UNSW Business School
FINS3616 International Business Finance
Term 1 2019
Midterm 2 Review
Unique Exam Number: 8008135
Student ID:
First name(s):
FAMILY NAME:
Instructions:
1. You must complete a Generalised Answer Sheet for this exam.
(a) Complete the top portion of the sheet, providing your family name,
initials, and student number.
(b) You must correctly enter your question booklet’sUnique Exam Num-
ber under the Other Data section of the Generalised Answer Sheet.
2. Your answer sheet will NOT be graded if you do not return the entire
question booklet at the completion of the examination. Do not remove the
staple or separate the pages of the booklet.
3. Only the single student whose full name, student number, AND signature is
written on this question booklet will be graded according to its answer key.
4. This exam paper has 39 pages and consists of 30 multiple choice questions
of EQUAL weight (2 marks each). There is no negative marking.
5. Time allowed: 100 mins (There is no reading time)
6. Total marks available: 60 marks (worth 25% of the overall course grade)
7. A ONE MARK penalty will be applied for failing to correctly enter both
your unique exam number and other details on the answer sheet.
Signature:
Equations
DO NOT DETACH
F (t, d/f) = S(t, d/f)× 1 + id
1 + if
(1)
E(rA) = rf + β [E(rm)− rf ] (2)
annualized rate = de− annualized rate× 360
N
× 100 (3)
E [S(t+ k, d/f)] = S(t, d/f)× 1 + id
1 + if
(4)
fmr(t+ k) =
S(t+ k)− F (t)
S(t)
(5)
exr(t+ k) =
S(t+ k)
S(t)
[1 + if ]− [1 + id] (6)
P (t) =
N∑
i=1
wiP (t, i) (7)
PI(t+ k) =
P (t+ k)
P (t)
(8)
1 + pi(t+ 1) =
P (t+ 1)
P (t)
(9)
S(t, d/f) =
P (t, d)
P (t, f)
(10)
1 + s(d/f) =
1 + pid
1 + pif
(11)
RS(t, d/f) =
S(t, d/f)× P (t, f)
P (t, d)
(12)
1 + rep =
1 + i
1 + pi
(13)
DO NOT DETACH
2
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 1
You just moved from the United Kingdom to Switzerland to go to school at the
University of Zurich for 7 months (210 days). Upon opening a bank account,
you realise that interest rates here are much higher than they are in the United
Kingdom. Lucky for you, you don’t need to incur any debt while you are in
Switzerland. However, you will need to invest some money.
You have two options: you can either invest in the United Kingdom where annu-
alised 7 month rates are currently 3.5% or you can convert your British pounds
into Swiss francs (with a current spot rate of GBP1.2829/CHF and invest in an
annualised 7 month rate of 7.4%.
Given this information, what is the annualised forward premium or discount that
the Swiss franc should trade at against the British pound in the 210-day forward
market as implied by interest rate parity?
a. 3.82% premium
b. 3.82% discount
c. 3.74% discount
d. 3.77% premium
e. 3.63% discount
Question 2
You live in Australia and want to try to make some money through interest rate
arbitrage abroad. You notice the following rates quoted online:
Bid Ask
Spot exchange rate AUD 1.1858/USD AUD 1.1899/USD
270-day Forward exchange rate AUD 1.2584/USD AUD 1.2632/USD
270-day USD interest rate 6.70% p.a. 6.92% p.a.
270-day AUD interest rate 8.82% p.a. 9.30% p.a.
What will your profit (in AUD) be 270 days from now if you borrow AUD7 million
and invest in the United States then convert back to the Australian dollar?
a. AUD 271,117
b. AUD 306,495
c. AUD 286,725
d. AUD 357,533
e. AUD 324,139
Exam code: 8008135 1
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 3
Suppose the current spot exchange rate between the U.S dollar (USD) and the
Canadian dollar (CAD) is USD0.7346/CAD. You estimate the beta of buying
Canadian dollar forward with U.S dollar and subsequently selling Canadian dollar
for U.S dollar in the spot market to be 0.8. You also estimate the expected rate of
return on the market portfolio in excess of the risk-free interest rate to be 9.0%.
What is the expected spot rate in one year given a one year forward rate of
USD0.6856/CAD?
a. USD0.7875/CAD
b. USD0.7385/CAD
c. USD0.7312/CAD
d. USD0.7840/CAD
e. USD0.7350/CAD
Question 4
What does the ’carry trade’ term mean?
a. Borrow in the domestic currency to earn only the higher yield of the dollar
implied by the regression.
b. None of these explanations define the term ’carry trade’.
c. Borrow in the foreign currency to earn both the higher yield and the expected
capital appreciation of the dollar implied by the regression.
d. Borrow in the domestic currency to earn both the higher yield and the
expected capital appreciation of the dollar implied by the regression.
e. Borrow in the foreign currency to earn only the expected capital appreciation
of the dollar implied by the regression.
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FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 5
Suppose the current one-year interest rate in Brazil is 10.00% while a similar
one-year rate in Bolivia is 3.00%. You estimate the beta of making an unhedged
investment of Brazilian Real in the Bolivian Boliviano money market to be 1.75.
What is the beta of purchasing Bolivianos one-year forward with Real and selling
Boliviano in the spot market in one-year?
a. 1.70
b. 1.80
c. 1.61
d. 1.93
e. 1.59
Question 6
Assume that CHF14,053 is the current price level in Switzerland, while CAD15,698
is the current price level in Canada for an equivalent bundle of goods.
Given a spot exchange rate of CHF1.0494/CAD, what is the internal and external
purchasing power of CHF0.60 million? Is the Swiss franc overvalued or underval-
ued relative to the Canadian dollar?
a. 38.22 consumption bundles; 40.69 consumption bundles; undervalued
b. 40.69 consumption bundles; 38.22 consumption bundles; overvalued
c. 42.70 consumption bundles; 36.42 consumption bundles; undervalued
d. 38.22 consumption bundles; 40.69 consumption bundles; overvalued
e. 42.70 consumption bundles; 36.42 consumption bundles; overvalued
Exam code: 8008135 3
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 7
You are considering two job offers, one in France and one in Switzerland. The
position in France pays EUR184,000 per year. The price level for a basket of
goods in France is EUR22,074 and CHF18,223 for an equivalent basket of goods
in Switzerland. The current spot rate is EUR1.1445/CHF. Assume that you are
otherwise indifferent between these two locations.
How much would the job in Switzerland need to pay you to make you equally well
off as the job in France?
a. CHF151,900
b. CHF160,769
c. CHF210,588
d. CHF149,226
e. CHF222,884
Question 8
The American Consumer Price Index (CPI) is currently 159.3 and the French CPI
is currently 164.1. Economists expect that in one year the American CPI will be
169.4 and the French CPI will be 177.7. The current spot exchange rate between
the two countries is EUR0.8158/USD.
If relative purchasing power parity holds, what is the expected spot exchange rate
in one year?
a. EUR0.8307/USD
b. EUR0.7777/USD
c. EUR0.8011/USD
d. EUR0.8816/USD
e. EUR0.7919/USD
Exam code: 8008135 4
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 9
If ________ holds, then the real exchange rate is equal to 1.
a. uncovered interest rate parity
b. covered interest rate parity
c. the Fisher Effect
d. relative purchasing power parity
e. absolute purchasing power parity
Question 10
A local restaurant serves German (or at least as close to it as you can get in
Sydney) food prepared from local ingredients. They do, however, import several
brands of beer (bier) directly from Germany. Currently the average price they pay
for the beer is EUR34.82 per case. Last year the restaurant purchased 1,495 cases.
The restaurant had revenues (net of other costs) of AUD104,800 and they expect
that revenue to increase with the local rate of inflation, 4.1%, over the next year.
The price of German beer is expected to increase at the rate of German inflation,
1.7%. The current exchange rate is AUD1.2691/EUR and remained unchanged
from last year.
If the Euro experiences a real appreciation of 9.9% relative to the Australian dollar
this year, and if the restaurant purchases the same amount of beer as last year,
by how much will real profits change?
a. -12.22%
b. -17.17%
c. -13.48%
d. -16.88%
e. -12.56%
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FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 11
Assume that the Euro (EUR) futures price for September is $1.80. Given that
125,000 units are in a Euro futures contract, the seller of Euro futures will receive
______________ on the delivery date.
a. $125,000.0
b. $225,000.0
c. $69,444.4
d. $117,444.4
e. $405,000.0
Question 12
Which one of the statements below is TRUE regarding the features of currency
forward and currency futures contracts?
I. Forward contracts are over-the-counter contracts that can be customized
based on the hedger’s need.
II. Counter-party risk is limited in futures contract because of the margin re-
quirement and marking-to-market practice.
III. In futures markets, losses and profits are recognized on a daily basis.
IV. A company can negotiate the delivery date on a futures contract to make
the currency be delivered on the date it desires.
a. I, II, and III
b. I, II, and IV
c. I, III, and IV
d. II, III, and IV
e. I, II, III, and IV
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FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 13
An Canadian company has purchased currency put options to hedge a 200,000
Australian dollar (AUD) receivable. The premium is CAD0.0154 and the exercise
price of the option is CAD0.7750. Assume that the spot rate at the time of
maturity is CAD0.8204.
Ignoring the time value of money, what is the net amount received by the company
if it acts rationally?
a. CAD161,000
b. CAD167,160
c. CAD164,080
d. CAD155,000
e. CAD151,920
Question 14
Which of the following is false regarding options?
I. The writer of a call option has the obligation to purchase the underlying
currency from the option purchaser if the option is exercised.
II. The purchaser of a call option has the right to purchase the underlying
currency at the strike price
III. The purchaser of a put option has the right to sell the underlying currency
at the strike price.
IV. The writer of a put option has the obligation to purchase the underlying
currency from the option purchaser if the option is exercised
a. I
b. II
c. III
d. IV
e. None of the above. All statements are correct.
Exam code: 8008135 7
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 15
A put option is available for Swiss franc with an exercise price of AUD0.7268 and
a premium of AUD0.0220. Assume that there are no brokerage fees.
The future spot rate at which the _____________ of the option breaks even
is AUD_______ .
a. buyer; AUD0.7488
b. buyer; AUD0.7048
c. seller; AUD0.7048
d. Both a and c are correct.
e. Both b and c are correct.
Question 16
Consider the following fixed-for-fixed currency swap in Euros and British pounds.
The notional principals are GBP67,914,000 and EUR63,000,000, and the GBP
rate is 5.50% while the EUR rate is 3.75%. Payments are made semiannually, and
the current exchange rate is GBP1.0780/EUR. What are the interest payments
each period?
a. EUR1,732,500; GBP1,273,388
b. EUR1,273,388; GBP3,465,000
c. EUR1,181,250; GBP1,181,250
d. EUR1,867,635; GBP1,181,250
e. EUR1,181,250; GBP1,867,635
Exam code: 8008135 8
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 17
Consider the following fixed borrowing rates available to Brady Corp and to Grey
Corp in both the U.S. dollar (USD) and the Euro (EUR):
USD rate EUR rate
Brady Corp 10.00% p.a. 16.90% p.a.
Grey Corp 7.50% p.a. 11.30% p.a.
One firm has an absolute advantage in borrowing in both currencies. Assume
that each firm borrows at its comparative advantage and then enters into a swap
with a financial intermediary. Under the swap, the financial intermediary makes
the payments to the firms that each need to cover the loans borrowed at their
comparative advantages. In exchange, the financial intermediary requires payment
at 16.40% p.a. in the Euro from the firm that has a comparative advantage in
borrowing the U.S. dollar, while also requiring payment at 6.60% p.a. in the U.S.
dollar from the other firm.
What is the net benefit to the intermediary from such a swap?
a. 1.55% p.a.
b. 3.10% p.a.
c. 9.80% p.a.
d. 1.70% p.a.
e. This swap would be a net loss to the financial intermediary.
Question 18
Consider currency swaps. Which statement below is NOT TRUE?
a. Both counterparties can benefit from a swap even if one counterparty has
the comparative advantage in all types of borrowing.
b. The differences in how credit risk is priced gives rise to comparative advan-
tage in borrowing through swaps.
c. When an intermediary is involved in a swap, the intermediary assumes the
counterparty risk for both ends of the transaction.
d. All currency swaps have an NPV of zero when the contract is signed.
e. None of the above. All of the statements are correct.
Exam code: 8008135 9
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 19
Which of the following is NOT TRUE with respect to MNCs management of
transaction exposure?
a. An MNCmay decide not to hedge if its inflow currencies are highly correlated
with its outflow currencies.
b. Generally, decisions on whether to hedge, how much to hedge, and how to
hedge will vary with the MNC management’s degree of risk aversion.
c. MNCs generally perceive their foreign exchange management as a profit
centre.
d. MNCs that hedge most of their exposure do not necessarily expect that
hedging will always be beneficial.
e. None of the above. All of the statements are true.
Question 20
Furry Company needs 200,000 Canadian dollars (CAD) in 120 days and is trying
to determine whether or not to hedge this position. Furry has developed the
following probability distribution for the Canadian dollar:
Possible CAD value in 120 days Probability
AUD0.6100 12%
AUD0.6520 23%
AUD0.6760 41%
AUD0.6930 24%
The 120-day forward rate of the Canadian dollar is AUD0.6650, and the expected
spot rate of the Canadian dollar in 120 days is AUD0.6666. If Furry implements
a forward hedge, what is the probability that hedging will be more costly to the
company than not hedging?
a. 76%
b. 64%
c. 88%
d. 35%
e. 12%
Exam code: 8008135 10
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 21
If you fear the Australian dollar will rise against the euro, with a resulting adverse
change in the Australian dollar value of the equity of your Spanish subsidiary
which uses euros, you can hedge this translation exposure by
a. reducing cash in the Australian dollar.
b. increasing borrowing in the Australian dollar.
c. delaying accounts payable in the euro.
d. tighten credit terms to decrease accounts receivable in the Australian dollar.
e. None of the above will hedge this translation exposure.
Question 22
Suppose that La Oficina de Envigado, a Colombian multinational entity, is selling
its product in Australia for AUD127,000 per kilogram when the exchange rate is
AUD1 = COP2,350. If the AUD appreciates to COP2,470, what price must La
Oficina de Envigado charge to maintain its COP unit revenue?
a. AUD123,467
b. AUD127,364
c. AUD133,485
d. AUD120,830
e. AUD125,407
Exam code: 8008135 11
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 23
Hybrid Air Vehicles Limited is a British manufacturer of hybrid airships. These
aircraft use both aerodynamics and lighter-than-air technology to generate lift,
potentially allowing the vehicle to stay aloft for several weeks. The company
sells its products to U.S. airlines and buys parts from U.S. companies. Suppose
it has accounts receivable of $890 million and accounts payable of $350 million.
It also has borrowed $400 million. The current spot rate is $1.75/£. Which
of the following statement is NOT TRUE regarding Hybrid Air Vehicles’ dollar
transaction exposure?
a. If the pound appreciates to $1.95/£, the company will gain £8.2 million on
its dollar transaction exposure.
b. As the company’s cash inflows and outflows are in foreign currencies, the
company is exposed to risks from potential exchange rate changes between
now and when these transaction settle.
c. Hybrid Air Vehicles’ dollar transaction exposure is $140 million.
d. Hybrid Air Vehicles’ pound transaction exposure is £80 million.
e. None of the above. All statements are true.
Question 24
Press F, a BBB-rated firm, desires a fixed rate, long-term loan. Press F presently
has access to floating interest rate funds at a margin of 1.75% p.a. over LIBOR.
Its direct borrowing cost is 9.61% p.a. in the fixed rate bond market. In contrast,
B.D. Energy, which prefers a floating rate loan, has access to fixed rate funds in
the Eurodollar bond market at 6.45% p.a. and floating rate funds at LIBOR +
0.24% p.a. Suppose they enter into an interest rate swap contract, which a broker
agrees to arrange for a fee of 0.35% p.a. and they agree to split the cost savings
equally. Due to this arrangement, Press F will have achieved a cost of ____ p.a.
for its fixed rate money and B.D. Energy will have achieved a cost of ____ p.a.
for its floating rate money?
a. 8.96%; LIBOR− 0.41%
b. 8.79%; LIBOR− 0.59%
c. 8.86%; LIBOR− 1.06%
d. 8.96%; LIBOR− 0.59%
e. 8.86%; LIBOR− 0.41%
Exam code: 8008135 12
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 25
Suppose the Swiss franc revalues from $0.4213 at the beginning of the year to
$0.4680 at the end of the year. U.S. inflation is 4.2% and Swiss inflation is 7.6%
during the year. What is the real devaluation (-) or real revaluation (+) of the
Swiss franc during the year?
a. -12.1%
b. +12.1%
c. +7.6%
d. +14.7%
e. -12.8%
Exam code: 8008135 13
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
The following information is used for the next THREE questions
American Airlines is trying to decide how to go about hedging CHF80 million in
ticket sales receivable in 300 days. Suppose it faces the following exchange and
interest rates:
Spot rate: USD1.0335/CHF
Forward rate (300 days): USD1.0017/CHF
300-day put option on CHF at USD1.03/CHF 1% premium
300-day call option on CHF at USD1.00/CHF 2% premium
300-day CHF interest rate (annualized): 8.5%
300-day USD interest rate (annualized): 4.6%
Question 26
Which hedging strategy does NOT help American Airlines hedge the transaction
risk on the exchange rate changes?
a. Invoicing ticket sales in US dollars rather than Swiss Franc.
b. Enter into currency risk sharing contract and include Price Adjustment
Clause.
c. Buy a 300-day CHF call option.
d. Buy a 300-day CHF put option.
e. Enter into a forward contract to sell CHF at USD1.0017/CHF.
Question 27
Which of the following is closest to the hedged value of American Airlines’ ticket
sales using a forward market hedge?
a. USD80,928,430
b. USD80,136,000
c. USD82,680,000
d. USD79,864,230
e. USD77,406,870
Question 28
Which of the following is closest to the hedged value of American Airlines’ ticket
sales using a money market hedge?
a. USD79,829,720
b. USD80,170,650
c. USD80,292,980
d. USD79,708,090
e. USD80,662,350
Exam code: 8008135 14
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Question 29
Caterpillar, a U.S. large construction equipment manufacturer, exports 40% of
its $500 million in annual sales: 15% to Canada and 5% each to Japan, U.K,
Germany, France, and Italy. It incurs all its costs in U.S. dollars, while most of
its export sales are priced in the local currency. Which one of the statements is
NOT TRUE regarding the impact of exchange rate changes
a. If the U.S. dollar appreciates, revenue will increase in dollar terms.
b. If Caterpillar raises its foreign currency prices in response to dollar appreci-
ation, it will lose market shares in foreign markets.
c. Caterpillar can lower operating exposure by financing 40% of its financing
in foreign currencies.
d. Caterpillar can hedge its transaction exposure by selling its foreign currency
receipts forward for dollars.
e. None of the above. All statements are true.
Question 30
Suppose the current spot rate for the AUD is GBP0.7211. The call premium on
a call option with an exercise price of GBP0.6767 is GBP0.0578. What is the
intrinsic value of one AUD62,500 call option?
a. GBP3,612.50
b. GBP6,387.50
c. GBP837.50
d. GBP2,775.00
e. GBP38,681.25
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FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 1: c
We must de-annualize the rates from 360 days down to the per 210-day (i.e. per
7-month) periodic rate.
First, the British pound:
r210GBP = rAPRGBP × n
360
= 3.5%× 210
360
= 0.0204167 = 2.04167% per 210 days
(1)
Then, the Swiss franc:
r210CHF = rAPRCHF × n
360
= 7.4%× 210
360
= 0.0431667 = 4.31667% per 210 days
(2)
Then calculate the forward premium or discount using the Covered Interest Rate
Parity relationship. As we are calculating the percentage premium or discount and
not the outright forward rates, we do not need the spot exchange rate. That is, the
answer to this question can be calculated solely from the interest rate differential.
fCHF210 =
[
1 + r210GBP
1 + r210CHF
]
− 1
=
[
1 + 0.0204167
1 + 0.0431667
]
− 1
= 0.9781914− 1
= −0.0218086 = −2.18086% per 210 days
(3)
Then we re-annualize this percentage back to a 360-day year:
fCHF = fCHF210 ×
360
n
= −0.0218086× 360
210
= −0.0373862 = −3.73862% per annum
(4)
As this number is negative, this means that the Swiss franc trades at an annualized
forward discount of 3.74% per annum against the British pound.
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FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 2: c
As we are borrowing the Australian dollar from the market, we pay the higher
9.30% p.a. ask rate (...and not the lower bid rate) on our money-market loan.
This rate is annualized for a 360-day year, so we must first de-annualize it to
match the 270-day maturity of the forward contract.
r270AUD = rAPRAUD × n
360
= 9.30000%× 270
360
= 0.0697500 = 6.97500% per 270 days
(1)
As we are investing in the U.S dollar, we will receive the lower 8.82% p.a. bid rate
(...and not the higher ask rate) on our money-market investment. Again, we must
de-annualize this rate from a 360-day year to match the 270-day maturity of the
forward contract:
r270USD = rAPRUSD × n
360
= 6.70000%× 270
360
= 0.0502500 = 5.02500% per 270 days
(2)
In order to borrow AUD7 million today in the present, we must pay back the
future value of that amount in 270 days at the above periodic interest rate of
6.975000%. That is, our Australian dollar repayment (interest plus principal) is:
FVAUD270 = PVAUD0 ×
(
1 + r270AUD
)
= AUD7, 000, 000.00× (1 + 0.0697500)
= AUD7, 488, 250.00 repaid 270 days from now
(3)
To invest our borrowed AUD7 million in the U.S dollar, we must first convert
our funds in today’s spot market. That is, we sell our AUD in order to buy
USD. As the exchange rates are quoted AUD......./USD, we can view this as the
Australian dollar price of one U.S dollar. In order to buy the U.S dollar, we must
pay the higher AUD 1.1899/USD ask price (...and not the lower bid price). We
are therefore able to convert our borrowed Australian dollar funds into:
PVUSD0 =
PVAUD0
SpotAUD/USD0
=
AUD7, 000, 000.00
AUD1.1899/USD
= USD5, 882, 847.30 bought at today’s spot rate
(4)
With the above U.S dollar that we have bought at today’s spot ask rate, we then
invest it at the U.S dollar bid interest rate of 5.025000% per 270 days (...which
comes from the deannualized 6.70% p.a.). At the end of the 270 days, our initial
AUD investment will have grown to and ending balance of:
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FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
FVUSD270 = PVUSD0 ×
(
1 + r270USD
)
= USD5, 882, 847.30× (1 + 0.0502500)
= USD6, 178, 460.37 received 270 days from now
(5)
As this is a money-market investment where our yield is locked in at the time of
the initial investment, the above U.S dollar investment return is a known quantity
and not just an estimated amount. Therefore, we can confidently enter into a
forward contract to convert these USD to get back to AUD. That is, buy AUD
by selling USD. As always, to determine whether to use the bid forward rate
or the ask forward rate, we should focus on the action that we are taking with
the base currency of the quotes. That is, as the exchange rates are quoted in
terms of AUD......../USD, we should focus on the fact that we are selling the U.S
dollar (USD) at the forward rate. And when we sell, we must do so at the lower
forward bid rate of AUD 1.2584/USD (...and not the higher forward ask price).
We calculate the locked-in Australian dollar value of our U.S dollar investment
returns at this forward bid rate as follows:
FVAUD270 = FVUSD270 × ForwardAUD/USD270
= USD6, 178, 460.37× AUD1.2584/USD
= AUD7, 774, 974.54 received at the 270-day forward bid rate
(6)
A critical and common mistake that is frequently made at this stage of the ar-
bitrage calculation is to compare the amount received on the forward contract
(AUD7,774,974.54) to the amount we initially borrowed (AUD7,000,000.00) and
say that the difference is the arbitrage profit. However, we borrowed that initial
amount at a point of time 270 days before we receive the cash flow on the for-
ward contract. We cannot just ignore the time value of money nor the fact that
we have to pay interest on our borrowed funds. That is, at the end of the 270
days, we must pay back a total of AUD7,488,250.00 (i.e. 6.975000% more than
the AUD7,000,000.00 than we borrowed), as we calculated in Equation (3). Our
arbitrage profit is therefore the following difference between what we receive on
the forward contract (in 270 days) and what we must pay back on this loan (also
in 270 days):
Arbitrage ProfitAUD = FVAUD270 − FVUSD270
= AUD received on Forward− AUD repaid on loan
= AUD7, 774, 974.54− AUD7, 488, 250.00
= AUD286, 724.54 of arbitrage profit in 270 days
(7)
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FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 3: b
From the lecture slides, we know that the expected forward market return for each
unit of the Canadian dollar (CAD) bought at the forward rate can be written as
follows:
E (Forward Market Return) =
E
(
SpotUSD/CAD1 − ForwardUSD/CAD1
)
SpotUSD/CAD0
(1)
We also know the forward contract may command a risk premium and that the
above can be equated to CAPM:
E
(
SpotUSD/CAD1 − ForwardUSD/CAD1
)
SpotUSD/CAD0
= βForward ×Market Risk Premium (2)
Substituting in the values that we were given in the question:
E
(
SpotUSD/CAD1
)
− USD0.6856/CAD
USD0.7346/CAD = 0.8× 9.0%
(3)
We can then see that the amount by which the spot rate one year from now is
expected to exceed the today’s one-year forward rate (of USD0.6856/CAD) is a
function of today’s spot rate (of USD0.7346/CAD) and the risk premium on the
contact (of 7.20%):
E
(
SpotUSD/CAD1
)
− USD0.6856/CAD = USD0.7346/CAD× 7.20% (4)
Or expressed directly in currency units (in the format USD....../CAD), that pre-
mium is expected to be:
E
(
SpotUSD/CAD1
)
− USD0.6856/CAD = USD0.0529/CAD (5)
So the expected value of the spot rate in one year is therefore:
E
(
SpotUSD/CAD1
)
= USD0.6856/CAD+ USD0.0529/CAD
= USD0.7385/CAD
(6)
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FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 4: c
Answer 5: a
In the lecture slides we are told how to calculate this beta:
βForward =
βUnhedged
1 + rbase (1)
Given the specific values in this question, we can calculate the beta of purchasing
Bolivianos (BOB) forward with the Brazilian real (BRL) of:
βForward =
βUnhedged
1 + rBOB
=
1.75
1 + 0.0300
= 1.7000 = 1.70
(2)
To elaborate, this adjustment to the unhedged beta of the money market invest-
ment in Bolivianos is the same adjustment that would be made to the excess
return of that same money market investment to get the forward market return,
where by ”excess return on the money market investment” we mean the following
Excess Money Market Return = Spot
BRL/BOB
1
SpotBRL/BOB0
× (1 + rBOB)− (1 + rBRL) (3)
The lecture slides show us that, to account for the time value of money and the
corresponding different number of units invested, the relationship between the
excess money market return and the forward market return is:
Forward Market Return = Excess Money Market Return
1 + rBOB (4)
So, given the above, and given that we know the expected excess money market
return on the BRL investment into the BOB can be found with CAPM as follows:
E (Excess Money Market Return) = βUnhedged ×Market Risk Premium (5)
..and we know the market risk premium is a constant in CAPM, then the same
transformation that was done to the excess return earlier is what is done to the
unhedged beta to get the equivalent expected excess forward market return:
E (Excess Money Market Return)
1 + rBOB =
βUnhedged
1 + rBOB ×Market Risk Premium
E (Forward Market Return) = βForward ×Market Risk Premium
(6)
Exam code: 8008135 20
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 6: c
Answer 7: a
With an income of EUR184,000 in France and a price level EUR22,074 per con-
sumption bundle, each year your position could buy you:
Purchasing Power (EUR) = Income (EUR)Price Level (EUR)
=
EUR184, 000
EUR22, 074/bundle = 8.33560 bundles
(1)
In order to be ”equally well off” in Switzerland as in France, your Swiss franc
income each year would also need to allow you to buy 8.33560 bundles in Switzer-
land. That is:
Purchasing Power (CHF) = 8.33560 bundles = Purchasing Power (EUR) (2)
Given that a single consumption in Switzerland costs CHF18,223, our annual
income that makes us equally as well off as in France would need to be:
Income (CHF) = Purchasing Power (CHF)× Price Level (CHF)
= 8.33560 bundles× CHF18, 223/bundle
= CHF151, 900 per annum
(3)
Exam code: 8008135 21
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 8: a
This question requires a simple application of Relative PPP to calculate the ex-
pected spot rate. The only additional step is to first calculate the forecast inflation
rates (denoted pi in the equations below) in each country.
First, the inflation rate in France:
piEUR =
CPIEUR1 − CPIEUR0
CPIEUR0
=
177.7− 164.1
164.1
= 0.082876 = 8.2876% (1)
And then the inflation rate in the United States:
piUSD =
CPIUSD1 − CPIUSD0
CPIUSD0
=
169.4− 159.3
159.3
= 0.063402 = 6.3402% (2)
Finally, apply the Relative Purchasing Power Parity equation to forecast the ex-
change rate at the end of the year (using the actual spot exchange rate at the
start of the year and the two forecast inflation figures we have calculated above):
E
(
SEUR/USD1
)
= SEUR/USD0
[
1 + piEUR
1 + piUSD
]
= EUR0.8158/USD
[
1 + 0.082876
1 + 0.063402
]
= EUR0.8307/USD one year from now
(3)
Alternatively:
E
(
SEUR/USD1
)
= SEUR/USD0 ×
CPIUSD0
CPIEUR0
× CPI
EUR
1
CPIUSD1
= EUR0.8158/USD× 159.3
164.1
× 177.7
169.4
= EUR0.8307/USD one year from now
(4)
This second method essentially first strips today’s price levels from today’s spot
rate to calculates the real exchange rate right now. Then, holding that real ex-
change rate constant across the year (...which is the very definition of Relative
PPP holding), it applies the new forecast price levels to calculate what end-of-
year nominal spot rate would maintain that same real exchange rate.
Exam code: 8008135 22
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 9: e
Answer 10: d
To answer this question, there are four basic steps:
i. Calculate what the firm’s profit was in its domestic currency (the Australian
dollar) at the beginning of the period prior to any changes occurring.
ii. Calculate the new prices and new exchange rates after the year has passed.
iii. Recalculate the firm’s profit in the Australian dollar at the end of the year
using these new values.
iv. Remove the effects of the firm’s domestic AUD inflation in order to find the
change in the real profit.
ABRIDGED SOLUTION (no rounding done until final answer):
First, the original cost at t=0:
CostAUD0 = Q× PEUR0 × SAUD/EUR0
= 1, 495× EUR34.82/case× AUD1.2691/EUR = AUD66, 064.14 (1)
Then the t=0 profit:
ProfitAUD0 = RevAUD0 − CostAUD0
= AUD104, 800.00− AUD66, 064.14 = AUD38, 735.86 (2)
Then the new nominal spot rate at t=1:
SAUD/EUR1(Actual) = S
AUD/EUR
0
[
1 + piAUD
1 + piEUR
]
× (1 + ∆RSEUR% )
= AUD1.2691/EUR
[
1 + 0.041
1 + 0.017
]
× (1 + 0.099)
= AUD1.4277/EUR
(3)
And the new total cost at t=1:
CostAUD1 = Q× PEUR1 × SAUD/EUR1
= 1, 495× [EUR34.82/case (1 + 0.017)]× AUD1.4277/EUR
= AUD75, 581.28
(4)
And the new t=1 nominal profit:
ProfitAUD1 = RevAUD1 − CostAUD1
= AUD104, 800.00 (1 + 0.041)− AUD75, 581.28 = AUD33, 515.52 (5)
And the change in real profits from t=0 to t=1:
Exam code: 8008135 23
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∆Real ProfitAUD% =
Real ProfitAUD1
ProfitAUD0
=
AUD33, 515.52÷ (1 + 0.041)
AUD38, 735.86 − 1 = −16.88%
(6)
A longer STEP-BY-STEP SOLUTION solution is presented below.
At the start of the period, the firm buys each case at a price of EUR34.82/case.
In its domestic Australian dollar, this amounts to a price of:
Old PriceAUD = Old PriceEUR × SAUD/EUR0
= EUR34.82/case× AUD1.2691/EUR
= AUD44.19/case
(1)
With the firm importing 1,495 cases, the total cost in its domestic AUD must be:
Old Foreign CostAUD = Old PriceAUD ×Quantity Bought
= AUD44.19/case× 1, 495 cases
= AUD66, 064.14
(2)
And with the firm’s domestic revenue net of other costs (i.e. excluding the cases)
being AUD104,800.00, we can now include those foreign-based costs calculated
above and calculate the firm’s total nominal profit (at t=0) as follows:
Old ProfitAUD0 = Old RevenueAUD(less. Other Costs) −Old Foreign CostsAUD
= AUD104, 800.00− AUD66, 064.14
= AUD38, 735.86
(3)
This AUD38,735.86 above is the start of year profit that the firm will subsequently
compare our end-of-year profit against, both in nominal terms and in real terms.
But first, we must calculate the new values of each of the relevant figures that we
used above.
The new price of the imported goods is:
New PriceEUR = Old PriceEUR × (1 + piEUR)
= EUR34.82/case× (1 + 0.017)
= EUR35.41/case
(4)
Before we can calculate the equivalent price in our domestic Australian dollar, we
must first calculate the new end-of-year spot exchange rate.
Given the relative inflation figures, according to Relative PPP we would expect
the nominal spot rate to change to:
E
[
SAUD/EUR1
]
= SAUD/EUR0
[
1 + piAUD
1 + piEUR
]
= AUD1.2691/EUR
[
1 + 0.041
1 + 0.017
]
= AUD1.2990/EUR
(5)
Exam code: 8008135 24
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
But given the information about the 9.9% change in the real value (denoted below
as ∆RSEUR% ) of the Euro, the new nominal spot rate must have become:
1 + ∆RSEUR% =
SAUD/EUR1(Actual)
SAUD/EUR0
[
1 + piEUR
1 + piAUD
]
1 + 0.099 =
SAUD/EUR1(Actual)
AUD1.2691/EUR
[
1 + 0.017
1 + 0.041
]
SAUD/EUR1(Actual) = AUD1.2691/EUR
[
1 + 0.041
1 + 0.017
]
× (1 + 0.099)
SAUD/EUR1(Actual) = AUD1.4277/EUR
(6)
As you rearrange the second step to the third step in equation (6) above to solve
for the actual nominal spot rate, you might notice that you can replace part of
the calculation with our calculate of the expected spot rate in equation (5) above.
That is:
SAUD/EUR1(Actual) = S
AUD/EUR
0
[
1 + piAUD
1 + piEUR
]
× (1 + ∆RSEUR% )
= E
[
SAUD/EUR1
]
× (1 + ∆RSEUR% )
= AUD1.2990/EUR× (1 + 0.099)
= AUD1.4277/EUR
(7)
With our new end-of-year nominal spot rate of AUD1.4277/EUR above, we can
now calculate the firm’s domestic currency equivalent price per case.
New PriceAUD = New PriceEUR × SAUD/EUR1(Actual)
= EUR35.41/case× AUD1.4277/EUR
= AUD50.56/case
(8)
At this stage of the question, all calculations involving exchange rates are complete.
The remainder of the question will proceed in the firm’s domestic Australian dollar.
The firm is still selling 1,495 cases in this next period, so given the new price above
we can find the firm’s total cost of the foreign imports from Germany as:
New Foreign CostAUD = New PriceAUD ×Quantity Bought
= AUD50.56/case× 1, 495 cases
= AUD75, 581.28
(9)
The firm’s domestic revenues net of other costs would have inflated at their do-
mestic currency rate of inflation also, per the assumption given in the question.
So therefore:
Exam code: 8008135 25
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
New RevenueAUD(less. Other Costs) = Old RevenueAUD(less. Other Costs) ×
(
1 + piAUD
)
= AUD104, 800.00× (1 + 0.041)
= AUD109, 096.80
(10)
The firm’s new nominal profit at the end of the year (i.e. at t=1) is therefore:
New ProfitAUD1 = New RevenueAUD(less. Other Costs) − New Foreign CostsAUD
= AUD109, 096.80− AUD75, 581.28
= AUD33, 515.52
(11)
And the nominal percentage change in the firm’s profits is:
∆ProfitAUD% =
New ProfitAUD1
Old ProfitAUD0
− 1
=
AUD33, 515.52
AUD38, 735.86 − 1 = −13.48%
(12)
But given the domestic inflation figure of 4.1%, the firm’s real profit at the end
of the year (i.e. expressed in the purchasing power that the Australian dollar had
one year beforehand at t=0) was:
New Real ProfitAUD1 =
New ProfitAUD
1 + piAUD
=
AUD33, 515.52
1 + 0.041
= AUD32, 195.51
(13)
And so therefore the real change in the firm’s profits over this year is:
∆Real ProfitAUD% =
New Real ProfitAUD1
Old ProfitAUD0
− 1
=
AUD32, 195.51
AUD38, 735.86 − 1 = −16.88%
(14)
Exam code: 8008135 26
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 11: b
Answer 12: a
Answer 13: a
Answer 14: a
Answer 15: e
The breakeven point for an option does NOT vary with which side of the trans-
action you are on (i.e. buyer or seller), but only with the type of option that it is
(i.e. call or put).
A put option on the Swiss franc with an exercise price of AUD0.7268/CHF will
only finish ”in the money” if the price of the underlying CHF is below that exercise
price. That is, no-one who purchased a put option that gives them the right to sell
CHF at a price of AUD0.7268/CHF would exercise that right if they could instead
sell it in the spot market at a higher price. For every AUD0.0001 that the CHF
is below that exercise price at maturity, the put option will have a AUD0.0001
positive payoff (i.e. intrinsic value) at maturity.
However, the purchaser of a put option paid the option premium of AUD0.0220/CHF
in order to get that right. So even though the put option would be still exercised if
the underlying spot price is even slightly lower than the AUD0.7268/CHF exercise
price, the option will only break even if the payoff at maturity (i.e. the difference
between the exercise and the spot price) is at least as great as the option premium
paid of AUD0.0220/CHF.
Similarly, from the perspective of the put option seller, they have received the
option premium of AUD0.0220/CHF up front. However, they may be required to
purchase the underlying CHF at the option’s maturity if the purchaser decides to
exercise their option. If this does happen, the option seller will have to pay only
the exercise price of AUD0.7268/CHF as compensation to the buyer. So for each
AUD0.0001 that the price of the CHF in the spot market is below that exercise
price, the seller of the put option will be losing AUD0.0001. If the spot price of the
underlying CHF finishes exactly AUD0.0220/CHF below AUD0.7268/CHF, then
all of the premium they received would be wiped out from the negative payoff.
So for both the buyer AND seller of a put option:
BreakEvenPut = ExercisePricePut +OptionPremiumPut
= AUD0.7268/CHF− AUD0.0220/CHF
= AUD0.7048/CHF
(1)
The above is the correct answer and is the breakeven for the put option for both
the buyer and the seller.
Exam code: 8008135 27
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
If the question had instead asked about a call option with the same exercise price
and premium, the breakeven for both the buyer and seller of that call option would
be:
BreakEvenCall = ExercisePriceCall +OptionPremiumCall
= AUD0.7268/CHF+ AUD0.0220/CHF
= AUD0.7488/CHF
(2)
Exam code: 8008135 28
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 16: e
Answer 17: d
We shall go through two methods to answer this question. The first is probably
the most straightforward.
First, re-array the borrowing borrowing costs in a 2x2 table as below (note that
the axes have been flipped from the original table in the question):
Type Grey Corp Brady Corp
Fixed EUR 11.30% 16.90%
Fixed USD 7.50% 10.00%
It can be seen that Grey Corp can borrow at a cheaper cost than Brady Corp in
both fixed USD and fixed EUR. That is to say, that Grey Corp has the absolute
advantage in both types of financing.
We then calculate the magnitude of this absolute advantage in each type of fi-
nancing by subtracting the borrowing cost of Grey Corp from that of Brady Corp
for each type. We prefer to do it this way (as opposed to Grey Corp minus Brady
Corp) so we do not have to work with negative numbers in the results if we don’t
have to.
For fixed USD borrowing costs:
Absolute AdvantageGreyUSD = CostBradyUSD − CostGreyUSD
= 10.00%− 7.50% = 2.50% (1)
For fixed EUR borrowing costs:
Absolute AdvantageGreyEUR = CostBradyEUR − CostGreyEUR
= 16.90%− 11.30% = 5.60% (2)
We then add these numbers to the table:
Type Grey Corp Brady Corp Difference
Fixed EUR 11.30% 16.90% 5.60%
Fixed USD 7.50% 10.00% 2.50%
As Grey Corp’s absolute advantage is largest in fixed EUR, we say that it also
has the comparative advantage in borrowing fixed EUR. And as Brady Corp’s
absolute dis-advantage is the smallest in fixed USD, we say that it has the com-
parative advantage in fixed USD.
So to be specific:
• Grey Corp has the comparative advantage in borrowing fixed EUR at 11.30%
• Brady Corp has the comparative advantage in borrowing fixed USD at
10.00%
Exam code: 8008135 29
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
• Per the question info, each firm borrows from the market at those rates
Now to introduce the swap bank.
The question states that the swap bank will enter into a swap with each of the
two firms, where it will agree to pay each firm the amount they need to cover the
loans that it took from the market at their comparative advantages. So given this
fact and what we have identified above, we now know that means that the:
• Swap bank will pay fixed EUR at 11.30% to Grey Corp
• Swap bank will pay fixed USD at 10.00% to Brady Corp
The question also states that under the swap contract, the swap bank will receive
16.40% in the EUR from the firm that has a comparative advantage in borrowing
the USD (i.e. we now know this is Brady Corp), while also receiving payment at
6.60% in the USD from the firm with a comparative advantage in EUR (...which
we now know is Grey Corp).
So the swap bank has an outflow in each currency and an inflow in each currency.
Factoring in these four payment streams together, we can calculate the swap bank’s
net position as:
Swap Bank Gain =
(
Infrom GreyUSD −Outto BradyUSD
)
+
(
Infrom BradyEUR −Outto GreyEUR
)
= (6.60%− 10.00%) + (16.40%− 11.30%)
= (−3.40%) + (5.10%)
= 1.70%
(3)
The above is just one way that you could get to the final answer. Another method
is as follows:
i. Find the total gain from the swap to be shared between all parties (i.e.
Brady Corp, Grey Corp, and the swap bank)
ii. After having identified the comparative advantages per the earlier method,
work out how much of that total gain that both Brady Corp and Grey Corp
are receiving through the swap compared to if they had instead borrowed
directly in the market.
iii. The leftover gain must be attributed to the swap bank.
So coming back to the earlier table where we had included the magnitude of Grey
Corp’s absolute advantage in each type of loan as a final ”Difference” column:
Type Grey Corp Brady Corp Difference
Fixed EUR 11.30% 16.90% 5.60%
Fixed USD 7.50% 10.00% 2.50%
The total gain from the swap to be shared by all parties is therefore:
Exam code: 8008135 30
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Total Swap Gain = DifferenceEURFixed −DifferenceUSDFixed
= 5.60%− 2.50%
= 3.10%
(4)
Under Grey Corp’s swap with the bank:
• Grey pays fixed EUR at 11.30% to the market (its comparative advantage)
• Grey receives fixed EUR at 11.30% from the bank (canceling the above)
• Grey pays fixed USD at 6.60% to the swap bank
Given that two of the three above payments cancel out, we can say that Grey
Corp’s net borrowing cost after the swap is just its obligation to the swap bank
in fixed USD of 6.60%. Given that, according to the original information in the
table, Grey Corp could have borrowed fixed USD in the market directly at a cost
of 7.50%, the savings to Grey Corp due to the swap are:
Swap GainGrey = Market CostGreyUSD − Net Swap CostGreyUSD
= 7.50%− 6.60%
= 0.90%
(5)
Similarly, under Brady Corp’s swap with the bank:
• Brady pays fixed USD at 10.00% to the market (its comparative advantage)
• Brady receives fixed USD at 10.00% from the bank (canceling the above)
• Brady pays fixed EUR at 16.40% to the swap bank
Again, 2 of 3 payments cancel out, so we can say that Brady Corp’s net borrowing
cost after the swap is just its obligation to the swap bank in fixed EUR of 16.40%.
And again, according to the original information in the table, Brady Corp could
have borrowed fixed EUR in the market directly at a cost of 16.90%. So the
savings to Brady Corp due to the swap are:
Swap GainBrady = Market CostBradyEUR − Net Swap CostBradyEUR
= 16.90%− 16.40%
= 0.50%
(6)
So we now know that, out of the total 3.10% gain from the swap to be shared by
all parties, that Grey Corp and Brady Corp receive gains (i.e. reduced borrowing
costs) of 0.90% and 0.50% respectively. This means that the swap bank receives
as profit the leftover gain of:
Swap Bank Gain = Total Swap Gain− (Swap GainGrey + Swap GainBrady)
= 3.10%− (0.90% + 0.50%)
= 1.70%
(7)
Answer 18: a
Exam code: 8008135 31
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
Answer 19: c
Answer 20: d
Answer 21: c
Answer 22: d
Answer 23: a
Answer 24: a
First, array the borrowing borrowing costs in a 2x2 table as below:
Type B.D. Energy Press F
Fixed 6.45% 9.61%
Floating LIBOR+0.24% LIBOR+1.75%
It can be seen that B.D. Energy can borrow at a cheaper cost than Press F in both
fixed and floating. That is to say, that B.D. Energy has the absolute advantage
in both types of financing.
We then calculate the magnitude of this absolute advantage in each type of fi-
nancing by subtracting the borrowing cost of B.D. Energy from that of Press F
for each type. We do it this way (as opposed to B.D. Energy minus Press F) so
we do not have to work with negative numbers in the results if we don’t have to.
For fixed borrowing costs:
Absolute AdvantageB.D. EnergyFixed = CostPress FFixed − CostB.D. EnergyFixed
= 9.61%− 6.45%
= 3.16%
(1)
For floating borrowing costs:
Absolute AdvantageB.D. EnergyFloating = CostPress FFloating − CostB.D. EnergyFloating
= (LIBOR+ 1.75%)− (LIBOR+ 0.24%)
= 1.51%
(2)
We then add these numbers to the table:
Type B.D. Energy Press F Difference
Fixed 6.45% 9.61% 3.16%
Floating LIBOR+0.24% LIBOR+1.75% 1.51%
Exam code: 8008135 32
FINS3616 2019 T1 Midterm 2 Review Exam code: 8008135
As B.D. Energy’s absolute advantage is largest in fixed, we say that it also has
the comparative advantage in borrowing fixed. And as Press F’s absolute dis-
advantage is the smallest in floating, we say that it has the comparative advantage
in floating.
SIDETRACK : Not related to the question at hand, but if one firm has absolute
advantage in fixed and the other firm has the absolute advantage in floating, then
those firms’ absolute advantages are also their comparative advantages. However,
when taking the differences for the table above, we would still calculate them in
the same way (i.e. Press F − B.D. Energy). So one of the ’differences’ would
be a negative number, which we would flow through the subsequent calculations
below using all of the rules of working with negative numbers that you learned in
elementary school. NOW BACK ON TRACK...
Ignoring the existence of the broker and their fees, the total potential savings from
this swap is the difference between these two absolute advantages. That is:
Swap Gainpre-fees = DifferenceFixed −DifferenceFloating
= 3.16%− 1.51%
= 1.65%
(3)
If the broker takes a fee of 0.35%, then out of the total potential swap gain of
1.65% the two firms (B.D. Energy and Press F) can share the remaining:
Swap Gainafter fees = Swap Gainpre-fees − Broker Fees
= 1.65%− 0.35% = 1.30% (4)
If they share this 1.30% gain equally, per the question, then (...by dividing by two)
they will each have cost savings of 0.65% off what they could have borrowed at
in the market. Specifically, each firm borrows in the market at their comparative
advantage (fixed for B.D. Energy and floating for Press F) and swaps with the
broker in order to get the type of debt they really want and at a lower cost than
they could have obtained that debt directly in the market.
So per the question, Press F wants fixed-rate debt, which they could have borrowed
at 9.61% p.a. per the question information. However, by instead borrowing at
their comparative advantage at LIBOR+1.75% and swapping, they will achieve a
net fixed borrowing cost of:
Post-Swap CostPress FFixed = Market CostPress FFixed − Swap Cost Saving
= 9.61%− 0.65%
= 8.96%
(5)
Similarly, B.D. Energy wants floating-rate debt, which they could have borrowed at
LIBOR+0.24% p.a. per the question information. However, by instead borrowing
at their comparative advantage at 9.61% and swapping, they will achieve a net
floating borrowing cost of:
Post-Swap CostB.D. EnergyFloating = Market CostB.D. EnergyFloating − Swap Cost Saving
= LIBOR+ 0.24%− 0.65%
= LIBOR− 0.41%
(6)
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The above two equations are all that is needed to answer this question.
We don’t actually need to specify the exact swap transactions that the parties
agree on with each other in order to split the gains of the swap equally between
them. In fact, there is essentially an infinite number of structures that could give
them each a 0.65% cost saving after borrowing at their comparative advantages.
But for curiosity and the sake of learning, if we instead said that the broker was
not just a broker but rather a swap bank (with the same 0.35% fee) that was acting
as a counterparty to each firm, then we can demonstrate a potential transaction
structure. We typically assume that the floating rate side of any swap contract
with a swap bank is always the straight reference rate (i.e. ”LIBOR”) without any
spread above or below it. That way, clients can just directly compare the fixed
rates that different banks are offering.
So given this assumption of the floating rate side of a swap with a swap bank
being LIBOR...
...then Press F:
• Has a comparative advantage in floating, so they borrow from the market
at LIBOR+1.75%
• Wants to pay fixed, so will pay fixed at 7.21% to the swap bank instead of
in the market
• Will receive the floating rate LIBOR from the swap bank in exchange for
paying them the fixed rate above.
And B.D. Energy:
• Has a comparative advantage in fixed, so they borrow from the market at
6.45%
• Wants to pay floating, so will pay floating LIBOR to the swap bank instead
of in the market
• Will receive the fixed rate of 6.86% from the swap bank in exchange for
paying them floating LIBOR above.
The above would perfectly split the swap gains for each firm according to what
we described in our solution to the question as well as giving the swap bank their
0.35% spread. That is, the swap bank makes no money on the floating side by
receiving exactly LIBOR from B.D. Energy and paying exactly LIBOR to Press
F. But on the fixed side, the swap bank would receive 7.21% from Press F and
pay only 6.86% to B.D. Energy, giving the swap bank a gain of 0.35% per annum.
However, we could only structure the actual swaps above by making some assump-
tion about the floating rate side of each (i.e. exactly equal to LIBOR; no more, no
less). In reality, swaps between two firms can be structured however they want,
so it’s entirely possible than one firm would pay the other LIBOR + 0.05% on the
floating side. In this case, the other firm would have to pay the first firm a fixed
rate that was 0.05% higher also in order offset that (...such that they still split the
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cost savings equally and their net borrowing costs still wind up being 8.96% and
LIBOR−0.41%).
Answer 25: d
Where ∆RSCHF% represents the change in the real value of the Swiss franc (CHF)
against the U.S. dollar (USD):
∆RSCHF% =
SUSD/CHF1(Actual)
SUSD/CHF0
[
1 + piCHF
1 + piUSD
]
− 1
=
USD0.4680/CHF
USD0.4213/CHF
[
1 + 0.076
1 + 0.042
]
− 1
= 1.14706− 1
= 0.14706 = +14.7%
(1)
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Answer 26: c
Answer 27: b
The value of the CHF80,000,000 receivable (t=300 days from now) when converted
at the forward rate of 1.0017 (locked in at t=0 today) is:
HedgedValueUSD300 = FUSD/CHF300 × ForeignExposureCHF300
= USD1.0017/CHF× CHF80, 000, 000 receivable
= USD80, 136, 000
(1)
Upon receiving the CHF80,000,000 receivable from their customer 300 days from
now, the firm will use it to pay the CHF80,000,000 contractual obligation they
now have under the forward contract to their counterparty bank. In exchange,
the bank will pay them USD80,136,000.
The firm now has zero net exposure to the Swiss franc in 300 days (with respect to
this transaction) as their obligation under the forward contract is perfectly covered
by the inflow from their customers. There is neither a shortfall in CHF nor any
excess CHF left over.
Answer 28: b
We must de-annualize the rates from 360 days down to the per 300-day periodic
rates.
First, the Swiss franc (CHF):
rCHF300 = rCHFAPR ×
n
360
= 8.5%× 300
360
= 0.07083 = 7.083% per 300 days
(1)
Then, the U.S. dollar (USD):
rUSD300 = rUSDAPR ×
n
360
= 4.6%× 300
360
= 0.03833 = 3.833% per 300 days
(2)
A money market hedge for our CHF80,000,000 receivable 300 days from now must
achieve the same thing that is achieved with the forward contract hedge. That
is, an obligation to the bank of exactly CHF80,000,000 that must be paid exactly
300 days from now, where the amount of our receivable when collected from the
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customer perfectly pays off our obligation without any shortfall nor any excess
Swiss franc left over.
In order to create an obligation of exactly CHF80,000,000 at t=300, we borrow
the present value of that amount today at t=0:
AmountBorrowedCHF0 =
ForeignExposureCHF300
1 + rCHF300
=
CHF80, 000, 000
1 + 0.07083
= CHF74, 708, 171.21 at t=0
(3)
After borrowing the CHF74,708,171.21, it is immediately sold at today’s spot rate
of USD1.0335/CHF in order to buy an equivalent amount of the U.S. dollar:
CurrencyBoughtUSD0 = SUSD/CHF0 × AmountBorrowedCHF0
= USD1.0335/CHF× CHF74, 708, 171.21
= USD77, 210, 894.94
(4)
At this point, now that we have our funds in our domestic U.S. dollar, we are
technically ”hedged”. Just like how our receivable will perfectly cover the amount
of our obligation to the bank in 300 days time (without excess or shortfall), we sold
all of our borrowed Swiss franc at the spot rate. So with regard to this underlying
receivable transaction, we have zero net CHF exposure both today at t=300 and
at the collection date at t=300.
However, so that we can compare the outcome of the hedge with that of the
forward hedge (or any other hedge such as the option or the unhedged value at
whatever the future spot rate turns out to be), the final step of the money market
hedge is to invest the USD77,210,894.94 that we have bought for 300 days at the
USD interest rate (i.e. we find its future value):
InvestmentPayoffUSD0 = CurrencyBoughtUSD0 ×
(
1 + rUSD300
)
= USD77, 210, 894.94× (1 + 0.03833)
= USD80, 170, 645.91 at t=300
(5)
The value of the CHF80,000,000 receivable when hedged with a money market
hedge is the investment payoff above of USD80,170,645.91.
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Answer 29: a
Answer 30: d
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