Question 1
- Assume that you are a foreign exchange trader based in London. The computer screen provides you with the following mid-quotes:
- An Italian company knows that it will have to pay 10 million Swiss francs in three months. The current spot exchange rate is 0.6000 EUR/CHF. The three-month forward rate is 0.603 EUR/CHF. The treasurer is worried that EUR will depreciate in the next few weeks.
Spot exchange rate: HKD12.1069/GBP
3-month forward rate: HKD12.0882/GBP
3-month HKD rate: 0.28%
3-month GBP rate: 0.80%
- Ignoring transaction costs, is the covered interest parity condition holding? Explain your answer.
- Is there any arbitrage opportunity? If so, what are the steps needed to make an arbitrage profit?
- How much would the arbitrage profit be if you are authorized to work with GBP 1 million or GBP 100 million? Show your calculations in both cases.
(10 marks)
(15 marks)
- marks)
- What action can be taken?
- Three months later, the spot exchange rate turns out to be 0.620 EUR/CHF. Explain whether the action taken in (a) was wise.
(5 marks)
(10 marks)
(Total: 50 marks)
Question 2
- You are given the following quotes:
- The Argentine peso was fixed through a currency board at 1.00 ARS/USD throughout the 1990s. In January 2002, the Argentine peso was floated. On January 29, 2003 it was trading at 3.20 ARS/USD. During that one year period, Argentina’s inflation rate was 20% on an annualized basis. Inflation in the United States during that same period was 2.2% annualized.
USD/EUR: 1.2930/1.2935
JPY/USD: 83.30/83.50
The one-month interest rates are:
USD: 0.23%/0.33%
EUR: 0.69%/0.79%
JPY: 0.04%/0.48%
Compute:
- The arbitrage-free quotes of the JPY/EUR exchange rate.
- The arbitrage-free one-month JPY/USD forward bid exchange rate.
- The arbitrage-free one-month EUR/USD forward bid and ask exchange rate.
- What is the economic interpretation of the values computed in (c)?
(5 Marks)
(10 marks)
(15 marks)
(5 marks)
- What should have been the exchange rate in January 2003 if purchasing power parity held?
(5 marks)
- By what percentage was the Argentine peso undervalued on an annualized basis?
(10 marks)
(Total: 50 marks)
SECTION B
Question 3
- Define the terms “covered interest arbitrage” and “uncovered interest arbitrage”. What is the difference between these two transactions?
- Some forecasters believe that foreign exchange markets for the major floating currencies are “efficient” and forward exchange rates are unbiased predictors of future spot exchange rates. What is meant by “unbiased predictor” in terms of how the forward rate performs in estimating future spot exchange rates?
- Discuss the ways to empirically test foreign exchange market efficiency.
- Discuss empirical evidence on foreign exchange market efficiency.
(25 marks)
(25 marks)
(Total: 50 marks)
Question 4
Financial markets (and FX markets) care about macroeconomic news. Assume that the Reuters screen on a trader’s desk prints out the following separate announcements in two different dates:
- “The Federal Reserve announces that the money supply grew by US$3 billion in the past week.”
- “Market rates for 3-month T-bills rise from 3.50% to 3.60% and the other rates adjusted accordingly.”
Assume that the market expectation was US$2 billion rise in money supply, hence a positive surprise occurred. Should the US$ weaken or strengthen? Explain.
(25 marks)
Assume that the market expectation was that no changes in interest rates were expected. Should the US$ weaken or strengthen? Explain.
(25 marks)
(Total: 50 marks)
Question 5
Suppose that the participants in the foreign exchange market know the interest rates for all maturities and have reliable forecasts for inflation rates. If the foreign exchange market is efficient, discuss what is the expected future spot exchange rate if the
- market participants are risk-neutral
- market participants are risk-averse.
(25 marks)
(25 marks)
(Total: 50 marks)
2017-2018 SECTION A
Question 1
- Assume that you are a foreign exchange trader based in London and the following exchange rate and interest rate mid-quotes quotes are provided to you:
- The euro is quoted as USD/EUR = 1.1420/1.1425, and the Canadian dollar is quoted as CAD/USD = 1.3540/1.3545. What are the implicit CAD/EUR bid and ask quotations?
Spot GBP/EUR = 0.8277
3-month Forward GBP/EUR = 0.8285
3-month interest rate GBP = 0.6125%
3-month interest rate EUR = 0.1321%
Using the above quotes:
- Verify the covered interest parity (CIP) condition.
(10 marks)
- If in the previous point (a) the CIP condition is violated: (1) set up the strategy that is able to exploit this violation; and (2) demonstrate that an opposite strategy would be loss-making.
(15 marks)
- Quantify the return obtained from the CIP arbitrage strategy (only when profitable).
(10 marks)
(15 marks)
(Total: 50 marks)
Question 2
- Assume that you are currently managing an import-export company based in the UK trading in spirits and liquors. You have recently contracted to import some wine from France. The wine is valued at EUR 5 million and you will pay this amount after receiving the wine in 90 days (3 month). The transaction is in EUR and you would be exposed to foreign exchange risk if you do not hedge your exposure. You are provided with the following quotes:
- You are given with the following information:
Spot GBP/EUR = 0.90
3-month Forward GBP/EUR = 0.95
3-month interest rate GBP = 5.00%
3-month interest rate EUR = 10.00%
- Show how you would be able to eliminate currency risk using the forward market or a money market hedging strategy where you buy the present value of the EUR liability at the spot exchange and invest the proceeds in the EUR money market.
- Which of the two hedging alternatives is more convenient? Explain the result using the covered interest parity condition.
(15 marks)
(20 marks)
Spot exchange rate:
JPY/USD = 102.40/102.48
Interest rates:
One-year interest rate in JPY = 11/2 %/1 5/8%
One-year interest rate in USD = 91/8 %/9 1/4%
What is the quotation for the one-year JPY/USD forward exchange rate?
(15 marks)
(Total: 50 marks)
SECTION B
Question 3
(30 marks)
(20 marks)
(Total: 50 marks)
Question 4
- For each of the foreign exchange market participants, identify their motive for buying or selling foreign exchange.
- Discuss the determinants of bid-ask spread in foreign exchange markets.
(30 marks)
(20 marks)
(Total: 50 marks)
Question 5
- Discuss exchange rate determination puzzle and excess volatility puzzle.
- Discuss carry trade profitability and currency crash risk in the light of Burnside, Eichenbaum and Rebelo (2007) and Brunnermeier, Nagel and Pedersen (2009), respectively.
(20 marks)
(30 marks)
(Total: 50 marks)