HKUST Department of Finance

FINA 4403 Spring 2020

International Finance Dr. Kai Li

Assignment 6

Instructions: The assignment is individual based. The due date is May

18 (Monday), 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 ques-
tions, 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: For quantitative multiple choice questions, please include necessary

calculation steps.
1. Consider the graph of a call option shown at right. The option is a three-
month American call option on e62; 500 with a strike price of $1:50 =e1:00 and
an option premium of $3; 125. What are the values of A, B, and C, respectively?

A. A = -$3,125 (or -$.05 depending on your scale); B = $1.50; C = $1.55

B. A = -e3,750 (or -e.06 depending on your scale); B = $1.50; C = $1.55
C. A = -$.05; B = $1.55; C = $1.60

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 D. none of the above

2. Suppose the quote for a …ve-year swap with semiannual payments is 8.50—
8.60 percent. This means
A. the swap bank will pay semiannual …xed-rate dollar payments of 8.50
percent against receiving six-month dollar LIBOR.
B. the swap bank will receive semiannual …xed-rate dollar payments of 8.60
percent against paying six-month dollar LIBOR.
C. both a) and b)
D. none of the above

3. Company X wants to borrow $10; 000; 000 ‡oating for 5 years; company
Y wants to borrow $10,000,000 …xed for 5 years. Their external borrowing
opportunities are shown below:

Fixed-rate Borrowing Cost Floating-rate Borrowing Cost

Company X 10% LIBOR
Company Y 12% LIBOR+1:5%

A swap bank proposes the following interest only swap: X will pay the
swap bank annual payments on $10,000,000 with the coupon rate of LIBOR -
0.15%; in exchange the swap bank will pay to company X interest payments on
$10,000,000 at a …xed rate of 9.90%. What is the value of this swap to company
X?
A. Company X will lose money on the deal.
B. Company X will save 25 basis points per year on $10,000,000 = $25,000
per year.
C. Company X will only break even on the deal.
D. Company X will save 5 basis points per year on $10,000,000 = $5,000 per
year.

4. Suppose that Boeing Corporation exported a Boeing 747 to Lufthansa

and billed e10 million payable in one year. The money market interest rates
and foreign exchange rates are given as follows:

Assume that Boeing sells a currency forward contract of e10 million for delivery
in one year, in exchange for a predetermined amount of U.S. dollar. Which of
the following is (or are) true? Let us use the exact version if IRP in this question.
On the maturity date of the contract Boeing will:
(i) have to deliver e10 million to the bank (the counterparty of the forward
contract)

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 (ii) take delivery of $14.6 million (i.e. receive $14.6 million)
(iii) have a zero net e exposure
(iv) have a pro…t, or a loss, depending on the future changes in the exchange
rate, from this Boeing 747 sale
A. (i) and (iv)
B. (ii) and (iv)
C. (ii), (iii), and (iv)
D. (i), (ii), and (iii)

5. Your …rm is a U.K.-based exporter of bicycles. You have sold an order

to a French …rm for e1,000,000 worth of bicycles. Payment from the French
…rm (in euro) is due in 12 months. Use a money market hedge to redenominate
this one-year receivable into a pound-denominated receivable with a one-year
maturity.

The following were computed without rounding. Let us use exact version of
IRP for this question. Select the answer closest to yours.
A. £ 803,721.49
B. e800,000
C. £ 780,312.13
D. £ 72,352.94

6. A Japanese EXPORTER has a e1,000,000 receivable due in one year.

Detail a strategy using options that will eliminate exchange rate risk.

A. Buy 16 put options on euro, sell 10 call options on yen.

B. Buy 16 put options on euro, buy 10 call options on yen.
C. Sell 16 call options on euro, buy 10 put options on yen.
D. None of the above

7. XYZ Corporation, located in the United States, has an accounts payable

obligation of U750 million payable in one year to a bank in Tokyo. The current

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spot rate is U116=$1:00 and the one year forward rate is U109=$1:00. The
annual interest rate is 3 percent in Japan and 6 percent in the United States.
XYZ can also buy a one-year call option on yen at the strike price of $0:0086
per yen for a premium of $0:012 cent per yen. Assume that the forward rate
is the best predictor of the future spot rate. Let us assume to ignore the time
vaule of money for the option premium paid upfornt. The future dollar cost of
meeting this obligation using the option hedge is
A. $6,540,000.
B. $6,545,400.
C. $6,653,833.
D. $6,880,734.

8. On a recent sale, Boeing allowed British Airways to pay either $18 million
or £ 10 million.
A. At the due date, British airways will be indi¤erent between paying dollars
or pounds since they would of course have hedged their exposure either way.
B. Boeing has provided British Airways with a free option to buy $18 million
with an exercise price of £ 10 million.
C. Boeing has provided British Airways with a free option to sell up to £ 10
million with an exercise price of $18 million.
D. All of the above

9. Emerald Energy is an oil exploration and production company that trades

on the London stock market. Assume that when purchased by an international
investor the stock’s price and the exchange rate were £ 5 and £ 0.64/$1.00 re-
spectively. At selling time, one year after the purchase date, they were £ 6 and
£ 0.60/$1.00. Calculate the investor’s annual percentage rate of return in terms
of the U.S. dollars.
A. 0.20%
B. 20.00%
C. 1.28%
D. 28.00%

10. Emerald Energy is an oil exploration and production company that trades
on the London stock market. Over the past year, the stock has gone from £ 50 per
share to £ 55, but over the same period, the dollar has depreciated ten percent
against pounds. Calculate the investor’s annual percentage rate of return in
terms of the U.S. dollars.
A. 3.5%
B. -.01%
C. 22.2%
D. There is not enough information to compute the investor’s annual per-
centage rate of return in terms of the U.S. dollars.

11. The realized dollar returns for a U.S. resident investing in a foreign
market will depend on the return in the foreign market as well as on the exchange

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rate ‡uctuations between the dollar and the foreign currency. Calculate the
variance of the monthly rate of return in dollar terms, if the variance of the
foreign market’s return (in terms of its own currency) is 1.14, the variance
between the U.S. dollar and the foreign currency is 17.64, the covariance is 2.34,
and the contribution of the cross-product term is 0.04.
A. 21.16
B. 23.50
C. 26.89
D. 28.65

12. Assume spot Swiss franc is $0.7000/SF and the six-month forward rate is
$0.6950/SF. What is the minimum price that a six-month European call option
with a striking price of $0.6800 should sell for in a rational market? Assume
the annualized six-month Eurodollar interest rate is 3.5 percent.

13. Do problem 12 again assuming an European put option instead of a call

option.

14. Assume today’s settlement price on a CME EUR futures contract is

$1.3140/EUR. You have a short position in one contract. Your margin account
currently has a balance of $1,700. The next three days’ settlement prices are
$1:3126, $1:3133, and $1:3049. Calculate the changes in the margin account
from daily marking-to-market and its balance after the third day.

15. As an Japanese importer of grain into Japan from the United States, you
have agreed to pay $377,287 in 90 days after you receive your grain. You face
the following exchange rates and interest rates: spot rate, U106:35=$; 90-day
forward rate, U106:02=$; 90-day USD interest rate, 3:25% per year; and 90-day
JPY interest rate, 1:9735% per year.
a) Describe the nature and extent of your transaction foreign exchange risk
from the persepctive this Japanese importer.
b) Expain two ways to hedge the risk. Speicy clearly the long/short position,
hedging amount and the underlying currency of the hedging instrument.
c) Which of the alternatives in part b is superior?

16. Suppose that in Japan the current interest rate is 5% per annum and
one-year in‡ation rate is expected to be 3%. Meanwhile, the expected one-year
in‡ation rate in France is 4%, and the US current interest rate is 3% per annum.
The currency used in France is Euro. In the current period, assume absolute
version PPP and as well as other international parity relationships hold.
(a) What is the best estimate of the one-year forward premium (discount)
at which the USD will be selling relative to the Euro (consider USD as the base
currency)? What is the best estimate of the expected one-year in‡ation rate
in US? Only in this sub-question, assume the approximate versions of various
international parity relationship work reasonably well.

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 (b) Suppose one year later, the realized spot exchange rate ($/e) is 5%
higher than the predictor in American term based on the unbiased hypothesis,
but the realized in‡ation rates in France and US are consistent with the forecasts
made one year earlier, as we learned from the question and your answer in (a),
respectively. Please calculate the real exchange rate of Euro at this time point
(i.e. one year after the current period), considering US dollar as the domestic
currency.
(c) Based your calculation in (b), what is the percentage over/under valua-
tion of Euro against US dollar?

17. You plan to visit Geneva, Switzerland in three months to attend an

international business conference. You expect to incur the total cost of SF5,000
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. Let us
assume to ignore the time value of money for the option premium paid upfront.
(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 indi¤erent 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.

18. Suppose that Baltimore Machinery sold a drilling machine to a Swiss

…rm and gave the Swiss client a choice of paying either $10,000 or SF15,000 in
three months.
(a) In the above example, Baltimore Machinery e¤ectively gave the Swiss
client a free option to buy up to $10,000 dollars using Swiss franc. What is the
‘implied’exercise exchange rate?
(b) If the spot exchange rate turns out to be $0.62/SF, which currency do
you think the Swiss client will choose to use for payment? What is the value of
this free option for the Swiss client?
(c) What is the best way for Baltimore Machinery to deal with the exchange
exposure?

19. Mr. James K. Silber, an avid international investor, just sold a share of
Nestle a Swiss …rm, for SF5,080. The share was bought for SF4,600 a year ago.
The exchange rate is SF1.60 per U.S. dollar now and was SF1.78 per dollar a
year ago. Mr. Silber received SF120 as a cash dividend immediately before the

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share was sold. Compute the rate of return on this investment in terms of U.S.
dollars.

20. In the above problem, suppose that Mr. Silber sold SF4,600, his principal
investment amount, forward at the forward exchange rate of SF1.62 per dollar.
How would this a¤ect the dollar rate of return on this Swiss stock investment?
In hindsight, should Mr. Silber have sold the Swiss franc amount forward or
not? Why or why not?