Question 1. Short answer questions. (5 marks per question; 15 marks total) Provide a brief explanation in the space provided to justify your answer.
Q1a). What is home bias? Provide at least two possible explanations for this phenomena.
-Definition as per lectures: Tendency for investors to overweight domestic securities in their portfolios and seemingly forgo the diversification benefits of investing in international companies.
- Reasons include: barriers to trade (taxes, restrictions on foreign ownership etc); information asymmetry (domestic investors are at a relatively greater informational disadvantage in foreign markets than home markets); psychological factors; domestic stocks may provide an inflation hedge (not true empirically though).
Q1b). Explain the random walk model for exchange rate forecasting. Can it be consistent with the existence of profitable technical analysis strategies?
- Key property of the RW model: E[St+1] = St with explanation
- Define technical analysis: Trading strategies that rely on certain patterns repeating themselves (e.g. Head and Shoulders, Fibbonaci levels).
- Explanation: They key property of RW is that all information about the future is reflected in current prices. If this is true, then patterns cannot repeat themselves or alternatively future price movements are not predictable based on past history. So these are incompatible.
Q1c). “Investors investing abroad need to only consider political risk when they invest in emerging economies.” True or False? Explain.
- Define political risk — changes in laws and regulations that are unexpected and materially affect the your objective function (make sure you word this well and completely).
- This statement is false. A good example would provide some counter examples from current affairs (Brexit, unexpected changes to US trade and foreign policy, possibility of EU breakup are all good examples).
- Should clearly make the link that these are ex-post unexpected and can materially affect household or firm objective functions.
Q2. Consider a US importer with an account payable of EUR 10,000 to a French exporter due in one year’s time. The US importer has decided to buy call options on the EUR against the USD. Currently the spot rate is S(USD/EUR) = 1.5. Interest rates in the US and France are 10% and 5% respectively. The option contract size is €10,000 with a strike price K = 1.5. The spot rate in one year time will be either S(USD/EUR) = 1.6 or S(USD/EUR) = 1.4.
(a) (5 marks) Calculate the call option price today.
- Call option in EUR => gains value when EUR ↑ so borrow USD to lend in EUR.
- FC amounts that replicate the option payoffs for one contract: EUR5,000 and USD7,
- PV of these is USD779.22 (FV in one year’s time is 857.14)
(b) (5 marks) Suppose the importer purchases one option contract. Is the importer perfectly hedged from currency movements in this case? Explain your answer and show your working.
- With one contract, the cost of the account payable is 15,000 + 857.14 if S = 1.6
(and we exercise)
- The cost of the account payable is 14,000 + 857.14 if S = 1.4 (and we do not exer-
- These costs are not equal, there is still some exchange rate risk for the importer.
(c) (7 marks) Now suppose the importer purchases two option contracts. Is the importer perfectly now hedged from currency movements? Explain your answer and show your working. What factors might the importer take into account when deciding between one or two option contracts?
- With two contracts, we have the right to buy EUR 20,000 for USD 30,000 in one year’s time. If S = 1.6 and we exercise, we spend $30k to receive EUR20k. We use EUR 10k to pay the account and then sell the remaining EUR 10k at the prevailing spot rate of 1.6. Net cost: 30 + 2 x 857.14 – 10 x 1.6 = $15,714.28.
- If S = 1.4, we don’t exercise and so just buy the EUR in the spot market. Net cost: 14,000 + 2 x 857.14 = $15,714.28.
- Whether the importer chooses two or one option contracts will come down to their risk tolerance and their expectations for the spot price.
Q3. Alpha and Beta Companies can borrow for a five-year term at the following rates:
Table 1: Fixed and Floating Borrowing Costs
|Floating Rate LIBOR LIBOR+110bp|
(a) (3 marks) Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. Calculate the Quality Spread Differential for Alpha and Beta. Is there an opportunity for the two companies to enter into a profitable interest rate swap?
QSD = (5% – 3% ) – ((LIBOR+1.1%) – LIBOR) = 0.9%
- There is a positive QSD so there is the possibility for mutually profitable IRS.
(b) (6 marks) Again, assume Alpha desires floating-rate debt and Beta desires fixedrate debt. You are a dealer in an international swap bank. Calculate bid and ask swap rates quotations for five year fixed-for-floating interest rate swaps against USD LIBOR flat that generate annual interest rate savings of 30bps for both Alpha and Beta and an annual profit of 30bps for your swap bank. Show your working
- The following swap rates will achieve these savings and profit:
|Floating Rate LIBOR LIBOR|
- Alpha issues fixed to the market at 3% and receives fixed from the Swap Bank at 3.3% / pays LIBOR. Their total costs are LIBOR – 0.30%
- Beta issues floating to the market at LIBOR + 1.1% and pay fixed at 3.6% / receive LIBOR. Their total costs are 4.7%.
- Swap Bank receives 3.3% from Beta and pays 3% to Alpha, a profit every year of 30bps. – Note that you would want to show your working in more detail than I have here, e.g. set up the problem with a diagram and write down an equation that delivers you the swap rates.
Q4 (a) (5 marks) A Japanese company has issued a two year dual currency note with the following features. It pays an annual JPY coupon of 3% on a face value of JPY 100,000 and it pays an dollar amount of USD 920 at maturity. The current spot rate S(JPY/USD) = 90.00. The one and two year yield in is 3% in the US . The one and two year yield is 2% in Japan. What is the present value of this bond in JPY? Show your working.
- Two sets of cash flows: JPY coupons of 3k per year and USD of 920
- Get the NPV of them both in JPY and USD respectively
- Convert the USD CFs to JPY
NPVJPY coup = = JPY 5824.7 (1)
NPVUSDface = 19 (2)
NPVJPY total = 5824.7 + 867.19 × 90 = 83,871.6 (3)
Q4 (b) (5 marks) A two year dual currency bond with a principal value of GBP 250 pays annual coupons of USD 10.00. The USD yield is 4%. The present value of the bond is currently USD 403.50. What is the forward exchange rate for converting GBP into USD in two year?s time that is implied by the bond price? Show your working.
- As above, but now we need to solve for F(USD/GBP) that equates the cash flows of the bond, all in USD, to the PV in the question:
|403.50 = +
403.50 − = F(USD/GBP) (5)
F(USD/GBP) = 1.6641 (6)