# International Financial Management. Prerequisites

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1 International Financial Management Prerequisites 1. The quoted interest rate is 5% p.a. What is the effective interest rate for 6 months if the quoted interest rate is a) simple, b) annually compounded, c) quarterly compounded or d) continuously compounded? 2. A deposit earns interest of 12% p.a., compounded quarterly. At which continuously compounded interest rate would a bond yield the same effective return as this deposit over a period of a) half a year and b) one year? Spot Exchange Markets 3. You have just graduated from the University of Florida and are leaving on a whirlwind tour of Europe. You wish to spend USD 1,000 each in Switzerland, France, and Great Britian (USD 3,000 in total). Your bank offers you the following bid-ask quotes: USD/ CHF , USD/EUR , and USD/GBP a) If you accept these quotes, how many CHF, EUR, and GBP do you have at departure? b) If you return with CHF 300, EUR 1,00, and GBP 75, and the exchange rates are unchanged, how many USD do you have? c) Suppose that instead of selling your remaining CHF 300 once you return home, you want to sell them in Paris. At the train station, you are offered EUR/CHF , while a bank three blocks from the station offers EUR/CHF At what rate are you willing to sell your CHF 300? How many EUR will you receive? 4. BankAustria quotes USD/EUR , and BankAmerica quotes EUR/USD a) Are these quotes identical? b) If not, is there a possibility for least cost dealing or arbitrage? c) If there is an arbitrage opportunity, how would you profit from it? 5. Please use these quotes to answer the following exercises: 1

3 9. Suppose that the expected spot rate between the Canadian Dollar and the US Dollar in one year is CAD/USD Moreover, let the current forward rate for 1 year equal this expected future spot rate. Draw a diagram which depicts the payoff from a) a forward sale and b) a forward purchase of 1 million USD for 1 year when the realized spot rate differs from the expected rate. The Value of a Forward Contract and Its Implication 10. Which of the following statements are correct? a) A forward purchase contract can be replicated by borrowing foreign currency, converting it into domestic currency, and investing the domestic currency. b) A forward purchase contract can be replicated by borrowing domestic currency, converting it into foreign currency, and investing the foreign currency. c) A forward sale contract can be replicated by borrowing foreign currency, converting it into domestic currency, and investing the domestic currency. d) A forward sale contract can be replicated by borrowing domestic currency, converting it into foreign currency, and investing the foreign currency. 11. After completion of your studies, you work as a trader at a bank's foreign exchange trading room. One day, you enter into a one-year forward purchase of EUR 10 m at USD/EUR An hour later, you see that the rate is now at USD/EUR a) How could you "lock in" your gain? b) At which price would you be willing to enter into the contract needed to set up this hedge? (Suppose that another trader offers to act as the counterparty to this contract conditional on the two of you "splitting the gain". What would be your reaction?) c) At which price would you sell your contract from one hour ago if the US interest rate is 2.25 % p.a.? 12. Please solve the following exercises: a) Given the following data, compute the value today of an outstanding forward purchase contract initiated at t 0 for units of foreign currency (where the exchange rate is HC/FC). Does the new value represent a gain or a loss to the holder of the old contract? (Hint: First compute the new forward rate.) Spot Rate Old Forward Rate r t,t r* t,t (1) USD/GBP 1,96 1,99 6,35% 5,10% (2) JPY/USD 107,62 109,05 3,20% 6,35% b) Repeat the previous question using the same data, but with an outstanding forward sale contract. 3

6 his margin account whenever he may do so, but that the first time he must make a margin-call, he fails to do so. (i.e. he does pay the initial margin as required). a) Show the value of any withdrawals which the man made, and the value of all margin-calls. b) If the man fails to pay the first margin-call, what does the broker do? What is the final settlement? 19. A German firm wants to hedge the EUR value of a CAD 1m inflow using futures contracts. On Germany's exchange, there is a futures contract for USD 100,000 at EUR/USD a) Your assistant runs a bunch of regressions: (1) S [ EUR / CAD] = α 1 + β1 f [ USD / EUR] (2) S [ EUR / CAD] = α 2 + β 2 f [ EUR / USD] (3) S [ CAD / EUR] = α 3 + β 3 f [ EUR / USD] (4) S [ CAD / EUR] = α 4 + β 4 f [ USD / EUR] Which regression is relevant to you? b) If the relevant β is 0.85, how many contracts do you buy? Sell? 20. A German exporter wants to hedge an outflow of NZD 1m. She decides to hedge the risk with a EUR/USD contract and a EUR/AUD contract. The regression output is, with the t-statistics shown in parentheses, and R2 = 0.59: [ EUR / NZD] = f [ EUR / USD] f [ EUR AUD] S α / (1.57) (17.2) a) How will you hedge if you use both contracts, and if the face value of a USD contract is for USD 50,000 and AUD contract for AUD 75,000? b) Should you use the USD contract, in view of the low t-statistic? Or should you only use the AUD contract? 21. On September 30 th 2004 a US importer learns that she will pay EUR 1,250,000 on January 30th The US importer decided to hedge this position, using EUR futures contracts with an expiration date on the third Wednesday in March On September 30 th the following exchange rates were quoted: Spot rate USD/EUR= 1,2700, futures rate for the expiration month of March 2005 is USD/EUR 1,3020. On January 30 th the CFO of the US importer reports that the total gain/loss on the hedged position (spot position plus futures position) was US\$ 10,000. a) Explain what the CFO must have done to implement this hedge. b) What must the basis have been on January 30 th? c) What would the basis on January 30 th need to be in order to make gain/loss of the hedged position zero? 22. When does a currency futures contract have a higher price than does a forward contract with the same time to maturity? Why? 6

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