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Explain the difference between a natural hedge and a contractual hedge. Provide a hypothetical example.

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  1. Explain the difference between a natural hedge and a contractual hedge. Provide a hypothetical example.
  2. Explain the difference between foreign currency options and forwards. Explain when either might be most appropriately used.
  3. Define and explain the theory of comparative advantage. What are the major limitations of the theory in explaining international trade?
  4. Define and interpret the theory of purchasing power parity. Provide at least two specific managerial decision scenarios, where as a manager, you will apply the main elements of this theory.
  5. Define foreign exchange exposure, and explain the differences among transaction, operating, and translation exposures.

 

Question 2:     Answer both short essays.                                           (total of 40 points)

  1. What are the three major functions of the foreign exchange market? (total of 15 points)
  2. Define and explain each of the following. 5 points each (total of 25 points)
    1. Interest rate parity
    2. International Fisher effect
    3. Covered interest arbitrage
    4. Yen carry trade
    5. Exchange rate pass-through

Question 3:                                                                                         (total of 50 points)

Singh Designer Corporation is expecting to receive 2,000,000 euros in 3 months. The treasury department provides the following information in Table 3.1.

Table 3.1. Transaction Exposure Example

Financial Information Values
Transaction amount € 2,000,000
Spot rate $/euro 1.754
90-day forward 1.765
Cost of capital 14%
Euro 3-month borrow 0.02
Euro 3-month investment 0.02
U.S. 3-month borrow 0.03
U.S. 3-month investment 0.015
Expected spot 1.78
Options  
Maturity 90 days
Strike price: X 1.65
Premium 1.25%

 

You are required to furnish a recommendation as to whether Singh Corporation should:

  1. remain unhedged,
  2. hedge with forwards,
  3. set up a money market hedge, or
  4. hedge with options.

Make sure you support your recommendation with potential payoffs attributable to each possible alternative described above.

 

Question 4:                                                                                         (total of 50 points)

  1. Use Table 4.1 for the spot and forward bid-ask rates for the Japanese yen/U.S. dollar (¥/$) exchange rate to answer the following questions.

Table 4.1. Spot and Forward Bid-ask Rates                                      

Period   Days Forward   Bid Rate   Ask Rate
spot        114.23    114.27
1 month   30    113.82    113.87
6 months   180    112.05    112.11
24 months   720    106.83    106.98

 

 

 

 

 

  1. Calculate the mid-rates from the bid-ask rate quotes.
  2. Calculate the forward premium on the different maturities using the mid-rates from Part A of Question 4.
  1. You have SF 10,000,000. Given the information in Table 4.2 on the three currency rates of different banks, can you make riskless profit on the Swiss francs by triangular arbitrage? Show your steps and the amount of profit.

Table 4.2. Currency Rates

Given Parameter Values
Beginning funds in Swiss francs (SF)  10,000,000.00
Bank of Japan (¥/$)  120.00
Swiss Banking Corp (SF/$)  1.6000
Royal Bank (¥/SF)  80.00

 

Question 5:                                                                                         (total of 30 points)

Jason Smith is a currency trader.  He has $10 million (or its Swiss franc equivalent) for a short-term money market investment. He faces the following quotes:

Arbitrage funds available                                            $10,000,000

Spot exchange rate (SFr./$)                                        1.1050

3-month forward rate (SFr./$)                                     1.0575

U.S. dollar 3-month interest rate                                5.800%

Swiss franc 3-month interest rate                               4.100%

Make a recommendation if he should invest in U.S. dollars for three months, or make a covered interest arbitrage investment in the Swiss franc. Show the steps and arbitrage profits payoffs.

 

Question 6:                                                                                        (total of 40 points)

Matt works for a currency trader. He expects that the Australian dollar (AUD) will appreciate versus the U.S. dollar over the coming 90 days. The current spot rate is $0.5750/AUD. Matt has the following options available based on the Australian dollar as shown in Table 6.1:

Table 6.1. Australian Dollar

Current spot rate (US$/AUD) $0.5750  
Days to maturity 90  
     
Option choices on the AUD): Call option Put option
    Strike price (US$/AUD) $0.6000 $0.6000
    Premium (US$/AUD) $0.0149 $0.0004

 

  1. Which option should Matt buy?
  2. What is Matt’s breakeven price on the option purchased?
  3. What is Matt’s gross profit and net profit (including premium) if the ending spot rate is $0.6600/AUD?
  4. What is Matt’s payoff if the spot rate is $0.5550/AUD