Week 1

Exercise 1.1

A foreign exchange trader with a U.S. bank took a short position of £5,000,000 when the $/£ exchange
rate was 1.55. Subsequently, the exchange rate has changed to 1.61. Is this movement in the
exchange rate good from the point of view of the position taken by the trader? By how much has the
bank’s liability changed because of the change in the exchange rate?

Exercise 1.2
A bank is quoting the following exchange rates against the dollar for the Swiss franc and the
Australian dollar:

SFr/$ = 1.5960--70

A$/$ = 1.7225--35

An Australian firm asks the bank for an A$/SFr quote. What cross-rate would the bank quote?

Exercise 1.3
Given the following information, what are the NZD/SGD currency against currency bid-ask
quotations?
American Terms European Terms
Bank Quotations Bid Ask Bid Ask
New Zealand dollar .7265 .7272 1.3751 1.3765
Singapore dollar .6135 .6140 1.6287 1.6300

Exercise 1.4
Doug Bernard specializes in cross-rate arbitrage. He notices the following quotes:

Swiss franc/dollar = SFr 1.5971/$

Australian dollar/U.S. dollar = A$1.8215/$

Australian dollar/Swiss franc = A$1.1440/SFr

Ignoring transaction costs, does Doug Bernard have an arbitrage opportunity based on these quotes? If
there is an arbitrage opportunity, what steps would he take to make an arbitrage profit, and how would
he profit if he has $1,000,000 available for this purpose.
Exercise 1.5
Assume you are a trader with Banque Paribas. From the quote screen on your computer terminal, you
notice that Commerzbank is quoting €0.7627/$1.00 and Credit Suisse is offering SF1.1806/$1.00.
You learn that ABN Amro is making a direct market between the Swiss franc and the euro, with a
current €/SF quote of .6395. Show how you can make a triangular arbitrage profit by trading at these
prices. (Ignore bid-ask spreads for this problem.) Assume you have $5,000,000 with which to
conduct the arbitrage. What happens if you initially sell dollars for Swiss francs? What €/SF price
will eliminate triangular arbitrage?

Exercise 1.6
The current spot exchange rate is $1.35/€ and the three-month forward rate is $1.30/€. Based on your
analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.32/€ in
three months. Assume that you would like to buy or sell €5,000,000.
a.) What actions do you need to take to speculate in the forward market? What is the expected dollar
profit from speculation?
b.) What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to
be $1.26/€.

Exercise 1.7
Omni Advisors, an international pension fund manager, plans to sell equities denominated in Swiss
Francs (CHF) and purchase an equivalent amount of equities denominated in South African rands
(ZAR). Omni will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate
the risk that the ZAR will appreciate relative to the CHF during this 30-day period. The following
exhibit shows current exchange rates between the ZAR, CHF, and the U.S. dollar (USD).

ZAR/USD CHF/USD
Maturity Bid Ask Bid Ask
Spot 6.2681 6.2789 1.5282 1.5343
30-day 6.2538 6.2641 1.5226 1.5285
90-day 6.2104 6.2200 1.5058 1.5115

a. Describe the currency transaction that Omni should undertake to eliminate currency risk over the
30-day period.
b. Calculate the following:
• The CHF/ZAR cross-currency rate Omni would use in valuing the Swiss equity portfolio.
• The current value of Omni’s Swiss equity portfolio in ZAR.
Week 2

Exercise 2.1

Consider Ex 1.7 of Week 1. Compute the annualized forward premium or discount at which the ZAR
is trading versus the CHF (use the bid rates computed for Ex 1.7).

Exercise 2.2

While you were visiting Frankfurt, you purchased a BMW for €50,000, payable in three months. You
have enough cash in U.S. dollars at your bank in New York City, which pays 0.35% interest per
month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.35/€ and the
three-month forward exchange rate is $1.30/€. In Frankfurt, the money market interest rate is 2.0% for
a three-month investment. There are two alternative ways of paying for your BMW.

(a) Keep the funds at your bank in the U.S. and buy €50,000 forward.

(b) Buy a certain euro amount spot today and invest the amount in Germany for three months so that
the maturity value becomes equal to €50,000.

Evaluate each payment method. Which method would you prefer? Why?

Exercise 2.3

Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.53/£. The
three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that
you can borrow as much as $1,500,000 or £1,000,000.

a. Determine whether the interest rate parity is currently holding.

b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps
and determine the arbitrage profit.

c. Explain how the IRP will be restored as a result of covered arbitrage activities.

Exercise 2.4

Suppose that the current spot exchange rate is €0.80/$ and the three-month forward exchange rate is
€0.7813/$. The three-month interest rate is 8 percent per annum in the United States and 5.40 percent
per annum in France. Assume that you can borrow up to $1,000,000 or €800,000.

a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize
profit in terms of U.S. dollars. Also determine the size of your arbitrage profit.
b. Assume that you want to realize profit in terms of euros. Show the covered arbitrage process and
determine the arbitrage profit in euros.

Exercise 2.5

Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate is
€1.58/₤. The one-year interest rate is 6.0% in euros and 5.2% in pounds. You can borrow at most
€1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot exchange rate.

a. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that
you are a euro-based investor. Also determine the size of the arbitrage profit.

b. Discuss how the interest rate parity may be restored as a result of the above transactions.

c. Suppose you are a pound-based investor. Show the covered arbitrage process and

determine the pound profit amount.

Exercise 2.6

The expected 1-year inflation in the US is 2% and in Europe is 1.5%. The 1-year interest rate in the
US is 1%. The current exchange rate is 1.3 USD / EUR.

a. Use the (approximated) international Fisher effect to compute the interest rate in Europe
b. Use the relative PPP to compute the expected exchange rate 2 years from now
c. Use the covered interest rate parity to compute the 3-year forward exchange rate
Week 3

Exercise 3.1

Assume today’s settlement price on a CME GBP futures contract is $1.8050/£. You have a short
position in one contract. The size of the contract is £62,500. Your performance bond account currently
has a balance of $2,200. The next three days’ settlement prices are $1.8058, $1.8011, and $1.7995.
Calculate the daily changes in the performance bond account from daily marking-to-market and the
balance of the performance bond account after the third day.

Exercise 3.2

Do exercise 3.1 again assuming you have a long position in the futures contract.

Exercise 3.3

Using the quotations from the table below, calculate the face values of the open interests in the June
2010 and September 2010 Euro/Japanese yen futures contracts.

Exercise 3.4

Using the quotations from the table above, note that the September 2010 Mexican peso futures
contract has a price of $0.77275 per 10 MXN. You believe the spot price in September will be
$0.83800 per 10 MXN. What speculative position would you enter into to attempt to profit from your
beliefs? Calculate your anticipated profits, assuming you take a position in three contracts. What is
the size of your profit (loss) if the futures price is indeed an unbiased predictor of the future spot price
and this price materializes?

Exercise 3.5

Do Ex 3.4 again assuming you believe the September 2010 spot price will be $0.70500 per 10 MXN.

Ex 3.6

A trader has two risk-free bonds with equal maturity and notional value in her portfolio. Bond A pays
a fixed coupon every 6 months. Bond B pays a floating rate that resets every 6 months. The trader
thinks interest rates on the market are about to increase.

a. Which of the two bonds the trader should sell? Explain

Ex 3.7

A bank goes long in a “three against six” Forward Rate Agreement on the 3-month LIBOR. The
agreement rate is 3%. The notional amount is USD 1 million. By the end of the agreement period, the
3-month LIBOR is 4%. Rates are as customary on an annual basis.

a. Without doing any computation, determine if the bank will pay or receive money at the end of
the agreement period
b. Compute the amount paid or received by the bank at the end of the agreement period.

Ex 3.8

Nine months from now, a company will need to borrow USD 10 million for 3 months. The company
wants to hedge the interest rate risk using a Eurodollar future currently priced at 99.200. Nine months
later, the 3-month LIBOR is 0.7% on an annual basis.

a. Determine if the company should go long or short the future contract to hedge the risk
b. Compute the final gain/loss for the company on the future contract
c. Compute the effective interest paid on the loan by the company (in USD) with and without
hedging.
Week 4

Ex 4.1

Using the market data in the table below, show the net terminal value of a long position in one 108 Jun
Japanese yen European call contract at the following terminal spot prices (stated in U.S. cents per 100
yen): 104, 106, 108, 110, and 112. Ignore any time value of money effect.

Exercise 4.2

Using the market data in the table above, show the net terminal value of a long position in one 108 Jun
Japanese yen European put contract at the following terminal spot prices (stated in U.S. cents per 100
yen): 104, 106, 108, 110, and 112. Ignore any time value of money effect.

Exercise 4.3

Assume that the euro is trading at a spot price of $1.49/€. Further assume that the premium of an
American call (put) option with an exercise price of $1.50 is 1.55 (3.70) cents. Calculate the intrinsic
value and the time value of the call and put options.

Exercise 4.4

Assume spot Swiss franc is $0.7000 and the six-month forward rate is $0.6950. What is the minimum
price that a six-month American call option with a striking price of $0.6800 should sell for in a
rational market? Assume the annualized six-month U.S. dollar interest rate is 3 ½ percent.
Exercise 4.5

Do Exercise 4.4 again assuming an American put option instead of a call option.

Exercise 4.6

Use the continuous pricing model to value the call of Exercise 4.4 and the put of Exercise 4.5 as if
they were European options. Assume the annualized volatility of the Swiss franc is 14.2 percent. You
can compute N(x) using the excel formula =NORM.S.DIST(x, TRUE).

Exercise 4.7

Use the binomial option-pricing model developed in the chapter to value the call of Exercise 4.4. The
volatility of the Swiss franc is 14.2 percent.
Week 6

Exercise 6.1

Gamma and Delta Companies can borrow for a ten-year term at the following rates:

Gamma Gamma Delta

Develop an interest rate swap in which both Gamma and Delta have equal cost savings in their
borrowing costs. Assume Gamma desires floating-rate debt and Delta desires fixed-rate debt. A swap
bank is involved in the swap as an intermediary. Assume the swap bank is quoting ten-year dollar
interest rate swaps at 10.7–10.8 percent against LIBOR flat.

Exercise 6.2

ABC Corporation is a AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue
FRNs at six-month LIBOR + .125 percent or at three-month LIBOR + .125 percent. Given its asset
structure, three-month LIBOR is the preferred index. XYZ Corporation is an A-rated firm that also
desires to issue five-year FRNs. It finds it can issue at six-month LIBOR + 1.0 percent or at three-
month LIBOR + .625 percent. Given its asset structure, six-month LIBOR is the preferred index.
Assume a notional principal of $15,000,000. Determine the QSD and set up a floating-for-floating
rate swap where the swap bank receives .125 percent and the two counterparties share the remaining
savings equally.

Exercise 6.3
A company based in the United Kingdom has an Italian subsidiary. The subsidiary generates
€25,000,000 a year, received in equivalent semiannual installments of €12,500,000. The British
company wishes to convert the euro cash flows to pounds twice a year. It plans to engage in a
currency swap in order to lock in the exchange rate at which it can convert the euros to pounds. The
current exchange rate is €1.5/£. The fixed rate on a plain vanilla currency swap in pounds is 7.5
percent per year, and the fixed rate on a plain vanilla currency swap in euros is 6.5 percent per year.
a. Determine the notional principals in euros and pounds for a swap with semiannual payments that
will help achieve the objective.
b. Determine the semiannual cash flows from this swap.
Exercise 6.4

Dell Inc. purchased DRAM integrated circuits from Elpida Memory, Inc., a Japanese manufacturer,
and was billed ¥250 million payable in three months. Currently, the spot exchange rate is ¥105/$ and
the three-month forward rate is ¥100/$. The three-month money market interest rate is 8 percent per
annum in the U.S. and 7 percent per annum in Japan. The management of Dell decided to use the
money market hedge to deal with this yen account payable.

(a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen
obligation.

(b) Conduct the cash flow analysis of the money market hedge.

Exercise 6.5

You plan to visit Geneva, Switzerland in three months to attend an international business conference.
You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay.
As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can
buy the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per
SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-
month interest rate is 6 percent per annum in the United States and 4 percent per annum in
Switzerland.

(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on
SF.

(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a
forward contract.

(c) At what future spot exchange rate will you be indifferent between the forward and option market
hedges?

(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate
under both the options and forward market hedges.

Exercise 6.6

Assume the time from acceptance to maturity on a ¥50,000,000 banker’s acceptance (B/A) is 90 days.
Further assume that the importing bank’s acceptance commission is 1.50 percent and that the market
rate for 90-day B/As is 6.50 percent. Determine the amount the exporter will receive if he holds the
B/A until maturity and also the amount the exporter will receive if he discounts the B/A with the
importer’s bank.
Week 7

Exercise 7.1

Carnival Corporation & plc of the U.K. purchased a ship from Mitsubishi Heavy Industry. Carnival
owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per
pound and the one-year forward rate is 110 yen per pound. The annual interest rate is 5% in Japan and
8% in the U.K. Carnival can also buy a one-year call option on yen at the strike price of £.0081 per
yen for a premium of .014 pence per yen.

(a) Compute the future pound costs of meeting this obligation using the money market hedge and the
forward hedges.

(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the
expected future pound cost of meeting this obligation when the option hedge is used.

(c) At what future spot rate do you think PCC may be indifferent between the option and forward
hedge?

Exercise 7.2

The Trendy Designs Company of Singapore manufactures fashion jewelry, and sells it through sales
affiliates in Hong Kong, the United Kingdom, and the United States. For a recent month, the
following payments matrix of interaffiliate cash flows, stated in Singapore dollars, was forecasted.
Show how Trendy Designs Company can use multilateral netting to minimize the foreign exchange
transactions necessary to settle interaffiliate payments. If foreign exchange transactions cost the
company .5 percent, what savings result from netting?

Disbursement
Receipts SINGAPORE HONG UK US TOT
KONG RECEPITS
SINGAPORE 40 75 55 170
HONG KONG 8 22 30
UK 15 17 32
US 11 25 9 45
TOT 34 65 84 94 277
DISBOURSEMENTS

Exercise 7.3

The table below provides the correlations among Mechel OAO, a Russian mining and steel company,
the Russian stock market index, and the world market index, together with the standard deviations
(SD) of returns and the expected returns ( R ). The risk-free rate is 4%.
 Correlation Coefficients

Mechel Russia World SD(%) R (%)

Mechel 1.00 .90 0.60 20 ?

Russia 1.00 0.75 15 11

World 1.00 10 9

a. Compute the domestic country beta of Mechel as well as its world beta. What do these betas
measure?
b. Suppose the Russian stock market is segmented from the rest of the world. Using the CAPM
paradigm, estimate the equity cost of capital of Mechel.
c. Suppose now that Mechel has made its shares tradable internationally via cross-listing on
NYSE. Again using the CAPM paradigm, estimate Mechel’s equity cost of capital. Discuss
the possible effects of international pricing of Mechel shares on the share prices and the firm’s
investment decisions.

Exercise 7.4

Siam, Inc., a Thai company, has an optimal debt ratio of 35 percent. Its cost of equity capital is 14
percent and its before-tax borrowing rate is 10 percent. Given a marginal tax rate of 30 percent,
calculate (a) the weighted-average cost of capital, and (b) the cost of equity for an equivalent all-equity
financed firm.

Exercise 7.5

Zeda, Inc., a US MNC, is considering making a fixed direct investment in Denmark. The Danish
government has offered Zeda a concessionary loan of DKK 15,000,000 at a rate of 4 percent per
annum. The normal borrowing rate for the Zeda is 6 percent in dollars and 5.5 percent in Danish
krone. The load schedule calls for the principal to be repaid in three equal annual installments. What is
the present value of the benefit of the concessionary loan? The current spot rate is DKK5.60/$1.00 and
the expected inflation rate is 3 percent in the US and 2.5 percent in Denmark.

Exercise 7.6

Omega Industries, a U.S. MNC, is contemplating making a foreign capital expenditure in South
Africa. The initial cost of the project is ZAR 10,000. The annual cash flows over the five year
economic life of the project in ZAR are estimated to be 3,000, 4,000, 5,000, 6000, and 7,000. The
parent firm’s cost of capital in dollars is 9.5 percent. Long-run inflation is forecasted to be 3 percent
per annum in the U.S. and 7 percent in South Africa. The current spot foreign exchange rate is
ZAR/USD = 3.75. Determine the NPV for the project in USD by:

a. Calculating the NPV in ZAR using the ZAR equivalent cost of capital according to the Fisher
Effect and then converting to USD at the current spot rate.

b. Converting all cash flows from ZAR to USD at Purchasing Power Parity forecasted exchange rates
and then calculating the NPV at the dollar cost of capital. Are the two dollar NPVs different or the
same? Explain.

c. What is the NPV in dollars if the actual pattern of ZAR/USD exchange rates is: S(0) = 3.75, S(1) =
5.7, S(2) = 6.7, S(3) = 7.2, S(4) = 7.7, and S(5) = 8.2?

Exercise 7.7

Boeing just signed a contract to sell a Boeing 747 aircraft to Air France. Air France will be billed €300
million which is payable in one year. The current spot exchange rate is $1.05/€ and the one-year
forward rate is $1.10/€. The annual interest rate is 6.0% in the U.S. and 5.0% in France. Boeing is
concerned with the volatile exchange rate between the dollar and the euro and would like to hedge
exchange exposure.

(a) It is considering two hedging alternatives: sell the euro proceeds from the sale forward or borrow
euros from Credit Lyonnaise against the euro receivable. Which alternative would you recommend?
Why?

(b) Other things being equal, at what forward exchange rate would Boeing be indifferent between the
two hedging methods?

Ex 7.8 [“real world perspective” voluntary exercise]: Minicase Dorchester (Chapter 18, p.474).