Question: Critically evaluate the theory of comparative advantage; Explain the different types of risks confronting an interest rate and currency swap dealer.

Question 1 (A)

The following spot exchange rates are currently being quoted by three different banks:

JP Morgan offers a spot rate of € 0.0071-0.0079/¥ Societe Generale offers a spot rate of € 0.879-0.888/$ Bank of America offers a spot rate of ¥ 100.9-101.5/$

Required:

(i) Calculate the implied cross exchange rate between the euro (€) and the yen (¥).

(10 marks)

(ii) Demonstrate how an arbitrageur could make a profit from this situation and calculate the amount of the profit if 1m (millions) dollars ($) was arbitraged. You need to show all your workings.

(15 marks)

(iii) Now assume that you have ¥ 50m instead of $ 1m. Calculate the profit that can be made through triangular arbitrage. You need to show all your workings.

(15 marks)

(B)

The 3-month forward rate dollar($)/sterling(£) is currently $ 1.33/£. Based on your analysis of the exchange rate, you are quite confident that the spot exchange rate will be $ 1.31/£ in 3 months’ time. Assume you want to speculate on the $/£ spot rate by buying or selling £ 5m (millions) in the forward market.

Required:

(i) Explain how you could speculate in the forward market and calculate your expected $ outcome from the speculation.

(15 marks)

(ii) Calculate your speculative $ outcome if the spot exchange rate actually turns out to be $ 1.36/£.

(15 marks)

(iii) Illustrate both speculative outcomes in a payoff diagram.

(10 marks)

(C)

Critically evaluate the theory of comparative advantage.

(20 marks)

(Total 100 marks)

Question 2

(A)

The spot exchange rate today is $0.85/A$ and the one-year forward exchange rate is $0.81/A$. One-year interest is 3.5% in the United States and 4.2% in Australia. You may borrow up to $1,000,000 or A$1,176,471, which is equivalent to $1,000,000 at the current spot rate.

Required:

(i)        Determine if interest rate parity (IRP) is holding between Australia and the United States. (10 marks)

(ii)       If IRP is not holding, explain in detail how you would realize certain profit in U.S. dollar terms. You need to show all your workings.

(10 marks)

(iii)       Explain how IRP will be restored as a result of arbitrage transactions you carry out above. (10 marks)

(B)

Global Transport (GT), a Swedish transport company with subsidiaries all over Asia, has been funding its Kuala Lumpur subsidiary, GT-Malaysia, primarily with U.S. Dollar ($) debt, because of the cost and availability of Dollar capital, as opposed to with Malaysian Ringgit-denominated (MYR) debt. The treasurer of GT-Malaysia is considering a one-year bank loan for $ 1,500,000. The current spot rate is MYR 4.31/$, and the Dollar-based interest is 4.75% for the one year period. One year loans are available at 10.00% interest in MYR.

Note: Assume there are 360 days in a year.

Required:

(i)        For the forthcoming year, according to the purchasing power parity relationship and assuming expected inflation rates of 3.8% and 0.50% in Malaysia and the United States, respectively, what would the effective cost of funds be in MYR terms?

(15 marks)

(ii)       If GT-Malaysia's foreign exchange advisers believe strongly that the Malaysian government wants to push the value of the MYR down against the dollar by 2.5% over the coming year, what might the effective cost of funds end up being in MYR terms? Would this change the funding strategy?

(15 marks)

(iii)      If GT-Malaysia could borrow MYR at 8% per annum, would this be cheaper than the funding sources on offer in either part (i) or part (ii) above?

(10 marks)

(iv)      Discuss why the purchasing power parity may not hold in reality.

(30 marks)

(Total 100 marks)

Question 3

(A)

Suppose you are a Scottish venture capitalist holding a major stake in an e-commerce start-up in Silicon Valley. As a Scottish resident, you are concerned with the pound value of your U.S. equity position. Assume that if the American economy booms in the future, your equity stake will be worth $1,000,000, and the exchange rate will be $1.40/£. If the American economy experiences a recession, on the other hand, your American equity stake will be worth $500,000, and the exchange rate will be $1.60/£. You assess that the American economy will experience a boom with a 70 percent probability and a recession with a 30 percent probability.

Required:

(i)        Estimate your exposure to the exchange risk.

(15 marks)

(ii)       Compute the variance of the pound value of your American equity position that is attributable to the exchange rate uncertainty.

(15 marks)

(iii)      How would you hedge this exposure? If you hedge, what is the variance of the pound value of the hedged position?

(15 marks)

(B)

Company Alpha is an A-rated firm desiring to issue five-year floating-rate notes (FRNs). Company Alpha finds that it can issue FRNs at six-month LIBOR + 0.125 percent or at three-month LIBOR + 0.125 percent. Given its asset structure, three-month LIBOR is the preferred index. Company Beta is a B-rated firm that also desires to issue five-year FRNs. Company Beta finds it can issue at six-month LIBOR + 1.0 percent or at three-month LIBOR + 0.625 percent. Given its asset structure, six-month LIBOR is the preferred index. Assume a notional principal of $15,000,000.

Required:

(i)        Calculate the quality spread differential (QSD).

(10 marks)

(ii)       Set up a floating-for-floating rate swap where the swap bank receives 0.125 percent and the two counterparties share the remaining savings equally.

(20 marks)

(C)

Explain the different types of risks confronting an interest rate and currency swap dealer.

(25 marks)

(Total 100 marks)

Question 4

(A)

A French aircraft manufacturer, BAM Ltd., sold an aircraft to American Airlines, a U.S. company, and billed $30 million payable in six months. BAM is concerned with the euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $1.05/€and six-month forward exchange rate is $1.10/€ at themoment. BAMcanbuya six-month put option on U.S. dollars with a strike price of €0.95/$ for a premium of €0.02 per U.S. dollar. Currently, six-month interest rate is 2.5% in the euro zone and 3.0% in the U.S.

Required:

(i)        Compute the guaranteed euro proceeds from the American sale if BAM decides to hedge using a forward contract.

(10 marks)

(ii)       If BAM decides to hedge using money market instruments, what action does BAM need to take? What would be the guaranteed euro proceeds from the American sale in this case?

(20 marks)

(iii)      If BAM decides to hedge using put options on U.S. dollars, what would be the ‘expected’ euro proceeds from the American sale? Assume that BAM regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.

(20 marks)

(iv)      At what future spot exchange rate do you think BAM will be indifferent between the option and money market hedge?

(15 marks)

(B)

According to a recent survey of corporate foreign exchange risk management practices, many firms simply do not hedge foreign exchange risk.

Required:

(i)        Discuss the possible reasons why some firms, in this survey, do not hedge foreign exchange risk.

(15 marks)

(ii)       Discuss the reasons why you, as an expert on international financial management, may want to suggest that firms need to hedge foreign exchange risk.

(20 marks)

(Total 100 marks)

Formula Sheet

Currency Depreciation

Currency Appreciation

Forward Premium/Discount

Purchasing Power Parity

International Fisher Effect

Interest Rate Parity

(St - St+1) St+1

(St+1 - St ) St

St                #days contract

E(e) = p$ - p£

E(e) = i$ - i£

(F-S)/S = ( i$ - i£) / (1 + i£)