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HOMEWORK3SOLUTION

Chapter8

1.

AssumethatyourcompanyexportstoJapanandearnsyenrevenues,thusforecastsoftheYen/$
rate are important. Suppose two forecasters issue their predictions for the Yen/$ exchange rate.
ThecurrentspotrateisYen90/$.ForecasterApredictsarateof98nextmonthandforecasterB
predictsarateof88.Theforwardrateisat89,reflectingtheinterestratedifferentialbetweenthe
twocurrencies.Onemonthlater,thespotratereaches92Yen/$.

a.

WhichoftheforecastersA,Bortheforwardratemadethemostaccurateforecast?

b.

Whichoneisthemostuseful?

SOLUTIONS:

a.

Threeforecasters(SA,SB,andSForward)forecast98,88and89Yen/$respectively.Thefuture
spotrateSt+1=92Yen/$.Theforwardratewasthemostaccuratewithanerrorof3/92or
3.26%.

b.

ForecasterAhadthemostusefulforecastsincehecorrectlypredictedthattheyenwould
fallagainstthedollar.ForecasterBwouldhaveadvisednottohedgeandthefirmwould
haveincurredaforeignexchangelossonitsJapanesesales.Eventhoughtheforecastisfar
off,ForecasterAgavethecorrectadviceleadingtoacorrectahedgingdecisionbythefirm.
ForwardsaleofYenat89wouldhavesavedthefirmsomeforeignexchangelosses

2.

You are the treasurer of a large multinational company. Suppose that you receive every month
exchangerateforecastsfortheYen/$exchangeratefromfivedifferentforecastinginstitutions:A,
B,C,D,andE.Fromyourpastexperience,thebestforecasterhasbeenfirmC,followedbyA,D,B,
andE.

ThehistoricRMSE(standarddeviationofforecastingerrors)forthefiveforecastersandthecurrent
predictionsareshowninthefollowingtable:

Forecaster

RMSE

YenForecast

80

15

82

85

10

81

20

88

a.

Calculatethecompositeforecastthatresultsfromevenlyweightingthesefiveforecasts.

b.

Calculateacompositeforecastasdescribedinthechapterthatassignsgreaterweightto
forecastswithgreateraccuracy.

c.

Discusstheadvantagesanddisadvantagesofusingtheforecastin(b)versus(a).

SOLUTIONS:

a.

Theevenlyweightedforecastis0.2x80+0.2x82+0.2x85+0.2x81+0.2x88=83.2

b.

Thissystemassignsweightsinverselyproportionaltoeachforecaster'sstandarddeviation.
TheseweightsarewA=25.53%,wB=11.91%,wC=35.74%,wD=17.87%,andwE=8.94%.
Thecompositeforecast:25.53%x80+11.91%x82+35.74%x85+17.87%x81+8.94%x88=
Yen82.92/$

c.

Composite forecast (b) should be a superior forecast with a smaller RMSE and less bias
since it places greater weights on forecasters that have been more accurate. The
superiority of composite forecast (b), however, depends upon the individual forecasters
retaining their relative accuracy ratings. If the rankings of RMSE were to change, then a
simpleevenlyweightedcompositeforecast,asin(a),couldbesuperior.

3.

Supposeyouareevaluatingtwoforecastersbasedonthefollowinginformation.

ForecasterAmade30"correct"forecastsofatotalof50forecastsduringthelastyear.ForecasterB
made114"correct"forecastsofatotalof200forecastsduringthelastyear,.

a.

WhatistheprobabilitythatforecasterA'strackrecordofcorrectforecastswassimplydue
tochance?(Note:youmayusethenormalapproximationtothebinomialdistribution.)

b.

WhatistheprobabilitythatB'strackrecordofcorrectforecastswassimplyduetochance?
(Note:youmayusethenormalapproximationtothebinomialdistribution.)

c.

DiscusswhetheryouwouldprefertousetheforecastspreparedbyAorB.

SOLUTIONS:
a.

b.

c.

A's track record is p = r/n = 30/50 = 60%. This is greater than 50%. But with only 50
observations, the standard error of the estimate is fairly large, 0.0707 = (0.5*(1
0.5)/50)0.5=(p*(1p)/n)0.5.Sothetvalueagainstthenullhypothesisthatp=0.5[t=(0.60
0.50)/0.0707]is1.414,whichdoesnot fallintotherejectregion at=0.025level(t
2.009)andwefailtorejectthenullhypothesis(Astrackrecordofcorrectforecastswas
simplyduetochance).
B's track record is p = r/n = 114/200 = 57%. This is also greater than 50%. With 200
observations,thestandarderroroftheestimateissmaller,0.0354=(0.5*(10.5)/200)0.5
= (p*(1p)/n)0.5. So the tvalue against the null hypothesis that p=0.5 [t=(0.57
0.50)/0.0354] is 1.977, which does fall into the rejection region at =0.025 level (t
1.960)andwerejectthenullhypothesis(Bstrackrecordofcorrectforecastswassimply
duetochance)andacceptthealternative.
ThereisatradeoffbetweenAandB.Aappearstohaveabetterrecord,butitisbased
on a shorter history so we have less confidence in it. B's track record is slightly less
impressive,butstillshowssignificantexpertisewithatrackrecordbetterthan50%.

4.

AsamultinationalfirmwithsalesinJapan,yourequireforecastsoftheYen/$exchangerate.You
havebeenusingaprofessionalforecastingfirm,CrystalBallAssociates,andnowwanttomeasure
the performance of their predictions. Following is a table showing the Crystal Ball forecasts, the
actualendofperiodratesandtheoneperiodaheadforwardrates.

Period

10

11

12

CrystalBall

Forecast

100

106

102

108

115

109

103

95

93

90

91

85

Actualspotrate

(endofperiod)

101

110

108

105

110

110

98

90

91

85

88

84

1period
forwardrate

98

105

100

102

108

112

105

98

90

89

90

86

(endofperiod)

a.

CalculatetheperformanceoftheCrystalBallforecastsandtheforwardrateusingtheMSE
andRMSEmethodtomeasuretheiraccuracy.

b.

Calculate the performance of the Crystal Ball forecasts and the forward rate using the
percentagecorrectmethodtomeasuretheirusefulness.

c.

Has Crystal Ball Associates demonstrated unusual forecasting expertise according to the
percentagecorrectmethod?

d.

Compareyourresultsusingthetwomethods.Whatdoyouconclude?

SOLUTIONS:

a.

For the forward rate, MSE = 0.0022; RMSE = 0.0468 or 4.68% error in the onemonth
forecast.FortheCrystalBallforecast,MSE=0.0015;RMSE=0.0392or3.92%errorinthe
onemonthforecast.

b.

CrystalBallAssociatesforecastswere"correct"orontherightsideoftheforwardrate10
timesoutof12months,or83.3%.Thepercentagecorrectmethodcannotbeusedforthe
forwardrate.

c.

Crystal Ball Associates track record, 83.3%, is highly unusual, signifying expertise and
makingtheforecastveryuseful.Theprobabilityofgetting10,11or12correctforecastsout
of12(assumingthattheforecasterhasnoexpertise)is(66+11+1)/4096=1.9%,sothisisa
very rare and statistically significant event. The forecaster appears to have significant
expertise.[NOTE:66=12!/(10!2!);11=12!/(11!1!);1=12!/(12!0!);and4096=212which
representsthenumberofpatternsfortossingafaircointwelvetimes.]

d.

CrystalBallAssociatesarenotmuchmoreaccuratethantheforwardrate,buttheycould
beveryusefulifthefirmhashedgingdecisionstomakeonaonemonthhorizon.

Chapter9

3.

GeneralMotorsfinancesitself,amongotherchannels,byusingoneyear,floatingratenoteswhose
ratesarerecalculatedeverythreemonthsatLIBOR+1/8.Anew$250,000,000issueisplannedfor
midSeptember2001withaoneyearmaturity.

a.

Describe how GM could hedge its interest payments for the year. [For convenience,
assumethatCMEmaturitydatescoincidewiththefirm'srolloverdates.]

b.

UsingTable9.3,whatistheyearlyratethatGMcansecureifithedges?

c.

CalculateGM'stotalcostsforthe$250,000,000issueassumingthatithedges.

SOLUTIONS:

a.

GM could sell 250 Eurodollar interest rate futures for every maturity where its interest
paymentsaresetinitiallyorreset;thatis,SeptemberandDecember2001andMarchand
June2002.

b.

Forthenextyear,GMcanlockinLIBORratesof7.13%(Sept2001at92.87);7.17%(Dec
2001at92.83);7.11%(Mar02at92.89);and7.11%(June02at92.89).TheannualLIBOR
rateis:7.13%/4+7.17%/4+7.11%/4+7.11%/4=7.13%/4=1.7825%;or(1+7.13%/4)x(1
+7.17%/4)x(1+7.11%/4)x(1+7.11%/4)1=2.33%.

c.

GMwillpay$250,000,000*(0.017825+0.00125)=$4,768,750.

4.

TheABCfirmisconsideringborrowing$50,000,000foroneyeareitheratafixedrateof6.50%in
the US domestic market or at a floating rate indexed to threemonth LIBOR+1/4 in the
Eurocurrencymarket.Currently,3monthLIBORis5.25%andexpectedtoremainconstantforthe
year.

a.

HowmuchwouldABCsaveifitusestheEuromarketsandtheseexpectationsaremet?[For
convenience,assumethatCMEmaturitydatescoincidewiththefirm'srolloverdates.]

b.

WhataretherisksinusingaEuromarketloan?

c.

Calculate the eventual saving for ABC in the case where LIBOR increases by .50% every
threemonths.

SOLUTIONS:

a.

Savingsare1%oftheoutstandingamountforoneyear,or$500,000.

b.

TherisksareinterestrateriskbecausetheEuromarketloanisonfloatingrateterms,and
rolloverriskifthebankhastheoptiontorefusetoreneworrollovertheloan.IfABChasa
commitment for the year, then it has no rollover risk as long as the bank remains in
operation.

c.

Fixedratecosts:6.5%of$50,000,000=$3,250,000

Floatingratecosts:(1+5.5%/4)*(1+6.0%/4)*(1+6.5%/4)*(1+7.0%/4)=1.0625,ora
costof6.25%.On$50,000,000principaltheinterestbillwillbe$3,125,000;stillbetterthan
a6.5%fixedrate.

5.
Suppose that threemonth Eurodollars are quoted in the interbank markets at 6.0% 6.125% by
Londonbanks,and6.25%6.375%bySingaporebanks.

a.

Explainhowyoucouldattempttomakearbitrageprofitsintheabovecase.

b.

Howlargeistheprofitfromarbitraging$1,000,000inthiscase?

c.

Whatrisksand/orcostsdoyoufaceinattemptingthearbitrage?

SOLUTIONS:

a.

A trader would attempt to borrow dollars from a bank in London at 6.125% and then
depositthematabankinSingaporefor6.25%.

b.

The potential profit is 0.00125 * $1,000,000 / 4 = $312.50. Remember, these are per
annuminterestratesforathreemonthperiod.

c.

The trader carries the political risk of deposits in Singapore. If funds were blocked in
Singapore, he might not be able to pay back his London loan. Time differences between
LondonandSingaporemayalsoincreasethedifficultyofthistransaction.

Chapter10
1.

Suppose IBM is issuing $100 million in 7year Eurobonds priced at U.S. Treasury minus 25 basis
points.Thereisgreatdemandfortheissueandyouarewillingtobid102for10%oftheissue.

a.

Ifyouactuallygetyourbidexecuted,howmuchwillyoupayforthebond?

b.

Ayearlater,theIBMEurobondsaretradedontheLuxembourgExchangeat105.Whatis
thevalueofyourinvestment?Whatisyourcapitalgain(loss)?

c.

Youdecidetosellthebondattheabovepricetopursueotheropportunities.Whatamount
ofwithholdingtaxesareyourequiredtopay?

SOLUTIONS:

a.

Priceis102%ofparor1,020perbond;102%*10%*100million=$10.20millionforyour
shareoftheissue.

b.

Priceis105%*10%*100=$10.50million.Gainis$300,000.

c.

NowithholdingtaxesapplyintheEurobondmarket.

2.
SupposeCreditSuisseFirstBoston(CSFB)isthesoleleadmanagerina$100millionboughtdealfor
theWorldBank.CSFBdecidestopricethesevenyearissueatpartoyield8%.

a.

WhatwillbeCSFBspositioniftheFeddecidestoincreaseshortterminterestratesby50
basispointsduringtheofferingperiod?

b.

InsteadoftheFedmovedescribedinaabove,supposethatinternationaltradetalksbreak
down leading to a depreciation of the dollar on currency markets. What will be CSFBs
positioninthiscase?

c.

CalculatethegainorlossforCSFBifthesevenyearEurobondraterisesto8.25%onthe
offeringday.(Note:Eurobondspayinterestonlyonceeachyear.)

d.

SupposeCSFBcollects2%infeesforleadmanagingtheissue.Again,calculatetheoverall
gainorlossforCSFBifthesevenyearEurobondraterisesto8.25%ontheofferingday.

e.

(Optional)HowcouldCSFBhedgetherisksdescribedin(a)and(b)?

SOLUTIONS:

a.

b.
Sameasin(a).Toattractinvestorsthatshyawayfromdollarassets,CSFBwillhavetolower
theEurobondpricetoalevelattractivetolenders.

The yield required bythe marketonlongterm bondsmay changein response to the 50


basispointincreaseinshorttermrates.Iflongterminterestratesrise,thenbypledgingto
sell the Eurobonds at par, CSFB will lose the difference between par and the new lower
priceofthebond.Longterminterestratesmayfall,however,ifthemarketsensesthatthe
increaseinshorttermrateswillreducelongerruninflationarypressures.Inthiscase,CSFB
enjoysacapitalgain.

c.

TheEurobondpricefallsto$987.09per$1,000.00facevalue.
7

$987.09 =

T =1

80
1.0825

1000
7

1.0825

Theunderwriterloses1.291%onthe$100,000,000issueor$1,291,000.

d.

IfCSFBcollects2.0%infees,ittransfersonly$980perbond,or$98,000,000ontheentire
issuetotheWorldBank.CSFB'snetprofitisthen$2,000,000$1,291,000=$709,000.

e.

CSFBcanhedgetheincreaseininterestratesbysellinginterestratefutures.