International Portfolio Management

Question 1

What is the difference between the direct and indirect currency exchange rate?

Answer 1

Direct Exchange Rate: Domestic price of one unit of foreign currency

Indirect Exchange Rate: Amount of foreign currency equivalent to one unit of domestic currency.

Question 2

What is the Forward Premium? How is it calculated?

Answer 2

It is the percentage difference between the forward rate and the spot rate.

The formula is (F - S)/S

Question 3

Say a domestic currency is at a “discount”. What does it imply for the forward premium.

Answer 3

It implies a positive Forward Premium.

Question 4

Explain how excess returns are defined w.r.t currencies?

Answer 4

The borrowing of one unit of domestic currency converted in foreign currency at spot price, earning the foreign interest rate and then converting back to domestic at spot rate.

Question 5

What is the formula for currency excess returns?

Answer 5

Question 6

What two components can increase excess returns on currencies?

Answer 6

Interest rate differentials (known) and appreciation of foreing currency (unknown).

Question 7

What formula relating forward rates, exchange rates and interest rates is used as a Parity rule?

Answer 7

Covered interest parity:

Question 8

Describe the trading strategy underpinned by Covered interest parity?

Answer 8

Borrow in foreign currency, exchange at spot rate while simulatneously buying a forward contract equivalent to foreign currency borrowing. Receive domestic interest rate.

Question 9

What is the Uncovered Interest Parity? How does one explain it?

Answer 9

Expected Spot rate at time T is equal to a forward contract at time T. Given risk neutrality, agents should be indifferent between buying a forward or waiting for spot.

Answer 10

Question 11

What is the conclusion of Froot and Thaler with respect to the UIP?

Answer 11

High Interest rate currencies on average do not experience large depreciation. Invalidating the thesis.

Question 12

What would one expect alpha and beta coefficient to be on a regression testing UIP? Explain why.

Answer 12

Alpha of 0 and Beta of 1

Question 13

What is Chinn and Meredith’s conclusion about UIP in short vs long term?

Answer 13

In the short term, Alpha are not zero and Beta are negative. In the long run, Beta are much closer to 1 and alpha are not significantly different from zero.

Question 14

What is the carry trade. Explain its relationship to the forward premium puzzle.

Answer 14

UIP doesn’t hold, and so we do not expect high interest country’s currencies to depreciate. Thus, it is profitable to borrow domestic currencies and invest in high interest countries, while borrowing in low interest countries and investing in domestic. In effect, we short low interest rate countries and long high interest rate ones.

Question 15

What are Lustig and Verdelhan’s fidings w.r.t the carry-trade?

Answer 15

Indeed, portfolios sorted by increasing interest rate differential display increasing excess returns.

Question 16

Briefly explain the consumption CAPM and how it might explain the returns to the Carry Trade.

Answer 16

From a US perspective, High interest countries’ currencies depreciate when US consumption growth is low. This provides negative pay-off exactly when the economy is doing poorly. The carry-trade simply exposes investors to poor diversification properties.

Question 17

What is the general expression for Currency-Hedged Returns?

Answer 17

Question for Kibo: What do we mean by “removes the exposure to currency fluct. to a first-ord.”??

Question 18

What is one effect of globalization on the hedging benefits of an International CAPM.

Answer 18

As international asset correlation increases, the benefits of hedging are reduced.

Question 19

What is the one assumption for UIP to hold?

Answer 19

Risk-Neutrality.