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Butler, Solutions for Multinational Finance, 4th edition

**Chapter 3 Foreign Exchange and Currency Risk Management
**

Answers to Conceptual Questions 3.1 3.2 Define liquidity. Liquidity: the ease with which you can exchange an asset for another asset of equal value. What is the difference between a money market and a capital market? Money markets are markets for financial assets and liabilities of short maturity, usually considered to be less than one year. Capital markets are markets for financial assets and liabilities with maturities greater than one year. 3.3 What is the difference between an internal and an external market? Debt placed in an internal market is denominated in the currency of a host country and placed within that country. Debt placed in an external market is placed outside the borders of the country issuing the currency. 3.4 What is the Eurocurrency market and what is its function? The Eurocurrency market is an external credit market in bank deposits and loans. Like a national credit market, the Eurocurrency market permits the transfer of value over time in a given currency. 3.5 In what way is the Eurocurrency market different from an internal credit market? There are typically no reserve requirements, interest rate regulations or caps, withholding taxes, deposit insurance requirements, or regulations influencing credit allocation decisions. There are also less stringent disclosure requirements. 3.6 3.7 What is the London Interbank Offer Rate (LIBOR)? LIBOR is the rate at which a Euromarket bank offers to make a loan to another Euromarket bank. What effect did the Basle Accord have on international banks? The Basle Accord imposed minimum capital adequacy requirements on international banks as a protection against the credit risk of the banks’ loan portfolios. The Basle Accord also encouraged the use of value-at-risk (VaR) measures to quantify the risk of losses greater than a certain amount over a given time period. 3.8 What is the difference between spot and forward markets for foreign exchange? In the spot market, trades are for immediate delivery. In the forward market, trades are for future delivery according to an agreed-upon delivery date, exchange rate, and amount. 3.9 What is Rule #1 when dealing with foreign exchange? Why is it important? Rule #1 says to “Keep track of your currency units.” It is important because foreign exchange prices have a currency in both the numerator and the denominator. Most prices (for instance, a $15,000/car price on a new car) have a non-currency asset in the denominator and a currency in the numerator. 3.10 What is Rule #2 when dealing with foreign exchange? Why is it important? Rule #2 says to “Always think of buying or selling the currency in the denominator of a foreign exchange quote.” The importance of this rule is related to that of Rule #1. Foreign exchange quotes have a currency in both the numerator and the denominator. The rule “buy low and sell high” only works for the currency in the denominator. 3.11 What are the functions of the foreign exchange market? Currency markets transfer purchasing power from one currency to another, either today (in the spot market) or at a future date (in the forward market). When used with Eurocurrency markets, foreign exchange markets allow investors to move value both across currencies and over time. Foreign 4

c.2 3. Forward premiums/discounts are as stated above regardless of where a trader resides.008772945/¥ – $0. As the forecast horizon is lengthened. perspective are as follows: Six months forward The premiums/discounts on the two currencies are opposite in sign and nearly equal in magnitude. spot rate changes are random with a nearly equal probability of rising or falling. 3. or –2.87/$.87/$). 3.Kirt C.4 a.62/$) and selling dollars at $0. The bid is less than the offer. the international parity conditions exert themselves and the forward rate begins to dominate the current spot rate as a predictor of future nominal exchange rates.S.000) = DKr250. You need to pay SKr10.62/$ bid rate and selling dollars at the DKr5. You’re selling dollars.87/$–DKr5.S.1704/DKr (or DKr5. 3. Operational efficiency refers to how large an influence transactions costs and other market frictions have on a market’s operation.681% Bid (C$) –0. so these are rates at which the bank is willing to buy or sell dollars (in the denominator).12 Define operational.1779/DKr. In direct terms. A currency is trading at a forward discount when the nominal value of that currency in the forward market is lower than in the spot market.1779/DKr (which is equivalent to DKr5. Eventually.000. the correlation between interest and inflation differentials and nominal spot rate changes rises.445.1401 percent. The ask price is higher than the bid. Citicorp is buying dollars at $0. Problem Solutions 3.000. d.13 What is a forward premium? What is a forward discount? A currency is trading at a forward premium when the nominal value of that currency in the forward market is higher than in the spot market. Instead.758% 3. Allocational efficiency refers to how efficiently a market channels capital toward its most productive uses. so you’ll get the bank’s dollar bid price. the bid price is $0. Annualized forward premia on the U.000. Citicorp is buying dollars at the DKr5.678% Ask ($) +0.62/$)($1. dollar are: Six months forward Bid ($) +0.1704/DKr and the ask price is $0.1704/DKr. b. As a percentage over the 90-day period.1 a. the bid quote for the dollar is $0. exchange rate volatility is not constant. Finally. informational.62/$ and selling one million dollars at DKr5. In American terms.009057355/¥) = –$0.332. b. 3.000284410/¥. The bank will receive the bid-ask spread on each dollar. convention.761% Ask (C$) –0. the bank’s profit on the bid-ask spread will be (DKr5.1779/DKr and the ask price is $0.87/$ offer rate. 4th edition exchange markets also facilitate hedging and speculation.3 Percent per annum on the Canadian dollar from the U. As an annualized forward premium following the U. Butler. Solutions for Multinational Finance. and allocational efficiency. The U. or –3. When buying one million dollars at DKr5. Citicorp is buying and selling the kroner at these quotes.8441 basis points. Forward premiums and discounts are of slightly different magnitude because the bases (U$ vs. C$) on which they are calculated are different.031401. The forward premium is equal to (F1$/¥ – S0$/¥) = ($0. so Citicorp is quoting the currency in the denominator. Over daily intervals. Informational efficiency refers to whether or not prices reflect value. volatility comes in waves. so the Canadian dollar must be selling at a forward discount. dollar (in the denominator) is selling at a forward premium.14 Describe the empirical behavior of exchange rates.S.000/(SKr7. this is (F1$/¥ – S0$/¥) / S0$/¥ = –0. this is equal to 5 .5050/$) ≈ $1.S.

σt2 = (0. (1+sRbl/$) = 11 = 1/(1+s$/Rbl) ⇔ s$/Rbl = (1/11)–1 = –0.Kirt C.5841/SFr ASK is buying dollars (in the numerator) at $0.9 3. or 8%.2520/PZ Payment is made on the second business day after the three-month expiration date. Warsaw’s bid price for PZ is their ask price for dollars.2055.8/$)–(DM1.08.18536/DKr = –0.8 3. Banks make a profit on the bid-ask spread. or (–0.84/€ BID and ¥130.442%)*4 = –1.7465/$) = –0. (1+s¥/$) = 0.000.111.7945.9690/$ is equivalent to $0.18500/DKr–$0.05)2 + (0.007634/¥) = ¥130.12 3. you pay P1$ = P1¥/S1¥/$ = (¥104. Yen quotes yield S¥/€ = 1/S€/¥ = 1/(€0. The percentage dollar forward premium is (F1SFr/$–S0SFr/$)/S0SFr/$ = (SFr0.15 6 .18536/DKr)/$0.04 million.84/€.0200/$ is equivalent to $0.6 3. As an APR.56/DM)/($0.14 3.80/$ or $0.5841/SFr and selling francs at $0.164 a.7465/$)/(SFr0.000) / (PZ3. 3.119811. PZ4.5841/SFr BID and $0.000. A bank quoting $0.194% 180 day: ($0.259% a. so s$/¥ = 0. So. ($0. 1984-87 The mark depreciated 10. so euro quotes (in the denominator) are ¥130.99/€ and S¥/€ = 1/(€0.5/$)/(DM1.000.125604.56/DM 1987 DM2.99/€ ASK. ($0.092% 90 day: ($0.2488/PZ.55% (Ftd/f–S0d/f)/S0d/f = [(1/Ftf/d)–(1/S0f/d)]/(1/S0f/d) = [(S0f/d/Ftf/d)–(S0f/d/S0f/d)]/(S0f/d/S0f/d) = [(S0f/d /Ftf/d) – 1] = (S0f/d – Ftf/d) / Ftf/d.0033/$.18536/DKr)/$0.67/DM 1997 DM1.8/$)/(DM1.67/DM)–1 = –0.13 3.2586) = 0.0/$)–(DM1. Hence. (1+ s¥/$) = S1¥/$/S0¥/$ = (1/S1$/¥) / (1/S0$/¥) = 1 / (S1$/¥/S0$/¥) = 1 / (1+ s$/¥) = 1 / (1.0/$) = –0. b. (PZ20.0%.5841/SFr ASK.039.9% depreciation.56/DM a. Your loss is $40.053 PZ3. or –12. you are simultaneously selling another. 4th edition (n)(F1$/¥–S0$/¥)/S0$/¥ = (4)(–0.442% per 90 days.768% on an annualized basis.7%.781.20 b.10 3.000)/(¥100/$) = $1.5 1984 DM1.40)(0.007643/¥) = ¥130. or –11.1% appreciation.00/$ or $0. ((DM1.2586) = ($0.56/DM)–1= –0.0/$)/(DM2.4%. 3.18536/DKr)/$0.000) / (PZ4. the premium is (F1$/¥/S0$/¥)4–1 = –0.11 3.000. so a yen bid price is a euro ask price.18536/DKr = –0.7465/$) = –SFr0.111 1987-92 The dollar depreciated 25%.5852/SFr BID and $0.10)2 = 0. S1$/¥ = S0$/¥ (1+ s$/¥) = ($0. DKr is at a forward discount 30 day: ($0.031401) = –0.67/DM)/($0.000.50/DM)/($0.340 1992-97 The mark depreciated 16.90)–1 = +0.90 = 1/(1+s$/¥) ⇔ s$/¥ = (1/0.243.909. these are equivalent.0064 ⇒ σt = 0. ((DM2.7 3.8/$) = +0.50/DM 1992 DM1.18519/DKr–$0.0200/$) = $1.0034) + (0. a. (PZ5.5/$)–(DM2. c. ((DM1.18488/DKr–$0. You initially receive P0$ = P0¥/S0¥/$ = (¥104.7432/$– SFr0.000)/(¥104/$) = $1 million. A bank quoting $0.7432/$–SFr0.20)(0.25 1992-97 The dollar appreciated 20%.0100/¥)(1. The 90-day dollar forward price is 33 bps below the spot price: F1SFr/$–S0SFr/$ = (SFr0. Butler. or = –20.18536/DKr = –0.5/$) = +0. When buying one currency.5852/SFr BID and selling dollars at $0.5852/SFr ASK.9690/$) = $5.107 1987-92 The mark appreciated 34.50/$ or $0.7945 – 1 = –.5604 percent.012586/¥) b.1%. or a 90.50/DM)–1= +0. When you buy back the yen. ($0. 1984-87 The dollar appreciated 11.9811 percent. b.5852/SFr ASK is buying francs (in the denominator) at $0. or an 11.80/$ or $0. Solutions for Multinational Finance.

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