Problem Set 1 of FINA 3404 Instructor: Dr.

Du Du

Select the best answers for questions (2 points each for questions 1-8) 1. Of the following exchange rates, which are quoted in European terms? (Answer: D)
i) ii) iii) iv) 2 USD for one British pound; 0.75 euro for one USD; 7.8 HKD for one USD; 100 yen for one USD

A) only i) B) only ii) C) iii) and iv) D) ii), iii) and iv)

2. Which of the following statements about forward rate/forward contract is FALSE? (Answer: D) A) the forward rate is determined when both the long side and the short side enter into the forward contract B) The forward rate will not be executed until the forward contract expires
C) The forward rate represents the market prediction of the future spot rate D) The forward rate is determined when the forward contract is about to expire 3. A WSJ (wall street journal) article reports that: “the euro was at $1.3653 up from $1.3674 at Monday’s close, while the dollar was at 115.09 yen from 116.08 yen” (answer: A) That means the dollar_________against euro, and the yen_____________against dollar

A) appreciated; appreciated B) appreciated; depreciated C) depreciated; depreciated D) depreciated; appreciated 4. The AUD/$ spot exchange rate is AUD1.60/$ and the SF/$ exchange rate is

dollar: The spot rate is ¥108/$.7813 B) 2. C) yen is expected to depreciate against dollar.0000 C) 1.S.6 for £1. and according to IRP. whereas the 90 day forward rate is ¥110/$. respectively. and according to IRP.SF1. interest rate prevailing . Applying what you’ve learned from interest rate parity (IRP). interest rate prevailing in Japan should be lower than that prevailing in the U.2800 D) 0.K.S.S. (Answer: D) A) Pressure from arbitrageurs should bring exchange rates and interest rates back into line B) It may fail to hold due to transactions costs C) It may be due to the government-imposed capital controls D) All of the above 6. Consider the two quotations about Japanese yen against the U. which of the following is correct? (Answer: A) A) yen is expected to depreciate against dollar.3500 5. If IRP fails to hold. and according to IRP. B) yen is expected to appreciate against dollar. D) yen is expected to appreciate against dollar. and in the U. Suppose the current exchange rate is $1.S. and according to IRP. The AUD/SF cross exchange rate is thus: (Answer: C) A) 0. in the coming year. interest rate prevailing in Japan should be higher than that prevailing in the U. are 2% and 4%. According to the relative PPP.S.25/$. (Answer: A) A) $ is expected to appreciate against £ in one year B) $ is expected to depreciate against £ in one year C) the $/£ exchange rate is expected to remain unchanged in the coming year D) none of the above 7. interest rate prevailing in Japan should be higher than that prevailing in the U. and the expected inflation rate in the U.

000 Hence.000*10-10. 8. At that time each share of Toyota Corporation cost 10.S.33 dollar payoff one year later: 11. and the prevailing spot exchange rate was 120 yen/dollar. the inflation rate in country A is expected to be _________ the inflation rate in country B.000*10)*100%=10% b) initial dollar investment: 10.000*10)/(10.14 . Suppose a U. investor bought 100 shares of Toyota Corporation in year 2001.in Japan should be lower than that prevailing in the U. repeat the computation in b) d) (4 points) what do you learn from the computations in a)-c)? Answer: a) one year net return in terms of yen is: (11. (Answer: B) A) lower than B) higher than C) the same as D) no enough information to tell 9.000-8333. the price of Toyota Corporation increased to 11.000*100/120=$8333. Suppose one year later.S.000*100/140=$7857.33*100%=20% c) initial dollar investment: 10. According to Fisher effect. one year net return in terms of dollar is: (10. a) (2 points) Compute the investor’s one year net return (in percentage) from this investment in terms of yen b) (3 points) if the spot exchange rate one year later was 110 yen/dollar.000*100/110=$10.000 yen share. compute the investor’s net return (in percentage) in terms of dollar c) (3 points) if the spot exchange rate one year later was instead 140 yen/dollar.33 dollar payoff one year later: 11.000*100/120=$8333. when interest rate in country A is higher than interest rate in country B.33)/8333.000 yen.

investor who considers doing international investment.8074 0.8043 6 Months Forward0.2442 1.8904 Canada (Dollar) 0.3735 Britain (Pound) 1.8037 1 Month Forward0. and the investor may even lose money in dollar terms.2395 1.7830 Brazil (Real) 0.5275 1. as the computation in c) shows.8983 6 Months Forward1.2393 1.5290 1. In particular.3309 Australia (Dollar) 0.2442 1. he faces the so called foreign exchange risk.9044 3 Months Forward1.9077 1 Month Forward1. Using the same table for question 10 to calculate the one-.9101 1.5235 0.5268 0.33*100%=-5.2412 Currency per USD Thursday 3. and six-month .7836 0.0221 1.7% d) For a U.9135 1. even though he earns profits in a foreign currency (such as yen in this question).Hence. three-.2364*1. USD equiv Country Friday Argentina (Peso) 0. That is. 10.0221*1.S.7653/£ b) F180 (CAD/£)= F180 (CAD/USD)* F180 (USD/£) =1.8959= CAD2. and then report the numerical results. calculate a) (3 points) spot cross exchange rate between Argentina Peso and British pound (peso price of pound) on Friday. b) (3 points) six-month forward cross exchange rate between Canadian and British pound (price of pound denominated in CAD) on Thursday.2364 Answer: a) S(peso/£)=S(peso/USD)*S(USD/£) =3.3791 1.S.8088 Currency per USD Friday 3.8069 0.3441/£ 11. On the other hand.8068 0.5253 0. it is not necessary that the same investment will bring him profits in dollar terms. the investor may earn higher profits in dollar terms than in the foreign currency if the U. dollar appreciates against the foreign currency. Using the following table.3292 0.2771 2.0377 1.5226 0.8959 0. Please list the formulas that you use.8037 3 Months Forward0.2385 1.8057 USD equiv Thursday 0. foreign currency profits may evaporate due to the depreciation of the foreign currency.2433 1.5242 0.6378 0.2762 2.9038 1.14-8333.6774 0.9077= peso 5.5251 0.33)/8333. one year net return in dollar is: (7857.

813.. Assume you are a trader with Deutsche Bank.1806/$1. dollar on Friday using American term quotations.8037] *360/30 = .5pts) The trade of selling €3. dollars the further into the future 12. Suppose you start with $5. finally sell SF to Credit Suisse for $.036..(annualized) forward premium or discount for the Canadian dollar versus the U. (1.8043 .CD = [(. (2 points each) For simplicity.0000 f3.963.00 and Credit Suisse is offering SF1.8037 .0% per annum in the . assume each month has 30 days.000.8037)/.000..1806 (1.52/£.0030 f6.5pts) Hence.7627/$1. with a current €/SF quote of 0.50/£ and the three-month forward exchange rate is $1.8037)/.253 to Credit Suisse would yield $5.813. then sell € to UBS for SF.8037)/.000. a (triangular arbitrage) profit of $51.500/.5pts) The trade of selling SF5.7627/$1.00.6395/SF1. That is.253/1.00 would yield SF5.8037] *360/90 = . From the quote screen on your computer terminal. dollar.S. The three-month interest rate is 8. You learn that UBS is making a direct market between the Swiss franc and the euro. What is the interpretation of your results? (2 points) Answer: The formula we want to use is: fN.000 to Dresdner Bank at €0.000 x0 .963.051.253 = €3.813. the spot exchange rate is $1.8037] *360/180 = .S(USD /CAD)/S(USD /CAD)] * 360/N f1. (1.6395. Calculate the profit/loss for the following trading strategy: first sell $ to Dresdner Bank for €.8057 .7627. Currently.000.0050 The pattern of forward premiums indicates that the Canadian dollar is trading at an increasing premium versus the U.00 would yield €3.500 to UBS at €0.S.500 = $5.CD = [(. (6pts) Answer: The trade of selling $5.S.6395.CD = [(FN(USD/CAD) .036 = SF5. you notice that Dresdner Bank is quoting €0.CD = [(. (1.5pts) 13. it becomes more expensive (in both absolute and percentage terms) to buy a Canadian dollar forward for U.963.

000. Answer: Let’s first summarize the information that is given: S = $1.K.U. and 5.0145)(1.45% Credit = $1.500.0%.000. maturity value will be £1. The forward exchange rate will fall. .52/1.040 Arbitrage profit will be $12. The pound interest rate will fall.0280 Thus.000.45%.52/£. b) (1) Borrow the maximum amount of $1. I£ = 1.530. Assume that you can borrow as much as $1.000.000. a) (3 points) Determine whether the interest rate parity holds or not b) (8 points) If the IRP does not hold. The dollar interest rate will rise. I$ = 2.02 (1+I£)(F/S) = (1. a) (1+I$) = 1.542. The spot exchange rate will rise.500 forward for $1.500.000 or £1.000.000 at the pound interest rate of 1. F = $1.000 spot using $1. These adjustments will continue until IRP holds.500. IRP is not holding exactly.500.000 or £1.000. (4) Sell £1.500.000.000. (2) Buy £1. c) (5 points) Explain how the IRP will be restored as a result of covered arbitrage activities.040 c) Following the arbitrage transactions described above.5/£.S.014. how would you carry out covered interest arbitrage? Show all the steps and determine the maximum arbitrage profit.014. (3) Invest £1.50) = 1. repayment will be $1.8% per annum in the U.

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