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FIN4514, Section 2Exam 2Chapter 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 moneyInflation premium: Reflects the way the general price level is changing. Measures how rapidly the money standard is losing its powerRisk premium: Reflects compensation for risk to risk-averse investors. Is a function of how much risk a security carriesex. 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 dailyForward 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 monthsNOTE: 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 - Understand the implications of interest rate parity Similar to put-call parityStates 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 signex. If there’s a forward premium (discount), then the foreign currency will exhibit a lower(higher) interest rateNOTE: 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 theforeign currency, and invest in the foreign countryOur 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 ratesPurchasing 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 currencyAbsolute purchasing power parity: A basket of goods in one country should cost the same in another country after conversion to common currencyNOTE: 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 currencyex. A U.S. investor might invest in Switzerland, use the forward market to sell Swissfrancs for Japanese yen, and convert the yen back to dollarsNet 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 ANOTES: Hedging (Covering): Take one position in the market to offside another positionCall option: Right to buy at the strike pricePut 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 asa put option for the sale of US dollars with an exercise prices quoted in eurosPro: Hedging with foreign currency options is more flexible and precise than futures contractsCon: More expensive than futures contracts. Hedger must pay a premium- Be familiar with the components of country riskA 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 historyex. Extreme: Government takeover of a company, political unrest, physical damage, forceex. Modest (with portfolio investment): Local nationals holding supervisory postions,changes in operating rules, restrictions of repatriation of capitalContributing factors: “Buy local” attitude, public attitude, government attitudeHow to deal: Seek a foreign investment guarantee from Overseas Private Investment Corp.(2) Economic risk: Ability to payChapter 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 priceOut of the money: No intrinsic valueCall: (strike price) > (stock price) Put: (stock price) > (strike price)In the money: Intrinsic valueCall: (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 priceex. You have a game ticket. You may (1) Exercise it and go to the game (2) Sell it (3) Letit expireBuying 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 optionAsk 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 expirationEuropean: 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 premiumCurrent stock price: The higher the stock price, the higher the call premium and lower the put premiumRisk-free interest rate: The higher the risk-free rate, the higher the call premium and lower the putpremiumDividend yield on the underlying stock: The higher the dividend yield, the lower the call

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FSU FIN 4514 - Exam 2

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