FIN4514 Section 2 Exam 2 Chapter 7 International Investment Diversification Know how to use exchange rates to convert prices from one currency to another New country price quantity old country price spot rate Be able to compute the holding period return on a foreign investment HPR end price start price start price Be familiar with the three components of interest rates Real rate Reflects the rate of return investors demand for giving up the current use of funds Indicates people s willingness to postpone spending their money Inflation premium Reflects the way the general price level is changing Measures how rapidly the money standard is losing its power Risk premium Reflects compensation for risk to risk averse investors Is a function of how much risk a security carries ex Common stock vs T bill Be able to distinguish between the forward rate and the spot rate Spot rate Current price of a foreign security Changes daily Forward rate Contractual rate between a bank and a client for the future delivery of currency Typically quoted on the basis of 1 2 3 6 or 12 months NOTE The forward rate is the best estimate of the spot rate in the future ex Forward rate indicates that the dollar will strengthen importers should delay payment Know how to compute the forward rate premium or discount Forward rate Spot rate 12 n Spot rate 100 n where the contract length in months Understand the implications of interest rate parity Similar to put call parity States that difference in national interest rates will be reflected in the currency forward market Two securities of similar risk and maturity will show a difference in their interest rates equal to the forward premium discount but with the opposite sign ex If there s a forward premium discount then the foreign currency will exhibit a lower higher interest rate NOTE Covered interest arbitrage is possible when the conditions of interest rate parity are violated ex If the foreign interest rate is too high then borrow US dollars convert them to the foreign currency and invest in the foreign country Our interest rate is more appealing than the foreign country s Know how to use relative purchasing power parity to determine the expected change in the spot exchange rate Relative purchasing power parity Differences in countries inflation rates determine exchange rates D S 1 1 I I F D 1 where D S change in the spot exchange rate I I F D foreign country inflation rate domestic country inflation rate Purchasing power parity Refers to the situation in which the exchange rate equals the ratio of domestic and foreign price levels A relative change in the prevailing inflation rate in one country will be reflected as an equal but opposite change in the value of its currency Absolute purchasing power parity A basket of goods in one country should cost the same in another country after conversion to common currency NOTE A country with an increase in inflation will experience a depreciation of its currency due to 1 Decline in exports 2 Increase in imports 3 Less demand for domestic goods Understand the meaning of cross hedging and know how to calculate the net return from cross hedging To cross hedge a foreign investment into a different currency Invest in country A hedging into country B s currency then convert to the home currency ex A U S investor might invest in Switzerland use the forward market to sell Swiss francs for Japanese yen and convert the yen back to dollars Net return return from investment in A forward market premium discount actual change in country B s exchange rate where forward market premium discount interest rate of country B interest rate of country A NOTES Hedging Covering Take one position in the market to offside another position Call option Right to buy at the strike price Put option Right to sell at the strike price A call option for the purchase of euros with an exercise price quoted in US dollars is the same as a put option for the sale of US dollars with an exercise prices quoted in euros Pro Hedging with foreign currency options is more flexible and precise than futures contracts Con More expensive than futures contracts Hedger must pay a premium Be familiar with the components of country risk A country s ability and willingness to meet its foreign exchange obligations Most important in emerging markets Components 1 Political risk Willingness to honor its foreign obligations Determined by stability union attitudes ideological background past history ex Extreme Government takeover of a company political unrest physical damage force ex Modest with portfolio investment Local nationals holding supervisory postions changes in operating rules restrictions of repatriation of capital Contributing factors Buy local attitude public attitude government attitude How to deal Seek a foreign investment guarantee from Overseas Private Investment Corp 2 Economic risk Ability to pay Chapter 17 Principles of Options Option Pricing Be prepared to compute the intrinsic value and time value of an option Two components of option price Intrinsic value For a call option stock price strike price For a put option strike price stock price At the money stock price strike price Out of the money No intrinsic value Call strike price stock price Put stock price strike price In the money Intrinsic value Call stock price strike price Put strike price stock price Time value option premium intrinsic value Buying a call option gives you the right to buy at the strike price ex You have a game ticket You may 1 Exercise it and go to the game 2 Sell it 3 Let it expire Buying a put option gives you the right to sell at the strike price Not necessary to own the asset Bid price Highest price at which the marketmaker specialist is willing to buy an option Ask price Lowest price at which the marketmaker specialist is willing to sell an option Be able to distinguish between American and European exercise terms American Can be exercised any time prior to expiration European Only can be exercised at expiration Be familiar with the manner in which market factors affect option premiums Strike price The lower the strike price the higher the call premium and lower the put premium Current stock price The higher the stock price the higher the call premium and lower the put premium Risk free interest rate The higher the risk free rate the higher the call premium and lower the put premium Dividend yield on the underlying stock The higher the dividend yield the lower the call premium and
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