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ANSWER SCHEME / FIN 542 /APRIL

2010

Question 1
a) i)

UK FC ; US HC
(1 + rhc)
(1 + rfc)

et
e0

(1 + 0.035) x 1.6923 =
(1 + 0.04)
USD1.6842

b)

et

ii)

An increase in UK rate would cause an increase in the expected inflation rate. As a


result of that, the demand for UK goods and its pounds would decrease and thus
weaken the UK currency.

iii)

No. The pound sterling would depreciate over time.


Spot RM5.6625/; UK (FC) inflation = 4%; Msia (HC) inflation = 3%
PPP:

c)

et

(1 + ihc)
(1 + ifc)

et
e0

(1 + 0.03) x 5.6625
(1 + 0.04)

RM5.6081

et

Spot
US1.6340/
180 days fwd US1.6165/
Spot

=
=
=

Bid FC / Ask HC
1.6340 / 0.6283
2.6007 /

Annualized premium / disct

=
=
=

et

Spot
US0.6283/
180 days fwd US0.6245/
180 days fwd = Bid FC / Ask HC
= 1.6165 / 0.6245
= 2.5885 /
Forward Spot x
360___ x 100
Spot
Fwd days
2.5885 2.6007 x
360
x 100
2.6007
180
- 0.94% (discount)

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 2
a) A balance of payments deficit indicates that there is more money flowing out of the
economy. That is, the supply of money to the foreign exchange market is high, while the
demand is low. This will result in depreciation of currency.
The depreciation of currency means that imports will be more expensive. This will also
increases the demand for exports which will automatically increases the price of exports.
The increase in price of these classes of goods will push up the prices of other classes of
goods, as long as they are considered as substitutes. So, inflation occurs.
Another reason is that by requiring a balance of payments in trade, the supply of items
imported into the home country would have to be decreased dramatically as there is no way
for other countries to increase their purchases of our products at the same rate we purchase
theirs. Therefore, the only option is for imports from other countries to be statutorily reduced.
Once the supply of imports is reduced, the problem simply devolves to one of supply and
demand economics. If supply decrease, price will increase and will result to inflationary
pressure.
b) i)

Amount of interest
=
500,000 x 0.06 = 30,000
Compensating Balance (CB) =
500,000 x 0.15 = 75,000
Effective Cost
=
Annual interest paid / Usable funds
=
30,000 / (500,000 0)
=
0.06 (6%)
**No deduction on CB since current balance (RM150,000) is more than the CB requirement.
ii) Compensating Balance (CB) =
Effective Cost
=
=
=
iii) Total Loan
Usable Loan
500,000
500,000 + 25,000
525,000 / 0.84
RM625,000

=
=
=
=
=
=

500,000 x 0.10 = 50,000


Annual interest paid / Usable funds
30,000 / (500,000 30,000)
0.0638 (6.38%)

L
L 0.06L 0.1L 25,000
0.84L 25,000
0.84L
L
L

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 3
a) i)

USD0.90/CAD FC (strong)
USD0.30/NZD HC (weak)
Do cross rate in order to get NZD/CAD, common currency on many unit side
Bid FC / Ask HC

=
=

Compare with

0.90 / 0.30
NZD3.0000/CAD
NZD3.0200/CAD
3.02 3.00 , Therefore opportunity arbitrage exist.

ii) Triangular arbitrage


USD0.90/CAD
compare
convert

NZD3.02/CAD

convert

US0.30/NZD

Strategy is to convert US to CAD, then to NZD and convert back to USD to compare
how much profit has been made.
1) Convert USD1million to CAD

=
=

USD1,000,000 / 0.90
CAD1,111,111.11

2) From CAD, convert to NZD

=
=

CAD1,111,111.11 x 3.02
NZD3,355,555.56

3) From NZD, convert to USD

=
=

NZD3,355,555.56 x 0.30
USD1,006,666.67

Therefore, USD1,006,666.67 USD1,000,000 = USD6,666.67 (profit)


iii) As more USD seek to be switched to CAD, the CAD exchange rate will rise. In addition,
as more CAD is sold to exchange for NZD, the rate will fall and as more NZD is sold for
USD, the rate will also decrease, eventually eliminating the arbitrage profit.
b)

Higher inflation in Eastern European countries will cause a balance of trade adjustment
whereby the US will reduce its purchases of goods from these countries (when the
countries goods become more expensive due to higher price increase) while the
demand for US goods by these countries should increase (when the rate of price
increase is lower in the US) according to PPP. Consequently, there will be downward
pressure on the value of these Eastern European currencies relative to the US dollar.

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 4
a)

When the goods are shipped by exporter to the importer by ship, at the same time
exporter will send shipping documents to his bank, which after that will send the shipping
documents to importers bank. Upon receiving the documents and taking the title of
goods via bill of lading, the importers bank will accept the time draft. At this point, it is
called bankers acceptance (B/A).

b)

Two ways for the exporter to receive payment in bankers acceptance 1) hold the B/A
until maturity and importers bank will pay at face value minus acceptance fee.
Alternatively 2) sell the B/A at once or discount where importers bank will pay at face
value minus acceptance fee, discount fee and commission fee (sells at money market)
prior to maturity.

c) i)

=
=
=

e1 e0 / e0
(3.4780 - 3.5010) / 3.5010
- 0.66%

After tax ringgit cost of borrowing ringgit (HC)


Chc

=
=
=

rhc (1 t) + c
0.10 (1 0.32) + (- 0.0066 x 0.32)
0.0659 (6.59%)

After tax ringgit cost of borrowing dollar (FC)


Chfc

=
=
=

rfc (1 + c)(1 t) + c
0.08 (1 + (-0.0066))(1 0.32) + (-0.0066)
0.0474 (4.74%)

Cost of borrowing dollar is better option because the cost is lower compared to ringgit
loan.
ii) Indifference / Breakeven
(1 + rhc)
(1 + rfc)

e1
e0

3.5010 x (1 + 0.1)
(1 + 0.08)

e1

RM3.5658/USD

e1

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 5
a) i)

Spot USD0.54/NZD ; US HC; NZ FC


Money Market Hedge: Acct Receivables; Borrow FC ; Invest HC
Borrow FC

PV

=
=
=

FV / (1 + r)
4,000,000
(1 + 0.08)
NZD3,703,703.704

Convert NZD to USD:


NZD3,703,703.704 x 0.54 = USD 2,000,000
T=0

NZD

USD

Borrow @ 8%
Convert to USD @ USD0.54
Invest @ 9%

3,703,703.704
(3,703,703.704)

2,000,000
(2,000,000)

0
0
T=1
Return from investment @ 9%
(2,000,000 x 1.09)
Receive payment from buyer
Pay borrowings @ 8%
Total amount received

2,180,000
4,000,000
(4,000,000)
0

________
2,180,000

ii) Option: Since it is a receivable, the corporation needs to sell NZD in the future, they
should enter into PUT Option on NZD now.
Exercise price : 0.52 x 4,000,000 = USD2,080,000
Less Premium : 0.03 x 4,000,000 = USD 120,000
Net receipt
:
USD1,960,000
iii) Select money market hedge because it would provide higher receivables in terms of US
dollar.
b)

Options hedge are useful for hedging contingent exposure, in which an MNCs exposure
is contingent on a specific event happening. It does not want to be obligated to obtain or
dispose of foreign currency unless the event is certain to occur. The options hedge does
not have to be exercised if the MNC would be better off un-hedged.
Currency options hedge is generally more costly than forward hedge. A premium has to
be paid to purchase the currency options and so there is a cost for the flexibility they
provide compared to forward hedge. Moreover, the size of options contract is
standardized and one may be over or under-hedged with fixed date of expiry which
might not exactly coincide with the delivery dates.

ANSWER SCHEME / FIN 542 /APRIL

2010

*** Please refer to Shapiro textbook on Options


Question 6
a) i)

Customer needs RM, have SGD, so sell SGD to get RM, Bank buy SGD @ 2.5682
RM3,000 2.5682 = SGD1,168.13

ii) Customer receives SGD, wants RM. So sell SGD to get RM, Bank buy SGD @ 2.5717
(2.5682 + 0.0035) 3months fwd
SGD5,000 x 2.5717 = RM12,858.50
iii) Customer wants to buy YEN, Bank will sell Yen @ 3.6202 (3.6132 + 0.0070) 2 mths
fwd
200,000 / 100 x 3.6202 = RM7,240.40
iv) Bank pays RM to get AUD, so Bank wants to buy AUD @ 3.1350 (3.1426 0.0064)
2 mths fwd
RM60,000 3.1350 = AUD19,138.76
v)

Percentage spread on spot RM/AUD


=
=

Ask Bid / Ask x 100


(3.1442 3.1426) x 100
3.1442
0.05%

vi) Annualized premium on 2 mths offer fwd RM/Yen


=

Fwd Spot x
360
____
Spot
no. of days contract

3.6202 3.6132
3.6132

=
b)

360
60

x 100

x 100

1.16%

Fixed exchange rate is a system that is set by the government, while floating exchange
rate is a system that the rate being set by the interactions between the demand and
supply of the currencies against each other.
In the fixed exchange rate system, the rates are less volatile and therefore less risky,
unlike in the floating exchange rate system whereby the rates are very volatile and very
risky. However, the rates in the fixed system sometimes do not reflect the true value of
the currencies.

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 7
a)

Interest rates differential and the availability of the forward market IRP
Step 1: Determine the existence of arbitrage
IRP: f1 e0 x 360 x 100 =
.e0
n

rhc rfc

3.6399 3.6338 x 360 x 100 = 9%/4 8%/4


3.6338
90
0.67% 0.25%
Therefore, opportunity arbitrage exist
Step 2: Determine where to invest and borrow
(1 + rhc)

(1 + 0.09/4) =
1.0225

>

(1 + rfc) x f1
.e0
(1 + 0.08/4) x 3.6399
3.6338
1.0217

Therefore, Borrow FC, Invest HC


T=0

USD

Borrow USD250,000 @ 2%(8%/4)


Convert to RM @ 3.6338
Invest in RM @ 2.25% (9%/4)

250,000
(250,000)
0

RM
908,450
(908,450)
0

T = 3 months
Receive from investments
(RM908,450 x 1.0225)
Convert to USD @ 3.6399
(928,890.13 3.6399)
Pay borrowings
(250,000 x 1.02)
Profit

928,890.13
255,196.61

(928,890.13)

255,000.00
196.61

Convert USD to RM USD196.61 x 3.6399 = RM715.64


b)

The likely reason for a rise in real interest rates is pickup in economic activity.
Historically, an increase in real interest rates has usually signaled good economic
times, while a real interest rate decrease has typically signaled economic decline.
Specifically, real interest rates tend to be at their low point during a recession because
of the low demand for capital. As the world economy comes out of recession, real rates
typically rise. Hence, a high interest rate likely signifies that economic growth is picking

ANSWER SCHEME / FIN 542 /APRIL

2010

up. Demand for capital is the one that determines the factor for real interest rates not
the supply.