1. (2.5 Points) You are given the following information: U.S. France Japan Nomin

Question

1. (2.5 Points) You are given the following information:

U.S.

France

Japan

Nominal one year interest rate

5%

6%

7%

Spot rate

-----

$1.16

$0.008

Interest rate parity exists between the U.S. and France as well as the U.S. and Japan. The international Fisher effect exists between the U.S. and France as well as the U.S. and Japan.

Bill (based in the U.S.) invests in a one-year CD (certificate of deposit) in France and sells euros one year forward to cover his position.

Erica (based in France) invests in a one-year CD in Japan and does not cover her position.

What are the returns on funds invested for Bill and Erica respectively? Please justify your explanation both in terms of theory and calculations. (2.5 points) (Hint: You can get the exchange rate between euro and Japanese Yen from their respective rate to USD)

ANS: Please clearly label your return calculations, i.e., the investment return for Bill and Erica respectively.

2. (2.5 Points) The U.S. three-month interest rate (unannualized) is 1%. The Canadian three-month interest rate (unannualized) is 4%. A put option with a three-month expiration date on Canadian dollars is available for a premium of $0.02 and a strike price of $0.62. The spot rate of the Canadian dollar is $0.65. Assume that you believe in International Fisher Effect (IFE).

Forecast the dollar amount of your profit or loss from buying a put option contract specifying C$100,000. (1.25 points)

Forecasr the USD received by A&M company which uses the put option to hedge against its 3 month receivables of C$ 100,000. (1.25 points)

ANS: Please label a/b in your response to the two sub-questions respectively.

U.S.

France

Japan

Nominal one year interest rate

5%

6%

7%

Spot rate

-----

$1.16

$0.008

Explanation / Answer

Soln: Interest Rate parity says that in case of no arbitrage opportunity the given below eqn should hold :

(1+i$) = E(St +k)*(1+ic)/St

where i = interest rate in different countries, E = expected exchange rate after k period and St = current exchange rate

So, for Bill the expected exchange rate E = (1+0.05)*1.16/1.06 = $1.15, Dollar rate has been reduced after an year

Bill has invested $1 i.e. Euro1.16 and book a forward and cover its position. So, he will get the return as 1.16*1.06 = Euro 1.23.

So, return will be = (1.23- 1.16)/1.16 or 6% as position is covered.

In case of Erica, the Yen/Euro rate spot = 0.008/1.16 = 0.0069 and after an year it has been reduced to 0.0068

And the position not covered. So, interest earned = (1.07*0.0068 - 0.0069)/0.0069, we get around 5% return, which actually is not helping erica to invest in Euro better is to cover the position like Bill.

Q2. a) As Interest rate parity again we can find out the exchange rate after 3 months which will be = 1.01*0.65/1.04 = $0.63

So, net cash flow in case if put option is being bought = -0.02 + value from exercising put option

Put option will not be exercised as strike price< forward market rate or $0.62<$0.63

Hence,a s loss of $0.02 from buying a put option contract.

(b) A&M company uses put option to hedge for 3 month receivables of C$100,000

As we see in the above part a the put option will not be executed as strike price of the same is lower than market price. So, company will get its C$ converted at market exchange rate i.e. $0.63 or they receive $63000, as using the put option if they execute, they can sell for $62000.

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