College Bowl Final Round Question 1 Suppose

College Bowl Final Round

Question #1 Suppose that Purchasing Power Parity holds. Annual inflation in the US is currently 7% annually (from the latest CPI numbers) while annualized inflation in Britain is 2%. If the current exchange rate is $1. 90 per pound, what will the exchange rate be in 6 months? $1. 90 (1. 025) = $1. 9475

Question #2 Suppose that the annual interest rate in the US is 3% while in Europe, a comparable asset pays 4%. The current spot rate is $1. 35 per Euro, and the one year forward rate is $1. 40. How could you make money off this information and what would your annual return be? By borrowing the US and lending in Europe, you earn 1% (the interest differential), plus 3. 7% (the pound appreciation)

Question #3 US inflation is currently 7% annually while European inflation is 5%. The dollar depreciates by 4% against the Euro, what happens to the real exchange rate? The real exchange rate depreciates by 4% + 5% - 7% = 2%

Question #4 All else equal, if US economic growth outpaces European growth, what should happen to the value of the dollar? It should appreciate relative to the Euro

Question #5 The US is running a $600 B trade deficit: 1) All else equal, what should happen to the dollar? 2) Changes is the exchange rate should correct the trade deficit unless this is true? The trade deficit should cause the dollar to depreciate (making US goods cheaper and foreign goods more expensive). This will fix the deficit unless import/export elasticities are low.

Question #6 Suppose that the price of services (a non-traded good) rises in the US. All else equal, what should happen to the nominal AND real exchange rate? Nothing happens to the nominal exchange rate, the dollar, however, appreciates in real terms (US goods become more expensive relative to foreign goods.

Question #7 What is a currency straddle and why is it useful? A straddle combines a put option with a call option. It protects the buyer from both currency appreciations AND depreciations.

Question #8 You have a L 100, 000 payable that will come due in one year. Currently the pound is trading at $1. 80. Your point estimate for the pound one year from now is a 5% appreciation (5% depreciation of the dollar) with a standard error of 1%. What is the 95% confidence for you expected dollar costs? A 5% depreciation implies a future exchange rate of $1. 80(1. 05) = $1. 89($100, 000) = $189, 000 two standard deviations is 2% (+/- $3, 780) [$185, 220, $192, 780]

Question #9 If you had a payable denominated in Yen, how would you hedge this in the option market? You would buy a call option on Yen.

Question #10 How does economic exposure differ from transaction exposure? Transaction exposure deals with fixed cash flows while economic exposure deals with variable cash flows

Question #11 Variable Intercept % Change e ($/E) Regression Results Coefficients Standard Error t Stat . 05 1. 5 . 03 -3. 35 . 97 -3. 45 Given this regression of $ cash flows and the exchange rate, how could you hedge your risk in the futures market? You are losing money when the Euro appreciates. Therefore, you could offset this loss by taking a long position in Euro.

Question #11 Some people would argue that you shouldn’t have to hedge translation exposure. Why is this? Translation exposure doesn’t involve actual cash flows. Only the conversion of financial statements into the company’s home currency.

Question #12 China is currently pegging to the dollar. As the dollar continues to depreciate, what must the Peoples Bank of China do and why is it a bad policy in the long run? China must buy up dollars in the world markets. This expands the Chinese money supply which will ultimately lead to inflation.

Question #13 What is contagion and why does it occur? Contagion describes the transmission of currency crises across neighboring countries. It is due to • Common policies/shocks • Trade linkages • Financial linkages • Information Problems

Question #14 What are the costs/benefits of using an option hedge rather than a forward hedge? An option hedge allows the holder to benefit from profitable exchange rate movements, but costs more up front (the premium)

Question #15 If you knew that the Dollar/Euro exchange rate was going to fluctuate between $1. 35 and $1. 45, what would be the most efficient hedge? An bullish spread (Buy a call option w/ a strike price of $1. 35 and sell a call with a strike price of $1. 45. The proceeds from the call sale should offset the purchase price of the other call.

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