FM303: International Finance

School of Accounting, Finance and Economics

Final Examination
Semester 1 2021

Open Book Exam

(This paper is for Fiji-Based Students Only)
Exam Date: 5 July 2021
Duration: 3 hours

Instructions

1. This exam has FIVE (5) questions

2. ALL questions are compulsory.
3. You should present your solutions using a word-processor like
Microsoft (MS) Word clearly documenting the steps taken to
answer, or use MS Excel with clear cell referencing, (or a
combination of the two if necessary).
4. All solutions should be clearly labeled with the correct question
numbers.
5. Partial marks will be given for incorrect or incomplete but well-
presented and partly correct answers.
6. Upload all your solution files in the Final Exam Drop Box which
will remain open for an hour after the end of this exam.
7. Late submission will be assigned a 0 mark
8. Some useful Formulas are provided on page 7.
9. The examination is worth 50% of your overall mark.
10. The minimum exam mark is 20/50.

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 Question 1 (10 marks)

(a) Suppose at 9.30am you call a foreign exchange dealer and ask for a quote on
FJD/AUD exchange rate. The dealer responds by quoting 1.5500-1.5900. You
decide to buy AUD1,000 at the quoted rate. At 3.30pm the same day, the dealer
quotes 1.5545-1.5585. Calculate the profit or loss you make by selling AUD at
3.30pm? What will be your amount of profit or loss? [5 marks]

(b) The exchange rate between Fiji dollar and VUV (Ni-Vanuatu vatu) is (VUV/FJD)
currently 52.400-53.500. You decide to take a speculative position on FJD, and
this position is squared two months later when the exchange rate is
(𝑉𝑈𝑉/𝐹𝐽𝐷) = 51.400 − 52.500.

(i) Is taking short position on FJD profitable?

(ii) Calculate the gain or loss by taking a short position on FJD1000, given the
bid-offer rates of the two periods. [5 marks]

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 Question 2 (25 marks)

Suppose a bank manager provides you with the following data for a bank.
Asset Value Return PD LGD(%) EAD
Category (FJD (%) (FJD
million) million)
𝐴1 500 8 0.8 50 300
𝐴2 800 9 0.6 65 200
𝐴3 200 9.5 0.4 35 500
𝐴4 900 10 0.3 40 700
𝐴5 600 8.5 0.5 50 300
Note: PD=probability of default, LGD=loss given default, EAD=exposure at default, and
𝑘 = 0.08

Moreover, the manager would like to perform analysis on three plans (Plan A, Plan B
and Plan C). In Plan A, the bank will keep all its assets on the balance sheet. In Plan B,
the bank wishes to indulge in regulatory capital arbitrage by only holding Asset 3 and
Asset 4, and evenly distributing the amounts of the other (three) assets to these two
assets. In Plan C, the bank wishes to securitize Asset 1 and Asset 2.

Required
Assuming that risk weights are proportional to the probability of default, evaluate the
three plans and prepare a short report (of no more than 400 words). Your report should
address the following:
(i) the capital requirement amount (K) with and without adjusting for risk in each
plan,
(ii) the return of asset portfolio in each plan,
(iii) the expected loss in each plan,
(iv) Possible effects (if any) of each plan on bank’s profitability and operational
risk/loss.
Based on your analyses which plan (A, B, C) would you recommend? Justify your
recommendation.

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 Question 3 (20 marks)
(a) A hybrid five-year swap contract is designed between A and B that includes
currency and interest rate swaps. The contract states that A will receive annual
payments in Australian dollars based on a floating interest rate, and B will receive
annual payments in New Zealand dollars based on a fixed interest rate. The
notional amount involved is AUD100,000, the fixed rate is 6 per cent, and the
contracted exchange rate is 1.20 (NZD/AUD). On each payment date, the
floating interest rate assumes the values 7.75, 9.75, 5.50, 4.75 and 6.5 per cent,
respectively, and the market exchange rate assumes the values 1.25, 1.18, 1.12,
1.30 and 1.15

Required
Determine the payments flows between A and B, and the amount and direction of
net payments for this swap contract all in NZD. Clearly mention the currency which
has appreciated/depreciated in each flow. [15 marks]

(b) A call option has an exercise exchange rate of 1.7500 (AUD/USD). The premium
paid is 0.8 Australian cents per USD. Considering a call option on USD100,000,
determine the net payoffs for the holder at the following spot exchange rates (i-
iv):
(i) 1.8000,
(ii) 1.7050,
(iii) 1.7550
(iv) 1.7450
(v) Determine the exchange rate at which the holder of the option will break-
even
[5 marks]

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 Question 4 (20 marks)
(a) The following information is available at the end of December, 2021:
Spot exchange rate (AUD/USD) 1.9540
Three-month forward rate (AUD/USD) 1.9750
Price of a call option AUD0.02
Price of a put option AUD0.03
Exercise exchange rate for call option 1.9650
Exercise exchange rate for put option 2.0500
A forecaster has produced the following values of AUD/USD exchange rates prevailing
at the end of March, 2022:
(i) 1.9900 with probability of 0.65
(ii) 1.9400 with probability of 0.35.

Required
Based on the information above, determine the strategy which will provide the highest
positive return (net profit) for the speculator, assuming that the speculator acts on the
basis of the expected value of the forecast (You may use one unit of the underlying
currency). [10 marks]

(b) You are given the following information:

Spot exchange rate (AUD/EUR) 1.7100
One year forward rate (AUD/EUR) 1.7300
One year interest rate on AUD 8.5% p.a.
One year interest rate on EUR 6.5% p.a.
Using the information, answer the following:
(i) Calculate the covered margin (going short on the AUD) [4 marks]
(ii) Calculate the interest parity forward rate and compare it with actual forward
rate. [1 mark]
(iii) Calculate the forward spread and compare it with the interest differential.
[1 mark]
(iv) Develop a profitable strategy from an arbitrageur’s perspective.
[4 marks]

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 Question 5 (25 marks)
(a) Calculate the effective financing rate of a six-month Swiss franc loan based on
the given information:
Swiss six month interest rate 4.55-6.75
Initial exchange rate (AUD/CHF) 1.1575-1.1625
Exchange rate on maturity (AUD/CHF) 1.1375-1.1465
[5 marks]

(b) The current one-year US interest rate is 9% p.a., and AUD/USD exchange rate is
1.3100. The exchange rate that is expected to prevail in one year has the
following probability distribution:
AUD/USD Probability
1.25 0.08
1.29 0.12
1.31 0.15
1.35 0.30
1.38 0.35
Using above information, calculate the expected value and the standard deviation of the
effective financing rate in USD. [20 marks]

~END~

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 Formulas
 Expected Loss: 𝐸𝐿 = ∑𝑛𝑖=1 𝐸𝐴𝐷𝑖 × 𝐿𝐺𝐷𝑖 × 𝑃𝐷𝑖
𝐴
 Weight of an asset: 𝜔𝑖 = ∑ 𝑖 , where 𝐴𝑖 = 𝑖 𝑡ℎ asset.
𝐴𝑖
∑𝑛
𝑖=1 𝜔𝑖 𝐴𝑖
 Regulatory Capital amount with adjustment for risk: 𝐾 = 𝑘 × ∑𝑛
𝑖=1 𝜔𝑖
 Regulatory Capital amount: 𝐾 = 𝑘 × 𝐴, where K=amount of capital, A
= the value of asset., 𝑘 = capital adequacy requirement.
 Portfolio Mean: 𝜇𝑝 = ∑𝑛𝑖=1 𝜔𝑖 𝜇𝑖
 Gross payoff per unit of the underlying, of a call option: Π𝐺 =
max(𝑆 − 𝐾, 0), and net-payoff per unit of the underlying, of a call
option is: Π𝑁 = max(𝑆 − 𝐾, 0) − 𝑐
1+𝑖
 Interest parity forward rate: 𝐹̅ = 𝑆 [ ∗ ]
1+𝑖
 Effective 𝑒𝑖 = (1 + 𝑖𝑖∗ )(1 + 𝑆𝑖̇ ) − 1, where 𝑒𝑖 = effective financing
rate, 𝑖 and 𝑖 ∗ are interest rate on domestic and foreign currency, and
𝑆𝑖̇ = percentage change of the 𝑖 𝑡ℎ S(d/f) with respect to the initial
𝑆 (𝑑/𝑓)
S(d/f), that is: 𝑆𝑖̇ = [ 𝑖 − 1].
𝑆0 (𝑑/𝑓)
 Expected Value: 𝐸(𝑒) = ∑5𝑖=1 𝑝𝑖 𝑒𝑖
 Variance: 𝑉𝑎𝑟(𝑒) = 𝜎 2 (𝑒) = ∑5𝑖=1 𝑝𝑖 [𝑒𝑖 − 𝐸(𝑒)]2 or 𝑉𝑎𝑟(𝑒) = 𝜎 2 (𝑒) =
2
(∑5𝑖=1 𝑝𝑖 𝑒𝑖2 ) − (∑5𝑖=1 𝑝𝑖 𝑒𝑖 )

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