HKUST Department of Finance

FINA 4403 Spring 2020

International Finance Dr. Kai Li

Assignment 5
Instructions: The assignment is individual based. The due date is
May 15 (Friday), before midnight (11:59pm required by Canvas system).
Please submit your write-up of the assignment elecntronically (either typed or
scanned version) through the Canvas system. Your full name and student ID
must be clearly printed on the front page of your write-up. For the multiple-
choice questions, choose ONLY one best answer. No need for explanations.
Except for multiple-choice questions, you should list every relevant step used
to arrive at the answer/justi…cation. If you just give a numerical answer
without listing work, you may not be given full points.

Note: In this assignment, when you work on option hedging exercises,

please ignore the time value of money of the option premium paid upfront.

Questions 1-4 are multiple choice questions. For each question, please
only choose one best answer.
D 1. The best …nancial instrument to hedge a recurrent exposure is:
A) forwards
B) futures
C) options
D) swaps

2. Which of the following statements about the portfolio frontier is (are)

D correct?
i) Portfolio frontier includes both the e¢ cient frontier and the ine¢ cient
frontier.
ii) Given the expected return, a portfolio on the portfolio frontier has
the smallest return variance among all portfolios.
iii) Given the return volatility, a portfolio on the portfolio frontier has
the largest expected return.
A) i) only
B) i) and ii)
C) ii) and iii)
D) i), ii), and iii)

3. The mean and standard deviation (SD) of two stocks, A and B, are
as follows

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 Stock Mean (%) SD (%)
A 10 18
B 12 20
Suppose the two stocks are not correlated. Consider a portfolio with 30%
investment in A and 70% investment in B. What is the standard deviation
for the portfolio return?
D A) 13.5%
B) 14%
C) 15%
D) 19.4%

4. In the above question, what is the expected return for the global
C minimum variance portfolio?
A) 13.67% wA = 0.2^2 / (0.18^2+0.2^2) = 55.25%
B) 13.38%
C) 10.89%
D) 11.11%

5. Suppose today the (annualized) interest rates on USD and AUD are
0% and 4%, respectively, and the exchange rate is $1/AU$. Consider the
following two strategies. In strategy A, you borrow one million USD and
use the proceeds to buy one million AUD and invest in AUD. In strategy B,
you long a one-year forward contract which is written on one million AUD.
The investment horizon is one year and interests are only paid at the end
of the one-year horizon. Suppose the exchange rate changes to $1.1/AU$ in
one year.
a) Calculate your pro…t/loss (quoted in USD) from strategy A.
b) Calculate your pro…t/loss (quoted in USD) from strategy B. (Hint:
…rst determine the forward rate using the strict form of IRP)
c) Repeat b) when a forward contract is written on USD 1,000,000/F in-
stead, where F denotes the forward exchange rate calculated in b). Compare
your result with that in a): what conclusion can you draw?

6. You are considering investing in one or both assets called A and B.

Both A and B have identical expected returns and standard deviations. One
of your friends have made the following comments: (I) “No matter how you
set up your portfolio between A and B, you will have the same expected
return” (II) “No matter how you set up your portfolio between A and B,
you will have the same portfolio return volatility.”
a) Suppose the returns of the two assets have 0 correlation. Evaluate (I)
and (II), i.e. are they true or false and why.
b) Now suppose the return correlation between the two assets is 1. Again
Evaluate (I) and (II).

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 7. Based on Ti¤any & Co. — 1993. Suppose now is June 1993,
Ti¤any & Co., a US company, will have U100; 000; 000 cash in‡ow in
three month (i.e. September 1993). The company decides to use option
with strike price "92" (The quotation is based on the following Table) to
hedge for the exchange risk. What should the manager do? Suppose the
spot exchange rate in September 1993 turns out to be U102:01=$, what
is the gain or loss on the option position net of the option premium paid
upfront? What is the gain or loss on the USD dollar value of U100; 000; 000
receivables relative to that of the spot exchange rate in June 1993, with
the spot exchange rate in June 1993 as JPY106.35/USD? What is
the total gain or loss comparing with not hedging in the …rst place?

Questions 8 10 are based on same company: Hedging Currency

Risks at AIFS
8. The AIFS, a US company, will receive revenue of $60; 000; 000 and
incur a cost of e25; 000; 000 in one year. Suppose there are three exchange
rate scenarios (stable dollar: 1.22 USD/EUR; strong dollar 1.01 USD/EUR;
weak dollar 1.48 USD/EUR) which are expected to happen in one year
with equal probability (1/3) and the company has an income tax of 30%,
the taxable income of which is di¤erence of revenue and cost. What is the
expected dollar pro…t of AIFS (i.e. revenue minus cost and tax payment)
with no hedge?

9. Suppose the forward contract on e is now quoting at $1:22=e, what

is the expected dollar pro…t of AIFS based on exchange rate scenarios in

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question 8 with with forward market hedge of the foreign currency cost of
e25; 000; 000? In your answer to this quesiton, please clearly specify the
long/short position, and hedging amount, and the underly currency of your
hedging instrument.

10. What is the expected dollar pro…t (net of option premium) of AIFS
based on exchange rate scenarios in question 8 with the option market hedge?
For the option strategy, AIFS would have to pay an option premium of 5%
of the USD notional value. For example, if AIFS decided to use options on
e to hedge projected costs of one million euros at the current exchange rate
of $1:22=e, it would pay an option premium of $61; 000. In your answer
to this quesiton, please clearly specify the long/short position, and hedging
amount, and the underly currency of your hedging instrument.

Questions 11-13 are based on the same company: TCAS

11. TCAS, a U.S. …rm, bids C$ 2,900,000 for the project. If the bid gets
accepted, TCAS expects to have C$ 2,900,000 receivables. The manager
considers three scenarios for the future spot exchange rate: the stable dollar
scenario $0.73/C$, the strong dollar scenario $0.68/C$, the weak dollar sce-
nario $0.76/C$. Suppose the company wouldn’t know if the bid is successful
until 90 days later. Conditional on the bid being successful, what would be
the payo¤ in 90 days (i.e. dollar amount of payo¤ net of any hedging costs)
for forward hedging and option hedging respectively under each exchange
scenario? At the time, the 90-day forward price was 1C$=US$0.7324. The
90-day currency option premium rates on a strike of 1C$ = US$ 0.7200 were:
call premium– US$0.0356/C$; and put premium– US$0.0225/C$. In your
answer to this quesiton, please clearly specify the long/short position, and
hedging amount, and the underly currency of your hedging instrument.

12. If the company’s bid fails, what would be the payo¤ in 90 days (i.e.
dollar amount of payo¤ net of any hedging costs) for forward hedging, option
hedging respectively under each exchange scenario?

13. Suppose the probability of a successful bid is 12 and three exchange

rate scenarios happen with equal probability, and suppose these two events
are independent (i.e. the successful bid does not depend on the exchange
rate scenarios), calculate the expected payo¤ for forward hedging and option
hedging respectively.

14. Note this is a stand-alone question independent of cases. Suppose

…rm A can issue …xed-rate debt of the same maturity at 10:3% or ‡oating-
rate debt at LIBOR + 0:5%. Firm B can issue …xed-rate debt at 9:3% or
‡oating-rate debt at LIBOR + 0:3%.

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 A B
Fixed 10.3% 9.3%
Floating LIBOR+0.5% LIBOR+0.3%
Suppose that A prefers to issue …xed-rate debt whereas B prefers to
issue ‡oating-rate debt. If you were an investment banker, how could you
arrange an interest rate swap between A and B to make everybody happy?
Write in the …gure the cash ‡ows with arrows to describe your answers.
In addition, compute the net borrowing position for both …rms and the
percentage returns for the international banker. (Hint: you may use the
following numbers: 9.7%, 9.6%, LIBOR+0.1%, and LIBOR+0.2%)