FOREIGN EXCHANGE MARKETS - QUESTION

Chapter 9. Foreign Exchange Markets

Foreign exchange (FX) hedges

Learning objectives: Describe how a non-arbitrage assumption in the foreign exchange markets leads to the
interest rate parity theorem, and use this theorem to calculate forward foreign exchange rates. Explain why
diversification in multicurrency asset liability positions could reduce portfolio risk. Describe the relationship
between nominal and real interest rates.

1. A bank purchases a six-month, $1.0 million Eurodollar deposit at an interest rate of 2.5% per annum
with semiannual compounding. It invests the funds in a six-month Swedish krone AA-rated bond paying
3.5% per annum. The current SEKUSD spot rate is $0.1140 per 1.0 krona. The six-month forward rate on
the exposure using the FX forward market, which is nearest to the net spread earned on this investment
per annum with semiannual compounding?
A. 2.38%
B. 4.75%
C. 7.93%
D. 13.50%

2. Assume that interest rates are 1.0% per annum with annual compounding in the United States and 9.0%
in Brazil. A bank can borrow (by issuing CDs) or lend (by purchasing CDs) at these rates. The USDBRL
spot exchange rate is R$ 3.500 per 1.0 US dollar. Which is nearest to the forward exchange rate implied
by the interest rate parity theorem (quoted USDBRL with Brazilian real as the quote currency)?
A. R$ 2.85
B. R$ 3.54
C. R$ 3.78
D. R$ 4.07

3. Suppose the current EURUSD spot exchange rate is $1.1300. Eurozone inflation is 5.0% while U.S.
inflation is only 2.0%. According to purchasing power parity (PPP), which is nearest to the new EURUSD
spot exchange rate that should result from the difference in inflation rates?
A. $1.0961
B. $1.1128
C. $1.1300
D. $1.1403

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FOREIGN EXCHANGE MARKETS - QUESTION

Interest rate parity

AIMs: Describe the relationship between nominal and real interest rates. Describe how a non-arbitrage
assumption in the foreign exchange markets leads to the interest rate parity theorem; use this theorem to
calculate forward foreign exchange rates. Explain why diversification in multicurrency asset-liability
positions could reduce portfolio risk.

1. A US bank raises USD $10 million (liabilities) and invests this amount into a Russian project denominated
in Russian rubles (asset) with an expected foreign rate of return of 12%. The bank remains unhedged
with respect to this currency risk. If there is an sudden increase in the Russian inflation rate, without
any corresponding impact on the project’s nominal, foreign 12% return on the project, according to
purchasing power parity (PPP), what is the impact on the bank?
A. No impact
B. Ruble should appreciate, translating into a gain for the bank
C. Ruble should depreciate, translating into a gain for the bank
D. Ruble should depreciate, translating into a loss for the bank

2. The current spot exchange rate between the Euro and the U.S. dollar is EUR/USD $1.40 (base/quote).
Relative inflation rates shift from parity such that the inflation rate in the Eurozone is 2.0% but inflation
rate in the United States is 4.0%. According to purchasing power parity (PPP), what should be the impact
on the exchange rate?
A. The Euro will depreciate by $0.0510 to EUR/USD $1.4510
B. The Euro will depreciate by $0.0510 to EUR/USD $1.3490
C. The Euro will appreciate by $0.0280 to EUR/USD $1.4280
D. The Euro will appreciate by $0.0280 to EUR/USD $1.3720

3. The spot exchange rate EUR/USD is $1.40. The 18-month forward exchange rate is EUR/USD $1.35. If
the short-term US interest rate is flat at 1.00%, what is the 18-month Eurozone interest rate implied by
(covered) interest rate parity (IRP) if we assume continuous compounding? As a bonus, solve also under
an assumption of (discrete) annual compounding.
A. 0.87%
B. 1.45%
C. 2.38%
D. 3.42%

4. The spot exchange rate EUR/CHF is CHF 1.20. Interest rates are flat at 2.0% in the Eurozone (EUR) and
5.0% in Switzerland (CHF). According to interest rate parity (IRP), what should be the 12-month EUR/CHF
forward exchange rate if we assume annual (discrete) compounding?
A. EUR/CHF 1.14
B. EUR/CHF 1.20
C. EUR/CHF 1.24
D. EUR/CHF 1.28

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FOREIGN EXCHANGE MARKETS - QUESTION

Foreign exchange (FX) exposures

Learning outcomes: Calculate a financial institution’s overall foreign exchange exposure. Explain how a
financial institution could alter its net position exposure to reduce foreign exchange risk.

1. Below are spot exchange rates (on August 13th, 2015) for two currency pairs: EUR/USD and USD/CNY;
CNY is the currency code for the Chinese yuan, the basic unit of the renminbi.

Source is Yahoo! Finance (http://finance.yahoo.com). Please note that both of the above are given in
the base/quote format, which is typical; e.g., "The first currency that is quoted in a currency pair is
known as the base currency and the second is known as the counter currency," The Little Book of
Currency Trading: How to Make Big Profits in the World of Forex, p. 36. Wiley. Kindle Edition.
Therefore, in EUR/USD the base currency is EUR and the quote (aka, price, counter) currency is USD,
while in USD/CNY the base currency is USD and the quote currency is CNY.

What is the market-implied bid-ask on the EUR/CNY cross rate?

2. Recently China's central bank devalued the yuan against the US dollar. Consider the impact of a yuan
devaluation on the following four groups:
I. Chinese exporters to the US
II. American tourists to China
III. A US bank that has invested abroad in China--but without hedging--by making
yuandenominated loans
IV. A US manufacturer that exports to China

Which of the group(s) benefits directly from an appreciation of the USD against the CNY?
A. None benefit from yuan depreciation
B. Only I. and II. benefit from yuan depreciation
C. Only III. and IV. benefit from yuan depreciation
D. All benefit from yuan depreciation

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FOREIGN EXCHANGE MARKETS - QUESTION

3. The following are the foreign currency positions of a U.S. bank, expressed in the foreign currency:

The spot exchange rates are currently as follows (all given in base/quote format): USD/CHF 0.980,
GPD/USD $1.56, and USD/JPY ¥125.0
If the Japanese yen appreciates by 2.0%, what is the bank's expected gain or loss (note: this is variation
on Saunders’ Question #8) in US dollar terms?
A. Loss
B. Loss of about $61.0 dollars
C. Gain of about
D. Gain

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FOREIGN EXCHANGE MARKETS - QUESTION

Foreign exchange (FX) gain and loss

Learning objectives: Explain how a financial institution could alter its net position exposure to reduce foreign
exchange risk. Calculate a financial institution’s potential dollar gain or loss exposure to a particular
currency. Identify and describe the different types of foreign exchange trading activities.

1. The current EURUSD spot exchange rate is $1.1111 and the one-year forward exchange rate is $1.2240;
i.e., EUR is the base rate and USD is the quote rate. If you convert $500,000 U.S. dollars to euros in the
spot foreign exchange market and purchase a one-year forward contract to convert euros into dollars,
which is nearest to the effective annual return?
A. -1.50%
B. 2.08%
C. 5.79%
D. 10.16%

2. A bank has the following currency positions in the Brazilian real, expressed in Brazilian real ($R):
 Assets = R$ 125,000
 Liabilities = R$ 78,000
 FX Bought = R$ 27,000
 FX Sold = R$ 5,000
The spot exchange rate USDBRL is $R 3.497 (i.e., USD is the base currency). If the Brazilian real
depreciates by 3.0%, approximately what is the gain (loss) on the currency position expressed in US
dollars?
A. Loss of $3,365
B. Loss of $592
C. Gain of $1,270
D. Gain of $4,822

3. City Bank issued $200.0 million of one-year CDs in the United States at a rate of 3.50%. It invested part
of this money, $100.0 million, in the purchase of a one-year bond issued by a U.S. firm at an annual rate
of 4.0%. The remaining $100.0 million was invested in a one-year Brazilian government bond paying an
annual interest rate of 5.0%. The exchange rate at the time of the transaction was USDBRL R$ 3.5000.
If the Brazilian real appreciates (against the dollar) from R$ 3.5000 to R$ 3.0000, what is the net return
on this $200.0 million investment? (Note: variation on Saunders' Question #10).
A. +3.470%
B. +5.833%
C. +9.750%
D. +12.930%

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FOREIGN EXCHANGE MARKETS - QUESTION

Foreign exchange (FX) hedges

Learning objectives: Identify the sources of foreign exchange trading gains and losses. Calculate the
potential gain or loss from a foreign currency denominated investment. Explain balance-sheet hedging with
forwards.

1. Sun Bank USA purchased a 16.0 million one-year euro loan that pays 7.0% interest annually. The spot
rate of U.S. dollars per euro is $1.10. Sun Bank has funded this loan by accepting a British pound-
denominated deposit for the equivalent amount and maturity at an annual rate of 5.0%. The current
spot rate of U.S. dollars per British pound is $1.60. At the end of the year, assume the euro depreciates
such that the spot rate of U.S. dollars per euro falls to $1.00. Which is nearest to the required spot rate
of U.S. dollars per British pound at the end of the year, in order for the bank to earn a net interest margin
of 2.0%? (Note: this is a variation on Saunders' Question #11)
A. $1.40 per £1; i.e., GPBUSD
B. $1.50
C. $1.60
D. $1.70

2. Suppose that a U.S. financial institution has $200.0 million in assets at the start of the year. Half of its
assets are invested domestically in US loans, while the other $100.0 million is invested abroad in the
United Kingdom. The (default risk-free) US loans yield 4.0% and the (default-free) loans in the United
Kingdom, which denominated in pound sterlings, yield 10.0%:

This institution employs what Saunders calls an "on-balance sheet hedge;" it hedges by matching the
maturity and currency of its foreign asset-liability book. The promised one-year U.S. CD rate is 3.0%, to
be paid in dollars at the end of the year. The institution funds the British loans with $100.0 million
equivalent one-year pound CDs at a rate of 6.0%. The exchange rate of dollars for pounds at the
beginning of the year is $1.60/£1; i.e., GBPUSD $1.60. At the end of the year, assume the pound sterling
plummets (depreciates) against the dollar to $1.20. Which is nearest to the implied net interest margin?
(Note: variation on Saunders' Question #16)
A. -3.75%
B. -0.84%
C. +2.00%
D. +3.33

3. Suppose the a U.S. financial institution has $600.0 million in assets, at the start of the year, which are
funded by US certificates of deposit (CDs) with a promised one-year of 3.0%. The institution invests
$400.0 million domestically in U.S. loans that yield 5.0% and the remaining $200.0 million are invested
abroad in euro-denominated loans that yield 8.0%:

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FOREIGN EXCHANGE MARKETS - QUESTION

Rather than match foreign asset position with liabilities (i.e., on balance sheet hedging), the institution
uses the forward FX market to employ an off-balance-sheet hedge. The exchange rate of dollars for
euros at the beginning of the year is $1.15/€1. The current forward one-year exchange rate between
dollars and euros is $1.12/€1; that is, the forward trades at a $0.03 discount to the spot FX rate. Which
is nearest to return on investment (ROI or "net return" which is different than the net interest margin)
over the year?
A. 1.52%
B. 2.06%
C. 3.00%
D. 4.17%

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FOREIGN EXCHANGE MARKETS - QUESTION

Foreign exchange exposure

AIMs: Calculate a financial institution’s overall foreign exchange exposure. Demonstrate how a financial
institution could alter its net position exposure to reduce foreign exchange risk.

1. The spot foreign currency exchange rate is EUR/USD $1.4296/$1.4304. Each of the following is true
about this quote EXCEPT:
A. The spread is 8 pips
B. If the domestic currency is the US dollar (USD), from the perspective of an American trader, as EUR
is the base currency and the USD is the quoted currency, this is direct quote
C. We can buy one Euro for $1.4304 and sell one Euro for $1.4296
D. If the spot rate changes to EUR/USD $1.4416/$1.4424, then the EUR has weakened and the USD has
strengthened

2. Since the start of 2011, the spot foreign currency exchange rate between the U.S. dollar and Euro has
moved from about EUR/USD $1.30 to about EUR/USD $1.43 (EUR/USD = base/quoted currencies).
Which of the following is TRUE?
A. American goods are cheaper to European buyers (benefiting US exporters)
B. American goods are more expensive to European buyers (hurting US exporters)
C. European manufacturers benefit in American markets as their goods become cheaper to American
buyers
D. Interest rate parity and arbitrage tend to approximately nullify the impact of the currency exchange
rates on even un-hedged importers and exporters

3. A U.S. bank holds portfolios denominated in Swiss francs as follows: CHF 10.0 billion in assets and CHF
12.0 billion in liabilities. With regard to the bank’s trading activities, they have bought and sold the
following (i.e., spot, futures and forward contracts): bought CHF 3.0 billion and sold CHF 2.0 billion.
What is the bank’s net exposure to Swiss francs (CHF)?
A. CHF -3 billion net exposure
B. CHF -1 billion net exposure
C. zero net exposure
D. CHF +1 billion net exposure

4. A Japanese bank (whose domestic currency is the yen, JPY) has the following positions in US dollars:
$5.0 billion in assets, $3.0 billion in liabilities, $2.5 billion USD bought and $5.7 billion USD sold. The
bank is unhedged with respect to its USD exposure. If the exchange rate moves from USD/JPY 80.0000
to USD/JPY 72.0000, what is the impact on the bank?
A. The bank incurs losses on the US dollar depreciation (vis a vis the yen)
B. The bank earns profits on the US dollar depreciation
C. The bank incurs losses on the US dollar appreciation
D. The bank earns profits on the US dollar appreciation

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FOREIGN EXCHANGE MARKETS - QUESTION

5. A US bank has the following pound sterling exposures: GBP 10.0 billion in assets, GBP 7.0 billion in
liabilities, GBP 5.0 billion bought, GBP 6.0 billion sold. The bank is concerned that the pound sterling will
fall in value relative to the US dollar. Which of the following will reduce the bank’s exposure to pound
sterling depreciation?
A. Nothing, its net exposure implies a benefit if GBP depreciates
B. Add +2 billion in assets to the balance sheet that are denominated in pound sterlings
C. Add +2 billion in liabilities to the balance sheet that are denominated in pound sterlings
D. Add + 2 billion in long forward exposure to the pound sterling; i.e., promises to buy GBP in the future

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FOREIGN EXCHANGE MARKETS - QUESTION

Foreign exchange (FX) exposure

AIMs: Calculate a financial institution’s potential dollar gain or loss exposure to a particular currency. List
and describe the different types of foreign exchange trading activities. Identify the sources of foreign
exchange trading gains and losses.

1. A bank has a EUR 2.0 million trading position in spot Euros. The spot EUR/USD exchange rate is $1.40
(EUR is the base currency and USD is the quote currency). The daily volatility of the EUR/USD exchange
rate is 34 basis points (bps). If the bank assumes the exchange rate volatility is normally distributed,
what is the 95% confident daily earnings at risk (DEAR) of the position in US DOLLAR terms; i.e., the 95%
dollar VaR due only to foreign exchange (FX) exposure?
A. $7,997
B. $11,185
C. $15,659
D. $28,642

2. According to Saunders, which of the following is LEAST likely to minimize a bank’s foreign exchange
exposure?
A. Match assets and liabilities in a given currency
B. Match purchases and sales in a given currency
C. Purchase sovereign credit default swaps (CDS)
D. Aggregate foreign exchange exposures across businesses in a holding company

3. According to Saunders, which of the four trading activities most contributes to foreign exchange (FX)
risk exposure?
A. Open positions in a currency
B. Purchase and sale of currencies for hedging purposes
C. Purchase and sale of currencies to complete international transactions.
D. Facilitating positions in foreign real and financial investments

4. A French company manufactures and sells products in and for the EU market. The company sources
input components from Switzerland, paying the invoices for these inputs in Swiss francs (CHF). What is
French company’s currency risk and how can it hedge? (Note: modified version of handbook example
11.4).
A. CHF appreciation against EUR; sell CHF against buying EUR forward
B. CHF appreciation against EUR; sell EUR against buying CHF forward
C. CHF depreciation against EUR; sell CHF against buying EUR forward
D. CHF depreciation against EUR; sell EUR against buying CHF forward

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FOREIGN EXCHANGE MARKETS - QUESTION

On- and off-balance-sheet foreign exchange (FX) risk hedges

AIMs: Calculate the potential gain or loss from a foreign currency denominated investment. Explain balance-
sheet hedging with forwards.

1. A U.S. bank raises USD $200 million in liabilities that pay a domestic (USD) interest rate of 4.0%, in order
to fund two investments:
 $100 million invested into U.S. dollar denominated assets, and
 The remaining $100 million invested into Euro (EUR) denominated assets.
The expected net (of default risk) yield on the USD assets is 6.0% and the net yield on the EUR assets is
8.0%. In this way the expected return on the investment (ROI) is 3.0% as the difference between the
blended ROA of 7.0% (average of 6.0% and 8.0%) and the cost of funds (COF) of 4.0%. However, the
bank is un-hedged with respect to currency risk. At the beginning of the year, the exchange rate is
EUR/USD $1.40. At the end of the year, the exchange rate has moved to EUR/USD $1.26. The nominal
returns for the year were exactly as expected.

What is the one-year realized ROI if we account for the currency shift? Note: please assume all interest
rates are effective annual rates (EARs), consistent with Saunders' illustrations in the assigned readings.
For example, an effective annual rate of 8.0% is equivalent to 8.0% per annum with (discrete) annual
compounding.
A. ROI of +5.90% because the EUR appreciated against the USD
B. ROI of -4.30% because the EUR appreciated against the USD
C. ROI of +1.90% because the EUR depreciated against the USD
D. ROI of -2.40% because the EUR depreciated against the USD

2. Assume the same bank as in the previous question: the bank invests USD $100 million in assets to yield
6.0% and EUR 100 million to yield 8.0%. However, in the case, the bank employs an on-balance-sheet
hedge. Consequently, it borrows USD $100 million paying 4.0% and borrows EUR 100 million also paying
4.0%. This on-balance-sheet hedge matches the EUR 100 million invested abroad by funding with EUR
100 million. At the beginning of the year, the exchange rate is EUR/USD $1.40 which moves to EUR/USD
$1.26 by the end of the year. What is the bank's ROI given it has employed this on-balance-sheet hedge?
A. ROI -0.40% (losses contained)
B. ROI about zero (per the hedge)
C. ROI +2.80%
D. ROI +4.56%

3. Which of the following is true about the use of an ON-BALANCE-SHEET HEDGE to control a bank’s foreign
exchange (FX) exposure?
A. The hedge will lock-in (guarantee) a specific, predetermined net return
B. The hedge can ensure a positive, but nevertheless volatile, net return
C. The hedge cannot ensure a positive net return
D. By employing a forward foreign currency contract, the on-balance-sheet hedge can ensure a
positive return that is also not volatile

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FOREIGN EXCHANGE MARKETS - QUESTION

4. A Swiss bank raises CHF 200 million Swiss francs (liabilities) in order to fund half into a domestic
investment (asset) of CHF 100 million and the rest in Eurozone investment (asset in EUR). What is the
Swiss bank’s un-hedged currency risk and how could the Swiss bank manage this exposure with an OFF-
BALANCE-SHEET hedge?
A. Risk is depreciation of the Swiss franc against the Euro; off-balance-sheet hedge is sell forward
(deliver) EUR in exchange for receiving CHF
B. Risk is deprecation of the Swiss franc against the Euro; off-balance-sheet hedge is sell forward
(deliver) CHF in exchange for receiving EUR
C. Risk is appreciation of the Swiss franc against the Euro; off-balance-sheet hedge is sell forward
(deliver) EUR in exchange for receiving CHF
D. Risk is appreciation of the Swiss franc against the Euro; off-balance-sheet hedge is sell forward
(deliver) CHF in exchange for receiving EUR

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