Answers To Chapter Exercises

Assignment Problems (Editable)
*Chapter 3: Forward Exchange

1 Why are forward spreads on less-traded currencies larger than on heavily traded currencies? Forward spreads on less traded currencies are larger because the rates on heavily traded currencies (as a result of arbitrage profits) reach equilibrium. This reduces the probability of speculators to benefit from the bid ask spread in heavily traded currencies. However, since less traded currencies rates are not at equilibrium, they have higher arbitrage opportunities and hence higher spreads. 2 Why do banks quote mainly even-dated forward rates, for example, 1-month rates and 3-month rates, rather than uneven-dated rates? How would you prorate the rates of uneven-dated maturities? The reason banks quote even dated forward rates rather than uneven dated forward rates is that uneven dated rates are less profitable for the banks and hence the market for uneven dated rates has a higher Thinness. By higher thinness, we mean a smaller trading volume of uneven dated rates, which in turn means greater difficulty in offsetting positions in the interbank forward market after taking orders to buy or sell; since banks state their market and are then obligated if their bid or ask is accepted, they may want to enter the market at even dated rates to help offset the position they have just taken. 3 When would spreads widen quickly as we move forward in the forward market? Consider two sets of quotations, from a volatile time and from a stable time. 5 Could a bank that trades forward currency ever hope to balance the buys and sells of forward currencies for each and every future date? How do swap contracts help? Yes, the bank can balance almost all the trades in forward currency it does, by using the help of swaps. A swap, has two components, usually a spot transaction plus a forward transaction in the reverse direction, although a swap could involve two forward transactions in opposite directions. For example, a swap-in Canadian consists of an agreement to buy Canadian dollars spot, and also an agreement to sell Canadian dollars forward. A swap-out Canadian consists of an agreement to sell Canadian dollars spot and to buy Canadian dollars forward. 6 Why do banks operate a forward exchange market in only a limited number of currencies? Does it have to do with the ability to balance buy orders with sell orders, and is it the same reason why they rarely offer contracts of over 5 years? Banks trade in a limited number of currencies which are most frequently traded on the market and which are most frequently demanded by their clients. Banks tend to balance their forward positions by the use of swaps and rollovers, and since they can simultaneously buy and sell forward contracts for each maturity, they can avoid losses from changes in exchange rates during the terms of forward contracts; what a bank gains (loses) on a forward contract to sell it
loses (gains) on an offsetting forward contract to buy. Hence bank choose to enter the market in currencies which are commonly traded so that they can easily offest long and short positions and find buyers and sellers for those contracts easily. 7 Why is risk neutrality relevant for the conclusion that forward exchange rates equal the markets expected future spot exchange rates? If the speculator is averse to risk, he or she will not buy or sell forward unless the expected return is sufficient for the systematic risk that is taken. This risk depends on the correlation of the exchange rate with the values of other assets and liabilities. To the extent that exchange rate risk is not diversifiable, there may be a risk premium in the forward rate. This can cause the forward rate to differ from the markets expected future spot rate. 8 Why is it necessary to assume zero spreads when concluding that forward exchange rates equal expected future spot rates?
Chapter 4: Currency Futures and Options Markets

1 Why do you think that futures markets were developed when banks already offered forward contracts? What might currency futures offer which forward contracts do not? Currency Futures have a number of features which are not offered by forward contracts. 1. The daily settlement/marking to market on futures means that any losses or gains are realized as they occur on a daily cycle. With the loser supplementing the margin daily and in relatively modest amounts the risk of default is minimal. 2. Contracts in the forward market are traded over the counter and are customized while contracts in the futures market are standardized and traded in the futures exchange. Hence futures offer a more deeper market with easily available contracts albeit in limited customizations. 2 To what extent do margin requirements on futures represent an opportunity cost? There may be an opportunity cost with futures contracts, especially when contract prices have fallen and substantial cash payments have consequently been made into the margin account. Secondly, The amount of money that is kept as margin is an opportunity cost because it may be invested in a securities or kept in a savings out which would earn a fixed interest rate. Hence, amount of money that could have been earned by investing somewhere rather than keeping it in a margin account represents the opportunity cost. However, certain exchanges such as the Pakistan Merchantile Exchange, allow the account holder to keep the money in the margin account and earn interest on it. The money can be withdrawn on by the account holder with interest added to it. 3 How does the payoff profile of a futures sale of a currency compare to the profile of a
purchase of the same currency? See Diagram in Book! 4 Why is a futures contract similar to a string of bets on the exchange rate, settled every day? The bets are settled on each day: futures traders are trying to guess what will happen tomorrow to the markets view of what the spot rate will be on the date of contract maturity. When the buyers account is adjusted up, the sellers account is adjusted down by the same amount. That is, what buyers gain, sellers lose and vice versa. The two sides are taking bets against each other in a zero sum game. The fee for playing the game is the brokerage charge. 5 Do you think that a limit on daily price movements for currency futures would make these contracts more or less risky or liquid? Would a limitation on price movement make the futures contracts difficult to sell during highly turbulent times? A limit on daily price movements for currency futures would make the contracts less risky because the probability of earning profits on the bid ask spread would reduce. Higher volatility leads to higher prices of futures contracts. 6 How could arbitrage take place between forward exchange contracts and currency futures? Would this arbitrage be unprofitable only if the futures and forward rates were exactly the same? The most straightforward type of arbitrage involves offsetting outright forwards and futures positions. If, for example the 3 month forward price for buying euros were $1.1210/e, an arbitrager could buy euros forward from a bank and sell futures on the CME. The arbitrager would make $0.0010/e, so that on each contract E125,000, he or she could make a profit of $125. Action to profit from this arbitrage opportunity would quickly bring the forward price up to the future price. Similarly, arbitrage would bring the futures price up to the forward price. However, we should remember that since the futures market requires daily maintenance, or marking to market, the arbitrage involves risk which can allow the futures and forward rates to differ a little. 7 Does the need to hold a margin make forward and futures deals less desirable than if there were no margin requirements? Does your answer depend on the interest paid on margins? No, margins reduce the default risk and hence allow for more secure transactions between sellers and buyers and hence make forward and future deals not any less desirable but may act as a facility of convenience in the market. However, in the case of futures contracts, the interest paid on the margins results in marking to market risk, which can make futures deals less desirable than forward deals in some cases. 8 How does a currency option differ from a forward contract? How does an option differ from a currency future?
A currency option is the right but not the obligation to buy or sell the underlying at a future date with a payment of option premium upfront to the writer of the currency option, while a forward contract is an obligation to buy or sell the underlying at a future date between two parties. A forward contract has default risk while a currency option has no default risk because it is an obligation. A currency option is the right but not the obligation to buy or sell the underlying at a future date with a payment of option premium upfront to the writer of the currency option, while a futures contract is an obligation to buy or sell the underlying at a future date between two parties, which is traded on the futures exchange. A currency future requires a margin payment called the maintainence margin and there is no default risk (cleariing house). 9 Suppose a bank sells a call option to a company making a takeover offer where the option is contingent on the offer being accepted. Suppose the bank reinsures the option on an options exchange by buying a call for the same amount of foreign currency. Consider the consequences of the following four outcomes or states: a The foreign currency increases in value, and the takeover offer is accepted. b The foreign currency increases in value, and the takeover offer is rejected. c The foreign currency decreases in value, and the takeover offer is accepted. d The foreign currency decreases in value, and the takeover offer is rejected. Consider who gains and who loses in each state, and the source of gain or loss. Satisfy yourself why a bank that reinsures on an options exchange might charge less for writing the takeover-contingent option than the bank itself pays for the call option on the exchange. Does this example help explain why a bank-based over-the-counter market coexists with a formal options exchange market? 11 What type of option(s) would speculators buy if they thought the euro would increase more than the market believed? Speculators would buy a call option on the euro currency. Or sell a put option on the euro currency.

Answers To Chapter Exercises

Uploaded by

Copyright:

Available Formats

Answers To Chapter Exercises

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Answers To Chapter Exercises

Uploaded by

Copyright:

Available Formats

What are some reasons for forward spreads being larger on less-traded currencies compared to heavily traded currencies?

Why do banks quote mainly even-dated forward rates rather than uneven-dated rates?

Assignment Problems (Editable)

*Chapter 3: Forward Exchange

Chapter 4: Currency Futures and Options Markets

You might also like