International FinanceFin435.001Fall 2010Exam #2Prof. M. Rhee1. You took a short position in three contracts of Euro futures (125,000 Euros for one contract) at 10am CST on 11/9 for 2010 December delivery at $0.923/€. What is the initial margin amount at a 2% initial margin requirement? Given that you put down $200 more than the 2% initial margin requirement, what is the ending balance of your account at the end of 11/9 if the settlement price of 11/9 is $0.927/€? What is your new margin ratio at the end of the day of 11/9? Do you get a margin call, if the minimum maintenancemargin is1.5%? If so, how much is the variation margin? Assuming that you are going to add $300 more than the variation margin, if you get the margin call, what would be the ending balance of 11/9? If the futures rate increases to $0.929/€ on 11/10, do you get a margin call? What is the variation margin? What will be the ending balance if you add $300 more than the variation margin?2. Explain how you can use various parity conditions to predict future exchange rates (Hint: Focusing on E (e) using the relative PPP, relative PPP + International Fisher, Forward Parity) (1) Relative PPP-E(e)= E(I$) – E(I£)-Projected future exchange rate change rate (or the projected FC appreciation rate relative to $) is approximately equal to the difference in projected inflation rates between two countries(2) Relative PPP & International Fisher-From the International Fisher, E(I$) – E(I£) = i$ – i£ ⇨ the relative PPP becomes E(e) =E(I$) – E(I£) = i$ – i£ ⇨ E(e) = i$ – i£-Projected future exchange rate can be predicted by the nominal interest differential (the data on nominal interest rates can be easily obtained) rather than projected inflation differential (unobservable) between two countries.(3) Forward Parity-E(S1) = F ⇨ E(e) = (F – S0) / S0-The forward premium rate equals the expected % change in the exchange rate (or the projected FC appreciation rate against $)3. James Clark is a currency trader with Wachovia. He notices the following quotes:1/S0 = SF 1.2051/$, Six month forward rate (1/F6mo) = SF 1.1922/$Six-month $ interest rate 2.5% APR, Six-month Swiss franc interest rate 2.0% APRa) Does the CIRP hold?b) Determine the implied forward rate.c) Show steps needed to make arbitrage profits assuming that Clark is authorized to work with $1 million or equivalent amount in SFs.a) 1 + (0.025/2) vs. (1.2051) * {1 + (0.02/2)} *(1/1.1922)$1.0125 < $1.02092854Borrow Low Invest High ⇨ CIRP does not hold. Borrow low in the U.S. and invest high in Switzerland. Note that the exchange rates given are in European terms!b)1.0125 = (1.2051) * (1.01) * F ⇨ F = {1.0125 / (1.2051 * 1.01)} = $0.83186/SF ⇨ Since actual F ($0.8388/SF) > implied F, RHS will be greater than LHS indicating “Borrow low in the U.S. and invest high in Switzerland”c)i. Borrow $1M in the U.S.ii. Convert $1M to SFs at S0 = $(1/1.2051)/SF$1M * SF(1.2051)/$ = SF1,205,100iii. Invest SF1,205,100 in Switzerland at iSF = 2% APRSF1,205,100 * (1 + interest rate) = SF1,205,100 *{1 + (0.02/2)} = SF1,217,151iv. Convert SF into $ to realize revenue at F6mo = $(1/1.1922)/SFSF1,217,151 * $(1/1.1922)/SF = $1,020,928.54v. Calculate the debt$1M * (1 + interest rate) = $1M * {1 + (0.025/2)} = $1,012,500vi. Realize profit$1,020,928.54 - $1,012,500 = $8,428.54Comment: In reality, the bid – asked spreads exist for the exchange rates (both S0 and F), and the interest rates. Due to the spreads, the arbitrage gain may be smaller or non-existent. 4. If you notice that Credit Lyonnais is buying/selling dollars at e/$=0.6783. Similarly, you alsoobserve that Barclarys is buying/selling British pounds at $/£ = 1.9712. Finally, you find thatCredit Agricole is making a direct market between the euro and the pound with e/£ = 1.3310. Isthere a triangular arbitrage opportunity? If so, determine the arbitrage profit with $1,000 amountto start out with. (Use H & L to identify the trade directions).Credit Lyonnais: €/$ = 0.6783Barclays: $/£ = 1.9712Credit Agricole:€/£ = 1.3310Investment fund: $1,000(1) Triangular Arbitrage Opportunity?Barclays: $/£ = 1.9712 Sell HighCredit Lyonnais & Credit Agricole: $/€ * €/£ = (1/0.6783) * 1.3310 = $/£ = 1.9623 Buy Low⇨ Yes, there exists a triangular arbitrage opportunity(2) Realizing Triangular Arbitragei. Buy € using $1,000 at Credit Lyonnais$1,000 * €0.6783/$ = €678.3ii. Sell € for £ in Credit Agricole€678.3 *£ (1/1.3310)/ € = £509.62iii. Sell £ to get $ revenue at Barclays£509.61683 * $1.9712/£ = $1,004.56iv. Profitπ = $1,004.56 - $1,000 = $4.565. a) Explain how you can determine whether the relative PPP works well in real life. Based onwhether “q” is greater than or less than 1.0, what can you conclude about the competitiveness ofthe US economy?Relative PPPS0 = P$0 / P£0, Absolute PPP at t = 0, S1 = P$1 / P£1, Absolute PPP at t = 1, $1MSF1,205,100S0 = $(1/1.2051)/SFSF1,217,151$1,012,500F6mo = $(1/1.1922)/SFiCHF 6mo = 2% APRi$ 6mo = 2.5% APR$1,020,928.54π = $8,428.54To focus on changes in exchange rates and in the price levels in both countries, ⇨ S1/S0 = (P$1 / P£1) / (P$0 / P£0) = …⇨ ⇨ 1+e = (1 + I$) / (1 + I£) ⇨ 1 = (1 + I$) /( (e + 1) * (1 + I£)) if the relative PPP holds.⇨ Now, let us define q ≡ (1 + I$) / {(e + 1) * (1 + I£)}If q = 1.0: the relative PPP holds in real life. We can measure how the relative PPP works in real life by measuring the q being close to 1.0If q < 1.0: Inflation rate of a host country is less than counterpart country ⇨ Host country is more competitive than its counterpart.If q > 1.0: Inflation rate of a host country is greater than counterpart country ⇨ Host country is less competitive than its counterpart.b) Explain what are the factors determining the size of the spread. How do they affect the spread size? - Factors determining the size of spreadi. Trading volume increase→ Spread gets smaller ii. Trading frequency increase → Spread gets smaller iii. Volatility of exchange rate increase →Spread gets bigger (greater