International Financial Management Exam 2

Front 1

Explain the rationale of the PPP theory

Back 1

Purchasing Power Parity is the relationship between inflation and the exchange rate. Based on the on the notion that exchange rate adjustment is necessary for the relative purchasing power to be the “equal” everywhere. If purchasing power is not equal, then consumers will shift purchases to wherever products are cheaper until purchasing power equalizes.

Front 2

Explain why PPP does not hold

Back 2

PPP does not hold because it presumes that exchange rate movements are driven solely by the inflation differential between the two countries. Another limitation of PPP theory is there aren’t substitutes for traded goods.

Front 3

Compare and contrast interest rate parity, purchasing power parity(PPP), and the international Fisher effect (IFE).

Back 3

Interest rate parity = forward rate of one currency will contain a premium or discount determined by the differential in interest rates Purchasing power parity spot rate of one currency with respect to another will change in reaction to the differential in inflation rates. IFE states the spot rate of one currency will change in reaction to the differential in inflation rates between countries.

Front 4

One assumption made in developing the IFE is that all investors in allcountries have the same real interest rate. What does this mean?

Back 4

The real return is nominal return minus inflation rate. If all investors require the same real return, then the differences in nominal interest rates should be solely due to differences in anticipated inflation among the countries.

Front 5

If investors in the United States and Canada require the same realinterest rate, and the nominal rate of interest is 2 percent higher in Canada,what does this imply about expectations of U.S. inflation and Canadianinflation? What do these infla­tionary expectations suggest about futureexchange rates?

Back 5

They suggest that the expected inflation rate in Canada is 2% above the expected inflation rate in the U.S. If these inflation expectations come true, PPP would suggest that the value of the Canadian dollar should depreciate by 2% against the U.S. dollar.

Front 6

Assume that the inflation rate in Brazil is expected to increasesubstantially. How will this affect Brazil’s nominal interest rates andthe value of its currency (called the real)? If the IFE holds, how willthe nominal return to U.S. investors who invest in Brazil be affected by thehigher inflation in Brazil? Explain.

Back 6

Brazil’s nominal interest rate will increase to maintain the real interest return required by its’ investors. According to the IFE, the Brazilian Real should depreciate. If the IFE holds, then the return for US investors won’t be affected. Even though they are earning a higher nominal interest rate, the expected decline in Brazil offsets the additional interest earned.

Front 7

Assume that the spot exchange rate of theBritish pound is $1.73. How will this spot rate adjust according to PPPif the United Kingdom experiences an inflation rate of 7 percent while theUnited States experiences an inflation rate of 2 percent?

Back 7

The exchange rate of the pound will depreciate 4.7 percent. So, the spot rate will adjust to $1.73*(1+(-.467))=$1.649

Front 8

The opening of Russia's market has resulted in a highly volatileRussian currency (the ruble). Russia's inflation has commonly exceeded 20percent per month. Russian interest rates commonly exceed 150 percent, but thisis sometimes less than the annual inflation rate in Russia.

a. Explain why the high Russian inflation has put severe pressure onthe value of the Russian ruble.

Back 8

As the Russian prices are increasing, the purchasing power of Russians is decreasing. This will encourage them to purchase more US goods. This will decrease the demand for the ruble, and increase the supply available. The ruble’s value would depreciate against the dollar.

Front 9

The opening of Russia's market has resulted in a highly volatileRussian currency (the ruble). Russia's inflation has commonly exceeded 20percent per month. Russian interest rates commonly exceed 150 percent, but thisis sometimes less than the annual inflation rate in Russia.

b. Does the effect of Russian inflation on the decline in the ruble’svalue support the PPP theory? How might the relationship be distorted bypolitical conditions in Russia?

Back 9

The general relationship suggested by PPP is supported, but the ruble’s value won’t move exactly with the PPP. The political conditions that could restrict trade can prevent Russian consumers from purchasing foreign goods. The Russian ruble might not decline by the full amount to offset the inflation differences between the US and Russia. Also, the government might not allow for the currency to freely float.

Front 10

The opening of Russia's market has resulted in a highly volatileRussian currency (the ruble). Russia's inflation has commonly exceeded 20percent per month. Russian interest rates commonly exceed 150 percent, but thisis sometimes less than the annual inflation rate in Russia.

c. Does it appear that the prices of Russian goods will be equal tothe prices of U.S. goods from the perspective of Russian consumers (afterconsidering exchange rates)? Explain.

Back 10

Russian prices could be higher than US prices even after the exchange rate because the ruble might not have depreciated enough to offset the inflation. The exchange rate can’t fully adjust to trade barriers.

Front 11

The opening of Russia's market has resulted in a highly volatileRussian currency (the ruble). Russia's inflation has commonly exceeded 20percent per month. Russian interest rates commonly exceed 150 percent, but thisis sometimes less than the annual inflation rate in Russia.

d. Will the effects of the high Russian inflation and the decline inthe ruble offset each other for U.S. importers? That is, how will U.S. importersof Russian goods be affected by the conditions?

Back 11

US importers will likely see higher prices because of Russia’s inflation and it might not be offset by the depreciation of the ruble. This may decrease the demand for Russian goods.

Front 12

Beth Miller does not believe that theinternational Fisher effect (IFE) holds. Current one-year interest rates inEurope are 5 percent, while one-year interest rates in the U.S. are 3 percent.Beth converts $100,000 to euros and invests them in Germany. One year later,she converts the euros back to dollars. The current spot rate of the euro is$1.10.

a. According to the IFE, what shouldthe spot rate of the euro in one year be?

Back 12

Ef = 1.03/1.05 -1 = -2% New Spot rate = 1.10 (1 + -.02) = $1.08

Front 13

Beth Miller does not believe that theinternational Fisher effect (IFE) holds. Current one-year interest rates inEurope are 5 percent, while one-year interest rates in the U.S. are 3 percent.Beth converts $100,000 to euros and invests them in Germany. One year later,she converts the euros back to dollars. The current spot rate of the euro is$1.10.

b. If the spot rate of the euro inone year is $1.00, what is Beth’s percentage return from her strategy?

Back 13

Current = $100,000 /$1.10 = 90,909 Euros In one year = 90,909 Euros x 1.05 = 95,455 Euros x $1.00 = $95,455 Return = 95,455 - 100,000 / 100,000 = -4.5%

Front 14

Beth Miller does not believe that theinternational Fisher effect (IFE) holds. Current one-year interest rates inEurope are 5 percent, while one-year interest rates in the U.S. are 3 percent.Beth converts $100,000 to euros and invests them in Germany. One year later,she converts the euros back to dollars. The current spot rate of the euro is$1.10.

c. If the spot rate of the euro inone year is $1.08, what is Beth’s percentage return from her strategy?

Back 14

95,455 Euros x $1.08 = $103,092 = 3% return

Front 15

Beth Miller does not believe that theinternational Fisher effect (IFE) holds. Current one-year interest rates inEurope are 5 percent, while one-year interest rates in the U.S. are 3 percent.Beth converts $100,000 to euros and invests them in Germany. One year later,she converts the euros back to dollars. The current spot rate of the euro is$1.10.

d. What must the spot rate of theeuro be in one year for Beth’s strategy to be successful?

Back 15

The spot rate must be over $1.08 for it to be successful. Then the return will be greater than 3% which is what the return would be if invested in the U.S.

Front 16

Explain the concept of locational arbitrage and the scenario necessaryfor it to be plausible.

Back 16

Locational arbitrage happens when the spot rate of one currency varies among locations. This means that the ask rate at one location must be lower than the bid rate at another location. The difference in rates can happen because information is not always immediately available to all banks. If a discrepancy does exist, locational arbitrage is possible and the spot rates among locations should become realigned.

Front 17

Beal Bank Yardley Bank Bid price of New Zealand dollar $.401 $.398 Ask price of New Zealand dollar $.404 $.400Given this information, is locational arbitragepossible? If so, explain the steps involved in locational arbitrage, andcompute the profit from this arbitrage if you had $1,000,000 to use. Whatmarket forces would occur to eliminate any further possibilities of locationalarbitrage?

Back 17

Yes, if you purchase New Zealand dollars at Yardley Bank for $.40 and sell them to Beal Bank for $.401. With $1,000,000 available, 2.5 million New Zealand dollars could be purchased at Yardley Bank. These New Zealand dollars could then be sold to Beal Bank for $1,002,500, which would generate a profit of $2,500. The large demand for New Zealand dollars at Yardley Bank will force the banks ask price on New Zealand dollars to increase. The large sales of New Zealand dollars to Beal Bank will force bid price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank, locational arbitrage will no longer be beneficial.

Front 18

Explain the concept of triangular arbitrage and the scenario necessaryfor it to be plausible.

Back 18

Triangular arbitrage is possible when actual cross exchange rate between two currencies is different than what it should be. The right cross rate can be determined by the values of the two currencies with respect to some other currency.

Front 19

Quoted Price Value of Canadian dollar in U.S. dollars $.90 Value of New Zealand dollar in U.S. dollars $.30 Value of Canadian dollar in New Zealanddollars NZ$3.02

Given this information, is triangular arbitragepossible? If so, explain the steps that would reflect triangulararbitrage, and compute the profit from this strategy if you had $1,000,000 touse. What market forces would occur to eliminate any further possibilities oftriangular arbitrage?

Back 19

Using the Canadian dollar and New Zealand dollar values we compute an exchange rate of NZ$3.00 ($.90/$.30). So the bank is exchanging too many New Zealand dollars for Canadian dollars. To obtain a profit, first you would exchange USD for Canadian Dollars ($1,000,000/$.90) = 1,111,111 Canadian Dollars. Then you would exchange Canadian Dollars for NZ$ (1,111,111 x 3.02) = 3,355,555 NZ$. Finally you would exchange the New Zealand dollars back to USD (3,355,555 x $.30) = $1,006,666. This would give you a profit of $6,666. Market forces would cause the value of Canadian dollars in NZ$ to decrease to $3.

Front 20

Explain the concept of covered interest arbitrage and the scenarionecessary for it to be plausible.

Back 20

Covered interest arbitrage is for a short term investment in a foreign currency that’s covered by a forward contract to sell that currency when the investment matures. Covered interest arbitrage is plausible when the forward premium doesn’t reflect the difference in interest rates between the countries in the specified IRP. If other costs, like transaction costs, are involved the excess profit from covered interest arbitrage must be more than the other costs for it to be plausible.

Front 21

Quoted PriceSpot rate of Canadian dollar $.8090 day forward rate of Canadian dollar $.7990 day Canadian interest rate 4%90 day U.S. interest rate 2.5% Given this information, what would be theyield (percentage return) to a U.S. investor who used covered interestarbitrage? (Assume the investor invests $1,000,000.) What market forceswould occur to eliminate any further possibilities of covered interestarbitrage?

Back 21

$1,000,000/$.80 = 1,250,000 Canadian dollars. Sell forward contract for 1,300,000 Canadian dollars. In 90 days fulfill contract by converting back to USD (1,300,000 x .79) = $1,027,000. Yield = 2.7%. Market forces would realign the the forward rate of Canadian dollars to a lower value.

Front 22

Spot rate of Mexican peso = $.100180 day forward rate of Mexican peso = $.098180 day Mexican interest rate = 6%180 day U.S. interest rate = 5%Given this information, is covered interestarbitrage worthwhile for Mexican investors who have pesos to invest? Explain your answer.

Back 22

No it wouldn’t be worthwhile to invest because the interest rate for pesos is greater than that of USD. So if you invest pesos for US dollars the return is only 5%. But if you keep the pesos and invest in the Mexican interest rate you will earn 6%.

Front 23

Explain the concept of interest rate parity. Provide the rationalefor its possible existence.

Back 23

IRP states that the forward rate premium of a currency should reflect the difference in interest rates between the countries. If IRP didn’t exist, then covered interest arbitrage could occur, which would cause markets forces to move back towards conditions which reflect IRP.

Front 24

Assume that the existing U.S. one year interest rate is 10 percent andthe Canadian one year interest rate is 11 percent. Also assume thatinterest rate parity exists. Should the forward rate of the Canadiandollar exhibit a discount or a premium? If U.S. investors attempt coveredinterest arbitrage, what will be their return? If Canadian investorsattempt covered interest arbitrage, what will be their return?

Back 24

Since Canada has a higher interest rate the forward rate will be sold at a discount. Since IRP exists investors will only earn what their home country offers. U.S. investors will earn 10% while Canadian investors will earn 11%.

Front 25

Assume that the one-year U.S.interest rate is 11 percent, while the one-year interest rate in Malaysia is 40percent. Assume that a U.S. bank is willing to purchase the currency ofthat country from you one year from now at a discount of 13 percent. Wouldcovered interest arbitrage be worth considering? Is there any reason whyyou should not attempt covered interest arbitrage in this situation? (Ignore tax effects.)

Back 25

Covered interest arbitrage could be worth considering but might not be a wise decision even though Malaysia has a much greater interest rate. There are other factors that could impact your investment. Political and economic risk are two of the biggest factors. If the country experienced problems with their government or economy then your return might not be as high a

Front 26

Assume that annual interest rates in the U.S.are 4 percent, while interest rates in France are 6 percent.

a. According to IRP, what should the forwardrate premium or discount of the euro be?

Back 26

p=(1.04)/(1.06)-1= -.0189= -1.89%

Front 27

Assume that annual interest rates in the U.S.are 4 percent, while interest rates in France are 6 percent.

b. If the euro’s spot rate is $1.10, what shouldthe one-year forward rate of the euro be?

Back 27

F=$1.01(1-.0189)=$1.079

Front 28

• You have $500,000 to invest• The current spot rate of the Moroccan dirhamis $.110.• The 60-day forward rate of the Moroccan dirhamis $.108.• The 60-day interest rate in the U.S. is 1percent.• The 60-day interest rate in Morocco is 2percent.a. What is the yield to a U.S. investor whoconducts covered interest arbitrage? Did covered interest arbitrage work forthe investor in this case?

Back 28

500,000/$.110=4,545,455 Moroccan dirham 4,545,455 Moroccan dirham(1.02)=4,636,364 Moroccan dirham 4,636,364 Moroccan dirham*$.108=$500,727 ($500,727-$500,000)/$500,000= 0.145% In this case, the yield(0.145%) is less than the US interest rate(1%), so covered interest arbitrage doesn’t work for the investor.

Front 29

You have $500,000 to invest• The current spot rate of the Moroccan dirhamis $.110.• The 60-day forward rate of the Moroccan dirhamis $.108.• The 60-day interest rate in the U.S. is 1percent.• The 60-day interest rate in Morocco is 2percent.b. Would covered interest arbitrage be possiblefor a Moroccan investor in this case?

Back 29

It doesn’t due to Interest Rate Parity.

Front 30

Compare and contrast the fixed,freely floating, and managed float exchange rate systems. What are someadvantages and disadvantages of a freely floating exchange rate system versus afixed exchange rate system?

Back 30

Fixed exchange rate systems are when rates are constant or allowed to fluctuate only within very narrow boundaries. This is different from a freely floating exchange rate system because that is when exchange rates are determined by market forces without government intervention. Managed float exchange rate systems are similar but governments sometimes intervene to prevent currencies moving too far in one direction. Advantages of Fixed exchange rate systems is that it will insulate the country from risk of currency appreciation and it also allows firms to engage in DFI without currency risk. However there are downsides such as the risk that the government will alter the value of the currency and the country may be more vulnerable to economic conditions in other countries. Advantages of freely floating exchange rate system include insulation from other countries inflation and unemployment. But a disadvantage is that it can adversely affect a country with high inflation.

Front 31

Assume that Belgium, one of the European countries that uses the euro asits currency, would prefer that its currency depreciate against the dollar. Can it apply central bank intervention to achieve this objective? Explain.

Back 31

It can’t because that would involve monetary policy. Belgium uses the Euro and that decision is held by the ECB.

Front 32

How can a central bank use direct intervention to change the value of acurrency? Explain why a central bank may desire to smooth exchange ratemovements of its currency.

Back 32

A central bank can directly intervene by exchanging the currency in its reserves for currencies in foreign markets. By “flooding the market with its currency”, the central bank is putting downward pressure on its currency. Similarly, a central bank can exchange foreign currencies for its home currency in foreign markets, which puts upward pressure on its currency. A central bank may smooth exchange rate movements if it is concerned that its economy will be affected by abrupt movements in the home currency’s value. Smoothing currency movements over time can reduce fears in financial markets and may lead to increased international trade.

Front 33

How can a central bank use indirect intervention to change the value ofa currency?

Back 33

The central bank could increase interest rates to increase the value of its home currency. Doing this would attract a foreign demand for the home currency to buy high-yield securities. To decrease the value of its home currency, the central bank could to lower interest rates in order to reduce demand for the home currency by foreign investors. The central bank could also change the market's expectations, with a revaluation that will cause the market participants to act and drive the exchange rates in the intended direction.

Front 34

Briefly explain why the Federal Reserve may attempt to weaken thedollar?

Back 34

A weaker dollar will increase demand for U.S. goods because foreign firms will be able to buy U.S. goods at a cheaper price. The increase in demand for U.S. goods will result in an increase in U.S. exports. An increase in exports will improve productivity and reduce unemployment thus improving the economy.

Front 35

What is the impact of a weak home currency on the home economy,other things being equal? What is the impact of a strong home currency on thehome economy, other things being equal?

Back 35

A weak home currency can increase a country’s exports and decrease imports which lowers unemployment. It also can cause higher inflation since there is a decrease in foreign competition. Because of this, local producers can increase prices easily without concern about pricing themselves out of the market. A strong home currency can keep inflation low since it encourages consumers to buy abroad. Local producers must maintain low prices to remain competitive. Also, foreign supplies can be bought cheap and this helps to keep a low inflation. A strong home currency can increase unemployment because of the increase in imports and decrease in exports that comes with a strong home currency.

Front 36

The Hong Kong dollar’s value is tied to the U.S. dollar. Explainhow the following trade patterns would be affected by the appreciation of theJapanese yen against the dollar: (a) Hong Kong exports to Japan and (b)Hong Kong exports to the United States.

Back 36

a) Hong Kong should see an increase in exports to Japan because the yen has appreciated against the Hong Kong dollar, which would make Hong Kong goods less expensive to the Japanese (b) Hong Kong should also see an increase of exports to the United States. Japanese goods are more expensive because of the appreciation of the yen. The Japanese goods will be more expensive. Hong Kong’s exchange rate will remain unchanged and be more favorable for imports.

Front 37

U.S. bond prices are normally inversely related to U.S. inflation. Ifthe Fed planned to use intervention to weaken the dollar, how might bond pricesbe affected?

Back 37

Expectations of a weak dollar can cause expectations of higher inflation, because a weak dollar places upward pressure on U.S. prices. Higher inflation also places upward pressure on interest rates. Because there is an inverse relationship between interest rates and bond prices, bond prices would decline. With these expectations in mind, it causes bond portfolio managers to liquidate some of their bond holdings, thereby causing bond prices to decline immediately.

Front 38

If most countries in Europe experience a recession, how might theEuropean Central Bank use direct intervention to stimulate economic growth?

Back 38

The ECB can sell Euros in the foreign exchange market. This will help them to depreciate against currencies, which will make their products cheaper. This would increase the demand for European goods and stimulate economic growth.

Front 39

Explain the difference between sterilized and nonsterilizedintervention.

Back 39

Sterilized intervention is when the Fed intervenes in foreign exchange markets and simultaneously engages in offsetting transactions in the Treasury securities markets. Thus, the dollar money supply is unchanged. Nonsterilized intervention is when the Fed intervenes in the foreign exchange market without adjusting for the change in money supply. So in sterilized intervention the money supply is unchanged but in nonsterilized intervention, the money supply changes.

Front 40

Within a few days after the September 11, 2001 terrorist attack on theU.S., the Federal Reserve reduced short-term interest rates in the U.S. tostimulate the U.S. economy. How might this action have affected the foreignflow of funds into the U.S. and affected the value of the dollar? Howcould such an effect on the dollar increase the probability that the U.S. economywould strengthen?

Back 40

The lower interest rates will encourage borrowing and spending. The lower interest rates would reduce the amount of foreign flows to the US, which could reduce the value of the dollar. With a weakened dollar, the exports would be cheaper and will increase the demand for the US goods. The increase in demand will stimulate economic growth.

Front 41

Assume you have a subsidiary in Australia. The subsidiary sellsmobile homes to local consumers in Australia, who buy the homes using mostlyborrowed funds from local banks. Your subsidiary purchases all of its materialsfrom Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Yoursubsidiary borrowed funds from the U.S. parent, and must pay the parent$100,000 in interest each month. Australia has just raised its interest rate inorder to boost the value of its currency (Australian dollar, A$). TheAustralian dollar appreciates against the dollar as a result. Explain whetherthese actions would increase, reduce, or have no effect on:a. The volume of your subsidiary’s sales in Australia(measured in A$),

Back 41

Decrease because less consumers in Australia borrows money from local banks due to the higher interest rate

Front 42

Assume you have a subsidiary in Australia. The subsidiary sellsmobile homes to local consumers in Australia, who buy the homes using mostlyborrowed funds from local banks. Your subsidiary purchases all of its materialsfrom Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Yoursubsidiary borrowed funds from the U.S. parent, and must pay the parent$100,000 in interest each month. Australia has just raised its interest rate inorder to boost the value of its currency (Australian dollar, A$). TheAustralian dollar appreciates against the dollar as a result. Explain whetherthese actions would increase, reduce, or have no effect on:b. The cost to your subsidiary of purchasing materials(measured in A$) No effect

Back 42

No effect

Front 43

Assume you have asubsidiary in Australia. The subsidiary sells mobile homes to local consumersin Australia, who buy the homes using mostly borrowed funds from local banks.Your subsidiary purchases all of its materials from Hong Kong. The Hong Kongdollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S.parent, and must pay the parent $100,000 in interest each month. Australia hasjust raised its interest rate in order to boost the value of its currency(Australian dollar, A$). The Australian dollar appreciates against thedollar as a result. Explain whether these actions would increase, reduce, orhave no effect on:c. The cost to your subsidiary of making the interestpayments to the U.S. parent (measured in A$).

Back 43

Decrease

Front 44

The country of Zapakar has much international trade with the U.S. andother countries, as it has no significant barriers on trade or capital flows.Many firms in Zapakar export common products (denominated in zaps) that serveas substitutes for products produced in the U.S. and many other countries.Zapakar’s currency (called the zap) has been pegged at 8 zaps =$1 for the lastseveral years. Yesterday, the government of Zapakar reset the zap’s currencyvalue so that is now pegged at 7 zaps=$1.

Back 44

Since the government of Zapakar revalued its currecny against the US dollar, exports to the US and other countries decrease, which means their account surplus will be reduced. Revaluation usually helps manage inflation. In this case, Zapakar’s inflation rate will increase because the demand for goods and services drops.

Front 45

How can currency futures be used by corporations?

Back 45

Corporations can use currency futures for a number of reasons. Corporations can purchase futures to hedge payables. This locks in the price at which a firm can purchase a currency. Corporations can also sell futures to hedge receivables. This locks in the price that a company can sell a currency.

Front 46

How can currency futures be used by speculators?

Back 46

Speculators can use futures to capitalize on their expectation of a currency’s future movement. If a speculator expects a currency to appreciate in the future, they can buy a future contract that locks in the price for which they can buy the currency. Then at the settlement date, if the currency appreciated like the speculator expected, they buy the currency at the specified rate then sell it at the spot rate to make a profit. Currency futures can also be sold by speculators if they expect the spot rate of a currency to be less than the rate at which they would be obligated to sell it.

Front 47

. A put option on Australian dollars with a strikeprice of $.80 is purchased by a speculator for a premium of $.02. Assume theAustralian dollar’s spot rate is $.74 on the expiration date.

a. Should the speculator exercise the option on this date orlet the option expire?

Back 47

Yes the speculator should exercise the option

Front 48

A put option on Australian dollars with a strike price of $.80 ispurchased by a speculator for a premium of $.02. Assume the Australian dollar’sspot rate is $.74 on the expiration date.

b. What is the net profit per unit to the speculator?

Back 48

($.80-$.74-$.02) = $.04/unit

Front 49

A put option on Australian dollars with a strike price of $.80 ispurchased by a speculator for a premium of $.02. Assume the Australian dollar’sspot rate is $.74 on the expiration date.

c. What is the net profit per unit to the seller of this putoption?

Back 49

($.74-$.80+$.02) = -$.04/unit

Front 50

Differentiate between a currency call option and a currency put option.

Back 50

A currency call option grants the right to buy a specified currency at a designated strike price within a specific period of time. A currency put option grants the right to sell a currency at a specified strike price within a specified period of time. The main difference between the two is with a call option you are buying the currency, but with a put option you are selling a currency.

Front 51

Compute the forward discount or premium for the Mexican peso whose90-day forward rate is $.102 and spot rate is $.10. State whether youranswer is a discount or premium.

Back 51

(.102/.10) = 1.02 -1 = 2%. This is a premium because it is positive. The spot rate is greater than the forward rate.

Front 52

List the factors that affect currency call option premiums and brieflyexplain the relationship that exists for each. Do you think anat-the-money call option in euros has a higher or lower premium than anat-the-money call option in Mexican pesos (assuming the expiration date and thetotal dollar value represented by each option are the same for both options)?

Back 52

If the spot rate than the strike price, the call option is the greater value. If the time before the expiration date is longer, the call option is the greater value. If the currency’s exchange rate fluctuates a lot, the call option is the greater value. The at-the-money call option of euros has a lower premium than the at-the-money call option of pesos because the pesos are more volatile than the euro.

Front 53

List the factors that affect currency put options and briefly explainthe relationship that exists for each.

Back 53

The lower the existing spot rate to the strike price, the greater the put option value The longer the period before to the expiration date, the greater the put option value The greater the variability of the currency, the greater the put option value

Front 54

Alice Duever purchased a put option on British pounds for $.04 per unit. The strike price was $1.80 and the spot rate at the time the pound optionwas exercised was $1.59. Assume there are 31,250 units in a British poundoption. What was Alice’s net profit on the option?

Back 54

$1.80-1.59-.04=.17 31,250*.17=$5,312.50 So, $5312.50 was her net profit on the option.

Front 55

Mike Suerth sold a call option on Canadian dollars for $.01 per unit. The strike price was $.76, and the spot rate at the time the option wasexercised was $.82. Assume Mike did not obtain Canadian dollars until theoption was exercised. Also assume that there are 50,000 units in a Canadiandollar option. What was Mike’s net profit on the call option?

Back 55

$.76-.82+.01=-.05 50,000*-.05=-2,500 So, Mike’s net profit for the call option is -$2,500.

Front 56

Brian Tull sold a put option on Canadian dollars for $.03 per unit. The strike price was $.75, and the spot rate at the time the option wasexercised was $.72. Assume Brian immediately sold off the Canadiandollars received when the option was exercised. Also assume that there are50,000 units in a Canadian dollar option. What was Brian’s net profit onthe put option?

Back 56

$.75-.72-.03=0 50,000*0=0 So, Brian’s net profit is 0, or the break even point.