HKUST

FINA 3404
International Finance

Department of Finance
Spring 2015
Dr. Kai Li

Combined Assignments 3&4

Instructions: The assignment is degisned for a team work of 3 group
members. Each member should contribute to the entire assignment, and
should be ready to answer questions concerning his/her assignment in class
discussions. The due date is May 5, 2015 noon. Each group needs to submit
only one write-up or typed solution of the assignment to TAs (Chenjie Xu)
mailbox (close to LSK Room 5067) before that time.
Questions 1-14 are multiple choice questions. For each question, please
only choose one best answer.
1. Assume that the balance-of-payments accounts for a country are
recorded as follows.
balance on the current account = BCA = $130 billion
balance on the capital account = BKA = -$86 billion
Then, under the xed exchange rate regime, the balance on the reserves
account (BRA) should be (ignore statistical discrepancies):
A) $44 billion
B) $44 billion
C) $216 billion
D) none of the above

Dollar price per pound

(exchange rate)

2. Consider the supply-demand framework for the British pound relative

to the U.S. dollar shown in the following chart. The current demand and
supply curve is D and S, hence equilibrium exchange rate is $1.90 = 1.00.
Which of the following statements is correct?
S

$1.90

$1.80
D

D
S

D
D=S

A) Demand for British pounds exceeds the supply of pounds at the

exchange rate of $1:80 = $1:00.
B) Supply for British pounds exceeds the demand of pounds at the exchange rate of $1:80 = $1:00.
C) Suppose the demand curve shifts from D to D. Under a oating
exchange rate regime, the equilibrium pound exchange rate will depreciate
from $1:90 = $1:00 to $1:80 = $1:00:
D) Both A) and C) are correct.
3. The U.S. Trade Decit
A) is a capital account surplus
B) is a current account decit
C) is both a capital account surplus and a current account decit
D) none of the above
4. From the 1944 to 1971, the international monetary system is under
the so called Bretton Woods System, in which U.S. dollar is pegged to
gold at $35/oz and all other currencies are pegged to dollar. As a result,
gold and dollar are the two most important reserve assets for the central
banks. Since gold has a natural scarcity, to satisfy the growing need for
reserves, central banks from around the world have the incentive to accumulate dollars. The measures these foreign countries can take to attract
dollars include stimulating _____ and _____ interest rates.
A) imports from the US , raising
B) imports from the US, decreasing
C) exports to the US, raising
D) exports to the US, decreasing
5. Resuming Question 4, as the consequence that foreign countries tried
to attract US dollar, the U.S. is likely to run BOP _____ . As a result,
the dollar is expected to ____ against gold.
A) surpluses, appreciate
B) surpluses, depreciate
C) decits, appreciate
D) decits, depreciate
6. Suppose you enter into the long position of a Eurodollar interest rate
futures with the futures price of 96. At the expiration date of the futures
contract, the spot rate of the three month LIBOR is 6%. What is your
prot/loss from holding this futures position?
A) you lose $50
B) you gain $50
C) you lose $5,000
D) you gain $5,000
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7. Consider both a call option and a put option written on euro. When
the euro exchange rate becomes less volatile, which of the following statements is correct?
A) the call option becomes cheaper whereas the put option becomes more
expensive
B) the put option becomes cheaper whereas the call option becomes more
expensive
C) both the call and the put become cheaper
D) both the call and the put become more expensive.
8. Consider a put futures option written on one euro futures contract,
and each euro futures contract is written on e12,500. Suppose the option
premium and the strike price are $0.15/e and $1.5/e, respectively. At
expiration of the option contract, the spot and the futures exchange rate
are $1.405/e and $1.4/e, respectively. The total prot/loss for the option
writer is thus:
A) $1875
B) $687.5
C) $625
D) $-625

9. Suppose that your rm is a U.S.-based importer of German automobile accessories. You pay for them in euros and sell them in dollars. You
have just ordered next years inventory. In one year your rm owes a payment of e100,000 to your German supplier. Todays spot exchange rate is
e1.00 = $1.20; the one-year forward rate is e1.00 = $1.15. How can you x
the dollar cost of this order?
A) Enter into long position in the one-year euro futures contract at e1.00
= $1.15. This will x the cost of e100,000 at $115,000.
B) Enter into short position in the one-year euro futures contract at
e1.00 = $1.15. This will x the cost of e100,000 at $115,000.
C) Since the spot price is more than the forward price, you should trade
your dollars for euros today and pay your supplier early.
D) Sell a call option on the euro with a one-year maturity.

10. Suppose that your rm is a U.S.-based importer of German automobile accessories. You pay for them in euros and sell them in dollars. You
have just ordered next years inventory. In one year your rm owes a payment of e100,000 to your German supplier. Todays spot exchange rate is
e1.00 = $1.20, and you buy a one-year call option written on e100,000 with
the strike price of $1.20/e to hedge the risky payable. Suppose the option
premium is $0.06/e, and in one year the exchange rate turns out to be

$1.30/e. What the prot/loss on your hedged position relative to todays

exchange rate?
A) $10,000
B) $4000
C) -$6,000
D) -$10,000
11. The best nancial instrument to hedge a recurrent exposure is:
A) forwards
B) futures
C) options
D) swaps
12. Which of the following statements about the portfolio frontier is
(are) correct?
i) Portfolio frontier includes both the e cient frontier and the ine cient
frontier.
ii) Given the expected return, a portfolio on the portfolio frontier has
the smallest return variance among all portfolios.
iii) Given the return volatility, a portfolio on the portfolio frontier has
the largest expected return.
A) i) only
B) i) and ii)
C) ii) and iii)
D) i), ii), and iii)
13. The mean and standard deviation (SD) of two stocks, A and B, are
as follows
Stock
A
B

Mean (%)
10
12

SD (%)
18
20

Suppose the two stocks are not correlated. Consider a portfolio with 30%
investment in A and 70% investment in B. What is the standard deviation
for the portfolio return?
A) 13.5%
B) 14%
C) 15%
D) 19.4%
14. In the above question, what is the expected return for the global
minimum variance portfolio?
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A) 13.67%
B) 13.38%
C) 10.89%
D) 11.11%

15. Suppose today the (annualized) interest rates on USD and AUD are
0% and 4%, respectively, and the exchange rate is $1/AU$. Consider the
following two strategies. In strategy A, you borrow one million USD and
use the proceeds to buy one million AUD. In strategy B, you long a oneyear forward contract which is written on one million AUD. The investment
horizon is one year and interests are only paid at the end of the one-year
horizon. Suppose the exchange rate changes to $1.1/AU$ in one year.
a) Calculate your prot/loss (quoted in USD) from strategy A.
b) Calculate your prot/loss (quoted in USD) from strategy B. (Hint:
rst determine the forward rate using the strict form of IRP)
c) Repeat b) when a forward contract is written on AUD 1,000,000/F instead, where F denotes the forward exchange rate calculated in b). Compare
your result with that in a): what conclusion can you draw?

16. Use the European option pricing formula to nd the value of a sixmonth at-the-money (ATM) call option on Japanese yen. The strike price
is $1 = U100. The volatility is 25 percent per annum; The annualized the
interest rates are r$ = 5:5% and rU = 6%. (please round the numbers in
the nal results to three signicant digits only)
17. Suppose rm A can issue xed-rate debt of the same maturity at
10:3% or oating-rate debt at LIBOR + 0:5%. Firm B can issue xed-rate
debt at 9:3% or oating-rate debt at LIBOR + 0:3%.

Fixed
Floating

10.3%
LIBOR+0.5%

9.3%
LIBOR+0.3%

Suppose that A prefers to issue xed-rate debt whereas B prefers to

issue oating-rate debt. If you were an investment banker, how could you
arrange an interest rate swap between A and B to make everybody happy?
Write in the gure the cash ows with arrows to describe your answers.
In addition, compute the net borrowing position for both rms and the
percentage returns for the international banker. (Hint: you may use the
following numbers: 9.7%, 9.6%, LIBOR+0.1%, and LIBOR+0.2%)

18. Suppose you buy a call option with C0 = $0:03=$ and X = $1:5=$,
and buy a put option with P0 = $0:02=$ and X = $1:5=$ at the same time.
Both options are written on pounds and will expire in one year. In addition,
suppose that contract sizes are $1m:
a) draw the prot prole on this portfolio one year later
b) what is your prot (loss) when the pound exchange rate one year later
is
i) $1:5=$; ii) $1:6=$; iii) $1:3=$
19. Suppose that Boeing corporation exported a Boeing 747 to British
Airways and would receive $10 million in one year. Suppose that Boeing
decides to use option market hedge, and it purchased a put option on 10
million pounds with an exercise price of $1:46=$ and a one-year expiration.
Assume that the option premium was $0:02=$.
a) assume that the spot exchange rate turn out to be $1:30=$ on the
expiration date. What is Boeings dollar denominated receivable net of the
option premium?
b) the same question for the scenario when the spot exchange rate turns
out to be $1:5=$ on the expiration date.
20. You are considering investing in one or both assets called A and B.
Both A and B have identical expected returns and standard deviations. One
of your friends have made the following comments: (I) No matter how you
set up your portfolio between A and B, you will have the same expected
return (II) No matter how you set up your portfolio between A and B,
you will have the same portfolio return volatility.
a) Suppose the returns of the two assets have 0 correlation. Evaluate (I)
and (II), i.e. are they true or false and why.
b) Now suppose the return correlation between the two assets is 1. Again
Evaluate (I) and (II).
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Questions 21-22 are based on the case: Tiany & Co. 1993
21. Based on Exhibit 8, does the IRP hold for one month forward and
three month forward in June 1993 ?
22. Suppose in June 1993, the company will have U100,000,000 income
in three month (September). The company decide to use option with strike
price $0.0092/U to hedge away all the exchange risk. What should the
manager do? Suppose the exchange rate in September turns out to be
$0.0098/U, what is the gain or loss on the option position? What is the
gain or loss on the U100,000,000 income in terms of the spot exchange rate
in June? What is the total gain or loss comparing with not hedging in the
rst place?
Questions 23-25 are based on the case: Hedging Currency Risks at
AIFS
23. The company will receive revenue of $60,000,000 and incur a cost of
e25,000,000 in a year. Suppose each exchange rate scenario happens with
equal probability (1/3) and the company has an income tax of 30%, what is
the expected dollar prot (i.e. revenue minus cost and tax payment) with
no hedge?
24. Suppose the forward contract is now quoting at $1.22/e, what is the
expected dollar prot with 100% hedge with forwards?
25. What is the expected dollar prot with 100% hedge with options
(assuming the time value of option cost is 0 for simplicity)?
Questions 26-28 are based on the case: TCAS
26. TCAS bid C$290000 for the project. The manager consider three scenarios for the future spot exchange rate: the stable dollar scenario $0.7324/C$,
the strong dollar scenario $0.68/C$, the weak dollar scenario $0.76/C$. Suppose the company wouldnt know if the bid is successful until 90 days later.
Conditional on the bid being successful, what would be the payo for forward hedging, option hedging and tunnel forwards hedging respectively under each exchange scenario (assuming the time value of option cost is 0 for
simplicity)?
27. If the companys bid fails, what would be the payo for forward
hedging, option hedging and tunnel forwards hedging respectively under
each exchange scenario (assuming the time value of option cost is 0 for
simplicity)?
28. Suppose the probability of a successful bid is 21 and three exchange
rate scenarios happen with equal probability, and suppose these two events
are independent, calculate the expected payo for each strategy.
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