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3125 % pa Advise the UK importer on how this objective may be achieved. In order for the transaction to be profitable.5526 6 month £ interest rate 3.   (c) Briefly explain the nature of covered interest arbitrage and determine whether such an opportunity exists given the data presented in (b).2500 .000 invested.   ?  . Given the following information: Spot £1 = US\$ 1. the cost of the imported goods must not exceed £6.5520 .5875 ± 3.000.1.   (b) A UK importer has purchased goods from the USA. If it does.000.6500 % pa 6 month US\$ interest rate 1.000.1.000.400. calculate the profit per £10.1.5862 . Payment will be made against shipment in 6 months time for the amount of US\$10.    (a) Briefly discuss the theoretical relationships between interest rates and foreign exchange rates and summarise the empirical evidence relating to these.5866 6 months forward £1 = US\$ 1.

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if a high interest rate merely reflects high inflation. one would expect currency appreciation.5520 = £6. International Fisher Vffect.    !  "!# r? Buy US\$/sell sterling 6 months forward at £1 = US\$ 1.5520 r? üost of US\$ 10m = 10m/1. one would expect the currency to depreciate. Vg Governments attempt to support their currency by raising short-term interest rates. r? 2n the other hand. then other things being equal. r? Also expect brief discussion of relevant empirical evidence.443.299 r? *oes not satisfy criterion \$. Interest Rate Parity Theory and possibly Purchasing Power Parity. r? If a currency offers a higher real rate of interest.     r? Vxpect discussion of the Fisher Vffect.

218 * (1 + (6/12 * 1.937.265.888 spot and sell sterling at 1.00625 = 9.0365)) = £6.379.218 r? *eposit US\$ 9.5862 r? Sterling cost is 6.888 for 6 months at 1.558 r? Satisfies criterion '( !.265.%\$  &!# r? üreate *IY forward rate r? Buy US\$ 10m/1.25% pa r? alue of deposit is US\$ 10m in 6 months time r? Sterling cost plus borrowing cost is 6.937.

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5520 .01825 = 1.00625/1.5862 * 1. % r? Actual forward rate is £1 = US\$ 1.5675 r? i    .1.5526 r? Aoney market forward rate for buying US\$/selling £ is £1 = 1.

068  r? ÔÔ   .577.526.  r? Buy sterling 10m 6 months forward at a cost of 10m *1.771 spot at 1.5862 r? Borrow £ for 6 months at 3.loan becomes 10m in 6 mths time r? US\$ cost of purchase is 9.000 r?    r? Sell 10m/1.707 (1 + (6/12 * 0.250% pa r? *eposit grows to 15.820.01825 = £ 9.707 r? Place US\$ on deposit for 6 months at 1.577.820.5862 = US\$ 15.65% pa .675.5526 = US\$ 15.771*1.0125)) = US\$ 15.

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There are to be two consignments.9005 3 month forward rate £1 = \$1.   (b) Given the above and the market information provided below.000 units. A US exporter has entered into an agreement to supply goods to a UK company at a fixed cost of £25 per unit. (a) Briefly explain the nature of the exchange rate risk in this situation. Vach consignment will consist of a minimum of 100. devise and justify a suitable hedge strategy:   Spot rate £1 = \$1.000 units per consignment at the same price.8775 ± 1.8680  ' .8876 6 month forward rate £1 = \$1. The policy of the US exporter is to fully hedge future foreign currency cash flows.8870 ± 1.9000 ± 1. but the UK company also has the option of purchasing an additional 25. one in 3 months¶ time (1st September 2004) and the other in 6 months¶ time (1st *ecember 2004).

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125 ± 4.25%   +.    *)  3 months 6 months US *ollar 1.750 ± 1.000 ± 4.875% 1.875% Sterling 4.750 ± 1.125% 4.

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45 3.000 units were sold (d) Briefly discuss the factors affecting the cost of currency options.95 (c) üalculate the profit on the transaction given the following information: -  (i)? The cost of producing the goods was \$40 per unit for both consignments (ii)? The spot rate was £1 = \$1.22 2.8705 on 1st September 2004 and 100. Strike üalls Puts 3-mth 6-mth 3-mth 6-mth 1.0100 ± 2.9000 2.09 2.000 units were sold (iii)? The spot rate was £1 = \$2.     .8700 ± 1. ) .0105 on 1st *ecember 2004 and 125.

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use of options for the potential 25.   (a)? Transaction risk Sterling depreciates against the US\$ Uncertainty surrounding whether additional units will be purchased (b) For both consignments.000 units.000 additional units   '. use of either the forward or spot & AA hedge for 100.

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25*0.5m forward at \$4.717.075 Spot & AA provides the best rate   '.125% pa *eposit US\$ for 3-months at 1.75% pa Rate achieved = [1.722.88883 Sell £2.90 Borrow £ for 3-months at 4.500 Spot & AA Sell £ spot at \$1.25*0.  Forward market Sell £2.5m forward at 1.8870 = \$4.0175)]/[(1+(0.04125] Rate achieved = 1.90 * (1+(0.

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062.000* £25*0.50 '.  Buy 3-mth sterling puts at a cost of 25.0209 = \$13.

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5*00.425] Rate achieved = 1.691.75% pa Rate achieved = [1.693.  Forward market Sell £2.850 Forward market provides the best rate '.8775 = \$4.5m forward 1.0175)]/[(1+(0.750 Spot & AA Sell £ spot at \$1.90 Borrow £ for 6-months at 4.25% pa *eposit US\$ for 6-months at 1.5m forward at \$4.5*0.90 * (1+(0.87674 Sell £2.

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.50 (c) 3-mth put expires in the money profit = 625.000.722.693. maturity.437.750 25.000 sold at £25.000 sold at £25.  Buy 6-mth sterling puts at a cost of 25. spot & AA value = \$4.325 ü2GS 225. spot rate.01 = \$1.256. forward market value = \$4. spot value \$2.0295 = \$18.075 2nd consignment 100. interest rates on the two currencies.250 Net loss on options = \$12.000 * \$40 \$9.750 Total sales revenue \$10.659.687. American/Vuropean style and the expected volatility of the exchange rate.000* £25*0.87) = \$5.000 sold at £25. olatility is the most important.000*(1.50 6-mth put expires worthless loss = \$18.9-0.000 c 0     1/23/4 (d) Strike price.437.0209-1.50 1st consignment 100.

1. 8  (c) Forecasting exchange rates is extremely difficult.20 US\$1 = Yen 125 2ther market-based information available is as follows: Spot Vxchange Rate US\$1 = Yen 107. as well as taking advantage of the increased interest rates available on US\$-denominated deposits. Given Yen 500 million available as surplus cash flow for the next six months. explain why only uncovered interest arbitrage. calculate the approximate bid-ask spread of the six- month forward rate using the interest rate parity relationship. -   (d) Assuming the treasury department's forecasts to be accurate. the treasury department is looking to profit from its view of US\$ appreciation.4 The treasury department of a Japanese-based company believes that the US\$ is currently undervalued with respect to all major currencies. from exploiting uncovered interest arbitrage in this situation. Senior executives in the department also believe that this under-valuation will correct itself during the next six months.3000 ± 0.3125% pa 56 !7 (a)? Given the information provided above. including the Yen. based on fundamental economic indicators.5125% pa Six month Yen rates 0. calculate the expected return.80 Six month US\$ rates 1.50 ± 107.10 US\$1 = Yen 105 0. rather than covered interest rate arbitrage. as well as the range of returns.     . The treasury department's forecast of the exchange rate between the US\$ and Yen in six month¶s time is as follows: c  + %  )' !) 5  0.20 US\$1 = Yen 110 0. Vxplain two approaches commonly used and discuss the problems associated with each. would be expected to generate a profit in this situation.50 US\$1 = Yen 120 0. 2  (b)? Assuming the rates quoted above relate to euro-currency money markets.5000 .

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5125% pa for 6 months *eposit Yen at 0.85 Buy \$ spot at 107.0075) = 107.0075625) = 106.5% pa for 6 months Borrow Yen at 0.3% pa for 6 months Rate achieved 107.50 * (1.16 ) 9\$\$ )+!0  ! 1:.3125% pa for 6 months Rate achieved 107.80 * (1.0015/1.0015625/1.80 *eposit \$ at 1.  (a) Sell \$ spot at 107..50 Borrow \$ at 1.

The quoted forward rate would be the rate predicted by IRPT ± it merely adjusts for interest rate differentials. üIA is a simple risk free arbitrage. technical and market-based approaches (d)?       . and any temporary mis-pricing would be arbitraged away very quickly. (c)? ühoose between the fundamental. not taking a view of future exchange rate movements as in this case.-8<2 (b) Vuro-currency markets are efficient.-2<. have low transaction costs and there is no political risk.

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2  (d) What do you understand by the term ³verbal intervention´. -  (b) Given your knowledge of the relationships between interest rates and exchange rates.     . and thus the importance of the US attracting foreign portfolio inflows in this situation. distinguish that with direct intervention and comment on the likely effectiveness of both.  2  56 !7  (a) Given that the US has been running consistent current account deficits.    (c) *iscuss the potential basis for the comment that the dollar has been weakened because investors have hedged their positions. discuss why sterling might have tested new highs. clearly explain the relationship between the current account and capital accounts.

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but have hedged their exposure to the US\$ exchange rate by selling expected investment proceeds forward. interest rates in the UK are more likely to rise than fall in the near term. (b)? Vxpect discussion of the FV and IFV and the distinction between real and nominal rates of interest. and that the net between the two represents net outflow/inflows that impacts on foreign currency reserves. and therefore current account. (d)? erbal intervention ± trying to talk the value of the Vuro down ± as opposed to direct intervention. and thus providing a higher real rate of return. Through IRPT if the US\$ depreciates in the forward market it will also depreciate in the spot market. (c)? That investors may have been fairly bullish about. deficits that are not easily sustainable unless it continues to attract investors in US stocks and bonds. eg the performance of the US stock market. ?? ? ? ? ? ? . whereby the VüB sells Vuros and buys US\$ and/or buys £ in the market. We would not have discussed this specifically during the unit. boosting the attractiveness of holding sterling. Link that to the current level of interest rates in the US and the performance of the stock market. but hopefully students have been reading the FT?! Have mentioned the comparative ineffectiveness of large-scale sales of Yen against the dollar over the last few months and students might mention the arguments about whether the central bank has a better view of where their currency should trade relative to the market. Vxpect students to be aware that the US has consistently large balance of trade.  (a)? Vxpect clear description of what items are recorded in the current account and capital accounts. Given domestic concerns.

 BRA is a German based company with significant export sales to other Vuropean countries including the UK. the coupon payment) varies dependent upon the currency of issue   (b)? Assuming the forecast exchange rates to be accurate. Specifically. discuss the likely impact on BRA's currency risk exposure. calculate the effective cost of raising funds in Vuros.61 + 2 years 1Vuro = GBP 0.05% (ii)? The issue of GBP 300 million nominal 5-year bonds. over the 5-year period. Two financing options have been selected for consideration: (i)? The issue of Vuro 500 million nominal 5-year bonds.69 This compares to a current spot rate of 1Vuro = GBP 0.70 + 4 years 1Vuro = GBP 0.6125 56 !7 (a)? Briefly explain why the cost of raising funds by BRA (i. wanting to raise the equivalent of Vuro 500 million through the issue of five-year bonds. versus raising funds in GBP.63 + 3 years 1Vuro = GBP 0. the consensus view of the treasury department is that the Vuro will appreciate against GBP over the next 5 years.   (c)? If the GBP-denominated Vurobond option was selected. issued and redeemed at par.     . The treasury department of BRA is considering Vurobond financing options.e. issued and redeemed at par.75%. Although the coupon on GBP-denominated bonds is higher than that on equivalent Vuro- denominated bonds. the following exchange rates have been forecast:  ) ! )  >5  + 1 year 1Vuro = GBP 0.70 + 5 years 1Vuro = GBP 0. with an annual coupon of 5. with an annual coupon of 5. The objective is to minimise the cost of financing without exposing the company to undue currency risk.

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etc. would be approximately 3.05% The equivalent cost in Sterling.  (a)? üost for BRA = govt 5-year rate + risk premium Risk premium depends on the creditworthiness of the issuer.22% ü  ü      ! " #\$%   &%! " '%(ü  '%(ü  h hh h      h hh       hhh  h     hhhh    h   hhhh     h    hhh    h  . France. etc. sentiment in the market at the time. Aost likely that the cost varies because 5-year Gilts currently offer a higher yield than Vuro- denominated Treasuries offered by governments such as Germany. marketability of the issue. (b)? The costs of raising funds in Vuro would be 5. assuming the exchange rate forecasts to be accurate. size and likely liquidity of the issue.

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If sterling depreciates to the extent expected. If sterling appreciates instead. there would be a saving in financing costs and this might offset reduced price competitiveness and its impact on export sales to the UK (real operating exposure).  (c)? Given that BRA has export sales to the UK. but this might be offset by increased price competitiveness and increased exports to the UK. .". issuing debt in sterling may not increase the company's exposure to currency risk. against the forecast. the cost of raising funds would be higher. Since BRA exports to the UK. some sales are likely to be invoiced in GBP. and may even reduce it. and transaction exposure would be reduced to the extent that the company uses these GBP receivables to fund the coupon payments.

2 V   )    '     )  '  &    '    &     )     )  2 üritically evaluate this comment 4\$   2.

thereby increasing the cost of obtaining and raising finance r? Hedging translation exposure may create additional risk on the basis that: |? FX translation losses might be viewed as only ³paper´ profits/losses. using forward currency hedges might therefore create additional risk if the actual profit is very different from that forecasted .  Relevant points to mention might include: Vxtra marks for citing specific examples r? Transaction exposure is definitely relevant but some argue that translation exposure is not r? Transaction exposure may not always be hedged however: |? The size of the exposure may be negligible |? The company may take a view on the direction of FX movements |? The company may view FX risk as an integral part of its operations |? Future inflows and outflows may net off with one another |? Two foreign currency flows may be highly correlated ± e. but forward currency hedges create real cash flow losses/profits |? Profits from overseas subsidiaries may be difficult to forecast accurately. Vuro & *Kr r? 2nly some view translation exposure as irrelevant on the basis that: |? It may not have cash flow implications |? It is a purely accounting anomaly |? Investors can hedge the risk for themselves |? Profits from foreign subsidiaries may not be repatriated |? FX rates are volatile and do not always reflect economic fundamentals r? 2ther companies do hedge translation exposure however: |? It does have cash flow implications because profits are repatriated |? FX losses might increase the volatility of earnings.g.

( ) (c) *iscuss the arguments both for and against hedging translation risk. 4   8.e.8  (a) üompare and contrast the nature of transaction risk and translation risk. -  (b) Both internal and external hedging techniques may be used for the management of transaction risk. Briefly discuss  examples of each (i. two internal techniques and two external techniques).

balance sheet hedging. netting. futures. etc (c) For hedging translation exposure: [? It has cash flow implications if profits are repatriated [? Poor consolidated results may have an impact on the company¶s share price [? FX losses might increase the volatility of earnings. options. thereby increasing the cost of obtaining and raising finance Against hedging translation risk: [? It may not have cash flow implications if profits are not repatriated [? It is a purely accounting anomaly [? Investors can hedge the risk for themselves [? It is difficult to accurately forecast subsidiary earnings & exchange rates Additional marks if students quote actual examples . etc Vxternal ± two from the use of forwards. swaps.  (a) Vxpect brief definition of each Vxpect emphasis on the compare & contrast aspect Vase of measuring/forecasting transaction & translation exposure Impact on cash flows & the value of the firm (b) Vxplanation of the distinction between internal and external hedging techniques Internal ± two from leading & lagging.

-   .   (ii) üompare and contrast  different approaches for forecasting exchange rates. Suggest possible reasons for this. a reduced trade deficit or an increased trade surplus). briefly explain why one might expect this to lead to an improvement in the trade balance (i. (a) If a country¶s currency depreciates.e. 8  (b) üonsidering the situation in the USA. (i) Briefly describe the impact of  of these. this has not been the case over the last 3+ years. -  (c) Vxchange rates are affected by many factors.

direct intervention by Japan to keep the value of the Yen against the US\$ ³artificially´ low or by the ühinese authorities to peg the exchange rate to the US\$ at an undervalued rate [? *iscussion of the capital account ± US continues to attract both portfolio investment and F*I (c)(i) *iscussion of inflation. market based or mixed approaches Brief explanation of the two approaches *iscussion of the compare & contrast aspects *iscussion of the relative effectiveness of the two approaches ? . interest rates.g.  (a) Brief definition of the trade balance within the context of B2P generally üurrency depreciation makes the home country goods cheaper (expected to lead to increased exports) as well as making imports more expensive (expected to lead to decreased imports) Vxpect students to provide examples to make the point clear (b) Points that might be included: [? J-curve effect [? Action of international competitors ± e. etc. (c)(ii) *iscussion of fundamental. speculation. reduce the price in order to maintain market share [? Action of foreign governments ± e.g. income. technical.

95%. with an annual coupon of 5.000 million nominal 5-year bonds. Although your company currently transacts no business with Japanese clients. issued and redeemed at par. two funding options highlighted are: (i)? The issue of GBP 250 million nominal 5-year bonds.75% (ii)? The issue of Yen 45. issued and redeemed at par. with an annual coupon of 0. The funding requirement is to raise the equivalent of GBP 250 million through the issue of 5-year bonds in the Vurobond market.3  Assume the role of a recent recruit to the treasury department of a UK-based company. it is nevertheless considering the possibility of issuing a Yen-denominated bond in order to take advantage of reduced funding costs. Specifically. The exchange rate of the Yen against GBP over the last 5 years has been as follows: o    .

56 !7  (a) Briefly explain the advantages of raising funds through the Vurobond market rather than using the domestic bond market.     @ @ @ @           @   The consensus view of the treasury department is that the Yen is unlikely to appreciate significantly against GBP over the next 5 years. assuming the predicted worst-case scenario. compared to a current exchange rate of 1GBP = Yen 180. including discussion of the impact the financing decision would have on the company's currency exposure. the Yen appreciated such that 1GBP = Yen 150. -  . That is. Vven if it did. the view is that the worst case scenario would be an exchange rate of 1GBP = Yen 150. (at a spot rate of 1GBP = Yen 180). -  (b)? üalculate the effective GBP cost of raising funds in Yen. with respect to the two identified financing options. if immediately after issue.   (c) Write a brief report to the treasury department head outlining your recommendation. however.

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tax implications .Aore liquid market and cheaper cost of issue as a result .Aore choice of security type .Listing the Vurobond on an exchange with less onerous regulations (b) i    .Focusing on professional wholesale investors and the speed and efficiency of raising funds that results from this .Bearer vs registered security .  (a)? Advantages might include: .

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75%). the company would benefit from issuing in Yen rather than sterling (4. . given that it transacts no business with Japanese clients. the company would be exposing itself to increased currency risk.80% vs 5.' !)  (c) To the extent that the view of future exchange rates is correct. No correct answer on the recommended financing option .interested to read students' views and their justification. however. By issuing in Yen.

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Was that the right decision? Justify your answer.   (c) Lehman Brothers was allowed by the US Treasury to fail. -  (b) *iscuss the links between less regulation and the competitive rates of interest offered by Vurobanks. -   -.  2  56 !7 (a) Briefly outline the origins and development of the Vuromarkets.

  (a) Vxpect discussion to include: !? The ³cold war´ in the 1950s and 1960s !? So called ³petro-dollars´ in the 1970s !? Vuromarkets developing to circumvent seemingly overly restrictive national markets including Regulation Q and the interest equalisation tax (IVT) in the US !? Vurocurrency and Vurobond markets developing in parallel (b) Vxpect discussion to include: !? Vurobanks are free from regulatory control with respect to holding reserve assets !? Vurobanks do not have to pay deposit insurance !? Vurobanks avoid many of the costs associated with complying with domestic banking regulations !? The Vurobanking business is highly competitive internationally with relatively low entrance requirements !? Vurobanks benefit from economies of scale !? Vurobank lending is almost exclusively to high-quality customers with negligible default rates (c) No right answer in my view so will be flexible on awarding marks |? Vxpect discussion of the consequences of the Lehman Brothers bankruptcy |? Vxpect discussion of moral hazard |? Vxpect discussion of contagion |? Vxpect discussion of both the ³too big to fail´ and ³too connected´ arguments .

4-  c) Vxplain the differences between the following instruments . financial markets where they are issued. regularity and method of payment to holders. risk involved. 4-  b)? Vxamine the reasons why the supply and offer of bonds may vary over time. maturity. financial institutions involved in their issue. ownership rights.  ? 56 !7  a)? List the similarities /differences between equity and bonds regarding: objective of their use.

junk bonds. unsecured bonds/ debentures.free bonds. secured/ asset-backed bonds.! why the variety of instruments could be useful to international borrowers and international investors: risk-free /default. =-    .

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-  b) üonsider and explain why currency prices may not reflect the inflation rates and trade imbalances between countries. -  ii) üalculate the expected spot rate of the VUR and the GBP against the US* at the end of 2008 if the PPP holds. 4-  c) What are the possible damages that persistent deviations observed in the value of the US dollar have caused or may cause to the US economy and its business sector? 4-    .27 & %88  V3)     2   i  +9 ? US Vurope (VU) UK Vnd of 2008 Inflation Rates (annual) 2% 5% 6% üurrent spot rate \$1.00 per pound  56 !7  a) Using the information in the table: i) üalculate the percentage appreciation/ depreciation of the VUR against the US* and of the GBP against the dollar that according to the PPP should take place by the end of the year.54 per euro üurrent spot rate \$2. as expected by the Purchasing Power Parity (PPP).

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Better marks will be awarded to those answers explaining the differences between the absolute and relative versions of PPP. to justify the present imbalances.03774 : the Pound should depreciate against the US* by 3.02857 : the VUR should depreciate against the US* by 2.9623 = The US* should appreciate to US* 1. c) A clear understanding of the PPP theory is expected.02/1.05) ± 1 = . among others. and why the adjustment tends to occur only in the long-term.97143= the US* should appreciate to US* 1. particularly due to inflows of capital from the rest of the world.02/ 1.06) ± 1 = -0. showing that imbalances in the equilibrium as in the case of the US generate increasing imports and loss of competitiveness. According to the theory this disequilibria must be restored via adjustments in the exchange rate. b) The evident short-term imbalances in the prediction of the theory are a consequence of other factors not considered by the PPP: government intervention and interest rates are two of the most important in current times.857 % Against the Pound: (1.774 %  ii) Against the Vuro: (US*1. It is expected that students should quote the case of ühina and Japan capital flows. Factors to consider: government intervention and high saving rates from these countries that create outflows of currency invested in US markets.496 per VUR. in contrast to the theory.0/GBP) * 0.9245 per GBP.0. the adjustment to the deficit in the BoP of the US does not seem to work in the short-term. However. These imbalances can continue over longer periods of time. Against the Pound: (US*2.  a) i) Against the Vuro: (1. .54/VUR) * 0.