Spot Exchange Markets

Question 1

You need to buy CHF 1,000,000 to pay your Swiss watch supplier. Your bank quotes bid-ask
rates of CHF/USD 1.3990 – 1.4000. What will be your dollar cost of the CHF 1,000,000?

The bid-ask rates of USD/CHF are:

1 1

1.4000 1.3990
 0.7143  0.7148

The dollar cost:

1
CHF 1, 000, 000 
1.3990
 USD 714, 796.28

Question 2

As a FX trader, you see the following quotes:

 USD/CAD 0.7047
 MXN/CAD 6.4390
 MXN/USD 8.7535

Is there an arbitrage opportunity, and if so, how would you exploit it?

The direct quote for the cross-rate of MXN/CAD 6.4390 should equal the implied cross-rate
using the dollar as an intermediary currency; otherwise there exists a triangular arbitrage
opportunity. The indirect cross rate is:
MXN USD
  8.7535  0.7047
USD CAD
 6.1686

To exploit the arbitrage opportunity:

 Borrow USD 1.
 Sell USD 1 for CAD, you get CAD 1.4190.
 Sell CAD 1.4190 for MXN, you get MXN 9.1372.
 Convert MXN 9.1372 into USD, you get USD 1.0438.
 This would yield a profit of USD 0.0438.
In this situation, buying the CAD with MXN by first buying USD with MXN and then buying the
CAD with the USD and finally selling that amount of CAD directly for MXN would make a profit
because we would be buying the CAD at a low MXN price and selling the CAD at a high MXN
price.

Question 3

HSBC quotes bid-ask rates of USD/EUR 1.3005 – 1.3007 and JPY/USD 104.30 – 104.40. What
would be HSBC’s direct asking price of JPY/EUR?

The direct asking price of yen per euro (¥/€) is the amount of yen that the bank charges someone
who is buying euros with yen. The bank would want this to be the same as the price at which it
sells dollars for yen (the bank’s ask price) times the price at which it sells euros for dollars (also
the bank’s ask price). Thus, the asking price of yen per euro should be:
JPY 104.40 USD 1.3007
  JPY EUR 135.79
USD 1 EUR 1
Understanding Forward Exchange Contracts
Question 1

Consider the following spot and forward rates for JPY/EUR:

Spot 30 Days 60 Days 90 Days 180 Days 360 Days

146.30 145.75 145.15 144.75 143.37 137.85

Is the EUR at a forward premium or discount? What are the magnitudes of the forward
premiums or discounts when quoted in percentage per annum for a 360-day year?

The forward rates of yen per euro are lower than the spot rates. Therefore, the euro is at a
discount in the forward market. The annualized forward premium or discount for the n day
forward contract is:
St  Ft ,T 360
 100
Ft ,T n

If the value of this calculation is negative, say -2%, we say there is a 2% discount. Therefore, the
discounts are 4.51% for 30 days, 4.72% for 60 days, 4.24% for 90 days, 4.01% for 180 days, and
5.78% for 360 days.

Question 2

You see the following quotes on your Reuters screen:

Spot 1-Month 2-Month 3-Month 6-Month

USD/EUR 1.0435/45 20/25 52/62 75/90 97/115
JPY/USD 98.75/85 12/10 20/16 25/19 45/35
USD/GBP 1.6623/33 30/35 62/75 95/110 120/130

(a) What are the outright forward bid and ask quotes for the USD/EUR at the 3-month maturity?

The spot bid and ask quotes for USD/EUR are 1.0435/45. These quotes mean that the bank
buys euros with dollars spot at $1.0435/€, and the bank sells euros for dollars at $1.0445/€.
Because the forward points at the 3-month maturity are 75/90, we know that we must add the
points to get the outright forward bid and ask rates. Adding the points makes the bid-ask
spread in the forward market larger than the bid-ask spread in the spot market.
Consequently, the forward bid rate is $1.0435/€ + $0.0075/€ = $1.0510/€, and the forward
ask quote is $1.0445/€ + $0.0090/€ = $1.0535/€.
(b) Suppose you want to swap out of USD 10,000,000 and into JPY for 2 months. What are the
cash flows associated with the swap?

When you swap out of $10,000,000 into yen in the spot market, you are selling dollars to the
bank. The bank buys dollars at its low bid rate of ¥98.75/$, so you get
¥98.75/$ × $10,000,000 = ¥987,500,000

When you contract to buy the $10,000,000 back from the bank in the 2-month forward
market, you must pay the bank’s ask rate of:
¥98.85/$ - ¥00.16/$ = ¥98.69/$

You subtract the points because the 2-month forward quote is 20/16. Subtracting the points
makes the bid-ask spread in the forward market larger than the bid-ask spread in the spot
market. Hence, the amount of yen you pay is:
¥98.69/$ × $10,000,000 = ¥986,900,000

(c) If one of your clients calls you and wants to buy GBP with USD in 6 months, what price
would you quote?

If the customer wants to buy pounds with dollars, the customer must pay the bank’s 6-month
ask rate. The spot quotes are 1.6623/33 which means the spot ask rate is $1.6633/£. The 6-
month forward points are 120/130. We add the points because the first one, 120, is less than
the second, 130. Hence, the outright forward quote would be:
$1.6633/£ + $0.0130/£ = $1.6763/£
Purchasing Power Parity
Question 1

Suppose that there is no uncertainty and PPP holds. The domestic and foreign p.a. interest rate
are 5 percent and 10 percent, respectively. The real p.a. interest rate is 2 percent. Solve the
following questions in the exact form, not with linear approximations.

(a) What is the inflation differential across countries?

To calculate the inflation differential across countries in exact form, one has to compute the
respective inflation rate for each country. According to Fisher equation, the inflation rate
for domestic country is:
1  Rd  1  rd 1  id 
1  0.05  1  0.02 1  id 
1.05
id  1
1.02
 0.029412

And the inflation rate for foreign country is:

1  R f  1  rf 1  i f 
1  0.10  1  0.02  1  i f 
1.10
if  1
1.02
 0.078431

Thus, the inflation differential is the difference of the two inflation rates from above:
id  i f  0.029412  0.078431
 0.049019

(b) Is the inflation differential equal to the change in the spot rate that is implicit in the forward
premium?

From the Relative PPP, the percentage change in the exchange rate can be inferred from the
following expression:
1  I t ,t 1
st ,t 1  1
1  I t*,t 1
1.029412
 1
1.078431
 0.04545
Since the question states that there is no uncertainty and PPP holds, from Interest Rate
Parity:
1  rt ,t 1 
Ft ,t 1  St  
1  rt ,t 1 
*

Ft ,t 1 1  rt ,t 1

St 1  rt*,t 1

Under the no uncertainty assumption, forward rate must equal future spot rate. That is,
Ft ,t 1  St 1 . Substitute this result into the above expression:
Ft ,t 1 1  rt ,t 1

St 1  rt*,t 1
St 1 1  rt ,t 1

St 1  rt*,t 1
St 1 1  rt ,t 1
1  1
St 1  rt*,t 1
1.05
st ,t 1  1
1.10
 0.04545

The above computations state that the Relative PPP (based on the inflation differential)
predicts a 4.545% drop in the exchange rate. This result (a 4.545% drop in the exchange
S F
rate) is consistent with the predictions from forward rate premium, t 1  1  t ,t 1  1 .
St St
Clearly, this result must hold because it is a direct application of the Unbiased Expectations
Hypothesis (UEH) under certainty case.
Question 2

Suppose that the price level in Canada is CAD 16,600, the price level in France is EUR 11,750,
and the spot exchange rate is CAD/EUR 1.35.

(a) What is the internal purchasing power of the Canadian dollar?

It is probably best to calculate the purchasing power of CAD 10,000. If we divide this
amount by the price level in Canada of CAD 16,600, we find:
CAD 10, 000
 0.6024 consumption bundles
CAD 16, 600 consumption bundles

(b) What is the internal purchasing power of the euro in France?

Performing a similar calculation to the one in part (a), we find:

EUR 10, 000
 0.8511 consumption bundles
EUR 11, 750 consumption bundles

(c) What is the implied exchange rate of CAD/EUR that satisfies absolute PPP?

The implied PPP exchange rate equates the internal purchasing power of the CAD to its
external purchasing power. This implies that the PPP exchange rate is the ratio of the
Canadian price level in Canadian dollars to the French price level in euros:
CAD 16, 600
 CAD EUR 1.4128
EUR 11, 750

(d) Is the EUR overvalued or undervalued relative to the CAD?

Because the actual exchange rate of CAD/EUR 1.35 is less than the PPP exchange rate, the
euro is undervalued on the foreign exchange market because it would have to strengthen to
move from CAD/EUR 1.35 to CAD/EUR 1.4128.

(e) What amount of appreciation or depreciation of the EUR would be required to return the
actual exchange rate to its PPP value?

The exchange rate moves from the actual value of CAD/EUR 1.35 to the PPP value of
CAD/EUR 1.4128 for a percentage change of 1.4128/1.35 – 1 = 0.0466. This is a 4.66%
appreciation of the euro versus the Canadian dollar.
Question 3

Suppose that in 2011, the Japanese rate of inflation is 2%, and the German rate of inflation is 5%.
If the euro weakens relative to the yen by 10% during 2011, what would be the magnitude of the
real depreciation of the euro relative to the yen?

The approximately correct answer is that the yen should strengthen by the differential in the
rates of inflation or 5% - 2% = 3%.

The exact answer is found from this equation:

1  I t ,T
st ,T  1
1  I t*,T
I t ,T  I t*,T

1  I t*,T

Since we are concerned about the strengthening of the yen, let the yen be the foreign currency
(FC), and let the euro be the domestic currency (HC). Then, the relative PPP formula states that
the rate of appreciation of the yen is:
I t ,T  I t*,T 0.05  0.02

1  I t*,T 1  0.02
 2.94%
The Balance of Payments
For the following exercises use the stylized balance of payments as given:
Question 1

For each of the following events show how it enters the balance of payments of Switzerland, if it
does. Remember that every transaction enters both on the credit and the debit side such that both
sides are exactly equal in the end. All transactions are denoted in Swiss Francs (CHF).

(a) A Swiss bank receives 10 million US dollars in fees for financial services provided to U.S.
customers. The fees are paid to a bank account of the Swiss bank in the U.S. Assume an
exchange rate of 1:1 between CHF and USD.

Switzerland BOP Credit (+) Debit (-)

Fees for financial services provided to CA CHF 10m
U.S. customers
Capital in bank account KA CHF 10m

(b) The Swiss bank withdraws the USD 10m from the bank account and buys Facebook shares.

Switzerland BOP Credit (+) Debit (-)

Capital in bank account KA CHF 10m
Portfolio investments KA CHF 10m

(c) A little later, the Facebook shares lost 50% of its value.

No change on the balance of payments.

(d) A conglomerate of Russian farmers buys tractors for CHF 100m from a Swiss tractor factory.
It pays by taking a loan form a Swiss bank.

Switzerland BOP Credit (+) Debit (-)

Export of tractors to Russia CA CHF 100m
Bank loan KA CHF 100m

(e) An immigrant from Kosovo working in Switzerland transfers CHF 20,000 to his family in
Kosovo. The family in Kosovo uses the money to buy kitchen equipment from a producer in
Switzerland.

Switzerland BOP Credit (+) Debit (-)

Export of goods CA CHF 20,000
Unilateral transfers CA CHF 20,000
(f) A banker living near the Swiss border in Germany works in Zurich and gets a bonus payment
of CHF 10,000. He spends all the money by inviting his friends to a lavish, all-inclusive ski
weekend in Zermatt.

Switzerland BOP Credit (+) Debit (-)

Services CA CHF 10,000
Compensation of employees CA CHF 10,000

(g) A Swiss resource trading firm buys a coal mine in South Africa worth CHF 100m. They pay
by selling shares of various South African companies.

Switzerland BOP Credit (+) Debit (-)

Portfolio investment KA CHF 100m
Direct investment KA CHF 100m

(h) A little later, the Swiss resource trading firm makes a profit of CHF 1m from the operation of
the mine. It decides to donate all the profit to a South African charity.

Switzerland BOP Credit (+) Debit (-)

Investment income CA CHF 1m
Unilateral transfers CA CHF 1m

(i) A pensioner living in Germany wants to exchange EUR 100,000 of his savings into Swiss
Francs. He holds his savings in a bank account in Germany. His German bank exchanges
the Euros for CHF 120,000 at the Swiss National Bank.

Switzerland BOP Credit (+) Debit (-)

Capital in bank accounts KA CHF 120,000
Official reserves RFX CHF 120,000

(j) A French investor receives CHF 100,000 worth of dividends from shares of various Swiss
companies. He invests the money in Swiss government bonds.

Switzerland BOP Credit (+) Debit (-)

Portfolio investment KA CHF 100,000
Investment income CA CHF 100,000
Question 2

The following graph shows time series for the current account, government debt and total
investment in Greece and Latvia between 1995 and 2007. We see that both countries ran
consistent current account deficits during this period. Comment on the differences between the
two countries given the information in the graph. Do you think the current account deficits have
been rather something “good” or something “bad” in these two countries?
If a country runs current account deficits, it is essentially borrowing from abroad. This is
neither inherently “good” or “bad”. How we judge current account deficits can depend on how
the country uses the resources it borrows. From the statistics one can speculate that in Latvia
the borrowings have been used primarily to finance investments. This might show that Latvia
has been considered a good place to invest. Since the investments are likely to increase growth
in Latvia, and therefore increase the income of Latvians, they might have no problems to
eventually pay back the debt.

On the other hand, in Greece no correlation between the current account deficits and investment
can be seen. Looking at the statistics, it rather seems that the borrowed funds have been used for
government consumption. If the money borrowed from abroad is used for consumption, it might
be harder for a country to pay it back later.

Question 3

The Philippines have a strongly negative trade balance but still a positive current account. How
is this possible? Which particular entry on the balance of payments do you think explains the
difference in the case of the Philippines? How would you interpret the fact that the Philippines
exhibit a current account surplus?

Using the stylized balance of payments, we can see that several categories in the current account
could account for the difference: services, labor income, unilateral transfers and investment
income. Investment income could account for the difference if the residents of the Philippines
get large investment income from assets they hold abroad. For a not wealthy country such as the
Philippines this is rather unlikely. Labor income could account for the difference if many people
who live in the Philippines work abroad. That is, they commute daily to a different country for
work. But for an island state, this seems impossible. Service could account for the difference if
the Philippines have large financial sector or a large tourist sector. This does not seem to be
true. Unilateral transfers are most likely to explain the difference. Many people from the
Philippines emigrate to work abroad. If they regularly send money to their families at home, this
creates a positive entry under unilateral transfers that could explain the difference between the
trade balance and the current account.

Remember that a positive current account always means that there is a negative capital account
(ignoring statistical errors). This means that the residents of the Philippines buy more foreign
assets than foreign residents buy assets in the Philippines. One could speculate that the reason
for this might be that the Philippines are not considered to be a good place to invest. Of course
that is only one of several possible interpretations of the positive current account.
Asset Approach of Exchange Rate Determination
Question 1

According to Monetary Theory, which of the following events lead to an appreciation of the
foreign currency?

(a) An increase in the velocity of domestic money.

Spot increases.

(b) An increase in real foreign economic output.

Spot increases.

(c) An increase in the foreign money supply.

Spot decreases.

(d) An increase in real domestic economic output.

Spot decreases.

(e) An increase in the velocity of foreign money.

Spot decreases.

Note:
v Y* L
S  *   *s
v Y Ls
Question 2

When using portfolio theory, we must make a number of assumptions. Which of the following
assumptions are made? Which are not?

(a) There are no information or transactions costs.

Correct.

(b) There are no taxes.

Correct.

(c) Investors want to know the distribution of wealth at the end of the period.

Not correct. Investors care only about the end-of-period distribution.

(d) Investors care about the future expected return on their portfolio and the variability of this
return.

Correct.

Question 3

Read each phrase below and decide whether it corresponds with Balance of Payments Theory
(BOP), Monetary Theory (MT), or Portfolio Theory (PT).

(a) The long-run equilibrium exchange rate follows from the equilibrium in the markets for the
demand and supply of domestic money and foreign money and the PPP model.

MT. An increase in domestic money supply, leads to an increase in S, i.e., depreciation in

home currency.

(b) All else being equal, any real economic activity in the home country results in an
appreciation of the home currency.

MT. An increase in expected real economic activity at home, leads to a decrease in S, i.e.,
appreciation in home currency.
(c) The spot rate is affected by the release of new information.

MT & PT. From Monetary Theory perspective, the release of new information may be
related to changes either in expected inflation, interest rate or money supply. From Portfolio
Theory, any new information may affect the expected risk and return on the assets and
therefore, changes the portfolio weights and also the exchange rate.

(d) To determine the equilibrium exchange rate, it suffices to know the supply and demand for
domestic and foreign goods.

BOP. The supply and demand for domestic and foreign goods will affect the Current
Account in the Balanced of Payment.

(e) All else being equal, an increase in the expected return on a risk-free foreign asset leads to a
depreciation of the home currency.

BOP. The increase in the expected return on a risk-free foreign asset leads to an outflow of
investment funds. Thus the rising demand for foreign currency leads to a depreciation of the
home currency.

(f) A monetary expansion weakens the value of the home currency, but has little or no effect on
real activity.

MT. A monetary expansion can be achieved via decreases in interest rate. The decrease in
interest rate will lead to depreciation in home currency.

(g) All else being equal, an increase in real economic activity in the home country results in a
depreciation of the home currency.

BOP. The increase in real activity is supposed to lead to an increase in imports and
therefore, a depreciation of the home currency.

(h) The equilibrium exchange rate is the one that equates the demand and supply of domestic and
foreign risk-free and risky assets.

PT. When the demand and supply of assets change, the portfolio weights have to change and
therefore, affect the exchange rate.

(i) If there is a domestic capital account surplus, foreign investors are purchasing more of the
country’s assets. This leads to a depreciation of the domestic currency.

None of the three. In case of Balanced of Payments Theory, the purchase of the country’s
assets will push up the demand on domestic currency. Instead of depreciation, the domestic
currency should appreciate.
(j) Excessive government spending financed by a monetary expansion stimulates an economy,
resulting in greater real output and a depreciation of the home currency.

BOP. The increase in real activity is supposed to lead to an increase in imports and
therefore, a depreciation of the home currency.
Risk and Return in Forward Markets
Question 1

True or False?

(a) UEH assumes that investors demand a premium for interest rate risk.

False. The UEH assumes that either investors are risk-neutral, or that all exchange risk is
diversifiable – that is, investors are indifferent between the certain forward rate and the
expected value of the (random) future spot rate.

(b) When computing the return from investing abroad, the capital gain earned on the foreign
interest (that is, the cross product) is negligible when interest rates are high and exchange rate
changes are small.

False. The return from investing abroad can be summarized as

1  rt ,t 1  st ,t 1   rt*,t 1   st ,t 1  . From this expression, although the exchange rate changes
*

are small, high interest rates clearly will bias the computation and make the cross product
term significant.

(c) When the percentage change in the spot rate is regressed on the forward premium. UEH
predicts β = -1, because a positive forward premium must make up for the depreciation in the
spot rate in the future, while a negative forward premium must make up for the appreciation
in the spot rate in the future.

False. The regression test of UEH predicts β = 1.

(d) Tests of UEH are ambiguous because it is difficult to distinguish between a true risk
premium and inefficiency (predictability in the forecast error).

True. Tests of UEH are ambiguous because they suffer from the deficiency from joint
hypothesis. Since inefficiency cannot be ruled out a prior, it is hard to distinguish between a
true risk premium and the predictability of the error (market inefficiency).

(e) By using a trading rule, you can systematically make risk-free money by investing in
currencies with high interest rates while financing the investment by borrowing in low
interest rate currencies.

False; there is risk. It is important to understand, however, that evidence of positive returns
in the exchange market does not necessarily imply that there are abnormal returns to be
made. Investing in the high-interest-rate foreign currency is not risk free.
(f) Tests using trading rules suggest that interest rate differentials tend to overcompensate for
expected depreciations.

True. Thomas (1986) finds that investing in currencies with high interest rates yields
positive returns. Taylor (1992) also finds that simple trading rules can generate positive
returns.

(g) High-interest currencies offer the highest returns for the lowest level of risk.

False; not the lowest risk. Froot and Thaler (1990) shows that while investing in high-
interest-rate currency, the risks associate with this strategy is large.

(h) The Fisher Open Relationship explains international differences in interest rates by
international differences in inflation.

True. Mathematically, the relationship can be characterized by:

1  rt ,T

1   1  I 
t ,T t ,T

1 r *
t ,T 1   1  I 
*
t ,T
*
t ,T

(i) In a PPP framework, the Fisher Open Relationship explains international differences in
interest rates by international differences in inflation.

False. The PPP framework is a market arbitrage condition that explains the relationship in
inflation differential and rate of change of a spot rate. However, Fisher Open Relationship
is a general equilibrium condition derived from first order optimality conditions from
individual’s utility optimization.

(j) According to the Fisher Equation, the expected real rate of return is a function of expected
inflation and an exogenous nominal interest rate.

False. The Fisher Open Relationship gives:

      
Et  t*,T   Et  t ,T   Et  st ,t 1    rt ,T  rt*,T   Et  st ,t 1    Et I t ,T  Et I t*,T 
It is therefore a function of the forward bias and the expected deviation from Relative PPP.

(k) Because the forward rate is a biased predictor of the future spot rate, it is not useful for
evaluating projects whose payoffs depend on an uncertain future spot rate.

False. The bias in the forward rate does not necessarily imply that the forward rate contains
no information. The forward rate is still the certainty equivalent future spot rate. Thus, the
forward rate can be used to find the risk-adjusted value of future cash flows whose value
depends on the spot rate.
Question 2

It is often argued that forward exchange rates should be unbiased predictors of future spot
exchange rates if the foreign exchange market is efficient. Is this true or false? Why?

Market efficiency means that asset prices accurately incorporate all available information and
expected returns on assets correspond to true sources of risk. If forward rates are biased
predictors of future spot exchange rates, the source of the bias could be an equilibrium risk
premium. Thus, the claim that forward exchange rates should be unbiased predictors of future
spot exchange rates if the foreign exchange market is efficient is wrong.
Currency Options
Question 1

True or False?

(a) When you sell a put option on euros, you incur an obligation to buy euros at the option of the
purchaser of the contract.

True.

(b) A short put on pounds for dollars is equivalent to a long call on dollars for pounds.

False. The option writer has an obligation to sell pounds and to buy dollars.

(c) An option to buy pounds at a price of K($/£) is equivalent to an option to sell dollars at K(£/$)
= 1/ K($/£).

True.

(d) A synthetic forward contract can be constructed by combining a long call with a short put on
the same currency with exercise prices equal to the forward rate of exchange.

True.

Question 2

You write a call option on pounds and give it to John Ho to compensate him for some consulting
work on risk management. The contract size is £125,000 and the exercise is £0.6344/$. If the
option expires when the spot rate is £0.6285/$, will John’s treasure chest of dollars grow larger
or smaller? By how much? Assume John Ho takes any profit in dollars. What is your profit or
loss on this transaction?

This is an option on pounds, so it is convenient to use the dollar price of the pound. John’s call
is an option to buy pounds at (£0.6344/$)-1 =$1.5763/£. The spot rate at expiration is
(£0.6285/$)-1 =$1.5911/£.

John’s gain at expiration is ($1.5911/£ - $1.5763/£) = $0.0148/£, or $0.0148/£ × £125,000 =

$1,850. John has a long position in the option and you have the short position. So John’s gain
is your loss.
Contractual Exposure to Exchange Rate
Question 1

Consider a U.S.-based company that exports goods to Switzerland. The U.S. company expects
to receive payment on a shipment of goods in three months. Because the payment will be in
Swiss francs, the U.S. company wants to hedge against a decline in the value of the Swiss franc
over the next three months. The U.S. risk-free rate is 2 percent, and the Swiss risk-free rate is 5
percent. Assume that interest rates are expected to remain fixed over the next six months. The
current sport rate is $0.5974.

(a) Indicate whether the U.S. company should use a long or short forward contract to hedge
currency risk.

The risk to the U.S. company is that the value of the Swiss franc will decline and it will
receive fewer U.S. dollars on conversion. To hedge this risk, the company should enter into a
contract to sell Swiss francs forward.

(b) Calculate the no-arbitrage price at which the U.S. company could enter into a forward
contract that expires in three months.

S0 = $0.5974
T = 90/365
r = 0.02
r* = 0.05
 0.5974 
F (0, T )   90 / 365 
(1.02) 90/ 365  $0.5931
 (1.05) 

(c) It is now 30 days since the U.S. company entered into the forward contract. The spot rate is
$0.55. Interest rates are the same as before. Calculate the value of the U.S. company’s
forward position.

St = $0.55
T = 90/365
t = 30/365
T – t = 60/365
r = 0.02
r* = 0.05
$0.55 $0.5931
Vt (0, T )  60 / 365
  $0.0456
(1.05) (1.02) 60/ 365

This represents a gain to the short position of $0.0456 per Swiss franc. In this problem, the
U.S. company holds the short forward position.
Question 2

Suppose that you are a U.S.-based importer of goods from the United Kingdom. You expect the
value of the pound to increase against the U.S. dollar over the next 30 days. You will be making
payment on a shipment of imported goods in 30 days and want to hedge your currency exposure.
The U.S. risk-free rate is 5.5 percent, and over the U.K. risk-free rate is 4.5 percent. These rates
are expected to remain unchanged over the next month. The current sport rate is $1.50.

(a) Indicate whether you should use a long or short forward contract to hedge the currency risk.

The risk to you is that the value of the British pound will rise over the next 30 days and it will
require more U.S. dollars to buy the necessary pounds to make payment. To hedge this risk,
you should enter a forward contract to buy British pounds.

(b) Calculate the no-arbitrage price at which you could enter into a forward contract that expires
in 30 days.

S0 = $1.50
T = 30/365
r = 0.055
r* = 0.045
 $1.50 
F (0, T )   30 / 365 
(1.055) 30/ 365  $1.5018
 (1.045) 

(c) Move forward 10 days. The spot rate is $1.53. Interest rates are unchanged. Calculate the
value of your forward position.

St = $1.53
T = 30/365
t = 10/365
T – t = 20/365
r = 0.055
r* = 0.045
$1.53 $1.5012
Vt (0, T )  20 / 365
  $0.0295
(1.045) (1.055) 20/ 365

Because you are long, this is a gain of $0.0295 per British pound.
Question 3

As an importer of iPhone into Japan from the U.S., you have agreed to pay USD 377,287 in 90
days after you receive your iPhone. You face the following rates:
 Spot rate: JPY/USD 106.35.
 90-day forward rate: JPY/USD 106.02.
 90-day USD interest rate: 3.25% p.a.
 90-day JPY interest rate: 1.9375% p.a.

(a) Describe the nature and extent of your transaction foreign exchange risk.

As a Japanese importer, you are contractually obligated to pay $377,287 in 90 days. Any
weakening of the yen versus the dollar will increase the yen cost of your phone. The possible
loss is unbounded.

(b) Explain two ways to hedge the risk.

You could hedge your risk by buying dollars forward at ¥106.02/$. Alternatively, you could
determine the present value of the dollars that you owe and buy that amount of dollars today
in the spot market. You could borrow that amount of yen to avoid having to pay today.

(c) Which of the alternatives in part (b) is superior?

If you do the forward hedge, you will have to pay ¥106.02/$ × $377,287 = ¥39,999,967.74 in
90 days.

If you do the money market hedge, you first need to find the present value of $377,287 at
3.25%. The de-annualized interest rate is (3.25/100) × (90/360) = 0.008125. Thus, the
present value is:
$377,287 / 1.008125 = $374,246.25

Purchasing this amount of dollars in the spot market costs:

¥106.35/$ × $374,246.25 = ¥39,801,088.69

To compare this value to the forward hedge, we must take its future value at 1.9375% p.a.
The de-annualized interest rate is (1.9375/100) × (90/360) = 0.00484375, and the future
value is:
¥39,801,088.69 (1.00484375) = ¥39,993,875.21

The cost of the money market hedge is essentially the same as the cost of the forward hedge
because interest rate parity is satisfied.
Operating Exposure to Exchange Rate
Question 1

Suppose that you hold a piece of land in the city of Munich that you may want to sell in one year.
As a U.S. resident, you are concerned with the dollar value of the land. Assume that if the
German economy booms in the future, the land will be worth EUR 2,000, and one euro will be
worth USD 1.40. If the German economy slows down, on the other hand, the land will be worth
less, say, EUR 1,500, but the euro will be stronger, say USD/EUR 1.50. You feel that the
German economy will experience a boom with a 60 percent probability and a slowdown with a
40 percent probability.

(a) Estimate your exposure to the exchange risk.

Let us compute the necessary parameter values:

E(P) = (.6)($2,800) + (.4)($2,250) = $1,680 + $900 = $2,580

E(S) = (.6)(1.40) + (.4)(1.5) = 0.84 + 0.60 = $1.44

Var(S) = (.6)(1.40 – 1.44)2 + (.4)(1.50 – 1.44)2 = .00096 + .00144 = .0024

Cov(P,S) = (.6)(2,800 – 2,580)(1.4 – 1.44) + (.4)(2,250 – 2,580)(1.5 – 1.44)

= -5.28 + -7.92 = -13.20

b = Cov(P,S)/Var(S) = -13.20/.0024 = -€5,500

You have a negative exposure! As the euro gets stronger (weaker) against the dollar, the
dollar value of your German holding goes down (up).

(b) Compute the variance of the dollar value of your property that is attributable to exchange rate
uncertainty.

b2Var(S) = (-5500)2(.0024) =72,600($)2

(c) Discuss how you can hedge your exchange risk exposure and also examine the consequences
of hedging.

Buy €5,500 forward. By doing so, you can eliminate the volatility of the dollar value of your
German asset that is due to the exchange rate volatility.
Question 2

An Australian firm holds asset in Switzerland and faces the following scenario:

State 1 State 2 State 3 State 4

Probability 25% 25% 25% 25%
Spot Rate AUD/CHF 1.20 AUD/CHF 1.10 AUD/CHF 1.00 AUD/CHF 0..90
P* CHF 1,500 CHF 1,400 CHF 1,300 CHF 1,200
P AUD 1,800 AUD 1,540 AUD 1,300 AUD 1,080

In the previous table, P* is the Swiss franc price of the asset held by the Australian firm and P is
the Australian dollar price of the asset.

(a) Compute the exchange exposure faced by the Australian firm.

E(S) = .25(1.20 + 1.10 + 1.00 + 0.90) = AUD1.05/CHF

E(P) = .25(1,800 + 1,540 + 1,300 + 1,080) = AUD 1,430

Var(S) = .25[(1.20 – 1.05)2 + (1.10 – 1.05)2 + (1.00 – 1.05)2 + (0.90 – 1.05)2]

= .0125

Cov(P,S) = .25[(1,800 – 1,430)(1.20-1.05) + (1,540 – 1,430)(1.10 – 1.05)

(1,300 – 1,430)(1.00 – 1.05) + (1,080 – 1,430)(0.90 – 1.05)]
= 30

b = Cov(P,S)/Var(S) = 30/0.0125 = CHF 2,400

(b) What is the variance of the Australian dollar price of this asset if the Australian firm remains
unhedged against this exposure?

Var(P) = .25[(1,800 – 1,430)2 + (1,540 – 1,430)2 + (1,300 – 1,430)2 + (1,080 – 1,430)2]

= 72,100(AUD)2

(c) If the Australian firm hedges against this exposure using a forward contract, what is the
variance of the Australian dollar value of the hedged position?

Var(P) – b2Var(S) = 72,100 – (2,400)2(0.0125) = 100(AUD)2

This means that most of the volatility of the Australian dollar value of the Swiss asset can be
removed by hedging exchange risk. The hedging can be achieved by selling CHF2,400
forward.
Question 3

CWater, of Seattle, Washington, produces equipment to clean polluted waters. It has a

subsidiary in Canada that imports and markets its parent’s products. The value of this subsidiary,
in terms of CAD, has recently decreased to CAD 5m due to the depreciation of the CAD relative
to the USD (from the traditional level of USD/CAD 0.85 to about 0.75). CWater’s analysts
argue that the value of the CAD may very well return to its former level if, as seems reasonable,
the uncertainty created by Canada’s rising government deficit is resolved. If the CAD recovers,
CWater’s products would be less expensive in terms of CAD, and the CAD value of the
subsidiary would rise to about 6.5m.

(a) From the parent’s (USD) perspective, is the exposure of CWater Canada to the USD/CAD
exchange rate positive or negative? Explain the sign of the exposure.

When S(low) =0.75; the value in USD is 5m × 0.75 = USD 3.75m.

When S(high) = 0.85; the value in USD is 6.5m × 0.85 = USD 5.525m.

Thus, the exposure is strongly positive. This is because CWater Canada is an importing firm.
The stronger the CAD, the more competitive US products are in Canada and, therefore, the
more profits CWater Canada will make.

(b) Determine the exposure, and verify that the corresponding forward hedge eliminates this
exposure. Use a forward rate of USD/CAD 0.80, and USD/CAD 0.75 and 0.85 as the
possible future spot rates.

5.525m  3.75m
Exposure   17.75m
0.85  0.75
If S = 0.75, the value is 3.75m + 17.75m × (0.80 – 0.75) = USD 4.6375m.
If S = 0.85, the value is 5.525m + 17.75m × (0.80 – 0.85) = USD 4.6375m.

(c) CWater’s chairman argues that, as the exposure is positive and the only possible exchange-
rate change is an appreciation of the CAD, the only possible change is an increase in the
value of the subsidiary. Therefore, he continues, the firm should not hedge: why give away
the chance of gain? How do you evaluate this argument?

The chairman overlooks two facts. First, only part of the gain from an appreciation is
eliminated by the hedge. Second, if the appreciation does not materialize, CWater will have
a gain from the forward contract that alleviates the competitiveness problems associated
with a low value of the CAD. In short, the hedge swaps part of the gain from an appreciation
for a partial gain in case there is no appreciation.