MSc in Economics & Business Administration

Subject Area: Applied Economics and Finance

International Finance
(CAEFO1078U)

Final Exam
11th of May 2021

General Information

• If you think there is a mistake you are welcome to contact Lars Christian Larsen 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 Lars Christian Larsen 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 5 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 8 (numbered) pages.

Page 2
1. Arbitrage in FX spot and forward markets (20%)

You are an FX dealer and observe the (directly quoted) exchange rates from a competing
FX dealer A as well as market interest rates as given in the table below.

Spot FX 1-year MMkt (p.a.)

bid ask bid ask
DKK/USD 6.6133 6.6155 JPY 0.272% 0.297%
JPY/DKK 16.3353 16.3391 USD 1.614% 1.623%
DKK 0% 0.052%

(a) How would you set your spot DKK/USD and JPY/DKK bid and ask quotes if your
inventory is short of DKK? Explain why.

(b) What are the no-arbitrage bounds for the one-year JPY/DKK forward rate?
Another dealer B quotes the following bid and ask prices:

Spot FX
bid ask
JPY/USD 107.9332 107.9903
JPY/DKK 16.3360 16.3407

(c) Is there an arbitrage in the spot market? If so, describe the arbitrage. If not,
explain why.

Page 3
2. Currency trading in practice (20%)

You consider two of Danske Bank’s FX Top Trades, one from 2012 and one from 2021.
NB: Danske Bank uses the indirect quoting convention.

(a) “Trade #1 2012: sell EUR/SEK strangle”

• Compute and plot the payoffs and profits of this strategy for ST for the range
between 8.00 and 10.00. 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 such a strategy.

Page 4
(b) “Trade #2 2021: Short EUR/USD”

• Compute and plot the payoffs and profits of this strategy for ST for the range
between 1.10 and 1.30. 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 such a strategy. Compare the strategy to a
forward sale of EUR. Assume the forward rate is equal to the spot rate.

Page 5
3. Valuation of forward contracts and options (25%)

(a) The initial value of a forward contract, i.e. the value at the moment the contract
is signed, is always zero. True or False? Explain in max two sentences why.

(b) The time-t price of a European put option is equal to the time-t price of a European
call option on the same underlying exchange rate if both have the same maturity
and both have strike price equal to Ft,T . Show that this statement is true and
explain the underlying no-arbitrage relation.

(c) The current spot rate EUR/AUD is 0.85 and the volatility of the EUR/AUD ex-
change rate is 5%. The one-year interest rate is 0% p.a. in the Euro zone and
2.5 % p.a. in Australia. The interest rates are quoted using simple compounding.
Use a two-period binomial model to calculate the prices of a European call option
on EUR/AUD and a European put option on EUR/AUD both with strike price
X = 0.83 and expiry T = 1 year.

(d) Using the same data as in (c), use the two-period binomial model to compute the
price of an American put option on EUR/AUD with strike price X=0.83 and expiry
T=1 year.

(e) Consider a boosted call option: It has an expiry T , a strike price X and the payoff
is
(ST )2
 
1
max − X, 0
2 X
at expiry T .
Using the same data as in (c), use the two-period binomial model to compute the
price of a boosted call option on EUR/AUD with strike price X=0.83 and expiry
T=1 year.
Show that the price of a boosted call always is higher than the price of a European
call with the same strike price and expiry. Hint: Draw the payoff functions.

Page 6
4. Measuring and Managing FX Exposure: Conceptual Questions (20%)

(a) How is FX exposure defined, how do we measure it in regressions, and how do

measures of exposure help us when deciding on hedging strategies? Max 6 sentences.

(b) Discuss the difference between contractual exposure and operating exposure. Max
6 sentences.

(c) “A firm that has no operations abroad does not face any operating exposure.” Is
this statement true or false? Explain why! Max 2 sentences.

(d) Discuss the challenges arising when a firm wants to hedge foreign currency cash
flows that are subject to volume risk, i.e. when the magnitudes of cash flows in
foreign currency are uncertain. Discuss the advantages and disadvantages of not
hedging, hedging with forwards, hedging with options, and combinations of the
aforementioned. (If you want, you can use the AIFS case study that we have
discussed in the lecture to illustrate your arguments.)

Page 7
5. Measuring and Managing FX Exposure: Application (15%)

A Danish investor holds a US zero-coupon bond with a face value of USD 20m and a
remaining maturity of one year. To (partly) hedge the associated foreign exchange risk,
she has entered a forward sales contract on USD 10m at a rate of Ft0 ,t+1y = 6.245. The
contract has been initiated in the past at time t0 and will expire one year from now.
Furthermore, she holds a put option on USD 10m with strike price X = 6.000 maturing
on the same day as the bonds. Given the p.a. interest rates r = 0% and r∗ = 0%
(using continuous compounding), and the current spot rate DKK/USD 5.993, answer
the following questions:

(a) What is the current DKK value of the portfolio? To compute the value of the option
use the Black-Scholes model and use σ = 7%.

(b) What is the DKK/USD exchange rate exposure of the portfolio?

(c) What is the impact on the portfolio value as a function of ∆ST (i.e. write an
expression for the impact on the portfolio value where the variable ∆ST enters into
this expression)? If you have not solved (b) assume the portfolio exposure is USD
5m.

Page 8