FINAL WRITTEN EXAMINATION (MOCK EXAM)

Multinational Corporate Finance – GRA 6554

Exam date: 19/12/2018

Instructor: Giovanni PAGLIARDI, Department of Finance, giovanni.pagliardi@bi.no

General instructions

You have three hours to complete this final written exam. Please follow the guidelines presented
below.

a. You are allowed to answer the questions in the order that you prefer. It is not mandatory to
follow the numerical order of the questions.

b. Please make sure that your handwriting and your computations are reasonably
understandable. Confusing and hardly intelligible answers will be penalized.

c. Students are expected to write brief, concise and precise answers. Long and confusing
answers will be penalized.

2
 QUESTION A (25/100 points)

Triangular Arbitrage

You are a Norwegian trader with a liquidity amount equal to 1,000,000 NOK. The current spot exchange
rates in the market are 𝑁𝑂𝐾 9⁄𝐸𝑈𝑅 and 𝐸𝑈𝑅 0.85⁄𝑈𝑆𝐷.

a. On the market, you also observe that 𝑁𝑂𝐾 7.50⁄𝑈𝑆𝐷. Explain why there is a triangular
arbitrage opportunity. [2 points]

b. What is the triangular arbitrage profit in percentage points? Please start selling the overvalued
currency and show every step explaining the rationale behind your computations. [6 points]

We now introduce liquidity costs. You observe that Bank A quotes bid-ask rates of 𝑁𝑂𝐾 8.96⁄𝐸𝑈𝑅 −
𝑁𝑂𝐾 9.08⁄𝐸𝑈𝑅, and 𝐸𝑈𝑅 0.86⁄𝑈𝑆𝐷 − 𝐸𝑈𝑅 0.89⁄𝑈𝑆𝐷.

c. Derive the bid-ask quotes of 𝐸𝑈𝑅⁄𝑁𝑂𝐾 , 𝑈𝑆𝐷⁄𝐸𝑈𝑅, 𝑈𝑆𝐷⁄𝑁𝑂𝐾 and 𝑁𝑂𝐾⁄𝑈𝑆𝐷. [4 points]

You also observe that there is a bank B that quotes the following rates: 𝑁𝑂𝐾 7.34⁄𝑈𝑆𝐷 −
𝑁𝑂𝐾 7.82⁄𝑈𝑆𝐷. Is there a triangular arbitrage opportunity? Clearly explain your answer. Compute
the triangular arbitrage percentage profit. [6 points]

d. Derive and explain the theoretical conditions that must hold such that no triangular arbitrage
opportunities exist. [4 points]

e. Show if the former conditions are satisfied or violated in this example. [3 points]

3
 QUESTION B (25/100 points)

Balance of Payments, Purchasing Power Parity and International Fisher Effect

Answer the following questions. Please provide brief, concise and precise answers when asked. Please
report the clear mathematical proofs when asked.

a. Provide a brief definition of Balance of Payments, and write down the Balance of Payments
Identity under fixed exchange rates and under purely flexible exchange rates. [3 points]

b. Now imagine that there are only two countries in the world: country A and country B. Imagine
that country A pegs its exchange rate to country B. If country A imports from country B much
more than what it exports to country B, what must the central bank of country A do and what
is the effect on country A’s international reserves? [3 points]

c. Define Absolute PPP and Relative PPP, explaining the difference between them. Imagine that
Norway currently has 2% inflation rate, against 3% inflation rate in the United States. If you
believe in Relative PPP, everything else equal, what is the expected exchange rate variation?
Explain why. [5 points]

d. Discuss if PPP holds in the i) short-run, ii) medium-run, and/or iii) long-run. What is the main
reason because of which it might not hold in certain time periods? [3 points]

e. Write down the equation of the level of the exchange rate implied by Absolute PPP. Derive
and prove mathematically the formula of the percentage change of the exchange rate
between time t and time t+1 implied by Relative PPP. [6 points]

f. Write down and explain the Fisher effect. Starting from there, derive and prove
mathematically the International Fisher effect. Provide the economic interpretation of the
prediction of the International Fisher effect. [5 points]

4
 QUESTION C (25/100 points)

FX Strategies with Options

You are managing director of a Norwegian fund that trades in the FX market. The current spot
exchange rate between the Norwegian Krone and the British Pound is 𝑁𝑂𝐾 7.8⁄𝐺𝐵𝑃. The market
price of a call option written on the GBP with strike price 𝑁𝑂𝐾 7⁄𝐺𝐵𝑃 and 1-year maturity is 0.7 𝑁𝑂𝐾.

a. If the FX rate follows a random walk, would you expect to exercise the call option at maturity
or not? Explain why and compute the (potential) payoff and the profit in NOK, in case the
prediction turned out to be correct. [2 points]

b. Explain the put-call parity by drawing the appropriate graph that you need for the derivation.
Starting from the graph, write down and explain the mathematical derivation of the put-call
parity. [5 points]

c. Compute the price of the put option with strike price 𝑁𝑂𝐾 7⁄𝐺𝐵𝑃 and 1-year maturity that
stems from the corresponding call option. [2 points]

One of the analysts of the fund suggests you to buy the call option with strike price 𝑁𝑂𝐾 7⁄𝐺𝐵𝑃 and
1-year maturity, and, at the same time, buy the put option with the same strike price and the same
maturity as well. Your analyst also provides you with an estimation of the volatility of the exchange
rate 𝑁𝑂𝐾⁄𝐺𝐵𝑃, which is 0.15, and with the following data about interest rates: the 1-year interest
rate is 1% in Norway, and 3% in the UK.

d. Draw the graphs of the payoff and profit of the strategy that the analyst suggests. What is the
rationale to implement such a strategy? [3 points]

e. Instead of following your analyst’s piece of advice, you decide to implement the following
strategy: buy one call option with strike price 𝑁𝑂𝐾 7⁄𝐺𝐵𝑃, and buy two put options with the
same strike price. Draw the graphs of payoff and profit of such a strategy. [2 points]

f. Explain one pro and one con of this strategy with respect to the previous one. In which scenario
would you prefer this second strategy? [3 points]

g. Compute the price today of the call option through a two-step binomial tree. Compare the
price that you find with the market price of the call reported at the beginning of the exercise.
How could you exploit this difference in prices? [8 points]

1+𝑖
−𝑑
1+𝑖∗
Hint: the formula for the risk neutral probability is the following: 𝑞 = 𝑢−𝑑
.

5
 QUESTION D (25/100 points)

Hedging Economic Exposure

A Norwegian firm owns some assets in the United States. The values of the assets denominated in USD
are exposed to exchange rate risk as shown in the following table.

State 1 State 2 State 3 State 4

Probability 0.25 0.25 0.25 0.25
𝑺 (𝑵𝑶𝑲⁄𝑼𝑺𝑫) 10 11 12 13
USD Asset Value 250 200 170 150
NOK Asset Value

Answer the following questions.

a. Complete the table above and compute the economic exposure parameter. [7 points]

b. Decide whether you buy or sell a forward contract in order to hedge, and describe your hedging
strategy. Derive the formula of the hedged asset value that shows that the latter is not affected by
the uncertain FX-rate anymore. [5 points]

c. Imagine that the price of the forward is 11.5 𝑁𝑂𝐾 per 𝐺𝐵𝑃. Compute the value of the hedged
position for each state of the world by completing the following table. [7 points]

State 1 State 2 State 3 State 4

Probability 0.25 0.25 0.25 0.25
𝑺 (𝑵𝑶𝑲⁄𝑼𝑺𝑫) 10 11 12 13
USD Asset Value 250 200 170 150
NOK Asset Value
Derivative profit
Hedged Value

d. Compute the variance of the unhedged position and the variance of the hedged position. Compare
and comment why you obtain such result. [6 points]