International Financial Management FINA 4836 Rauli Susmel Fall 2018 First Midterm Exam - SOLUTIONS. I. Problems (15 points each).

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1 International Financial Management FINA 4836 Rauli Susmel Fall 2018 First Midterm Exam - SOLUTIONS No points will be given by simply writing down formulas, and writing down definitions or irrelevant statements from the book, or saying "yes," will get you zero points. Justify all your answers. If you cannot prove something give some intuition. Good luck. Reminder: this is an open book exam, but no open notes. Time: 1hr 20 minutes. I. Problems (15 points each). 1. It is September Paddy s Gas, a U.S.-based energy company, has a AUD 400 million payable due in December Paddy s Gas decides to use options to reduce FX risk. Available options with December maturity: X Calls p c Puts p p 0.76 USD/AUD USD/AUD USD/AUD , where X represents the strike price and premiums for calls (p c ) and puts (p p ) are expressed in USD cents i.e., 1.99 equals to USD Today, the exchange rate is S t = 0.78 USD/AUD. A. Calculate the premium cost and calculate the net cash flows (in USD), including premium paid, in December for Paddy s Gas under the following choices: i) in-the-money option ii) out-of-the money option B. Suppose Paddy s Gas can also use a conditional call option with a strike price 0.85 USD/AUD, but it is cancelled if S Dec > 0.90 USD/AUD. The premium for this conditional option is USD.005. Calculate the net cash flows (in USD) in December for Paddy s Gas under this conditional contract. What are the pros and cons of this conditional option relative to the alternatives in A? C. Draw a graph with the net cash flows (in USD) against S t=dec for the three hedging alternatives discussed above. FC Payables => use call options (right to buy FC) to hedge. A. (i) ITM call option: Xc = 0.76 USD/AUD pc = USD /AUD Total premium paid = AUD 400 M * USD /AUD = USD M - if SDec > 0.76 USD/AUD => AUD 400M * 0.76 USD/AUD + USD 28.3M = USD M - if SDec 0.76 USD/AUD => AUD 400M * SDec + USD 28.3 M (ii) OTM call option: Xc = 0.85 USD/AUD pc = USD /AUD Total premium paid = AUD 400 M * USD /AUD = USD 2 M - if SDec > 0.85 USD/AUD => AUD 400M * 0.85 USD/AUD + USD 2.75M = USD M - if SDec 0.85 USD/AUD => AUD 400M * SDec + USD 2.76 M Note: You could have selected Xc = 0.80 USD/AUD pc = USD /AUD Total premium paid = AUD 400 M * USD /AUD = USD 7.56 M - if SDec > 0.80 USD/AUD => AUD 400M * 0.80 USD/AUD + USD 7.56 M = USD M - if SDec 0.80 USD/AUD => AUD 400M * SDec + USD 7.56 M

2 B. Conditional call option: Xc = 0.85 USD/AUD pc = USD 0.005/AUD Total premium paid = AUD 400 M * USD 0.005/AUD = USD 2 M - if SDec > 0.90 USD/AUD => AUD 400M * SDec + USD 2 M - if.90 > SDec > 0.85 => AUD 400M * 0.85 USD/AUD + USD 2 M = USD 342 M - if SDec 0.85 USD/AUD => AUD 400M * SDec + USD 2 M C. (Check class notes for more graphs.) ITM & OTM with X c =.85 graphs: Net CFs in Dec USD M X c =.85 USD 326 M X c =.76 X c =.76 X=0.76 X=0.85 S Dec (USD/AUD)

3 2. It is October A Big Mac costs CZK 80 in the Czech Republic, while it costs USD 4.8 in the U.S. The spot rate is 20 CZK/USD (CZK= Czech Koruna). (a) According to PPP, what should be the USD/CZK exchange rate in October 2018? (b) Take the USD as the domestic currency. Calculate the real exchange rate, R t. What is the over/under-valuation of the CZK relative to the USD? (c) According to R t, which country is more efficient? (d) The GDP per capita in the Czech Republic is CZK 440,000. Translate the GDP per capita in CZK to (nominal) USD and to PPP USD prices. (e) Suppose in November 2018, the price of the Big Mac increases to CZK 84 in the Czech Republic, while it decreases to 4.56 in the U.S. According to the linearized version of relative PPP, what should the USD/CZK exchange rate be in November 2018? (f) Assume that in November 2018 the exchange rate is. 04 USD/CZK. Generate a trading signal based on PPP. (a) S t PPP = USD 4.8/CZK 80 = 0.06 USD/CZK (or CZK/USD) (b) R t = St Pf / Pd = [(1/20) USD/CZK * CZK 80]/USD 4.8 = => CZK is undervalued by 16.67% (c) R t < 1 => Czech Republic is more efficient. (d) GDP per capita (in USD, nominal) = CZK 440,000 * (1/20) USD/CZK = USD 22,000 GDP per capita (in USD, PPP) = CZK 440,000 * 0.06 USD/CZK = USD 26,400 (e) IUS = (4.56/4.80-1) = ICZ = (84/80-1) =.05 ef,nov 18 PPP IUS ICZ = -.10 S PPP Nov 18 = S t PPP x [1 + ef,nov 18 PPP ] = 0.06 USD/CZK x [1 + (-.10)] = USD/CZK Note: You could have also calculated: S PPP Nov 18 = SOct 18 x [1 + ef,nov 18 PPP ] = (1/20) USD/CZK x [1 + (-.10)] = USD/CZK (f) St=Nov 18 =.04 USD/CZK < S PPP Nov 18 = USD/CZK => According to PPP, the CZK is undervalued at St = 045 USD/CZK => Trading signal: Sell CZK/Buy USD Note: If you use S t PPP to calculate S PPP Nov 18 you get the same trading signal.

4 3. Suppose you use quarterly U.S. and U.K. data from 1978:Q1 to 2017:Q4. You fit the following regression: e f,t (USD/GBP) = (S t - S t-1 )/S t-1 = α + β (i UK i US ) t + ε t. SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 159 ANOVA df SS MS F Regression Residual Total Coefficients Standard Error t Stat P-value Intercept i UK i US (i) Are the signs of the coefficients consistent with IFE? (ii) Using individual t-tests, test IFE at the 5% level. (iii) Assume the sum of {e f,t - (i US i UK ) t } 2 during the estimation period is i.e., SSR(H 0 ). Using an F-test, test IFE at the 5% level. (iv) Suppose S 17:Q4 = USD/GBP and (i US i UK ) 18:Q1 = Using the regression model, forecast the exchange rate for the first quarter of 2018, that is, 2018:Q1 (S 18:Q1 ). (v) Suppose S 18:Q1 = USD/GBP. Which 2018:Q1 has a smaller forecast error: the regression model or the random walk model? (i) Intercept should be 0 (no sign per se); slope should be 1 (positive). Slope is not OK with IFE. (ii) t(α=0): ( )/ = ( < 1.96) t(β=1): ( )/ = ( > 1.96) => cannot reject H0 => reject H0 (iii) F(α=0 & β=1): [( )/2]/ [ /(159-2)] = ( >F2,159 3) => reject H0 (iv) EQ 17[e f,t=q 18 ] = EJan 17[(i US i UK ) t=q 18 ] = *.0105 = EQ 17[S,t=Q 18 ] = USD/GBP x ( ) = USD/GBP (v) Forecast error Model: = <= smaller error (closer to 0!). Forecast error RWM: =

5 4. Ms. Benes is a U.S. arbitrageur. The 180-day interest rate offered in the U.S. is 2%, while the 180-day interest rate offered in Brazil is 8% (both rates are annualized). The spot rate is 4.05 BRL/USD. Beckham Bank offers Ms. Benes a 180-day forward contract at 4.25 BRL/USD. (1) F IRP t,180-day = 4.05 BRL/USD * (1+.08/2)/(1+.02/2) = BRL/USD (2) F IRP t,180-day F BB t,180-day = 4.25 BRL/USD => Yes, arbitrage is possible. Covered arbitrage strategy (Key: BB overvalues USD forward at 4.25 BRL/USD). All steps simultaneously done: 1) Borrow BRL 1 at 8% for 180 days.. => In 180 days, repay: BRL ) Convert to BRL at St = 4.05 BRL/USD => Get USD ) Deposit USD.2469 at 2% for 180 days. => In 180 days, get BRL 3.90 * (1.01) = USD ) Sell USD/Buy BRL forward at Ft,180-day = 4.25 BRL/USD => In 1-yr, USD *4.25 BRL/USD = BRL (3) π = BRL BRL 1.04 = BRL (or 1.99% per USD borrowed) (4) p = (Ft,T St)/St x (360/T) = ( )/4.05 x 2 = id if = =.06 => p > id if => capital outflows from the domestic economy (Brazil) => capital outflows to the US from Brazil.

6 II. CASE (30 points) 1) According to the article, the Mexican peso should appreciate against the USD, due to the U.S. tariffs on Chinese goods. Show with a graph how the U.S. tariffs on Chinese goods affects the USD/MXP exchange rate. Briefly explain. Mexican goods are more attractive (more imports from Mexico, substituting imports from China). => Demand for MXP S t (USD/MXP) (Check graph from Lecture Notes) Note: You can also say that Trump s tariffs create uncertainty: => Less Mexican investments in US (Supply of MXP ) => More U.S. investments in Mexico (Demand for MXP ) => S t (USD/MXP) (Check graph from Lecture Notes) 2) Suppose Banxico (Mexico s Central Bank) decides to intervene to stop the appreciation of the MXP against the USD. Draw a graph to show the effects on FX Markets and on Money Markets. Banxico buys USD (& pays with MXP) => S t (MXP/USD) => i MX (higher Money Supply in Mexico) (Check graphs from Lecture Notes.) 3) According to the article, ECB s Governing Council member Ewald Nowotny is questioning the ECB s low interest rate policy. Money markets seem to be already pricing an increase in European interest rates. What is the effect of an increase in European interest rate on the USD/EUR exchange rate? Draw a graph. (i USD - i EUR => Less European investments in US (Supply of EUR ) => More U.S. investments in Europe (Demand for EUR ) => S t (USD/EUR) (Check graph from Lecture Notes) 4) According to Deutsche Bank, the euro is set to climb back toward 1.20 USD/EUR. According to what you learned in class, do you agree with Deutsche Bank s forecast? Briefly justify your answer. Nonsense. The RWM is a very good model in the short-run: Exchange rates are unpredictable. 5) Using the exchange rates given in the article, determine the EUR/GBP exchange rate. Suppose the 180-day forward rate is F t,180 =1.20 EUR/GBP. Calculate the forward premium. Does the forward rate contain a premium or a discount? S I t = USD/GBP / USD/EUR = EUR/GBP p = ( )/ * 2 = > 0 => F t,180 contains a 15% premium.