a U.S. dollar. You can buy a U.S. dollar for 17 Mexican pesos. The bank will pay you 16.5 Mexican pesos for a U.S. dollar. You have $1,000,000. Can you use triangular arbitrage to generate a profit? If so, explain the order of the transactions that you would execute, and the profit that you would earn. If you cannot earn a profit from triangular arbitrage, explain why. You have $1,000,000. Can you use triangular arbitrage to generate a profit? If so, explain the order of the transactions that you would execute, and the profit that you would earn. If you cannot earn a profit from triangular arbitrage, explain why.

You can covert $1,000,000 into Pesos: $1,000,000*16.5 = 16,500,000 Pesos Take the 16,500,000 Pesos and convert to Euros: 16,500,000 Peso/18 Pesos =€916,666.67 Take €916,666.67 and convert back to USD: €916,666.67 / 0.9 = $1,018,518.52 Yeah, you made $18,518.52 from arbitrage!

Compute the bid/ask percentage spread for Mexican peso retail transactions in which the ask rate is $.11 and the bid rate is $.10.

[($.11 - $.10)/$.11] = .091, or 9.1%.

Myrtle Beach Co. purchases imports that have a price of 400,000 Singapore dollars and it has to pay for the imports in 90 days. It can purchase a 90-day forward contract on Singapore dollars at $.50 or purchase a call option contract on Singapore dollars with an exercise price of $.50 to cover its payables. This morning, the spot rate of the Singapore dollar was $.50. At noon, the central bank of Singapore raised interest rates, while there was no change in interest rates in the U.S. These actions immediately increased the degree of uncertainty surrounding the future value of the Singapore dollar over the next three months. The Singapore dollar's spot rate remained at $.50 throughout the day. a. Myrtle Beach Co. is convinced that the Singapore dollar will definitely appreciate substantially over the next 90 days. Would a call option hedge or forward hedge be more appropriate given its opinion? b. Assume that Myrtle Beach uses a currency options contract to hedge rather than a forward contract. If Myrtle Beach Co. purchased a currency call option contract at the money on Singapore dollars this afternoon, would its total U.S. dollar cash outflows be more than, less than, or the same as the total U.S. dollar cash outflows if it had purchased a currency call option contract at the money this morning? Explain.

a. A forward hedge would be more appropriate, because it can lock in payment at $.50 per unit with either method, but it does not have to pay a premium when using the forward rate. It will not benefit from the flexibility of the call option since it is convinced that the Singapore dollar will appreciate. b. More, because the option premium increased due to more uncertainty