FIN 4514 Exam II Review Know how to use exchange rates to convert prices from one currency to another Example A U S importer has agreed to purchase 40 New Zealand leather vests at a price of NZ 110 each The vests will take two months to produce and payment is due before the vests are shipped The current spot rate of the NZ is 0 5855 What is the price of the vests to the importer if the spot rate remains unchanged in the next two months If it is 0 5500 If it is 0 6200 Solution If the spot rate does not change the cost to the importer is 40 NZ 110 0 5855 NZ 2 576 20 If the spot rate is 0 5500 40 NZ 110 0 5500 NZ 2 420 00 If the spot rate is 0 6200 40 NZ 110 0 6200 NZ 2 728 00 Be able to compute the holding period return on a foreign investment Example You just purchased 1 000 shares of Kangaroo Lager which trades on the Sydney Stock Exchange for AUD1 45 per share The exchange rate for the Australian dollar at the time of purchase was 0 7735 What is the U S dollar purchase price Assume Kangaroo Lager stock rises to AUD1 95 per share and the Australian dollar depreciates to 0 7000 What is your holding period return if you sell the shares If you sell the shares after the stock price increases and the Australian dollar depreciates you will receive Solution The purchase price in U S dollars is 1 000 AUD1 45 0 7735 AUD 1 121 58 1 000 AUD1 95 0 7000 AUD 1 365 00 The holding period return is 1 365 00 1 121 58 1 121 58 21 7 Be familiar with the three components of interest rates The Role of Interest Rates in Risk The real rate of interest reflects the rate of return investors demand for giving up the current use of funds In a world of no risk and no inflation the real rate indicates people s willingness to postpone spending their money Inflation Premium Risk Premium The inflation premium reflects the way the general price level is changing Inflation is normally positive The inflation premium measures how rapidly the money standard is losing its purchasing power The risk premium is the component of interest rates that reflects compensation for risk to risk averse investors The risk premium is a function of how much risk a security carries e g common stock vs T bills Be able to distinguish between the forward rate and the spot rate The spot rate is the current price of a foreign security Changes daily The forward rate is a contractual rate between a commercial bank and a client for the future delivery of a specified quantity of foreign currency Typically quoted on the basis of 1 2 3 6 and 12 months Know how to compute the forward rate premium or discount Forward rate premium or discount Example On April 29 2008 the British pound had a spot rate of 1 9146 The 3 month forward rate of the pound was 1 9041 on that date What is the forward Forward rate Spot rate Spot rate 2 19 premium or discount 12 n 100 1 9041 1 9146 1 9146 12 3 100 Solution There is a forward discount of 2 19 Understand the implications of interest rate parity Interest rate parity states that differences 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 or discount but with the opposite sign If there s a forward premium discount then the foreign currency will exhibit a lower higher interest rate Know how to use relative purchasing power parity to determine the expected change in the spot exchange rate Relative purchasing power parity states that differences in countries inflation rates determine exchange rates Example Germany Inflation Rate 3 U S Inflation Rate 1 Change in S 1 03 1 01 1 0198 1 98 Understand the meaning of cross hedging and know how to calculate the net return from crosshedging Crosshedging It is often desirable to cross hedge a foreign investment into a different currency This can be done by investing in Country A hedging into Country B s currency and converting to the home currency e g 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 The net return from cross hedging equals the sum of three components 1 the return from the investment in Country A 2 the forward market premium discount 3 the actual change in Country B s exchange rate Note Forward market premium discount interest rate in Country B interest rate in Country A The steps in foreign exchange risk management 1 Define and measure foreign exchange exposure 2 Organize a system that monitors this exposure and exchange rate changes 3 Assign responsibility for hedging 4 Formulate a strategy for hedging Example Given the data provided below what net return would result from investing in Chinese stocks and then cross hedging into German marks Equity Returns Change in Exchange Rate Relative to U S Dollar Money Market Return United States 9 5 0 0 4 0 China 10 5 2 0 4 5 Germany 10 0 1 5 3 5 Solution Cross hedging is accomplished by investing in Country A hedging into Country B s currency and converting into the home currency The net return from cross hedging is then computed as the sum of three components 1 The return from the investment in Country A 2 the forward market premium discount from converting Country A s currency to a forward market premium discount interest rate in Country B interest 3 the appreciation or depreciation of Country B s exchange rate relative to the Country B s currency rate in Country A home currency Net return from cross hedging Chinese equity returns forward market premium discount appreciation depreciation of mark 10 5 3 5 4 5 1 5 11 Be familiar with the components of country risk Country Risk Measure of a firm s ability and willingness to meet foreign exchange obligation 2 Key Components 1 Political Risk willingness portion 2 Economic Risk ability portion Be prepared to compute the intrinsic value and time value of an option Option prices are referred to as option premiums The price of an option has two components Intrinsic value For a call option equals the stock price minus the striking price For a put option equals the striking price minus the stock price Time value equals the option premium minus the intrinsic value If an option s striking price equals the stock price the option is at the money An option with no intrinsic value is out of the money An option with intrinsic value is in the money Be able to distinguish between American and European exercise terms European options can be exercised