MSc in Economics & Business Administration

Subject Area: Applied Economics and Finance

International Finance
(CAEFO1078U)

Final Exam
May 2020

General Information

• If you think there is a mistake you are welcome to contact Peter Feldhütter via Canvas.
Alternatively, if you believe there is an error, typo, etc, you can just state it and make
assumptions that enable you to proceed.

• If Peter Feldhütter announces any clarifications he will do so via Canvas.

Keep yourself updated on Canvas!

• The exam is open book: You can use any material you want. However, it is strictly
forbidden to communicate with other students or receive any help from other persons.

• You can hand in the exam in Word (or in some other electronic text format) or by
writing in hand and uploading pictures of the hand-written sheets. Handing in an
Excel workbook alone is not acceptable. It is not important in which text-format you
hand in, instead what is important is one can clearly read and understand

– what approach you have used,

– which inputs you have used.

• You are welcome to include screen dumps of figures created in some software. However,
axes should have clear tick-marks with numbers and there should be accompanying text
explaining what the figure shows, potential calculations underlying the graph, and
which question the figure is answering. You are also welcome to submit hand-drawn
figures as long as the figures follow the previously-mentioned requirements.

• The exam consists of 4 problems with a varying number of tasks. Each problem has
a weight. The weights provide rough guidance regarding the amount of time that you
are expected to spend on each problem. The final grade takes the overall impression
into account.
• Answer all questions, in all tasks, in all problems.

• To avoid any ambiguity, be sure to mark a final answer with two lines under it.

• Unless otherwise specified, you must explain all your answers. The overall assessment
will also be based on your explanations. A correct answer with no explanations will
not give points.

• Irrelevant statements or calculations will weaken the overall impression of your solu-
tions.

• If you are not able to answer a particular question in an exercise, you may still be
able to answer the subsequent questions. If you believe that you lack information to
proceed, you should make – and explicitly state – assumptions that enable you to
proceed.

• Anglo-American punctuation style (e.g. $1,000.05) is used in this assignment.

• The assignment contains 7 (numbered) pages.

Page 2
1. General questions (30%)

(a) If the relative PPP holds would an analysis of historical exchange rate data in order
to predict future exchange rates be useful? Why or why not?

(b) Consider a project that will (in expectation) pay off a foreign currency amount of
F C 250, 000 in one year. You estimated the following regression using historical
exchange rate data:

∗


st+1 = 0.001 − 1.8 × rt,t+1 − rt,t+1 ,

St+1
where st+1 = St
− 1 is the return on the exchange rate from t to t + 1. The time
between t and t + 1 is one year. The coefficients are both statistically significant at
the 5% level and R2 = 0.23. The interest rates are rt,t+1 = 0.05 (home currency),
∗
rt,t+1 = 0.02 (foreign currency) and the current spot rate is St = 4. Assume that
the foreign currency value of the project is uncorrelated with the spot exchange
rate. The annual home discount rate for the project is 15%. What is the present
value (PV) of the project in home currency?

(c) Suppose you work for company ABC in the US. The cash flows of the company does
U SD
not depend U SD/GBP whenever the spot price is less than GBP
1.25. However, if
U SD
GBP
> 1.25, then there is a linear relation, Ct = 10 + 20 × St , where Ct is the HC
U SD
cash flows and St is the GBP
spot rate. Your boss tells you that since the exposure
is just an “upside” exposure, we should not hedge it. Do you agree with your boss?
Why? Why not? If you decide to hedge it would a forward contract be a good
hedging tool?

(d) Consider the following statement: “As an exporter I should invoice my sales in my
home currency as this will reduce my exchange rate exposure”. Do you agree? Why
or why not?

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2. Currency trading in practice (20%)

You consider two of Danske Bank’s FX Top Trades 2020. (NB: Danske Bank uses the
indirect quoting convention.)

(a) “Trade #4 2020”

You disagree with Danske Bank and decide to go short in EUR/GBP instead of
going long as they suggest. However, you can not achieve the same prices as Danske
Bank and the cost for you is therefore 230 pips. Assume that interest rates are zero.

• Compute and plot the payoffs and profits of this strategy for ST for the range
between 0.80 and 0.90. Be sure to mark x- and y-axes clearly with relevant
numbers.
• What is the range for which the strategy is making a profit? What is the range
for which the strategy is making a loss?
• Explain the motivation behind going short in EUR/GBP in the way described
above.

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(b) “Trade #6 2020”’

• Compute and plot the payoffs and profits of this strategy for ST for the range
between 6.5 and 7.5. Be sure to mark x- and y-axes clearly with relevant
numbers.
• What is the range for which the strategy is making a profit? What is the range
for which the strategy is making a loss?
• Explain the motivation behind going short in EUR/GBP in the way described
above.
• What is the difference between using this strategy compared to going short in
EUR/GBP by the strategy above (buying a put with strike K1 and selling a
put with strike K2 with K2 < K1 )?

Page 5
3. Managing currency risk (30%)

AIFS, the student exchange organisation that we talked about in our case study, is
in the process of updating its hedging strategy. (You do not need to remember the
case study itself, all relevant information is given below.) Specifically, you are asked to
evaluate AIFS’ business line of sending students from the US to Europe. These students
pay a fixed catalogue price in USD and AIFS has to cover expenses (local organisation
in Europe, host families/student homes, etc.) in EUR. Based on their most recent
projections, AIFS expects 25,000 students to participate in the program. Moreover,
AIFS expects expenses of EUR 2,700 per student, which at their projected exchange
rate of USD/EUR 1.10 corresponds to USD 2,970 per student. Options with a strike
price of USD/EUR 1.10 are available at a premium of 3% of the USD notional of the
contract.

Given these projections, you want to evaluate four FX hedging strategies:

(i) No hedging.

(ii) 100% forward hedging. The relevant forward rate is USD/EUR 1.07 and there are
no costs associated with these forward contracts.

(iii) 100% hedging with call options.

(iv) 50% call option hedging and 50% forward hedging. Again, the relevant forward rate
is USD/EUR 1.07 and there are no costs associated with these forward contracts.

Questions:

(a) Discuss and compare the strengths and weaknesses of approaches (i), (ii), (iii), and
(iv) if cash flows turn out as expected

(b) Discuss and compare the strengths and weaknesses of approaches (i), (ii), (iii), and
(iv) if cash flows turn out stronger than expected at 35,000 students

(c) AIFS is especially concerned about surviving in a disaster scenario where there is
a pandemic and all travelling is halted. In this scenario 0 students will participate
in the program. Discuss and compare the strengths and weaknesses of approaches
(i), (ii), (iii), and (iv) in this disaster scenario.

(d) Which hedging strategy would you recommend to AIFS and why?

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4. International Cost of Capital (20%)

(a) What is the ‘FX exposure puzzle? Discuss the approach of Bartram et al. taken in
their paper ‘Resolving the exposure puzzle: The many facets of exchange rate expo-
sure’ (2010, Journal of Financial Economics) to resolve the FX exposure puzzle and
their main findings. Note: You do not have to provide a formal model description.
A discussion along the lines of the illustrative example for the automotive industry
in Bartram et al. (2010) is sufficient. (max 10 sentences)

(b) What are the opposing effects that global integration of markets has on the cost of
a firm’s equity capital? If you want, you can use the case study of Nestlé from our
lecture to discuss the effects. (max 5 sentences)

(c) Write down the equations of the standard (domestic) CAPM and the full interna-
tional CAPM. Discuss how and why they are different. What are the main assump-
tions of the standard CAPM that are violated in a globally integrated economy?
How do these violations have to be taken into account when moving from the stan-
dard to the international CAPM? Note: I am not asking you for a formal derivation
of the CAPM or international CAPM; if you want, you can do it of course. (max
10 sentences)

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