Tutorial 4+5

Question
6.2 Purchasing Power Parity. Define the two forms of purchasing power parity, absolute and relative.
• Absolute version: the spot exchange rate is determined by the relative prices of similar baskets
of goods, if the law of one price were true for all goods and services and the market is
efficient.
S(¥/$) = P¥/ P$
• Relative version:
The relative form of PPP accounts for the possibility of market imperfections such as
transportation costs, tariffs, and quotas.
RPPP holds that PPP is not particularly helpful in determining what the spot rate is today, but
that the relative change in prices between two countries over a period of time determines the
change in the exchange rate over that period.
If the spot exchange rate between two countries starts in equilibrium, any change in the
differential rate of inflation between them tends to be offset over the long run by an equal but
opposite change in the spot exchange rate.

6.3 Big Mac Index. How close does the Big Mac Index conform to the theoretical requirements for a
law of one price measurement of purchasing power parity?
This means that its price in each country is representative of domestic costs and prices and not imported
ones, MOSTLY FAST FOOD CHAINS LOCAL --use local currency which would be influenced by exchange
rates themselves--local
The index, however, still possesses limitations.
Big Macs cannot be traded across borders, and costs and prices are influenced by a variety of other
factors in each country market, such as real estate rental rates and taxes

6.4 Undervaluation and Purchasing Power Parity. According to the theory of purchasing power parity,
what should happen to a currency that is undervalued?
Theoretically, if the currency is undervalued then market participants, is in search of potential profits, will
continue to purchase the currency until they drive its price up eliminating the undervaluation
6.12 The International Fisher Effect. Define the international Fisher effect. Would it discourage local
investors from capitalizing on higher foreign interest rates?
• The relationship between the percentage change in the spot exchange rate over time and the
differential between comparable interest rates in different national capital markets is known as
the international Fisher effect.
• According to the IFE, higher foreign interest rates should not attract investors because these
rates imply high expected inflation rates, which in turn imply potential depreciation of these
currencies. Yet, some investors still invest in foreign countries where nominal interest rates are
high. This may suggest that some investors believe that (1) the anticipated inflation rate
embedded in a high nominal interest rate is overestimated, or (2) the potentially high inflation
will not cause substantial depreciation of the foreign currency (which could occur if adequate
substitute products were not available elsewhere), or (3) there are other factors that can offset
the possible impact of inflation on the foreign currency’s value.

6.13 Interest Rate Parity. Define interest rate parity. What would it say about interest rates if spot
rates and forward rates were the same?
• Interest rate parity: The difference in the national interest rates for securities of similar risk
and maturity should be equal to, but opposite in sign to, the forward rate discount or premium
for the foreign currency, except for transaction costs.

6.14 Covered Interest Arbitrage. Ignoring transaction costs, under what conditions will covered
interest arbitrage be plausible?
Covered interest arbitrage involves the short term investment in a foreign currency that is covered
by a forward contract to sell that currency when the investment matures. Covered interest
arbitrage is plausible when the forward premium does not reflect the interest rate differential
between two countries specified by the interest rate parity formula. If transactions costs or other
considerations are involved, the excess profit from covered interest arbitrage must more than
offset these other considerations for covered interest arbitrage to be plausible.
Problems
6.1 Malaysian Island Resort. Theresa Nunn is planning a 30-day vacation on Pulau Penang, Malaysia,
one year from now. The present charge for a luxury suite plus meals in Malaysian ringgit (RM) is
RM1,045/day. The Malaysian ringgit presently trades at RM3.1350/$. She determines that the dollar
cost today for a 30-day stay would be $10,000. The hotel informs her that any increase in its
room charges will be limited to any increase in the Malaysian cost of living. Malaysian inflation is
expected to be 2.75% per annum, while U.S. inflation is expected to be 1.25%.
a. How many dollars might Theresa expect to need one year hence to pay for her 30-day vacation?
b. By what percent will the dollar cost have gone up? Why?
Charge for a
luxury suite plus meals in RM RM 1, 045/ day
Spot rate RM 3 . 1350/$

Dollar cost today for a

30-day stay $10 ,
000

Malaysian inflation expected . 75 %

2
per annum

uS inflation expec
tecI 1 25 %
.

1 + Tf
Sz =
S, x
1 +
wh
2 75%
Expected spot
1
a .
rate in one
yr = RM 3 1350 / .
$ x
+ .

=
RM 3 18144/$
.

1 + 1 . 25 %

Hotel charge 1
yr =
30 x 1 045
,
(1 + 2 75 %
.
) = RM 32 212 , .
125 =
$10 ,
125

from now for 30 days RM 3 .

18144/$
10 , 125-10 000
b .
%A in $cost =
,

x
100 % =
1 25 %
.
=> Rises
by 1 25 %
. = Hus
10 , 000

6.2 Argentine Float. The Argentine peso was fixed through a currency board at Ps1.00/$
throughout the 1990s. In January 2002, the Argentine peso was floated. On January 29, 2003, it
was trading at Ps3.20/$. During that one-year period, Argentina’s inflation rate was 20% on an
annualized basis. Inflation in the United States during that same period was 2.2% annualized.
a. What should have been the exchange rate in January 2003 if PPP held?
b. By what percentage was the Argentine peso undervalued on an annualized basis?
c. What were the probable causes of undervaluation?
S1 = Ps 1 . 00/$(indirect) >
-

$ ↓ : Ps:f

↑ = 20 % if uS = 2 2% h
ps
= . =
.

(1 f)
20%0%
+ PS1 17/$
+
a .
Sc =
S, = (x = .

(1 + An)

Actual exchange
S overvalued/undervalued
b rate 1 17-3 2
. : Ps 3 2/$ .
=> % =
. .

=
-63 43 %
.

PPP held exchange rate : Ps 1 17/$ .

of Peso 3 2
.

c .
Ps ↓ due to inflation .
BOP deficit , political issues
6.3 Derek Tosh and Yen-Dollar Parity. Derek Tosh is attempting to determine whether U.S./Japanese
financial conditions are at parity. The current spot rate is a flat ¥89.00/$, while the 360-day
forward rate is ¥84.90/$. Forecast inflation is 1.100% for Japan, and 5.900% for the United States.
The 360- day euroyen deposit rate is 4.700%, and the 360-day eurodollar deposit rate is 9.500%.
a. Diagram and calculate whether international parity conditions hold between Japan and the United
các điều kiẹn ngang bằng quốc tế : là điều kiện ngang bằng lãi
States. suất
b. Find the forecasted change in the Japanese yen/ U.S. dollar (¥/$) exchange rate one year from
now.
360
S1 = 89 00 .
$ = = 84 90 .
$ +* = 1 1%
.
=
if #
*
=
π = 5 9% .

* =
if = 4 7%
.
$ =
in = 9 5%
.

f
if -in
S
= 4 7%.
-
9 5%.
= 48 .
% =>
if-ihl < +

f S F 89 84 9

So arbitrage opportunity doesn't hold

4 829 % int rate
parity
- -

=>
.

= x = = .
,

F s 84 9
invest borrow $
.

Invest in 1 yr => ,
> $1 095 mil
(1 + 9 5 %)
.

x
$ ( mil mili
0976
$1
.

E⑳
V
=
Invest 1yr
in

* 89 mil x (1 + 4. 7
.
% #93 183 mil .

6.4 Chan’s Homes: Hong Kong to Toronto. Albert Chan owns homes in Toronto, Canada and Hong
Kong, China. He travels between the two cities at least four times a year. Because of his frequent
trips, he wants to buy some high-quality luggage. He has done some research and has decided to
purchase a Samsonite three-piece luggage set. There are retail stores in Toronto and Hong Kong
that carry the luggage set he intends to purchase. Albert was a finance major and wants to use
purchasing power parity to determine if he is paying the same price regardless of where he makes
his purchase.
a. If the price of the three-piece luggage set in Toronto is C$950 and the price of the same three-
piece set is HK$5,650, using purchasing power parity, is the price of the luggage truly equal if the
spot rate is HK$6.0000/C$? h >
f
b. If the price of the luggage remains the same in Toronto one year from now, determine the price
of the luggage in Hong Kong in one year’s time if PPP holds true. The Canadian inflation rate is
2.0% and the Hong Kong inflation rate is 3.5%.
.
a S = $6 0000/C$ .
= Price of Luggage set in Toronto = C$950
$5 , 650
Price of
Luggage set in
Hong Kong = $5, 650 = = C$941 .
67
HK$6 C$
=> The price of Luggage set is not truly equal.
b .
Sc =
S.
A 6 x
13 .5% HR$6 0882
.

=> Price of the luggage set in K in

1yr time = C$950 x $6 0882 ($
. = $5 ,
783 82
.
6.7 Kamada: CIA Japan (A). Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is
exploring covered interest arbitrage possibilities. He wants to invest $5,000,000 or its yen
equivalent in a covered interest arbitrage between U.S. dollars and Japanese yen. He faced the
following exchange rate and interest rate quotes. Is CIA profit possible? If so, how?
Arbitrage funds available +
$5,000,000 118 6
N
593m x .
=

Spot rate (¥/$) 118.60

180-day forward rate (¥/$) 117.80
180-day U.S. dollar interest rate in
4.800% higher = >
-

180-day Japanese yen interest rate if 3.400% =

S
f h
i
J

3 4% 4 8% 1 4% => lif ; 1 > f => Invest in higher yielding currency

f
-

= . . = .
_

118 6 -117 8 360

30
S-F
f 358 % Invest $ borrow
.

1
.

= x = X = . => ,
F 117 8 .
180

.4%
3
Borrow 593m at 3 4%.
payable in
180-day = # 593mx (1 +
2 1 = 603 081m
.

Convert #593m to $at S = # 118 6 . $ : 593m # 118 6/$ .

= $5m
8%
days 4
.

Invest $5m in 180 days at 4 8 .

%. After 180 ,
receive : $5m x 11 + = $5 12.
M

Convert $5 .
12 m back to E at F = # 117 8 .
$ : $5 .
12 m x # 117 8/$ .
= # 603 136 .
m

=> Net profit =# 603 136m .

-
# 603 081 . m = # 0 055m .

6.12 Casper Landsten—CIA (A). Casper Landsten is a foreign exchange trader for a bank in New
York. He has $1 million (or its Swiss franc equivalent) for a short-term money market investment
and wonders whether he should invest in U.S. dollars for three months or make a CIA investment in
the Swiss franc. He faces the following quotes:
Arbitrage funds available. $1,000,000 SF 1 281m f h
= .

Spot exchange rate (SFr/$) 1.2810

3-month forward rate (SFr/$) 1.2740
U.S. dollar 3-month interest rate in 4.800% =

Swiss franc 3-month interest rate if 3.200% lower =

S
if -in = 3 2%
.
-

4 8 %
.
= 1 6%. = 1 :
st
-i$) =>
lif-ih/ < + => invest SF ,
borrow $
SF
f S -
F 360 ↓ 2810
.
-
1 . 2740 360 2 198 %
= x = X = .

F days 1 2740
. go

%
Borrow $1m at 4 8 %,
.

payable in 3 months =
$1m x (1 +
40 ) = $1 .
012m

Convert $1 to SF at S = SF1 2810 .

/$ : $1m x S1 .
2810/$ = S 1 2810 .
m

Invest SF 1 2810m in
. 3 months at 3 2%. After 3 months . receive : SF1 2810 m .
x (1 + %) = SF 1 2912m
.

back to $at SF 1 29/2m

Convert SF 1 2912m.
F = SF 1 2740 .
/ $ :
.

= $1 .
0135m
SF 1 .
2740/$

=> Net profit = $1 0135m

.
-

$1 012m .
= $0 0015m .
6.13 Casper Landsten—UIA (B). Casper Landsten, using the same values and assumptions as in
Problem 6.12, decides to seek the full 4.800% return available in U.S. dollars by not covering
his forward dollar receipts an uncovered interest arbitrage (UIA) transaction. Assess this
decision. => higher risk facing loss if i iS
,

6.17 Chamonix Rentals. You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from
now. You are negotiating the rental of a chateau. The chateau’s owner wishes to preserve his real
income against both inflation and exchange rate changes, and so the present weekly rent of €9,800
(Christmas season) will be adjusted upward or downward for any change in the French cost of living
between now and then. You are basing your budgeting on purchasing power parity (PPP). French
inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is expected to be
2.5%. The current spot rate is $1.3620/€. What should you budget as the U.S. dollar cost of the 1-week
rental? ft ↓
h

Spot exchange rate ($/€) $1.3620 Si $1 3620/E

= .

Expected U.S. inflation for coming year 2.500% -

H it
U S
.

2 5%
= = .

Expected French inflation for coming year 3.500% French

T 3 5% = =

Current chateau nominal weekly rent (€) 9,800.00

.

=
p = 9 800
=
p ? , => =

S = S,
I = $1 3620/Ex
.

250 = $1 348
.

=> p$ = 9 , 800 x $1 3488/E

.
= $13 , 218 24
.
Question
Tutorial 6
7.1 Foreign Currency Futures. What is a foreign currency future?
A future is an exchange-traded contract calling for future delivery of a standard amount of foreign
currency at a fixed time, place, and price. A future requires a mandatory delivery. The future is a
standardized exchange-traded contract often used as an alternative to a forward foreign exchange
agreement.
7.2 Futures Terminology. Explain the meaning and probable significance for international business of the
following contract specifications:
a. Notional principal: The required foreign currency size of the contract.
b. Margin: The requirement that the purchaser deposit a sum as an initial margin or collateral. This
requirement is similar to requiring a performance bond, and it can be met by a letter of credit from a
bank, Treasury bills, or cash.
c. Marked to market: Marked-to-market means that the value of the contract is revalued using the
closing price for the day.

7.3 Long and a Short. How can foreign currency futures be used to speculate on the exchange rate
movements, and what role do long and short positions play in that speculation?
Short Positions. If a currency speculator believes that a foreign currency will fall in value versus the
U.S. dollar (home currency) by a specific date, she could sell that date futures contract, taking a short
position. By selling that date contract, the speculator locks in the right to sell the foreign currency at
a set price—a price that the speculator believes would be higher than the spot rate in the market on
that future date.
Long Positions. If a currency speculator believes that a foreign currency will rise in value versus the
home currency by a specific date, she should buy a future date future on the foreign currency. By
buying a currency future the speculator is locking in the price to buy the foreign currency which the
speculator expects to be higher in value at that date, therefore generating a profit.

7.4 Futures and Forwards. How do foreign currency futures and foreign currency forwards compare?
Foreign currency futures contracts differ from forward contracts in a number of important
ways. Individuals find futures contracts useful for speculation because they usually do not have
access to forward contracts. For businesses, futures contracts are often considered inefficient and
burdensome because the futures position is marked to market on a daily basis over the life of the
contract. Although this does not require the business to pay or receive cash daily, it does result in
more frequent margin calls from its financial service providers than the business typically wants.
7.5 Hedging with Futures. What are the disadvantages of using futures contracts to hedge a firm’s exposure?
Problems
7.1 Mariko Fujimoto at Sakura Bank. Mariko Fujimoto, a currency trader for Tokyo-based Sakura Bank,
uses the following futures quotes on the British pound (£) to speculate on the value of the pound.
a. If Mariko buys 5 March pound futures, and the spot rate at maturity is ¥139.95/£, what is the value
of her position?
b. If Mariko sells 12 December pound futures, and the spot rate at maturity is ¥138.90/£, what is the
value of her position?
c. If Mariko buys 3 December pound futures, and the spot rate at maturity is ¥138.90/£, what is the
value of her position?
d. If Mariko sells 12 March pound futures, and the spot rate at maturity is ¥139.95/£, what is the value
of her position?

Maturity. No of contracts. Decision .

Ending spotrate · Efutures Value of position

5 (S-F) * 139 95/t * 139 3/t ↳ 125 000 5 x ( 139 95/5 * 139 3/t) 406 , 250
A Mar
Buy x -

. . =
,
.
. .

b. Dez 12 Sell (F S)
-

# 138 90/1.
# 139 75/ .
[125 000 x 12x
,
( # (39 75/1
.
-

#138 . 9/1) = 1 275 000

, .

* 138 90/ 139 75/ 3x ( * 138 9/ # 139 75/7) (318 750)

.
c Dec 3
Buy . .
-125 , 000 x .
-

.
=
,

d .
Mar 12 Set # 139 95/.
# 139 3/2 .
<125 , 000 x 12x ( * 139 3/1 .
-
* 139 . 95/H) = # (975 , 000)

7.2 Laura Cervantes. Laura Cervantes, the currency speculator we met in this chapter, sells eight June
futures contracts for 500,000 pesos at the closing price quoted in Exhibit 7.1.
a. What is the value of her position at maturity if the ending spot rate is $0.12000/Ps?
b. What is the value of her position at maturity if the ending spot rate is $0.09800/Ps?
c. What is the value of her position at maturity if the ending spot rate is $0.11000/Ps?
Sell 8 Jun .
futures contracts for 500 000 ,
pesos Initial exchange rate : $0 10773/ps
.

=> Initial position value = 500 , 000

ps x 8 x $0 .
10773/ps = $430 ,
920

.
a S = $0 12/Ps
. => Value of position = 500 , 000ps x 8 x $0 12/Ps
. = $480 ,
000

b .
S= $0 098/Ps
. => Value of position = 500 , 000 ps x 8 x $0 098/Ps
.
= $392 ,
000

c
. S = $0 .
11/Ps => Value of position = 500 , 000ps x 8 x $0 11/Ps
. = $440 ,
000
 7.4 Hoffman Bank, Basel (A). Stefan Boerig trades currency for the Hoffman Bank in Basel,
Switzerland. Stefan has 10 million Swiss francs (SF) to begin with, and he must state all profits at the
end of any speculation while the 30-day forward rate is SF1.1027/€.
a. If Stefan believes the euro will continue to rise in value against the Swiss franc and expects the
spot rate to be SF1.1375/€ at the end of 30 days, what should he do?
b. If Stefan believes the euro will depreciate in value against the Swiss franc and expect the spot rate
to be SF1.0925/€ at the end of 30 days, what should he do? , 2nd
.
a F= SF 1 1027/E .
S = SF1 1375/E . - EUR is expected to appreciate/CHF is
expected to depreciate
Today :
Long EUR fwd 30
days for CHF 10m at F = SF 1 1027/E
.
= Short CHA 10m food

After 30 days : Sell CHF 10m at F to settle forward contract ,

amt of EUR received : - 9 068 649 68
. , .

Sell EUR &

Buy CHF (Convert EUR to CHF) at S = SF 1 .
1375/E 10 315 , 589
,
. 01 CHF

Expected profit 315 , 589 01 CHF

.

. F
b = St 1 1027/E
.
S = SF 1 0925/ =
.
=> EUR is expected to depreciate/CHF is expected to appreciate
Today : Short EUR fwd 30 days for CHF at F = SF 1 .
1027/E

After 30 days : Sell CHF10m at S = SF 1 0925/E.

,
amt of EUR received : >
-
9 , 153 ,
318 08 .

Sell EUR with F = SF 1 1027/E

.
under find contract 10 , 093 , 363 84 .
CHF

Expected profit 93 , 363 84 CHF .

7.5 Hoffman Bank, Basel (B). Stefan Boerig of Hoffman Bank now believes that the Swiss franc will
appreciate against the British pound in the coming 3-month period. He has £250,000 to invest. The
cur- rent spot rate is £0.7829/SF, the 3-month forward rate is £0.7640/SF, and he expects the spot
rates to reach £0.7995/SF in three months.
a. Calculate Stefan’s expected profit, assuming a pure spot market speculation strategy.
b. Calculate Stefan’s expected profit, assuming he buys or sells Swiss francs three months forward.

3 Expect
a
. So = 10 7829/SF .
CHF to appreciate in 3 months

S3 = 0 7995/SF
.

Today Buy : CHF at S = 0 7829/SF

.

using 250 , 000 319 ,

325 58 .
CHF

After 3m : Sell CHF at Sc = 0 . 7995/SF & 255 300 80 , .

Expected profit 5 300 80 , ,

= Expect appreciate 3 months

b
. F3 = 50 764/SF .
CHF to in

S3 = 50 7995/SF .

Today :
Long CHF fwd 3 months at 3 = 10 764/SF
.
= Short 250 000 ,
food

After 3m Sell : & at 3

= . 764/SF
0 to settle fwd contract 327 225 , .
13 CHF

Convert CHF back toA at S = 0 .

7995/SF ↓ 261 616 , .
49

Expected profit & 11 , 616 .

49
Question
Tutorial 7
7.7 Put Contract Elements. The CME exchange-traded American put option has a contract size of
€125,000; the December puts with a strike price of 1.2900 are now quoted at 0.0297. Explain what these
figures mean for a put buyer.

7.8 Premiums, Prices, and Costs. What is the difference between the price of an option, the value of
an option, the premium on an option, and the cost of a foreign currency option?

7.9 Three Prices. What are the three different prices or “rates” integral to every foreign currency option
contract?
Problems
7.3 Cece Cao in Jakarta. Cece Cao trades currencies for Sumatra Funds in Jakarta. She focuses nearly
all her time and attention on the U.S. dollar/Singapore dollar ($/S$) cross-rate. The current spot rate
is$0.6000/S$. After considerable study,she has concluded that the Singapore dollar will appreciate
versus the U.S. dollar in the coming 90 days, probably to about $0.7000/S$. She has the following
options on the Singapore dollar to choose from:
↑ underlying currency >
-
base
currency

a. Should Cece buy a put on Singapore dollars or a call on Singapore dollars?

b. What is Cece’s break-even price on the option purchased in part (a)?
c. Using your answer from part (a), what is Cece’s gross profit and net profit (including premium) if
the spot rate at the end of 90 days is indeed $0.7000/S$?
d. Using your answer from part (a), what is Cece’s gross profit and net profit (including premium) if
the spot rate at the end of 90 days is $0.8000/S$? ATM
Profit ITM

S = $0 6/S$
.
n= 90 days Expected S = $0 7/S$
.

a .
S$ will appreciate => buy a call of S$

b
. $0 65/S$ X
Long call onS$x $0 65/S$ = . c = $0 00046/S$
.
.
=
# I > St

BE $0 65/5$ $0 00046/S$ $0 65046/S$ $0 $0 65046/5$ 5 $0 7/S$

price
00046s
= x + c = .
+ .
= .
-

. .
= .

c .

Sg = $0 7/S$ >.
X => exercise

Gross profit = 5 -

X = 0 7 -0 65
.
.
= $0 05/S$ .

Loss
Net profit = S-X -c = 0 7 -0 65 -0 00046
. . . = $0 04954/S$
.

.
d
Sg = $0 8/S$ X
. => exercise

Gross profit =
0 8-0 65 . .
= $0 15/S$ .

Net profit = 0 8 -0 65 -0 00046

. . . = $0 14954/S$
.
7.6 Kiko Peleh’s Puts. Kiko Peleh writes a put option on Japanese yen with a strike price of
$0.008000/¥ (¥125.00/$) at a premium of 0.0080¢ per yen and with an expiration date six months
from now. The option is for ¥12,500,000. What is Kiko’s profit or loss at maturity if the ending spot
rates are ¥110/$, ¥115/$, ¥120/$, ¥125/$, ¥130/$, ¥135/$, and ¥140/$?
Short put on * x = $0 .
008 = # 125/$ p = 0 008
.
cent = $0 00008/ *
.

not exercise Profit ATM

St = 110 /$ = $0 009091/ >.
X => Do ITM OTM
1
↓
↓
Gross profit = $0 exercise Do not exercise

Net profit =
p = $0 00008/ *
.
x * 12 5m . = $1 ,
000

St # 115/$ Do not exercise X

= = $0 008696/* > =>
> St
BE
.

= X P
-

Gross profit = $0

Net profit =
p = $0 00008/ *
.
x * 12 5 m . = $1 ,
000 -P -

$0 00008/ *
.

St # 125/$ $0 008/E => Do not exercise

Loss
= = . =

Gross profit = $0

Net profit =
p = $0 00008/ *
.
x * 12 5 m . = $1 ,
000

St = # 130 /$ = $0 00769/ * <X

. => Exercise

Gross profit = - (X- St) =

-

(0 008
.
-
0 .
00769) =
-

$0 00031/ * .

Net profit = - (X - St) +

p =
-
(0 008
.
-
0 .
00769) + 0 00008
. =
-

$0 00023/ *
.

=> I profit/loss =
-

$0 00023/ * .
x * 12 5 m . =
-

$2 ,
875

St = # 135/$ = $0 007407/ * <X .

=> Exercise

Gross profit =
-
(x- St) =
-

(0 008
.
-
0 007407)
.
=
-

$0 .
000593 #

Net profit = - (X - St) +

p =
-
(0 008 .
-
0 . 007407) + 0 00008
. =
-

$0 000513/ *
.

=> I profit/loss =
-

$0 000513/ #.
x 12 5 m
. =
-
$6 ,
412 5 .

St = * 140/$ = $0 .
007143/ * <X => Exercise

Gross profit =
-
(X- St) =
-

(0 008
.
-
0 0071431
.
=
-

$0 000857 # .

Net profit = - (X - St) +

p =
-
(0 008
.
-
0 . 007143) + 0 00008
. =
-

$0 000777/ *
.

=> I profit /loss =

-

$0 000777/ *.
x # 12 5 m .
=
-

$9 712 5, .
 7.8 Valdor Capital. Baradan Kuppusamy works as a currency speculator for Valdor Capital
headquartered in Kuala Lumpur. His most recent speculative position is to profit from his expectation
that the Thai baht will rise significantly against the Malaysian ringgit. The current spot rate is
RM0.1382/baht. He must choose. between the following 90-day options on the Malaysian ringgit.

a. Should Baradan buy a put on Malaysian ringgit or a call on Malaysian ringgit?

b. What is Baradan’s break-even price on the option purchased in part (a)?
c. Using your answer from part (a), what are Baradan’s gross profit and net profit (including premium)
if the spot rate at the end of 90 days is RM0.2000/baht ?
baht will rise Profit
a .
Expect : Than => RMX => long put on RM
1
ITM
↓
ATM OTM
↓
X = RM0 . 16/B P= 10 .
005/RM exercise Do not exercise

= B6 .
25/RM

St X
b .
BE price =
X- p = 6 . 25/RM-B0 .
005/RM = 16 .
245/RM 1 > St
PBE
P-
-

X
=
p
-

c .
St = RMo .
2/ = B5/RM <X = B6 25/RM => Exercise
.

Gross profit X
=
-

St = $6 25/RM-15/RM
.
= B1 .
25/RM

Net profit = X -

St -

p = 6 25
.
-
5 -
0 005
.
= B 1 245/RM
. V
Loss

7.9 Henrik’s Options. Assume Henrik writes a call option on euros with a strike price of $1.2500/€ at a
premium of 3.80 cents per euro ($0.0380/€) and with an expiration date three months from now. The
option is for 100,000 euros. Calculate Henrik’s profit or loss should he exercise before maturity at a
time when the euro is traded spot at strike prices beginning at $1.10/€, rising to $1.40/€ in
increments of $0.05. Profit
M
OTM
ATM
ITM

X = $1 25 .
E n = 3m Short call > St
1 25
.

c = $0 038 .
E E 100 , 000

Loss
OTM ITM
ATM
--
$1 1/E $1 15/E $1 2/E $1 25/E $1 3/ $1 35 / $1 4/E
short call .
. . . .
. .

-( . 3 -
1 . 25) 1
-

.
35 -
1 .
25) -

(1 .
4-1 . 25)

Pay-off O O O 8 -

$0 05/ .
-
$0 1/E .
-

$0 15/E .

0 038-0 05
.
.
0 038-0 1
.
.
0 038-0 15
. .

Net profit $0 038 .

E $0 038 .
E $0 038.
E $0 038 .
E -

$0 012/E .
-

$0 062/E .
-

$0 112/E .
8.15 Aidan’s Cross-Currency Swap: Yen for Euros. Use the table of swap rates in the chapter, and assume
Aidan enters into a swap agreement to receive euros and pay Japanese yen, on a notional principal of
€10,000,000. The spot exchange rate at the time of the swap is ¥104/€.
a. Calculate all principal and interest payments, in both euros and Japanese yen, for the life of the swap
agreement.
b. Assume that one year into the swap agreement, Aidan decides it wants to unwind the swap agree-
ment and settle it in euros. Assuming that a 2-year fixed rate of interest on the Japanese yen is now
0.90%, a 2-year fixed rate of interest on the euro is now 3.80%, and the spot rate of exchange is now
¥115/€, what is the net present value of the swap agreement? Who pays whom what?

0 2% . E
4
A
0 .
19 % E

ECFs ↑ CFS

O -
E 10m So :
#104/Es + * 1 , 040 , 000

I + E20 , 000 -
1 , 976 , 000

2 + E 20, 000 -

1, 976 000 ,

E + E 10 020
, ,
000 -
71 041 976 , 000
, ,

a t = 1 PV (CF) =
20 , 000
+
10 , 020 , 000

1+ 38% .
(1 + 3 8 % .
)2

1 976 , 000 1 041 , 976 000

PV (CF) =
,

+
, ,

1 +0 9%
.
(1 + 0 .
9% )2

=> Net (F(E) = PV(CEE) -

PV(CFE)
115
↓
Si
Question
Tutorial 8
10.1 Foreign Exchange Exposure. Define the three types of foreign exchange exposure.
The three main types of foreign exchange exposure are transaction, translation, and operating:
• Transaction exposure measures changes in the value of outstanding financial obligations incurred
prior to a change in exchange rates but not due to be settled until after the exchange rates
change. Thus, it deals with changes in cash flows that result from existing contractual obligations.
• Translation exposure is the potential for accounting-derived changes in owner’s equity to occur
because of the need to “translate” foreign currency financial statements of foreign subsidiaries
into a single reporting currency to prepare worldwide consolidated financial statements.
• Operating exposure, also called economic exposure, competitive exposure, or strategic exposure,
measures the change in the present value of the firm resulting from any change in future
operating cash flows of the firm caused by an unexpected change in exchange rates. The change
in value depends on the effect of the exchange rate change on future sales volume, prices, and
costs.

10.2 Currency Exposure and Contracting. Which of the three currency exposures relate to cash flows
already contracted for, and which of the exposures do not?
Transaction exposures are existing exposures of the firm, resulting from identifiable transaction.
Operating exposures are exposures that are likely—anticipated—but not yet existing or contracted.

10.3 Currency Risk. Define currency risk

Currency risk is the variance in expected cash flows arising from unexpected exchange rate changes.

10.9 Hedging versus Speculating. What is the difference between hedging and speculating?
A hedge is the acquisition of a contract or a physical asset that will offset a change in value of some
other contract or physical asset. Hedges are entered into to reduce or eliminate risk, as opposed to
speculation, which is the taking of a position for the purposes of potential profit.
Problems
10.1 BioTron Medical, Inc. Brent Bush, CFO of a medical device distributor, BioTron Medical, Inc., was
approached by a Japanese customer, Numata, with a proposal to pay cash (in yen) for its typical
orders of ¥12,500,000 every other month if it were given a 4.5% discount. Numata’s current terms are
30 days with no discounts. Using the following quotes and estimated cost of capital for Numata, Bush
will compare the proposal with covering yen payments with forward contracts. Should Brent Bush
accept Numata’s proposal?
Spot rate: ¥111.40/$
30-day forward rate: ¥111.00/$
90-day forward rate: ¥110.40/$
180-day forward rate: ¥109.20/$
Numata’s WACC 8.850%
BioTron’s WACC 9.200%
BioTron's 30 day AR # 12 500 000
, ,

Desired discount on
purchase price 4 5%.

by Numata
1
.
Allow the discount receive put in in cash

AR * 12 500 000
, ,

Discount for cash pmt up-front ( * 12 500 000 , ,

x 4 5 %)
. (562 500) ,

Amt paid in cash net of discount * 11 , 937 , 500

Current spot rate * 111 4 .

/$
Amt received in $ $ 107 , 158 89 .

2
. Not offer
any
discounts for
early put cover
exposure with forwards
AR ↑ 12 500 000
,
,

I
30-day forward rate # 111/$ L

Amt received in cash in $ ,

in 30
day $112 ,
6/2 61 .

PV of dollar cash received $112

. 612 61 .

$) 111 755 82
, .

(1 + 9 2%
.

x 300)
=> Brent Bush should politely decline Numata's offer to cash in
exchange for the requested discount.
pay
10.2. Bobcat Company. Bobcat Company, a U.S.-based manufacturer of industrial equipment, just
purchased a Korean company that produces plastic nuts and bolts for heavy equipment. The purchase
price was 7,500 million. 1,000 million has already been paid, and the remaining 6,500 million is due in
six months. The current spot rate is 1,110/$, and the 6-month forward rate is 1,175/$. The 6-month
Korean won interest rate is 16% per annum, the 6-month U.S. dollar rate is 4% per annum. Bobcat can
invest at these interest rates, or borrow at 2% per annum above those rates. A 6-month call option on
won with a 1,200/$ strike rate has a 3.0% premium, while the 6-month put option at the same strike
rate has a 2.4% premium. Bobcat can invest at the rates given previously, or borrow at 2% per annum
above those rates. Bobcat’s weighted average cost of capital is 10%. Compare alternate ways that
Bobcat might deal with its foreign exchange exposure. What do you recommend and why?
Assumption
Purchase price of Korean manufacturer 7 , 500 , 000 , 000 Option on won call option Put option
Less initial pint L 1 ,
000 , 000 , 000) X (E) # 1 200/$
,
# 1 200/$
,

Net settlement needed ,

in 6 months # 6 500 , 000 000 , , Option premium 3% 2 4% .

Current spot rate # 1 110/$ ,

US
. Korea

6-month forward rate # 1 , 175/$ 6month investment (not borrow) in /yr 4% 16 %

+

Bobcat's cost of Capital (WACC) 10 % of 2% 2% 2%

Borrowing premium
6-month borrowing rate /yr 6% 18 %

Risk Mgt Alternatives Certainty

1 .
Remain uncovered ,
making won put in 6month at spot rate in effect at that date

AP # 6 500 000 000, , ,

Possible S in 6-month : Current spot rate 1 ,

110/ <

Cost of settlement in 6 months $5 855 855 , ,

.
86 Uncertain

AP # 6 500 000 000 , , ,

Possible S in 6-month : Forward rate # 1 ,

175/$/
Cost of settlement in 6 months $5 ,
531 , 914 89 .
Uncertain

.
2 Forward market hedge
. Buy won forward 6 months

AP # 6 500 000 000 , , ,

Forward rate # 1 ,
175/$/
Cost of settlement in 6 months $5 ,
531 , 914 89 .
Certain

hedge dollar for

. Exchange
.
3 Money market won now , invest for 6 months

AP E 6 500 000 000 , , ,

(1 + 16 % x /12)
PV of AP = Won needed now # 6 018 , 518 519L
, ,

110/$
US dollar needed now $) 5 422 088
, , .
762/ 1 ,

Carry forward rate for 6m (WACC) 10 % x (1 + 10% x %(2)

us dollar cost ,
in 6m ,
of settlement $5 693 , ,
193 192 .
Certain
 4. Call option hedge
.
(Need to buy won = call on won)

If exercised If not exercised

Option principal # 6 , 500 , 000 , 000

Current spot rate # 1 110/$ ,

# 1 300/$
,

Premium cost of option 3%

option premium (principal/spot rate x % pm) $175 675 68 , .

If option exercised/not exercised ,

dollar cost of won $5 416 , ,
666 .
67 $5 000
, ,
000 00
.

Premium carried forward 6 months (pm x 1 .

125 ,
WACC) $184 459 46 , .
$184 459 46 , .

Total net cost of call option hedge if exercised $ 5 601 , 126 13

,
. $5 ,
184 ,
459 46 .

The forward contract provides the lowest CERTAIN cost hedging method for payment settlement. If,
however, the firm believes the ending spot rate will be a weaker Won, Won1,200/$ or higher, then the
call option would be a lower cost alternative. This would require, however, that the firm accept foreign
exchange risk and be willing to suffer the higher cost of the call option in the event that the Won did
not fall to the needed level.
Bas chea
Forward Long 6 ,
500 m forward in 6m @ F = 1 ,
175/$

> $ cost
- of find hedge after 6m =
W6500m =
$5 531 914. 8
, ,

Money market hedge

Borrow $5 422 088
, ,
.
76 &
Convert to & S = #1 , 110/$ , get (AP) = # 6 018 , 518 , 519
,

Invest 6 018 518 519 &

,
, ,
16 %

At
maturity : Proceed from investment : 6 500 000 000
, , ,
Pays Ap = #6 500 000 , 000
, ,

US dollar cost of settlement : $5 693 , ,

193 19 .

option
*
Long call option W6 500m@X on ,
= W1 , 200 / , premium = 3%

~6 500m
+ Premium paid today =
,
x 3% = $175 ,
675 68 .

1110

10 %
+
FV(premium) after 6m = $175 675 68 , .
x (1 + /2) = $184 , 459 .
459

H If St <X = W 1 , 200 /$ -
> exercise Cost =
500M =
$5 416 , 666 6
, .

=> Total dollar cost of option hedge = $5 601 126 , ,

.
13

=> Conclusion : Choose food bcs lowest dollar cost

10.4 P&G India. Procter & Gamble’s affiliate in India, P&G India, procures much of its toiletries product
line from a Japanese company. Because of the short- age of working capital in India, payment terms
by Indian importers are typically 180 days or longer. P&G India wishes to hedge an 8.5 million
Japanese yen payable. Although options are not available on the Indian rupee ( ), forward rates are
available against the yen. Additionally, a common practice in India is for companies like P&G India to
work with a currency agent who will, in this case, lock in the current spot exchange rate in exchange
for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging
strategy.

180-day account payable ¥8,500,000

Spot rate: ¥120.60/$
Spot rate, Rs/$ Rs47.75/$
Implied (calculated) spot rate (¥/Rs) ¥2.5257/Rs (120.6/47.75)
180-day forward rate ¥2.400/ 2

Expected spot, 180 days ¥2.6000/ 2

180-day Indian rupee investing rate 8.000%

180-day Japanese yen investing rate 1.500%
Currency agent’s exchange rate 4.850%
P&G India's cost of capital 12.000%
Hedging alternatives Values Spotrate (Rp/$) Risk Assessment

1 .
Remain uncovered , setting AP in 180 days &S

Si current spot rate Rs 3 , 365 , 464 35 .

# 2 5257
.
Rs
Risky
forward rate Rs 3 , 541 666 67 # 2 4/Rs
Risky
Si , . .

&
180
=
expected spot rate Rs 3 , 269 230 77 ,
.
# 2 6/Rs .

Risky
.
2 Buy forward 180 days
Settlement amt & food rate Rs 3 541 , 666 67
, .
# 2 4 .
Rs Certain

3
.
Money market hedge
Principal * 8 500 , ,
000 (1 + 1 5%
.
x 180/360)

Principal needed to meet 57

AP in 180
days & 8 , 436 , 724 .

# 2 5257/Rs .

Indian rupee current ant Rs 3 340 411 262

, ,

180/360)
, .

x (1 + 8 % x
Future value of MM hedge Rs 3 540 , 835 942
, .
Certain
4
. Indian Currency Agent Hedge
Principal AlP 8 500, ,
000
12 5257/Rs .

Current AP Rs 3 365 464 342

, ,
.

Plus agent's fee

14 85 %) Rs 163 , 225 02
180/360)
. .

x (1 + 12% x

Total FV of agent's fee Rs 173 018 522

, .

Total AP ,
FV ,
Ap + fee Rs 3 538 482 87
, , .
Certain

The agent is the lowest total cost in CERTAIN future value of all certain alternatives.
currency , rupee ,