Deck 17: Forward Exchange and International Financial Investment

Question 1

You have been asked to determine whether covered interest parity holds for one-year government bonds issued by the U.S. and British governments. What data will you need How will you test

Answer 1

You will need data on four market rates: The current interest rate (or yield) on bonds issued by the U.S. government that mature in one year, the current interest rate (or yield) on bonds issued by the British government that mature in one year, the current spot exchange rate between the dollar and pound, and the current one-year forward exchange rate between the dollar and pound. Do these rates result in a covered interest differential that is very close to zero

Question 2

The current spot exchange rate is $0.010/yen. The current 60-day forward exchange rate is $0.009/yen. How would the U.S. firms and people described in question 3 each use a forward foreign exchange contract to hedge their risk exposure What are the amounts in each forward contract

Answer 2

a.The U.S. firm has an asset position in yen-it has a long position in yen. To hedge its exposure to exchange rate risk, the firm should enter into a forward exchange contract now in which the firm commits to sell yen and receive dollars at the current forward rate. The contract amounts are to sell 1 million yen and receive $9,000, both in 60 days.
b.The student has an asset position in yen-a long position in yen. To hedge the exposure to exchange rate risk, the student should enter into a forward exchange contract now in which the student commits to sell yen and receive dollars at the current forward rate. The contract amounts are to sell 10 million yen and receive $90,000, both in 60 days.
c.The U.S. firm has an liability position in yen-a short position in yen. To hedge its exposure to exchange rate risk, the firm should enter into a forward exchange contract now in which the firm commits to sell dollars and receive yen at the current forward rate. The contract amounts are to sell $900,000 and receive 100 million yen, both in 60 days.

Question 3

The current spot exchange rate is $1.20/euro. The current 90-day forward exchange rate is $1.18/euro. You expect the spot rate to be $1.22/euro in 90 days. How would you speculate using a forward contract If many people speculate in this way, what pressure is placed on the value of the current forward exchange rate

Answer 3

Relative to your expected spot value of the euro in 90 days ($1.22/euro), the current forward rate of the euro ($1.18/euro) is low-the forward value of the euro is relatively low. Using the principle of "buy low, sell high," you can speculate by entering into a forward contract now to buy euros at $1.18/euro. If you are correct in your expectation, then in 90 days you will be able to immediately resell those euros for $1.22/euro, pocketing a profit of $0.04 for each euro that you bought forward. If many people speculate in this way, then massive purchases now of euros forward (increasing the demand for euros forward) will tend to drive up the forward value of the euro, toward a current forward rate of $1.22/euro.

Question 4

The following rates are available in the markets:
Current spot exchange rate: $0.500/SFr
Current 30-day forward exchange rate: $0.505/SFr
Annualized interest rate on 30-day dollar-denominated bonds: 12% (1.0% for 30 days)
Annualized interest rate on 30-day Swiss franc-denominated bonds: 6% (0.5% for 30 days)
a. Is the Swiss franc at a forward premium or discount
b. Should a U.S.-based investor make a covered investment in Swiss franc- denominated 30-day bonds, rather than investing in 30-day dollar-denominated bonds Explain.
c. Because of covered interest arbitrage, what pressures are placed on the various rates If the only rate that actually changes is the forward exchange rate, to what value will it be driven

Question 5

Why is testing whether uncovered interest parity holds for actual rates more difficult than testing whether covered interest parity holds