FIN 649 – FINAL EXAM PRACTICE PROBLEMS

Answers have not been provided to encourage collaboration on Blackboard.
1. Assume that today is March 7, and, as the newest hire for Goldman Sachs, you must advise a client on the costs and benefits of hedging a transaction with options.
Your client (a small U.S. exporting firm) is scheduled to receive a payment of €5,250,000 on April 20, 44 days in the future. Assume that your client can borrow and lend at a 6% p.a. U.S. interest rate.
a. Use the appropriate American option with an April maturity and a strike price of 129¢/€ to determine the dollar cost today of hedging the transaction with an option strategy. The cost of the call option is 3.93¢/€, and the cost of the put option is 1.58¢/€.
b. What is the minimum dollar revenue your client will receive in April? Remember to take account of the transaction and opportunity cost of doing the option hedge.
c. Determine the value of the spot rate ($/€) in April that would make your client indifferent to having done the option transaction or a forward hedge. The forward rate for delivery on April 20 is $1.30/€.
1. Assume that today is June 11. Your firm is scheduled to pay £400,000 on August 15, 65 days in the future. The current spot is $1.75/£, and the 65-day forward rate is $1.73/£. You can borrow and lend dollars at 7% p.a. Suppose you think options are overpriced because you think the dollar will be in a tight trading range in the near
future. You have been thinking about selling an option as a way to reduce the dollar cost of your pound payable.
a. If an August pound option with a strike price of 175¢/£ costs 4.5¢/£ per pound for the call and 4¢/£ for the put, what is the minimum that you will have to pay in August to eliminate your pound payable? Over what range of future exchange rates will this price be achieved?
b. How much must the pound appreciate before your speculative option strategy ends up costing you more than the forward rate?

3. Suppose the spot exchange rate for the Canadian dollar is Can$1.26 and the sixmonth forward rate is Can$1.29.
a. Assuming absolute PPP holds, what is the cost in the United States of an Elkhead beer if the price in Canada is Can$2.49? Why might the beer actually sell at a different price in the United States?
b. Is the U.S. dollar selling at a premium or a discount relative to the Canadian dollar?
c. Which currency is expected to appreciate in value?
d. Which country do you think has higher interest rates—the United States or Canada? Explain.
4. Suppose the current exchange rate for the Polish zloty is PLN 3.94. The expected exchange rate in three years is PLN 4.12. What is the difference in the annual inflation rates for the United States and Poland over this period? Assume that the anticipated rate is constant for both countries. What relationship are you relying on in answering?
5. You plan to visit Geneva, Switzerland in three months to attend an international business conference.
You expect to incur the total cost of SF 10,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF.
Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.
(a) Calculate your expected dollar cost of buying SF10,000 if you choose to hedge via call option on SF.
(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.
(c) At what future spot exchange rate will you be indifferent between the forward and option market hedges?
(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.
6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry.

PCC owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the U.S. PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of .014 cents per yen.
(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used.
(c) At what future spot rate do you think PCC may be indifferent between the option and forward hedge?
7. On Monday morning, an investor takes a long position in a pound futures contract that matures on Wednesday afternoon. The agreedupon price is $1.78 for £62,500. At the close of trading on Monday, the futures price has risen to $1.79. At Tuesday close, the price rises further to $1.80. At Wednesday close, the price falls to $1.785, and the contract matures. The investor takes delivery of the pounds at the prevailing price of $1.785. Detail the daily settlement process. What will be the investor's profit (loss)?

8. Citigroup sells two call options on euros (contract size is €500,000) at a premium of $0.04 per euro. If the exercise price is $0.91 and the spot price of the euro at date of expiration is $0.93, what is Citigroup's profit (loss) on the options?

9. Suppose you buy three June PHLX euro call options with a 90 strike price at a price of 2.3 cents / €.
a. What would be your total dollar cost for these calls, ignoring broker fees?
b. After holding these calls for 60 days, you sell them for 3.8 cents / €. What is your net profit on the contracts, assuming that brokerage fees on both entry and exit were $5 per contract and that your opportunity cost was 8 percent per annum on the money tied up in the premium?
11. In July, the one year interest rate is 12% on British pounds and 9% on U.S. dollars.
a. If the current exchange rate is $1.63:1, what is the expected future exchange rate in one year?
b. Suppose a change in expectations regarding future U.S. inflation causes the expected future spot rate to decline to $1.52:£1. What should happen to the U.S. interest rate?
12. If expected inflation is 100% and the real required return is 5%, what will the nominal interest rate be according to the Fisher effect?

13. Suppose that in Japan the interest rate is 8% and inflation is expected to be 3%. Meanwhile, the expected inflation rate in France is 12%, and the English interest rate is
14%. To the nearest whole number, what is the best estimate of the one year forward exchange premium (discount) at which the pound will be selling relative to the French franc?
14. Assume that the contracts discussed below are described with the GBP as the home currency and that the option’s expiration date matches the expiration date of the cash flow to be hedged. Illustrate how the exchange rate affects the GBP value of:

(a) a NZD 500,000 accounts receivable and a purchase of ten puts each worth NZD 50,000 with a strike price of GBP/NZD 0.42.
(b) a JPY 10,000,000 accounts payable and a purchase of ten calls each worth JPY 1,000,000 with a strike price of GBP/JPY 0.0067.
15. Humongous International Inc. is headquartered in the UK but conducts metal ore mining in resource-rich countries for export to worldwide markets, primarily the US and China. It is evaluating where to locate a new mining operation that would have the lowest costs. South Africa is among the countries it is considering for the new mine and you have been requested to determine an appropriate cost of capital for the analysis. Since many metals are priced in USD, you have been asked to prepare your estimates from a US-centric perspective. Please estimate the cost of equity capital based on the data below for the following methods:

Identical global cost of capital
World CAPM
Segmented/Integrated CAPM
Goldman-Integrated
Damodaran.
CHINA

Risk free interest
rate
Expected Market
Return
Equity Risk
Premium
Beta
Equity market
capitalization to
GDP
Volatility of
country equity
market/Volatility
of country bonds

UK

US

6.00

SOUTH
AFRICA
5.5

World

.50

.25

11.90

12.90

6.10

5.25

6.32

5.90

7.40

5.60

5.00

6.07

2.50
45%

2.15
212%

2.00
118%

2.15
125%

1.90
100%

1.50

1.70

1.20

1.20

1.20