BUS3026W Finance 2
Objective Test 8
16 October 2007
Total marks: 30
Time: 40 minutes
All questions are to be completed on this worksheet. For each question, please circle the appropriate answer (where provided) clearly or answer in the provided ‘Workings’ sections. Multiple Choice Questions (Q 1 to 10): Incorrect answers: No answers:
1 marks each. -1/4 mark each. 0 marks each.
1. Gresham’s Law states that: a. Exchange Rates between currencies must equal the ratio of the price of gold in the two countries. b. Good money drives bad money out of circulation. c. Bad money drives good out of circulation. d. The Price-Specie Flow mechanism will automatically adjust exchange rates to their correct level.
2. Suppose that the pound is pegged to gold at £20 per ounce and the dollar is pegged to gold at $35 per ounce. This implies an exchange rate of $1.75 per pound. If the current market exchange rate is $1.80 per pound, how would you take advantage of this situation?
a. Start with $350. Buy 10 ounces of gold with dollars at $35 per ounce. Convert the gold to £200 at £20 per ounce. Exchange the £200 for dollars at the current rate of $1.80 per pound. b. Start with £350. Buy 17.5 ounces of gold at £20 per ounce. Convert the gold to dollars at $35 per ounce. Exchange the dollars for pounds at the current market exchange rate is $1.80 per pound. c. Both of the above are correct d. None of the above are correct
3. Suppose you observe the following exchange rates: €1 = $.85; £1 = $1.60; and €2.00 = £1.00. Starting with $1,000,000, how can you make money? a. Start with dollars, exchange for pounds at £1 = $1.60. Buy euros at €2 = £1.00; trade for dollars at €1 = $.85. b. Start with dollars, exchange for euros at €1 = $.85; exchange for pounds at €2.00 = £1.00; exchange for dollars at £1 = $1.60. c. Start with euros; exchange for pounds; exchange for dollars; exchange for euros d. There is no arbitrage opportunity.
4. Consider the following exchange rate quotation from Wall Street Journal. U.S.$ equiv.
Currency per U.S. $
Friday
Thursday
Friday
Thursday
Britain (Pound)
1.5760
1.5720
0.6345
0.6361
1 Month Forward
1.5726
1.5686
0.6359
0.6375
3 Months Forward
1.5661
1.5621
0.6385
0.6402
6 Months Forward
1.5564
1.5523
0.6425
0.6442
Judging by the exchange rates quoted above, which country has the higher rate of inflation? a. There is not enough information to say. b. The United States c. Britain d. Both should have the same expected rate of inflation.
5. Suppose you observe the following exchange rates: S($/€) = 0.85 (i.e. €1 = $.85) The one-year forward rate is F1($/€) = 0.935 (i.e. €1 = $.935) The risk-free interest rate in the U.S. is 5% and in Germany it is 2%. How can a dollar-based investor make money? a. There are no profitable arbitrage opportunities. b. Borrow dollars in the U.S., exchange for euros, invest in Germany, enter into a on-year forward contract; in one year, translate the euros back into dollars at the forward rate. c. Borrow euros, translate into dollars at the spot, invest in the U.S. at 5% for one year. At the end of the year, translate part of your dollar investment back into euros at the forward rate to repay your euro debt. d. By forming a forward market hedge.
6. Consider a trader who opens a short futures position. The contract size is £62,500, the maturity is six months, and the initial price is $1.50 = £1. The next day, the settlement price is $1.60 = £1. What is the amount of his gain or loss? a. b. c. d.
$6,250 gain $6,250 loss No loss or no gain since maturity has not arrived. $2,604.17 gain
7. Consider an investor who has short a PUT option on €100,000. The strike price is $0.80 = €1.00 and the option premium is $0.02 per euro. What is the theoretical maximum gain on this position? a. b. c. d.
There is unlimited upside potential. $80,000 $78,000 $2,000
8. Other things equal, investors will generally ______________ on bearer bonds than on registered bonds of comparable terms. a. b. c. d.
demand a higher credit rating demand a higher yield accept a lower yield a) and b) are both correct
9. An ADR a. Is a mechanism for the avoidance of taxes, especially capital gains taxes, on shares of foreign stocks. b. Are bearer securities, not registered securities. c. Is a receipt representing a number of foreign shares that are deposited in a U.S. bank. d. None of the above is true.
10. Changes in exchange rates a. Generally explain a larger portion of the variability of foreign bond indexes than foreign equity indexes. b. Generally explain a larger portion of the variability of foreign equity indexes than foreign bond indexes. c. Do not affect the variability of foreign equity indexes or foreign bond indexes. d. Affect all foreign stock markets equally.
11. You are a S.African importer of nuts from Seychelles. You have just ordered next year’s inventory. Payment of SR10,000,000 is due in one year. You want to hedge against the exchange risk that this future payment represents, but are disappointed to note that your bank does not make a forward market in SR (Seychelles Rupee). You are provided with the following information: Spot exchange rate S.A discount rate Seychelles discount rate
S(SR/R) iR iSR
= = =
SR2/R 5% 10%
a. Assuming that IRP holds, show the steps to form a forward market hedge to achieve your objective. b. If your bank were to offer a 1-year forward quote on the Seychelles Rupee, what would it be?
[4,1] Answer: a.
To form a forward market hedge:
1. Borrow R4,545,455 in South Africa (in one year you will owe 2. 3. 4. b.
R4,772,727). Translate R4,545,455 into Seychelles rupees at the spot rate S(SR/R) = SR2/R to receive SR9,090,909. Invest SR9,090,909 in the Seychelles at iSR = 10% for one year. In one year, your investment will be worth SR10,000,000 – exactly enough to pay your supplier.
The 1-year forward rate would be: 1-year forward rate = (1.10/1.05)*2 = SR2.0952/R
12. Consider 8.5 percent Swiss franc/U.S. dollar dual-currency bonds that pay $666.67 at maturity per SF1,000 of par value. What is the implicit SF/$ exchange rate at maturity? Will the investor be better or worse off at maturity if the actual SF/$ exchange rate is SF1.35/$1.00? [1,1] Answer: Implicitly, the dual currency bonds call for the exchange of SF1,000 of face value for $666.67. Therefore, the implicit exchange rate built into the dual currency bond issue is SF1,000/$666.67, or SF1.50/$1.00. If the exchange rate at maturity is SF1.35/$1.00, SF1,000 would buy $740.74 = SF1,000/SF1.35. Thus, the dual currency bond investor is worse off with $666.67 because the dollar is at a depreciated level in comparison to the implicit exchange rate of SF1.50/$1.00.
13. As an investor, what factors would you consider before investing in the emerging stock market of a developing country? [3] Answer: An investor in emerging market stocks needs to be concerned with the depth of the market (market concentration) and the market’s liquidity. Depth of the market refers to the opportunities to invest in the country. One measure of the depth of the market is the concentration ratio of a country’s stock market. The concentration ratio frequently is calculated to show the market value of the ten largest stocks traded as a fraction of the total market capitalization of all equities traded. The higher the concentration ratio, the less deep is the market. That is, most value is concentrated in only a few companies. While this does not necessarily imply that the largest stocks in the emerging market are not good
investments, it does, however, suggest that there are few opportunities for investment in that country and that proper diversification within the country may be difficult. In terms of liquidity, an investor would be wise to examine the market turnover ratio of the country’s stock market. High market turnover suggests that the market is liquid, or that there are opportunities for purchasing or selling the stock quickly at close to the current market price. This is important because liquidity means you can get in or out of a stock position quickly without spending more than you intended on purchase or receiving less than you expected on sale.
14. You are a UK-based trader with the following derivatives positions. A long position of 250 FTSE 100 index futures contracts traded on the London International Financial Futures Exchange (LIFFE) maturing in 6 months time. The contract multiplier on the LIFFE contract is £10 and the current value of the index is 4841.6. 200 long put options on the S&P 500 Index. The contracts are each currently worth $24 560 each, and have a delta of -0.66 to the S&P 500 index. The index level is 1240.3 and the contract multiplier is 10. The 6-month UK interest rate is 3.6% and that of the US is 4.55%. The dividend yield on the S&P 500 index is 1.4% and that on the FTSE 100 is 1.6% per annum. All dividend yields & interest rates are per annum NACC. What would your exposures be if you wished to perform a VaR calculation?
[6]
The FTSE 100 position is calculated as follows: 250 x 10 x 4841.6 x e(0.036-0.016)*0.5 = £12,225,647.22 The S&P 500 position is calculated as follows: -0.66 x 1240.3 x 10 x 200 = -$1,637,196 Lastly, the currency exposure is: 200 x 24 560 = $4,912,000
15. Bond A is a coupon bond with a modified duration of 11.5 year. Bond B is also a zero coupon bond with a modified duration of 4 years. A bond portfolio manager has R145m invested in Bond A. How much worth of Bond B should the manager go long/short in order to a) Reduce the modified duration of his net portfolio to 7 years?
V2 =
V1 × (D*V − D1* ) (D2* − D *V )
V2 = 145 x (7 – 11.5) (4-7) = R217.5m long position b) Reduce the modified duration of his net portfolio to 0 years? V2 = 145 x (0 – 11.5) (4-0) = -R416.88m