Solutions: Sample Exam 2: FINA 5500 Short Questions / Problems Section: (88 points) Q1. (8 points) The following are direct quotes from the spot and forward markets for pounds, yens and francs, for two points in time: 2/1/XX and three months latter, 5/1/XX. PLEASE READ AND USE THE QUOTES CAREFULLY. I WILL NOT GIVE PARTIAL CREDIT FOR ERRORS DUE TO MISREADING OR USING THE WRONG QUOTES. 2/1/XX 5/1/XX a. If you were a currency speculator, based on the information presented, would you rather take a long or a short position in the three-month forward contract for British pounds on 2/1/XX?: Long b. On 2/1/XX, GM sold a three-month forward contract for 250 million yen to CitiCorp. Based on this transaction, indicate whether each statement listed below is either true or false: (5 points) Statements True or false On 5/1/XX, GM will have to pay $1,875,250 to CitiCorp F On 2/1/XX, GM will have to deliver 250 million yen to CitiCorp F On 5/1/XX, CitiCorp will have to pay $2,071,250 to GM F On 5/1/XX, CitiCorp will have to deliver 250 million yen to GM F On 5/1/XX, CitiCorp will have to pay to $2,090,000 GM F c. Based on the information presented in part (h), what is the total dollar profit or loss in the forward market transaction for GM ? Please indicate the dollar amount, and also if it is a profit or a loss. (2 points): (0.007501 - 0.008285) * 250,000,000 = - $ 196,000 Q2. (4 points) Compared to the Forward market, in the Foreign Currency Futures market: (i) Transaction costs are based on: brokerage fee (ii) Margin is: required (iii) Trading is done via: an exchange (iv) Settlement is done: on a daily basis Q3. (8 points) Listed below are the closing spot and the December futures contract prices for BP for four consecutive days in October 2002. You sold two BP futures contract at the closing price on 10/01/02. Each BP futures contract requires the delivery of BP 62,500. Suppose, the initial and the maintenance margin for each BP futures contract are $3,000 and $2,500, respectively. Assume that you do not withdraw from your margin account during this period, but that you do meet your margin calls if you get any. Date 10/01/02 10/02/02 10/03/02 10/04/02 Closing BP Spot Price $1.4579 $1.4527 $1.4588 $1.4580 Closing December BP Futures Contract Price $1.5750 $1.5612 $1.5937 $1.5823 a) Please estimate the profit / loss posted to your account at the close of:. i) 10/02/02 : Profit of $1,725; ii) 10/04/02: Profit of $1,425 b) Assuming that you meet your margin calls, if you get any, please estimate how much money you will have in your margin account at the close of each trading day: i) 10/03/02: $5,000 ; ii) 10/04/02 : $7,425 c) On each of the following days indicate if you get a margin call from the exchange, and if so for how much: i) 10/02/02 : No; ii) 10/03/02 : Yes; How much (indicate amount)? $2,337.50 Q4. (2 points) A US company has made a bid for a French defense contract. If they get the contract, they will need 100 million French Franc to start the project. But the firm does not know if their bid will be accepted. Under this circumstance, what would be the best way for the US company to hedge against exchange rate risk? (Choose the best one): Buy FF call options contract Q5. (3 points) Assume that an investor purchased a call option on SF with an exercise price of $0.65 for $0.0095 per unit. There are 62,500 units in a SF options contract. At the time of the option expiration date, the spot price for SF was $0.6321. What was the net profit/loss on this option to the investor? - (0.0095) * 62,500 = - $ 593.75 Q6. (3 points) Assume that a speculator purchased a put option on BP with an exercise price of $1.40 for $0.0125 per unit. There are 31,250 units in a BP options contract.. At the time of the option expiration date, the spot price for BP was $1.3909. What was the net profit/loss on this option to the investor? (1.40 - 1.3909 - 0.0125) * 31,250 = - $ 106.25 Q7. (6 points) Please refer to the attached quotes on currency options contracts for Canadian Dollars (CD). Each contract has 50,000 CD. For each option listed in the table below: a) indicate if each option is in- or out-of-the-money, if the current spot price for CD is $0.7350 b) calculate the price of buying one contract c) for the buyer of each contract, calculate the profit or loss (per contract) on the expiration date, when the spot price for CD is $0.7350 Options (a) In/out (b) Price of 1 contract (c) Profit / Loss from 1 contract on expiration date 75 ½ Sep Put In $1,975 (0.755 - 0.735 - 0.0395)*50,000 = - $ 975 72 ½ Jul Call in $65 (0.735 - 0.725 - 0.0013) * 50,000 = $435 72 ½ Sep Put out $725 - (0.0145) * 50,000 = -725 Q8. (11 points) Please use the exact, not the approximate formula to answer all questions in this section. Suppose you have a credit line of $10,000,000 in the US and BP 5,000,000 in UK, and that you can borrow and lend at the prevailing rates of interest in these two countries. Current spot rate of BP = $2.00 ; Expected spot rate for BP, one year from now = $2.10 ; Interest rate in the U.S. = 10.0% ; Interest rate in the U.K. = 5.5% a) If the 1-year current forward rate for BP is $2.08 and you wanted to set up a covered interest rate arbitrage, you would: borrow in: UK / invest in: US b) Based on the previous question, calculate your covered interest arbitrage profit (after paying off the loan) either in Dollar or BP: FPh = 0.04; FPf = 1 /1.04 - 1 = -0.0385; Rcf = (1-0.0385)*(1.10) -1 = 0.05769 (0.05767 - 0.05)* 5,000,000 = BP 13,450 b) Which of the following forces should result from covered interest arbitrage: downward pressure on BP’s SR c) If the current 1-year forward rate for BP is $2.12 and you wanted to set up a covered interest rate arbitrage, you would: borrow in: US / invest in: UK d) Based on the previous question, calculate your covered interest arbitrage profit (after paying off the loan) either in Dollar or BP: FPh = 0.06; Rch = (1.06)*(1.055) -1 = 0.1183 (0.1183 - 0.10) * 10,000,000 = $ 183,000 e) Which of the following forces should result from covered interest arbitrage: downward pressure on BP’s FR i) What should be the current forward premium for BP according to Interest Rate Parity? 1.10/1.055 -1 = 4.265% Q9. (8 points) Please use the exact, not the approximate formula to answer all questions in this section. Suppose the annual inflation rate in the US is expected to be 3.5 %, while it is expected to be 8.00 % in Australia. The current spot rate (on 10/25/02) for the Australian Dollar (AD) is $0.7552 a) According to PPP, estimate the expected percentage change in the value of the AD during a one-year period: 1.035/1.08 - 1 = -4.167% b) According to PPP, estimate expected value of the AD on 3/25/03: 0.7552* (1-.04167) = $ 0.7237 c) If the value of AD is $0.7357 on 10/25/03, Australia experienced gain in real purchasing power? d) If the value of AD is $0.87 on 10/25/03: The net cash flow of a US exporter to Australia will: increase Q10. (8 points) Please use the exact, not the approximate formula to answer all questions in this section. Current SR of SF = $0.6543 ; Expected SR of SF, one year from now = $0.6925 ; Current 1-year forward rate for SF = $0.6808 ; 1-year interest rate in the U.S. = 7.5% ; 1-year interest rate in the Switzerland = 3.5% a) Calculate the covered rate of return: FPh = 0.0404; Rch = (1.0405)*(1.035) -1 = 7.69% b) Calculate the uncovered rate of return: % change in SR=0.05838; Ru = (1.05838)*(1.035) -1 = 9.543% c) If you could borrow $10,000,000 in the US, and set up a uncovered interest rate arbitrage, how many dollars will you have at the end of one-year: (0.09543 - 0.075)*10,000,000 = $204,264.10 d) Based on IFE, calculate the expected spot price of SF one year from now:(1.075/1.035)*0.6543 = $0.6796 Q11. (4 points) Please fill in the blanks with letter (a, b, c, etc.,) associated with the most appropriate phrases from the phrases listed below: 1. According to the Interest Rate Parity Theory, the difference between the domestic and foreign interest rates has an effect on the forward premium or discount 2. According to the Purchasing Power Parity Theory, the difference between the domestic and foreign inflation rates has an effect on the percentage difference between the current spot exchange rate and future spot exchange rate 3. According to the Fisher Effect, the sum of the real rate and inflation premium has an effect on the nominal rate of interest 4. According to the International Fisher Effect, the difference between the domestic and foreign interest rates has an effect on the percentage difference between the current spot exchange rate and future spot exchange rate Q12 (5 points): Assume that Texaco does a large part of its crude petroleum extraction and refining the UK. In both the US and UK markets it has to compete with other US and British firms. Please indicate whether the appreciation of the US dollar will increase, decrease or have no effect on the following factors: Factors The dollar value of Texaco's domestic revenue Decrease The dollar value of Texaco's sales in the UK, if exports are denominated in US $ Decrease The dollar value of Texaco's sales in the UK, if exports are denominated in BP Decrease The dollar value of Texaco's operating costs in the UK, if those payments have to be made inBP Decrease The level of Texaco's operating costs in the UK, if those payments have to be made in US $ No change Q13 (8 points): Assume that a US firm expects to make a payment of SF 2,500,000 in 1 year and wants to execute a money market hedge. The following information is available: US interest rate = 5% ; Swiss interest rate = 7% ; 1 year forward rate for SF = $0.60 ; Spot rate for SF = $0.59 a. In what currency should the firm borrow, and how much: (2,500,000/1.07)*0.59 = $ 1,378,504.67 b. In what currency should the firm invest, and how much: (2,500,000 / 1.07) = BP 2,336,448.60 c. If the US firm sets up the money market hedge, how many US dollars would it need to cover the payment of SF 2,500,000 payable at the end of one year? (2,500,000/1.07)*0.59*(1.05) = $1,447,429.91 d. Based on available information, should the firm use a forward hedge or money market hedge to cover the payment of SF 2,500,000 payable at the end of one year? money market hedge Q14 (8 points): The following table projects inflows and outflows in four different currencies for Nemonics.com, a US based firm. Also given are the projected exchange rates for these currencies and their projected ranges. Based on this information, estimate the information required in the last four rows of the table. Euro Japanese Yen Hong Kong $ Mexican Peso Inflows 500,000 25,000,000 0 400,000 Outflows 0 0 600,000 800,000 Projected exchange rates $0.90 $0.01 $0.75 $0.10 Projected range of exchange rates $0.75 - 1.10 $0.0075 - $0.0125 $0.55 - $0.85 0.02 - $0.25 Projected $ NCF + 450,000 + 250,000 <450,000> <40,000> Projected range of the $ NCF +375,000 +550,000 +187,000 +312,500 <330,000> <510,000> <8,000> <100,000> Projected overall $ NCF $210,000 Projected range of the overall $ NCF $524,500 - <47,500> B. Multiple Choice Section (2 X 7 = 14 points): 1. Firm A is a US based MNC with net cash inflows of Japanese Yen and net cash inflows of French Francs. Firm B is also a US based MNC with net cash outflows of Japanese Yen and net cash inflows of French Francs. These two currencies are positively correlated in their movements against the dollar. Which firm has a higher exposure to exchange rate risk?: Firm A 2. Firm J is a US based MNC with net cash inflows of Japanese Yen and net cash outflows of French Francs. Firm K is also a US based MNC with net cash inflows of German Marks and net cash outflows of French Francs. While Japanese Yen and French Francs are positively correlated, German Marks and French Francs are negatively correlated in their movements against the dollar. Which firm has a high exposure to exchange rate risk?: Firm K 3. Which of the following reflects a hedge of net receivable in British pounds by a US firm? A) purchase a currency put option in British pounds B) sell forward contracts on pounds D) A and B 4. Which of the following reflects a hedge of net payables on British pounds by a US firm: borrow US dollars, convert them to pounds, and invest in a British pound deposit 5. Assume that Parker company will receive SF200,000 in 360 days. Interest rates are 6% in the US and 5% in Switzerland. One-year forward rate for Swiss franc is $.50 and the current spot rate of Swiss franc is $.48. If Parker Company uses a money market hedge, it will receive $96,914 in 360 days. 6. Your company will receive CD1,200,000 in 90 days. The 90 day forward rate for Canadian dollars is $0.80 and the current spot rate is $0.75. If you use a forward hedge, estimate the cost of hedging the receivable if the spot rate for CD 90 days later turns out to be $0.82: $ 24,000 7. Your company will expected to pay DM 4,000,000 in 6-months. The 6-month forward rate for DM is $0.40 and the current spot rate is $0.50. If you use a forward hedge, estimate the cost of hedging the payable if the spot rate for DM 6-months later turns out to be $0.44: < $160,000 >