Posted: May 13th, 2018

Lancaster Universty ACf305 final exam

QUESTION
1: MULTIPLE CHOICE PART (30 marks in
total):

Answer all
sub-questions.

Required:

1) Identify
the one true statement about an exchange-rate regime with fixed
exchange rates relative to gold:

(A)
It will lead to central banks running out of
gold reserves.
(B)
It is unable to maintain a low level of
inflation.
(C)
It will lead to continuously increasing
prices of gold.
(D) It
suffers from the Triffin Dilemma, i.e. the necessity of choosing between
eco-nomic growth and maintaining a credible gold backing of the currency.
(E)
None of the above.
(3 marks)

2) Identify
the one false statement about bid and ask rates when you want to
buy foreign currency from a bank in the spot market:

(A)
The bank sells at the ask rate.
(B)
You buy at the ask rate.
(C)
The spread depends on the liquidity.
(D) The spread
depends on the maturity.
(E)
The spread depends on the
transaction volume.

(3 marks)

Please turn over

1

3)
Identify the one false
statement about forwards:

(A)
Forward markets are not
organised exchanges, but over-the-counter markets.
(B)
The general formula for the
delivery date of a forward is: day [t + 2 plus n months]. The
delivery date differs from the general formula in certain circum-stances.

(C)
A 90-day forward contract
signed on Thursday, 29 March 2012, is normally set-tled on Friday, 29 June
2012.
(D) The
outright rate for a forward is its actual rate.
(E) The
GBP trades at a premium if the swap rates of GBP/EUR forwards are posi-tive.

(3 marks)

4)
Identify the one false
statement about hedging contractual exposure:

(A)
Perfect hedging means that the contractual
exposure is hedged in the cheapest way possible.
(B)
Options are imperfect hedges
in the sense that they do not entirely eliminate un-certainty about future cash
flows.
(C)
For a hedge with a forward, there is reverse
risk due to credit risk.
(D) Hedging of
pooled cash flows can introduce interest risk.
(E)
A duration-matched hedge is
an example of a value hedge.
(3 marks)

5)
Identify the one true statement
about FX forwards and futures.

(A)
Forwards do not have default risk.
(B)
Forwards are less liquid than futures.
(C)
Forwards are more profitable
than futures.
(D) Forwards
can require a margin call.
(E)
None of the above.
(3 marks)

6)
Identify the one false
statement about swaps:

(A)
A fixed-for-fixed currency swap allows a
company to borrow in the market where it can obtain the lowest spread.
(B)
In a fixed-for-fixed currency
swap, the bank’s risks in case of default are limited because of the
right-of-offset clause.
(C)
A fixed-for-floating interest-rate swap
allows a company to swap fixed interest payments of one currency into variable
interest payments of another currency.
(D) In a
fixed-for-floating interest-rate swap, interest rates used in the swap contract
are (near) risk-free rates.
(E)
Coupon swap is an alternative
name for an interest-rate swap.
(3 marks)

Please turn over

2

7)
Identify the one true statement
about all currency options with a strike price of GBP/NZD

0.55 when the
current spot rate is GBP/NZD 0.50:

(A)
The option is said to be deep out of the
money.
(B)
The option is said to be out of the money.
(C)
The option is said to be at the money.
(D) The option
is said to be in the money.
(E)
None of the above.
(3 marks)

8)
Identify the one false
statement about corporate hedging of exchange risk:

(A)
Adding a zero-initial-value
financial instrument for hedging purposes can in-crease the value of the firm.
(B)
There is an agency conflict between
shareholders and managers if managers decide not to implement effective hedging
strategies.
(C)
If a company has always been profitable, no
risk of bankruptcy exists and corpo-rate taxes are linear, hedging will not
reduce expected taxes.
(D) Hedging
can reduce the costs of bankruptcy and financial distress.
(E)
It is possible to hedge
non-linear exposure with financial instruments.

(3 marks)

9)
Identify the one false
statement about the expected exposure of the USD value of assets to a change in
the USD/EUR exchange rate:

(A)
US government bonds have zero exposure.
(B)
European government bonds have positive
exposure.
(C)
Shares in an American importer have positive
exposure.
(D) Shares in
a European importer have positive exposure.
(E)
Shares in an American
exporter have positive exposure.

(3 marks)

10) Identify
the one false statement about international NPV calculations:

(A)
The valuation can be done in
either FC or HC if the home and host country are part of one integrated
financial market.
(B)
Political risks include transfer risk.
(C)
It may not be possible to perfectly hedge
against the political risk of expropria-tion.
(D)
The term ‘incremental cash
flows’ refers to the cash flows generated at the level of the foreign
subsidiary.
(E) Usually
you should assume that the international investment has a positive ter-minal
value.

(3 marks)

(TOTAL: 30 MARKS)

Please turn over

3

QUESTION
2 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
How would each of the
transactions below show up in the UK Balance of Payments, i.e. what is the
source of funds, what is the use of funds and in which sub-balances would the
source and the use be credited or debited?

Note that the sub-accounts of the balance of
payments are shown in the Appendix.

Required:

i)
A UK investment bank advises a Russian
company in a merger transaction, and gets its fee paid into its London bank
account.
ii)
GlaxoSmithKline S.A., the
French subsidiary of a UK pharmaceutical firm, buys drugs from Pfizer Inc., a
US pharmaceutical firm, and pays for these by transferring money into the New
York bank account of Pfizer.

iii)
Ericsson, a Swedish firm, sells network
equipment to Vodafone plc, a UK telecom-munications firm, and receives a trade
bill, payable in 90 days.
iv)
A UK investor sells shares of
a Turkish firm and uses the receipts to pay for a Turkish citizen to travel to
the UK and give him a Turkish massage.

(10 marks)

OR

b) Different currencies trade under different
exchange-rate regimes.

Required:

i)
Write a page paper – Describe what fixed against a single currency
means and give one example.
ii)
Name two other exchange-rate
regimes and give an example for each (you do not need to provide descriptions
of the exchange-rate regimes).
iii)
How do some governments
intervene in the exchange markets?
(10 marks)

Please turn over

4

QUESTION
3 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
The following table shows
spot rates against the GBP, i.e. XXX/GBP. Note: Bid-ask spreads show only the
last three decimal places. When the ask seems to be smaller than the bid, add
1,000.

Country

Code

Midpoint

Spread

Denmark

DKK

12.5994

816-172

Norway

NOK

11.5327

256-398

Turkey

TRY

2.7655

623-687

Required:

i)
What are the bid-ask quotes for DKK/GBP and
TRY/GBP?
ii)
What is the bid-ask quote for GBP/NOK?
iii)
What is the synthetic TRY/NOK
rate? Is there an opportunity of arbitrage or shopping around if the TRY/NOK
spot rate is 0.2398-0.2401?

(10 marks)

OR

b)
The following table shows
Big Mac prices and exchange rates from the Economist, 26 May 2006.

Currency
(HC)

Local price

HC/USD

Egypt

EGP

9.5

5.77

United
States

USD

3.1

1.00

Switzerland

CHF

6.3

1.21

Required:

i)
Calculate the USD price of a Big Mac in Egypt
and Switzerland using the exchange rates provided in the table above.
ii)
Calculate the implied
purchasing power parity rates in HC/USD for Egypt and Swit-zerland.
iii)
Calculate the real exchange rates in HC/USD
for Egypt and Switzerland.
iv)
According to the Big Mac
prices, which currency is undervalued compared to USD?
(10 marks)

Please turn over

5

QUESTION 4 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
You are given the following
data: the spot exchange rate is GBP/EUR 0.85; the p.a. sim-ple interest rate on
a three-month deposit is 6% in the UK and 4% in Europe. Note: t is today
and T is the end of the investment period.

Required:

Compute:

i)
The time-T EUR value of a time-t
EUR 100 investment.
ii)
The time-t GBP value of a time-T
GBP 100 loan.

iii)
The EUR/GBP forward rate for
a three-month forward contract.
iv)
The time-t EUR value
of a time-t GBP 100 spot sale.
v)
The time-t GBP value
of the proceeds of a time-T EUR 100 loan.

(10 marks)

OR

b)
Given the following data,
are there any arbitrage opportunities? If so, how would you make a risk-free
profit?

Required:

HC/FC

St

Ft,T

rt,T

r*t,T

i)

JPY/GBP

292.07

299.28

4.9%

3.1%

ii)

THB/NZD

22.17

22.43

3.8%

2.6%

iii)

USD/EUR

1.18

1.18

4.2%

2.5%

(10 marks)

Please turn over

6

QUESTION 5 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
A French exporter wants to
hedge an inflow of CAD 50m with futures contracts. However, no future on
EUR/CAD is available. After doing some research, she finds that EUR/CAD and
EUR/AUD are strongly correlated because both Canada’s and Australia’s economies
have a strong exposure to prices of commodities. Therefore she decides to hedge
the risk with a EUR/AUD future. Additionally, she considers a EUR/USD future.
The regres-sion output is, with t-statistics in parentheses and R2
= 0.72, as follows.

?S[EUR/CAD] = a
+ 0.59?f[EUR/AUS] + 0.21?f[EUR/USD].

(14.57) (7.22)

Required:

i)
Why does it make sense to consider a EUR/USD
future although the USD does not have a strong commodities exposure?
ii)
How will you hedge if you use
both contracts, and if an AUD contract is for AUD 5m and a USD contract for USD
2m?
iii)
Should you use both contracts if you base
your decision solely on the t-statistics? Note that a t-statistic
above (below) 1.96 (?1.96) indicates statistical significance.
iv)
If the French exporter does
not exclusively focus on futures, is there a way to hedge the CAD 50m cash
inflow perfectly? If yes, how?

(10 marks)

OR

b)
One year ago, a US firm
swapped USD 150m with a swap rate of 4% for GBP 75m with a swap rate of 5%. Both
assets had 2 years to maturity at that time. Currently, the USD swap rate is
5%, the GBP swap rate is 6% and the spot rate is USD/GBP 2.2.

Required:

i)
Calculate the current value of the USD leg of
the swap (in USD).
ii)
Calculate the current value of the GBP leg of
the swap (in GBP).
iii)
Calculate the value of the
swap in USD.
iv)
Has the US firm benefitted
from the swap? Why?
(10 marks)

Please turn over

7

QUESTION 6 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
Both forwards and options
can be used for hedging purposes. Consider a US company which wants to hedge a
future JPY cash inflow.

Required:

i)
Draw a diagram which shows the payoff at
expiration from selling a USD/JPY for-ward. Label the axes.
ii)
Draw a diagram which shows the payoff at
expiration from buying a USD/JPY put op-tion. Label the axes.
iii)
When does the US firm benefit from buying a
put but not from selling a forward?
iv)
What is the disadvantage of
buying a put instead of selling a forward?

(10 marks)

OR

b)
Options can be used for
hedging purposes. For this question, consider that you are the CFO of a German
firm.

Required:

i)
Draw a diagram which shows
the payoff at expiration of a EUR/JPY call option, a loan denominated in JPY
and the combined payoff. Label the axes. The option ex-pires on the day when
the loan has to be repaid.

ii)
What is the benefit of the hedge from i)?
iii)
What is the advantage of a
hedge with an option compared to a hedge with a for-ward?

(10 marks)

Please turn over

8

QUESTION 7 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
A firm can be affected by
different types of exposure to exchange rates. Your answers to the following
questions should concentrate on the main aspects.

Required:

i)
What is contractual exposure?
ii)
What is operating exposure?
iii)
What is accounting exposure?
iv)
What is the main difference
between contractual and operating exposure on the one side and accounting
exposure on the other?

(10 marks)

OR

b)
Forwards can be used to
hedge operating exposure. Consider the Italian firm Fiat. If the EUR is strong
against the USD, exporting becomes more difficult and the value of the firm
decreases. Additionally, the value of the firm depends on the general state of
the economy in Italy (bad or good).

State of
the economy

Bad

Good

Value
(joint probability) if EUR/USD=0.95

5.7bn
(30%)

6.7bn (10%)

Value (joint
probability) if EUR/USD=0.75

4.8bn (25%)

6.2bn (35%)

Required:

i)
Calculate the currency exposure.
ii)
What is the optimal forward hedge?
iii)
Calculate the value of the
hedged firm in each currency state if the forward rate is EUR/USD 0.83.

(10 marks)

Please turn over

9

QUESTION 8 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a) Consider the following information regarding
the returns of Google and Ford.

Expected return

Covariances

Google

Ford

Google

0.14

0.85

0.31

Ford

0.09

0.31

0.56

Required:

You hold a portfolio
of Google and Ford in which Google has a weight of 60%.
i)
Calculate the expected return.
ii)
Calculate the variance.
iii)
Draw a diagram which shows
the efficient portfolios and the tangency portfolio of a single-country CAPM.
Label the axes. You do not need to make any calculations for this question.

iv)
Explain the two key
differences between the standard CAPM and the international CAPM.

(10 marks)

OR

b)
There are three steps which
should be followed in international NPV calculations. Your answers to the
following questions should concentrate on the main aspects.

Required:

i)
What should be done in the branch stage?
ii)
What should be done in the unbundling stage?
iii)
What should be done in the external financing
stage?
iv)
Why is it useful to have a
separate branch stage?
(10 marks)

Please turn over

10

Appendix:
Sub-Accounts of the Balance of Payments
.jpg”>2013 examinations

QUESTION 1: MULTIPLE CHOICE PART (30 marks in total):

ANSWER ALL
SUB-QUESTIONS.

Required:

1)
Identify the one false
statement about the UK balance of payments (BOP):

(A)
The sale of computers of a UK company to a
Swedish company is recorded in the merchandise account of the current account.
(B)
The source side of a deal
tells us where the money in an international transaction was obtained.
(C)
The balance of payments has two categories:
the current account and the capital and financial account.
(D) The
following transaction will not be recorded in the UK BOP: AstraZeneca AG, the
German subsidiary of a UK pharmaceutical firm, buys drugs from Merck Inc., a US
pharmaceutical firm.
(E)
Securities bought
internationally are a use of funds.
(3 marks)

1 Please
turn over

2)
Identify the one false
statement about purchasing power parity (PPP):

(A)
Absolute PPP may not hold when the
consumption bundles of different countries are not the same.
(B)
Absolute PPP may not hold when the prices for
individual goods are sticky.
(C)
Absolute PPP holds when
commodity price parity holds for every individual good.
(D) Absolute
PPP holds if the real exchange rate equals 1.
(E)
Absolute PPP holds if
relative PPP holds.

(3 marks)

3)
Assume that you have bought
forward EUR (=FC) 2,000 at a forward rate of GBP/EUR 0.80, with delivery date
in six months. In addition, you will need to repay a loan of NZD (=FC) 5,000 in
six months. What will be the combined future payoff of your two cash flows in
GBP (=HC)? (Note: FC is foreign currency and HC is home currency.)

(A)
5,000*(future spot rate(EUR/GBP) – 0.80) –
2,000*(future spot rate(GBP/NZD).
(B)
5,000*(future spot
rate(GBP/EUR) – 0.80) + 2,000*(future spot rate(NZD/GBP).
(C)
2,000*(future spot rate(GBP/EUR) – 0.80) +
5,000*(future spot rate(GBP/NZD).
(D)
2,000*(future spot rate(GBP/EUR) – 0.80) –
5,000*(future spot rate(GBP/NZD).
(E)
2.000*(future spot
rate(EUR/GBP) – 0.80) + 5,000*(future spot rate(NZD/GBP).

(3 marks)

4)
Identify the one false
statement about the mechanisms used by banks that partially solve the problem
of default risk under a forward contract:

(A)
Margin requirements.
(B)
Restricted use.
(C)
Short lives.
(D) Right to
offset.
(E)
Credit agreements.

(3 marks)

5)
Identify the one false
statement about hedging with futures:

(A)
The expiration dates of the futures contract
rarely match those for the currency inflows/outflows that the contract is meant
to hedge.
(B)
The choice of underlying
assets in the futures market is limited, and the currency one wishes to hedge
may not have a futures contract.
(C)
Hedging with futures involves higher
transaction costs than hedging with forwards.
(D) A
currency-mismatch can be hedged via a cross-hedge.
(E)
A maturity-mismatch can be
hedged via a delta hedge.

(3 marks)

2 Please
turn over

6)
Identify the one true statement
about swaps:

(A)
In practice, swap rates are much higher than
risk-free rates in order to compensate banks for default risk.
(B)
A fixed-for-floating swap is insensitive to
changes in the interest rate.
(C)
A fixed-for-fixed currency
swap is insensitive to changes in the foreign interest rate.
(D)
A fixed-for-fixed currency swap is
insensitive to changes in the respective exchange rate.
(E)
Swaps allow a company to
borrow in the market where it can obtain the lowest spread.

(3 marks)

7)
Identify the one false
statement about a currency option with a strike price of EUR/EGP 8.00:

(A)
The underlying is the exchange rate between
the euro and the Egyptian pound.
(B)
A put on the EUR/EGP exchange rate can be
used to hedge a future cash outflow in EGP.
(C)
You will lose money at expiration if the
option is a call, you are short the call and the EUR/EGP spot rate is 8.50.
(D)
The option is said to be in
the money if it is a call and the EUR/EGP spot rate is 8.50.
(E)
Combining a short put and a
long call replicates the payoff of a forward purchase.

(3 marks)

8)
Identify the one false
statement about accounting exposure:

(A)
Accounting exposure arises because the
outcome of translating the accounting numbers of for-eign subsidiaries from FC
to HC depends on the exchange rate at the date of consolidation, which is
uncertain.

(B)
Accounting exposure is not an economic
exposure.
(C)
Accounting exposure cannot be
hedged.
(D) Examples
of accounting translation methods are: current/noncurrent method,
mone-tary/nonmonetary method and temporal method.
(E)
The HC value of total assets
of a foreign subsidiary is higher under the current-rate or closing-rate method
than under all other methods if the FC had appreciated.
(3 marks)

9)
Identify the one true
statement about the expected exposure of the GBP value of assets to a change in
the GBP/USD exchange rate:

(A)
US government bonds have zero exposure.
(B)
UK government bonds have
negative exposure.
(C)
Shares in an American importer have negative
exposure.
(D) Shares in
a British importer have negative exposure.
(E)
Shares in a British exporter
have negative exposure.

(3 marks)

3 Please turn
over

10)
Identify the one false
statement about international NPV calculations:

(A)
A three-step process can be used for valuing
international projects: branch stage, unbundling stage and external financing
stage.
(B)
In the branch stage, the foreign subsidiary
is treated as a legally separate company.
(C)
In the unbundling stage, the
costs and benefits of intragroup financial arrangements are ana-lysed.
(D) In the
external financing stage, it has to be decided whether the parent or the
subsidiary should borrow.
(E)
Political risks include
transfer risk and the risk of expropriation.

(3 marks) (Total 30 Marks)

4 Please turn
over

QUESTION
2 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)The
following questions are about money and banking.

Required:

i)
How was trade conducted before the
development of paper (fiat) money?
ii)
Was there any role for exchange rates before
the development of paper money? Explain.
iii)
In the current monetary system, how do
central banks influence the money supply?
iv)
Why are monetary policies of
central banks important for exchange rates? Hint: Consider the cov-ered
interest parity formula.

(10 marks)

OR

b)Over time,
different currencies traded under different exchange-rate regimes.

Required:

i)
How did the exchange-rate regime work which
involved gold?
ii)
Write a page paper – Describe one exchange-rate
regime which is currently used and give an example of a currency other than the
US dollar traded under this regime.
iii)
Under which different exchange rate-regimes
had the US dollar traded since 1900?
iv)
State one reason why the US
dollar is the most important currency in the world today?

(10 marks)

5 Please turn
over

QUESTION 3 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
Assume that a Big Mac costs
AUD 3.4 in Australia and USD 3.2 in the United States. You are also giv-en the
following official exchange rates: USD/EUR 1.20 and AUD/EUR 1.32.

Required:

i)
Calculate the USD price of a Big Mac in
Australia using the information provided above.
ii)
Calculate the implied purchasing power parity
(PPP) rate in USD/AUD.
iii)
Calculate the real exchange
rate in AUD/USD.
iv)
According to the Big Mac
prices, is the AUD overvalued or undervalued compared to the USD? Ex-plain.
(10 marks)

OR

b)
Assume that you observe the following data
regarding the NZD/GBP exchange rate:
– Spot rate:
2.32?2.34
– 6-month
forward rate: 2.365?2.394
–
6-month NZD interest rate
(simple, p.a.): 5.15?5.35%
– 6-month
GBP interest rate (simple, p.a.): 2.65?2.85%

Required:

i)
Which of the two values shown as spot rate is
the bid rate, and which one is the ask rate? Explain.
ii)
Calculate the synthetic 6-month forward rate
(both the bid and ask rate).
iii)
Is there any opportunity for
arbitrage or shopping around using the synthetic forward rate? Explain.
(10 marks)

6 Please
turn over

QUESTION 4 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
You are given the following
data: the spot exchange rate is INR/GBP 58; the p.a. simple interest rate on a
nine-month deposit is 9% in India and 3% in the UK. Note: t is today and
T is the end of the in-vestment period.

Required:

Compute:

i)
The INR/GBP forward rate for
a nine-month forward contract.
ii)
The INR/GBP swap rate for a
nine-month period.
iii)
The time-T INR value of a time-t
INR 10,000 investment.
iv)
The time-t GBP value of a time-t
INR 5,000 spot sale.
v)
The time-t INR value
of the proceeds of a time-T GBP 500 loan.
(10 marks)

OR

b)
The following questions are
about spot exchange quotes in the wholesale market, where different banks
provide different bid and ask quotes for various exchange rates.

Required:

i)
What does the law of one price for spot
exchange quotes state?
ii)
What does arbitrage mean? Give an example of
an arbitrage opportunity in the spot exchange mar-ket.
iii)
What does shopping around
mean? Give an example of an opportunity for shopping around in the spot
exchange market.
iv)
Why is arbitrage and shopping
around important in the spot exchange market?

(10 marks)

7 Please
turn over

QUESTION 5 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
You work for a Spanish firm
and are asked to hedge an outflow of MXN (Mexican peso) 400m with fu-tures
contracts. However, no future on EUR/MXN is available. After doing some
research, you find that EUR/MXN and EUR/USD are correlated because Mexico and
the United States share a border and therefore there is a high volume of trade
between the two countries. Therefore you decide to hedge the risk with EUR/USD
futures contracts. Additionally, you consider a EUR/AUD future. In order to
deter-mine your hedging positions, you estimate a multiple regression model.
The regression output is, with t-statistics in parentheses and R2
= 0.67, as follows.

?S[EUR/MXN] = a
+ 0.46 f[EUR/USD] ? 0.02 f[EUR/AUD].

(9.32) (?0.05)

Required:

i)
If a USD contract is for USD
10m and an AUD contract for AUD 5m, how will you hedge if you use both
contracts?
ii)
Should you use both contracts? Explain.
iii)
Now assume that the Spanish
firm hedges the outflow of MXN perfectly using forwards. Draw a dia-gram which
shows the payoff of the outflow of MXN and the forward position which hedges
the ex-posure. Label the axes.
(10 marks)

OR

b)
You borrow Canadian dollar
(CAD) 10m at 5% for one year, and you swap the loan into South African rand
(ZAR) at a spot rate of CAD/ZAR 0.20 and the one-year swap rates of 4% (CAD)
and 8% (ZAR).

Required:

i)
What are the payments on the loan, on the
swap, and on the combination of them? Show your re-sults in a table.
ii)
Is there a gain of using the
swap if you could have borrowed ZAR at 9%? Explain.
iii)
State two benefits of swaps.

(10 marks)

8 Please
turn over

QUESTION 6 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
Assume that the exchange
rate between the British pound (GBP) and the Chinese yuan (CNY) is CNY/GBP 10.
Also assume that the per annum interest rate in China is 6%, and the per annum
interest rate in Great Britain is 4%. A bank offers to sell you options on the
British pound with a time-to-maturity of one year and a strike price of CNY/GBP
9 for GBP 1.

Required:

i)
Draw a diagram which shows
the payoff at expiration from buying the above CNY/GBP call option. Label the
axes.
ii)
There are arbitrage conditions imposing
limits on the prices of options. What is the intuition underly-ing the
arbitrage condition between the value of a call option and the value of a long
forward con-tract?

iii)
Does the bank’s offer violate
this arbitrage condition? Should you therefore accept the offer or should you
reject it?
iv)
If you accept the offer, is
there an arbitrage opportunity? How would you exercise it?

(10 marks)

OR

b)
Consider that an Italian firm has the
following contract:
– It has to
sell USD in one year at a rate of EUR/USD 0.80 if the USD trades below 0.80.
– It has to
sell USD in one year at a rate of EUR/USD 0.90 if the USD trades above 0.90.
– It has to
sell USD in one year at the spot rate if the EUR/USD is between 0.80 and 0.90.

Required:

i)
Show the payoff of the contract graphically.
ii)
Show that the contract can be viewed as a
combination of European-style options.
iii)
What is the benefit of this
contract as a hedging instrument?

(10 marks)

9 Please
turn over

QUESTION 7 (10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
Corporate hedging can create
shareholder value in the presence of market imperfections, such as tax-es,
financial distress costs or agency costs.

Required:

i)
How can corporate hedging create shareholder
value in the presence of taxes?
ii)
How can corporate hedging create shareholder
value in the presence of financial distress costs?
iii)
What are agency costs? How
can corporate hedging create shareholder value in the presence of agency costs?

(10 marks)

OR

b)
Forwards can be used to
hedge operating exposure. Consider the US firm Ford. If the USD is weak against
the JPY, exporting becomes easier and the value of the firm increases.
Additionally, the value of the firm in USD depends on the general state of the
economy in the United States (bad or good). Ford’s management estimates
different firm values in USD depending on the level of the USD/JPY ex-change
rate and states of the US economy, as shown in the table below. It estimates
that it is equally likely that the USD will be strong or weak against the JPY.
It also estimates that it is equally likely that the US economy will be in a
bad or good state.

State of
the economy

Bad

Good

Value if
USD/JPY=80

36bn

46bn

Value if
USD/JPY=100

29bn

39bn

Required:

i)
A weak USD against the JPY
makes it easier for Ford to export to Japan. What is another benefit of a weak
USD against the JPY for Ford?
ii)
Calculate the currency exposure.
iii)
What is the optimal forward hedge?
iv)
Are the estimates of the firm
value by Ford’s management reasonable? Explain.

(10 marks)

10 Please turn
over

QUESTION 8
(10 marks in total):

ANSWER
EITHER SUB-QUESTION A) OR SUB-QUESTION B).

a)
You consider investing in
shares of BMW AG, a German carmaker. As part of your research on the company,
you determine BMW’s cost of capital using the international CAPM (InCAPM). You
use the FTSE World as world market portfolio and include the US and UK exchange
rates in your analysis. You obtain the following regression result:

~

?r

~

?r

~

+r

?

?r

~

+r

?

?r)

E(r

)=1.20 E(r

)+ 0.51 E(s

US

)?0.22 E(s

UK

BMW

0

w

0

0,US

0

0,UK

0

(4.38)

(2.13)

(?0.86)

Required:

i)
Interpret the output of the regression
analysis.
ii)
Write a page paper – Describe the difference
between the CAPM and the InCAPM.

(10 marks)

OR

b)
Assume that you are the CFO
of a large French company. The company is interested in evaluating a business
opportunity in Russia. You recall that domestic business opportunities can be
evaluated using a standard NPV rule.

Required:

i)
What is the additional complexity in case of
evaluating a business opportunity in a foreign country such as Russia?
ii)
What are the two approaches in which foreign
business opportunities can be evaluated using NPV analysis?
iii)
Why is the mathematical
result that E[x*y] is not equal to E[x]*E[y] (with x and y being two arbitrary
random variables) important for international capital budgeting?
iv)
Which of the two approaches
would you decide to use for evaluating a business opportunity in Rus-sia?
Explain.

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