UNIVERSITY OF MASSACHUSETTS BOSTON

Accounting & Finance Department

AF 455 Prof. Konan

International Financial Management
Week 7 Homework

Instructions: Answer all questions below. Make sure to show your work. Your answers
must be typed. (TOTAL = 100 POINTS)

1. How Factors Affect Exchange Rates The country of Luta has large capital flows with the
United States. It has no trade with the United States and will not have trade with the United
States in the future. Its interest rate is 7 percent, the same as the U.S. interest rate. Its rate of
inflation is 6 percent, the same as the U.S. inflation rate. You expect that the inflation rate in
Luta will rise to 8 percent this coming year, while the U.S. inflation rate will remain at 6
percent. You expect that Luta’s interest rate will rise to 9 percent during the next year. You
expect that the U.S. interest rate will remain at 7 percent this year. Do you think Luta’s
currency will appreciate, depreciate, or remain unchanged against the dollar? Briefly explain.

2. Speculation on Expected Exchange Rates

Kurnick Co. expects that the pound will depreciate from $1.72 to $1.68 in one year. It has no
money to invest, but it could borrow money to invest. A bank allows it to borrow either 1
million dollars or 1 million pounds for one year. It can borrow dollars at 6 percent or British
pounds at 5 percent for 1 year. It can invest in a risk-free dollar deposit at 5 percent for 1 year
or a risk-free British deposit at 4 percent for 1 year. Determine the expected profit or loss (in
dollars) if Kurnick Co. pursues a strategy to capitalize on the expected depreciation of the
pound.

3. Assessing Volatility of Exchange Rate Movements Assume you want to determine whether
the monthly movements in the Polish zloty against the dollar are more volatile than monthly
movements in some other currencies against the dollar. The zloty was valued at $.4602 on
May 1, $.4709 on June 1, $.4888 on July 1, $.4406 on August 1, and $.4260 on September 1.
Using Excel or another electronic spreadsheet, compute the standard deviation (a measure of
volatility) of the zloty’s monthly exchange rate movements. Show your spreadsheet.

4. Speculating with Currency Futures 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 $.093 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? See table below.
5. Speculating with Currency Call Options
LSU Corp. purchased Canadian dollar call options for speculative purposes. If these options
are exercised, LSU will immediately sell the Canadian dollars in the spot market. Each
option was purchased for a premium of $.04 per unit, with an exercise price of $.75. LSU
plans to wait until the expiration date before deciding whether to exercise the options. Of
course, LSU will exercise the options at that time only if it is feasible to do so. In the
following table, fill in the net profit (or loss) per unit to LSU Corp. based on the listed
possible spot rates of the Canadian dollar on the expiration date.

POSSIBLE SPOT RATE NET PROFIT (LOSS)

OF CANADIAN DOLLAR PER UNIT TO LSU CORP.
ON EXPIRATION DATE
0.76
0.78
0.80
0.82
0.85
0.87

6. Hedging with Currency Derivatives 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?

7. Direct Intervention 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.

8. Sterilized Intervention Explain the difference between sterilized and nonsterilized

intervention.

9. Effects of Indirect Intervention Suppose that the government of Chile reduces one of its key
interest rates. The values of several other Latin American currencies are expected to change
substantially against the Chilean peso in response to the news.
a. Explain why other Latin American currencies could be affected by a cut in Chile’s interest
rates.
b. How would the central banks of other Latin American countries be likely to adjust their
interest rates? How would the currencies of these countries respond to the central bank
intervention?
c. How would a U.S. firm that exports products to Latin American countries be affected by
the central bank intervention? (Assume the exports are denominated in the corresponding
Latin American currency for each country.)
10. Locational Arbitrage Assume the following in formation:
Given this information, is locational arbitrage possible? If so, explain the steps involved in
locational arbitrage, and compute the profit from this arbitrage if you had

BEAL BANK YARDLEY BANK

Bid price of New Zealand dollar $.402 $.398
Ask price of New Zealand dollar $.404 $.40

$2 million to use. What market forces would occur to eliminate any further possibilities of
locational arbitrage?

11. Triangular Arbitrage Assume the following information:

QUOTED PRICE
Value of Canadian dollar in U.S. dollars $.92
Value of New Zealand dollar in U.S. dollars $.30
Value of Canadian dollar in New Zealand dollars NZ$ 3.02

Given this information, is triangular arbitrage possible? If so, explain the steps that would
reflect triangular arbitrage, and compute the profit from this strategy if you had $2
million to use. What market forces would occur to eliminate any further possibilities of
triangular arbitrage?

12. Covered Interest Arbitrage Assume the following information:

Spot rate of Canadian dollar = $.81
90-day forward rate of Canadian dollar = $.80
90-day Canadian interest rate = 4%
90-day U.S. interest rate = 2.5%
Given this information, what would be the yield (per- centage return) to a U.S. investor who
used covered interest arbitrage? (Assume the investor invests $2 million.) What market
forces would occur to eliminate any further possibilities of covered interest arbitrage?

13. Interest Rate Parity Consider investors who invest in either U.S. or British 1-year Treasury
bills. Assume zero transaction costs and no taxes.
a. If interest rate parity exists, then the return for U.S. investors who use covered interest
arbitrage will be the same as the return for U.S. investors who invest in U.S. Treasury bills. Is
this statement true or false? If false, correct the statement.
b. If interest rate parity exists, then the return for British investors who use covered interest
arbitrage will be the same as the return for British investors who invest in British Treasury
bills. Is this statement true or false? If false, correct the statement.