True or False (2 points each)

1. When a country has a trade deficit, it imports more than it exports.

2. Because monitoring is costly, smaller shareholders have strong incentives to free ride.

3. American options should cost at least as much as European options, all else equal.

4. When a currency trades at a forward discount the market expects that the price of the currency
will fall.

5. Contractionary fiscal policy means a cut in government spending or an increase in taxes.

6. During the Mexican Peso Crisis, foreign investors sold off multiple asset classes of Mexican
securities.

7. Futures cannot be customized.

8. If a country implements controls on capital flows and independent monetary policy, it will forego
free floating exchange rates.

9. Financial development has been shown to increase economic growth.

10. In countries like the US and UK that have strong shareholder protections, publicly listed
companies are required to be widely held and have voting rights match control rights.

Multiple Choice

11. Over the last several decades, the US has run [current/capital] account deficits.

12. Foreign [direct/portfolio] investment generally involves the acquiring less than 10 percent of a
foreign company.

13. As a currency appreciates, we expect to observe [more/less] exports and capital outflows.

14. A commodity is trading at a forward discount. Since you agree with the market’s expectations,
you should write a [call/put] option.

15. Because of [the market for corporate control/concentrated ownership], corporate governance
reforms should protect shareholders from [manager/controlling shareholders/both].

16. In theory, shareholders hire [managers/the board of directors] to monitor [managers/board of

17. The current spot exchange rate is $1.50/€ and the three-month forward rate is $1.55/€. Based on
your analysis of the exchange rate, you are confident that the spot exchange rate will be $1.62/€

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 in three months. You would like to buy or sell €10M. Given your expectation, you should
[short/long] a €10M European call that expires in 3 months for K=$1.55/€.

18. The forward market involves contracting today for the [future purchase/right but not obligation
to the future purchase] of sale of foreign exchange at a price agreed upon today.

Forex

19. The SF/$ 180-day forward exchange rate is SF1.30/$ and the 180 forward premium is 8 percent.
What is the spot exchange rate?

20. You are a US-based treasurer with $1MUSD to invest. The dollar-euro exchange rate is quoted as
$1.60 = €1.00 and the dollar-pound exchange rate is quoted at $2.00 = £1.00. If a bank quotes
you a cross rate of £1.00 = €1.20 Can you make arbitrage the market? If so how?

21. Suppose you observe the following exchange rates: €1 = $1.45; £1 = $1.90. Calculate the euro-
pound exchange rate.

22. If the $/€ bid and ask prices are $1.60/€ and $1.62/€, respectively, the corresponding €/$ bid
and ask prices are:

Balance of Payments

23. Your company wants to open a shipping facility that would produce perpetual revenues of $4M
per year if exchange rates rise or $6M per year if exchange rates fall. The perpetual operating
costs will be $2M per year and grow by 3 percent per year. The likelihood of exchange rates rising
is 30 percent. The project has an upfront cost of $12M. Assume that the cost of capital is 8 percent
and that the same discount rate can be applied to the operating costs.
a. What is the NPV of the project? Is this a worthwhile investment?
b. Suppose that the currency of the country in which the firm is headquartered trades at a
forward premium, would this be good or bad news to the firm?
c. Suppose that we learn with certainty that exchange rates will rise. What is the NPV of this
investment?
d. Suppose that we learn with certainty that exchange rates will rise, but the upfront costs
can be delayed by two years. Would the investment be worthwhile?

Corporate Governance

24. As the financial manager of a tech company you have information that the public does not. Your
company has no debt and therefore faces no risk of default. Your main concern is that if the share
price falls below $100 USD per share that your stock options will be worthless. The company
announced plans to sell cloud computing services to local governments. 25 cities have signed up;
each will pay for $12M each year for the next 15 years. The services have no fixed cost, but the
operational cost of the project is uncertain. The public believes that there is 25 percent chance
that the operational cost will be $4M each year and a 75 percent chance that the cost will be $9M

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 each year. Assume the discount rate for all cash flows is 9 percent. There are no other lines of
business and the company has 8M share outstanding.
a. What is the market value of the company?
b. What is the company’s share price?
c. Suppose you know that the true likelihood that the operational cost will be $4M is 15
percent, what would be the share price if this information were made public?
d. How inflated is the current stock price? That is, if the true cost were to be revealed, the
share price would change by how many dollars per share?
e. Suppose that instead of revealing this information to the public, you exercise your options
and sell your shares. It will take a few months before your stock sales are made public.
Would we expect the stock price to go up or down upon the news of your sales?

Options

25. You are the financial manager of a semiconductor manufacturer that wants to reduce the volatility
of its cash flows by making its cash flows less sensitive to changes in the price of gold. It will do so
by buying a call option on a gold ETF with a strike price of $165 and selling a call option on the
gold ETF with a strike price of $180. Both options are American and expire in one year.
a. What does the option strategy protect you from? (Price of gold rising, falling, being stable,
volatile?)
b. Suppose one month passes and the gold ETF trades at $190. What is the payoff of this
option strategy?
c. Would we expect this portfolio to be more or less expensive if it were constructed of
European call options?
d. Why would we use this strategy instead of only purchasing a call?