Topic 5 Hedging strategies and their maths

Question 1

Due to ____, market forces should realign the relationship between the interest rate differential of two
currencies and the forward premium (or discount) on the forward exchange rate between the two
currencies.
a. forward realignment arbitrage
b. triangular arbitrage
c. covered interest arbitrage
d. locational arbitrage

Answer 1

c)

Question 2

Due to ____, market forces should realign the spot rate of a currency among banks.
a. forward realignment arbitrage
b. triangular arbitrage
c. covered interest arbitrage
d. locational arbitrage

Answer 2

d)

Question 3

Due to ____, market forces should realign the cross exchange rate between two foreign currencies
based on the spot exchange rates of the two currencies against the U.S. dollar.
a. forward realignment arbitrage
b. triangular arbitrage
c. covered interest arbitrage
d. locational arbitrage

Answer 3

b)

Question 4

If interest rate parity exists, then ____ is not feasible.
a. forward realignment arbitrage
b. triangular arbitrage
c. covered interest arbitrage
d. locational arbitrage

Answer 4

c)

Question 5

In which case will locational arbitrage most likely be feasible?
a. One bank’s ask price for a currency is greater than another bank’s bid price for the
currency.
b. One bank’s bid price for a currency is greater than another bank’s ask price for the
currency.
c. One bank’s ask price for a currency is less than another bank’s ask price for the currency.
d. One bank’s bid price for a currency is less than another bank’s bid price for the currency.

Answer 5

b)

Question 6

When using ____, funds are not tied up for any length of time.
a. covered interest arbitrage
b. locational arbitrage
c. triangular arbitrage
d. B and C

Answer 6

d)

Question 7

When using ____, funds are typically tied up for a significant period of time.
a. covered interest arbitrage
b. locational arbitrage
c. triangular arbitrage
d. B and C

Answer 7

a)

Question 8

Assume that the interest rate in the home country of Currency X is a much higher interest rate than the
Australian interest rate. According to interest rate parity, the forward rate of Currency X:
a. should exhibit a discount.
b. should exhibit a premium.
c. should be zero (i.e., it should equal its spot rate).
d. B or C

Answer 8

a)

Question 9

If the interest rate is higher in Australia than in the United Kingdom, and if the forward rate of the
British pound (in Australian dollars) is the same as the pound’s spot rate, then:
a. Australian investors could possibly benefit from covered interest arbitrage.
b. British investors could possibly benefit from covered interest arbitrage.
c. neither Australian nor British investors could benefit from covered interest arbitrage.
d. A and B

Answer 9

b)

Question 10

If the interest rate is lower in Australia than in the United Kingdom, and if the forward rate of the
British pound is the same as its spot rate:
a. Australian investors could possibly benefit from covered interest arbitrage.
b. British investors could possibly benefit from covered interest arbitrage.
c. neither Australian nor British investors could benefit from covered interest arbitrage.
d. A and B

Answer 10

a)

Question 11

Formal agreements between two parties to exchange a series of cash flows for a set period of
time would be termed a/an:
a. Swap.
b. Futures.
c. Forwards.
d. A and C.

Answer 11

a)

Question 12

MNCs can use ________to manage foreign currency exposure and interest rate risk that reduce the
cost of debt.
a. Swap
b. Futures contract
c. Forward contract
d. All of the above.

Answer 12

d)

Question 13

An Australian company enters into an agreement to ____ British pounds and____ Australian dollars. If the
A$ appreciates versus the pound, the company will realise an accounting profit on the swap
transaction.
a. pay; pay.
b. pay; receive.
c. receive; receive.
d. receive; pay.

Answer 13

b)

Question 14

According to the text, in 2016 which derivatives had the highest daily average foreign exchange
turnover?
a. Foreign Exchange Swap.
b. Interest rate futures.
c. Forward contract.
d. Options.

Answer 14

a)

Question 15

In a_______, two parties provide simultaneous loans with an agreement to repay at some specified
future time.
a. Bank loan
b. Front-to-front loan
c. Non-simultaneous loan
d. parallel loan

Answer 15

d)

Question 16

The use of _________ is particularly attractive if the MNC is conducting a project in a foreign
country, will receive the cash flows in the foreign currency, and is worried that the foreign currency
will ______ substantially.
a. parallel loans, depreciate
b. parallel loans, appreciate
c. Interest rate swap, depreciate
d. Interest rate swap, appreciate

Answer 16

a)

Question 17

Cross-currency interest rate swaps and single-currency interest rate swaps are known as ______ and
___________, respectively?
a. interest rate swaps, Currency swap
b. Currency swap, interest rate swaps
c. Currency swap, hedging
d. interest rate swaps, hedging

Answer 17

b)

Question 18

According to the text, since 2001, the trading volume of ______has been growing much faster
compared with any other part of the FX market.
a. Options and other products.
b. interest rate swap.
c. currency swaps.
d. none of the above

Answer 18

c)

Question 19

The matching strategy in currency swap is especially desirable when the foreign subsidiaries are based
in countries where interest rates are relatively _____.
a. Low
b. High
c. Fixed
d. Volatile

Answer 19

a)

Question 20

In a matching strategy, The MNC achieves a ______financing rate and also ______ its exchange rate
risk by matching its debt outflow payments with the currency denominating its cash inflows.
a. variable, reduces.
b. fixed, reduces
c. high, increases
d. low, reduces

Answer 20

d)

Question 21

Compute the forward discount or premium for the Mexican peso whose 60-day forward rate is A$0.102 and spot rate is A$0.10. State whether your answer is a discount or premium.

Answer 21

p = [(F - S) / S] * 360/n, in which n = 60
= [(A$0.102 - A$0.10) / A$0.10] × (360/60)
= 0.12, or 12%, which reflects a 12% premium

Question 22

Randy Rudecki purchased a call option on Chinese renminbi for US$0.0015 per unit. The strike price was US$0.16 and the spot rate at the time the option was exercised was US$0.1644. Also, there are 1 million units in a Chinese renminbi option. What was Randy’s net profit on this option?

Answer 22

Net profit/unit (buyer of a call option) = Spot rate – Strike rate – premium paid
= Selling price – Purchase price – premium paid
= US$0.1644 – US$0.16 – US$0.0015
= US$0.0029/unit
If there are 1 million units in a Chinese renminbi option, then net profit per option will be
Net profit/option = 1 million units × US$0.0029/unit = US$2900

Question 23

Organic Food China, a major Australian exporter of products to Japan, denominates its exports in Australian dollars and has no other international business. It can borrow dollars at 9 per cent to finance its operations or borrow yen at 3 per cent. If it borrows yen, it will be exposed to exchange rate risk. How can Organic Food China borrow yen and possibly reduce its economic exposure to exchange rate risk?

Answer 23

Organic Food China could invoice its exports in yen and use the proceeds to pay back loans. Its economic exposure would be reduced because Japanese consumers would not be subjected to exchange rate swings.

Question 24

What is the difference between a Forward Contract and Futures Contract?

Answer 24

Both specify a price in the future for the exchange of currency, however,
They differ on Market size, Futures is smaller. Futures are standardized and can easily be traded, whereas a forward contract is non standardized and made over the counter. Futures have less of a credit risk due to margin call adjustments

Question 25

What is a currency swap?

Answer 25

A Transaction in which two parties exchange specific amounts of two different currencies at the outset and repay them over time in accordance with a predetermined rule that reflects both interest payments and the amortisation of the principal. Normally, fixed interest rates are used for each currency. In some cases, there is no exchange of principal amounts initially and at maturity.

Question 26

What is an FX option?

Answer 26

It is a contract that confers on the holder the right (but not the obligation) to exchange an amount of one currency for another at a pre-agreed rate (strike rate) on or before a pre-agreed date.

Question 27

Put EUR 50M, call USD, at a strike of EUR-USD 1.18 (at the money spot) for an expiry of two years
EUR-USD is 1.17 in two years’ time
Is It worth exercising the option?

Answer 27

Converting by exercising the option: EUR 50M * 1.18 = USD 59M
Converting in the market using spot: EUR 50M * 1.17 = USD 58.5M
The option payout is the difference between the two: USD 59M – USD 58.5M = USD 0.5M. If the prevailing spot rate is more favourable to the holder than the option strike, then the payout is zero. The option expires worthless and the holder will simply transact at the prevailing spot. In this case it is worth exercising.

Question 28

What is the cost of an option?

Answer 28

An FX option is purchased with a premium, which is usually paid upfront. The premium has two components: the intrinsic value and the time value.

Question 29

What is the intrinsic value of an option?

Answer 29

The intrinsic value of the option is the difference between the amounts converted using the strike rate and the forward rate. It assumes that the option is exercised on the day of calculation and the payout is calculated as the intrinsic value.

Question 30

What is the time value of an option?

Answer 30

Time value is the monetary value associated with the amount of time remaining before expiry. It’s more complex to directly say what the calculation is, but it is impacted by a few factors including term, strike rate, volatility, and exercise style.