FINM 7406 Extra Practice Questions
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FINM 7406 Extra Practice Questions
Q1. Comment on the proposition that the Bretton Woods system was programmed to an eventual demise.
Q2. Doug Bernard specializes in cross-rate arbitrage. He notices the following quotes:
Swiss franc/dollar = SFr1.5971/$
Australian dollar/U.S. dollar = A$1.8215/$
Australian dollar/Swiss franc = A$1.1440/SFr
a. Ignoring transaction costs, does Doug Bernard have an arbitrage opportunity based on these quotes?
b. If there is an arbitrage opportunity, what steps would he take to make an arbitrage profit, and how would he profit if he has $1,000,000 available for this purpose.
Q3. James Clark is a foreign exchange trader with Citibank. He notices the following quotes.
Spot exchange rate SFr1.2051/$
Six-month forward exchange rate SFr1.1922/$
Six-month $ interest rate 2.5% per year
Six-month SFr interest rate 2.0% per year
a. Is the interest rate parity holding? You may ignore transaction costs.
b. Is there an arbitrage opportunity? If yes, show what steps need to be taken to make arbitrage profit. Assuming that James Clark is authorized to work with $1,000,000, compute the arbitrage profit in dollars.
Q4. Comment on the following statement: “Since the United States imports more than it exports, it is necessary for the United States to import capital from foreign countries to finance its current account deficits.”
Q5. Alpha and Beta Companies can borrow for a five-year term at the following rates:
Alpha Beta
Moody’s credit rating Aa Baa
Fixed-rate borrowing cost 10.5% 12.0%
Floating-rate borrowing cost LIBOR LIBOR + 1%
a. Calculate the quality spread differential (QSD).
b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed- rate debt. No swap bank is involved in this transaction.
Q6. Suppose that you are a U.S.-based importer of goods from the United Kingdom. You expect the value of the pound to increase against the U.S. dollar over the next 30 days. You will be making payment on a shipment of imported goods in 30 days and want to hedge your currency exposure. The U.S. risk-free rate is 5.5 percent, and the U.K. risk-free rate is 4.5 percent. These rates are expected to remain unchanged over the next month. The current spot rate is $1.50.
a. Indicate whether you should use a long or short forward contract to hedge currency risk.
b. Calculate the no-arbitrage price at which you could enter into a forward contract that expires in 30 days.
c. Move forward 10 days. The spot rate is $1.53. Interest rates are unchanged. Calculate the value of your forward position.
Q7. Evaluate the following statement: “A firm can reduce its currency exposure by diversifying across different business lines.”
Q8. Suppose you are a euro-based investor who just sold Microsoft shares that you had bought six months ago. You had invested 10,000 euros to buy Microsoft shares for $120 per share; the exchange rate was $1.15 per euro. You sold the stock for $135 per share and converted the dollar proceeds into euro at the exchange rate of $1.06 per euro. First, determine the profit from this investment in euro terms using an approximation formula. Second, compute the rate of return on your investment in euro terms. How much of the return is due to the exchange rate movement?
Q9. Discuss how the cost of capital is determined in segmented vs. integrated capital markets.
Q10. Delta Company, a U.S. MNC, is contemplating making a foreign capital expenditure in South Africa. The initial cost of the project is ZAR10,000. The annual cash flows over the five year economic life of the project in ZAR are estimated to be 3,000, 4,000, 5,000, 6000, and 7,000. The parent firm’s cost of capital in dollars is 9.5 percent. Long-run inflation is forecasted to be 3 percent per annum in the U.S. and 7 percent in South Africa. The current spot foreign exchange rate is ZAR/USD = 3.75. Determine the NPV for the project in USD by:
a) Calculating the NPV in ZAR using the ZAR equivalent cost of capital according to the Fisher Effect and then converting to USD at the current spot rate.
b) Converting all cash flows from ZAR to USD at Purchasing Power Parity forecasted exchange rates and then calculating the NPV at the dollar cost of capital.
c) What is the NPV in dollars if the actual pattern of ZAR/USD exchange rates is: S(0) = 3.75, S(1) = 5.7, S(2) = 6.7, S(3) = 7.2, S(4) = 7.7, and S(5) = 8.2?
2023-07-21