Requirement 1:
Requirement 1
Euro currency interest rates
Interest of 1 year 0.03
1 year interest on Swedish Krona (8.26-7.54) 0.72
Quote of 1 year Euro currency interest rate on Swedish Krona in % (0.72 x 100/7.54) 9.55
Requirement 2:
Initial amount ($) 10,00,000.00
Add: Interest on initial amount 30,000.00
Amount to be repaid after 1 year in $ 10,30,000.00
Invest in Eurocurrency 10,00,000.00
Add: Interest received @5% 50,000.00
Amount to be received after 1 year 10,50,000.00
Less: Amount to be repaid 10,30,000.00
Arbitrage profit 20,000.00
Thus, by borrowing US$ to invest in Eurocurrency will enable the speculator to earn an arbitrage profit of $20,000 assuming US$ to Eurocurrency exchange rate is 1.
Exercise 2:
Requirement 1:
RMB/USD 6.77
USD/RMB 1.4771
US interest rate for 6 months 1.62%
RMB interest rate for 6 month 0.51%
Interest on USD 1 0.0162
USD after 6 months 1.0162
Interest on RMB 1 0.0051
RMB after 6 months 1.0051
RMB 6.804527
USD 1.0162
RMB /USD after 6 months should be 6.696050974
Price of Chinese RMB call option 0.196050974
Price of put options of Chinese RMB 0.098025487
Forward rate of Chinese RMB in 6 months 6.696050974
Requirement 2:
Interest on USD 1 0.0324
USD after 1 year 1.0324
Interest on RMB 1 0.0102
RMB after 1 year 1.0102
RMB 6.839054
USD 1.0324
RMB /USD after 1 year should be 6.624422704
Price of Chinese RMB call option 0.124422704
Price of put options of Chinese RMB 0.062211352
Forward rate of Chinese RMB in 1 year 6.624422704
Requirement 3:
It is clear from the above that the Chinese RMB is expected to strengthen against the USD in future and hence, there is already a greater probability that the US Company will be benefitted from receiving Chinese RMB 1 million after a year. However; still considering the uncertainties of the market the CEO of the US Company should buy the put option to hedge the currency risk.
Advantages and disadvantages of options compared to forward contract:
I. Options give the buyer of the options the right to buy or sell an asset at a stated price. In contrast forward contract is an obligation to buy or sell an asset / assets.
II. Forward contracts on the other hand are highly customizable whereas options are not customizable at all.
Requirement 4:
In this case, obviously the call option to buy US dollar at a specified exchange rate against Chinese RMB should be brought by the speculator to hedge the risk against receiving Chinese RMB 1 million in 1 year’s time.
The price of the call option is 0.842342 (0.1244 x 6.77).
Exercise 3:
Requirement 1:
US China
(A) Nominal risk free government T bill rate 7.10% 12.20%
(B) Expected inflation 17.60% 10%
Nominal required return (A x B) 8.35% 13.42%
Requirement 2:
Year Cash flows (RMB) PV factors @12% PV RMB
0 -13,00,000.00 1 -13,00,000.00
1 3,95,000.00 0.892857 3,52,678.57
2 4,70,000.00 0.797194 3,74,681.12
3 14,12,400.00 0.71178 10,05,318.42
Net present value 4,32,678.12
NPV is RMB 432,678.12.
Requirement 3:
Year Cash flows (RMB) Cash flows in USD PV factors @12% PV USD
0 -13,00,000.00 -1,92,023.63 1 -1,92,023.63
1 3,95,000.00 59,627.84 1 59,627.84
2 4,70,000.00 70,949.82 1 70,949.82
3 14,12,400.00 2,13,211.76 1 2,13,211.76
Net present value 1,51,765.79
The answer are not same as required rate of return is 0% with USD hence, the NPV with USD is much higher at USD151,765.79 compared to the NPV of RMB 432,678.12.
Requirement 4:
Yes, the investor should invest in the project since the NPV of the project is positive. Yes, the profit should not be repatriated since the NPV in USD is much higher than the NPV in RMB. Hedging exchange risk is definitely an option to consider in case there is expected to unfavorable fluctuation in exchange rate.
Exercise 4:
Requirement 1:
Estimates of risk exposures (Beta) and risk premia (y) are obtained by considering the fluctuations in exchange rates between domestic and other currencies. Along with the exchange rate the rate of inflation and interest rate in a country are also to be evaluated to obtain risks exposures and risk premia.
Requirement 2:
(a) Null Hypothesis:
(b) Firstly, it is important to determine likelihood of the sample relationship if it is true. If the likelihood of sample relationship is extremely bleak then rejection of null hypothesis in favor of alternative hypothesis is recommended.
(c) UDS/EUR is definitely priced as per the null hypothesis.
Requirement 3:
(a) Price error on each of the five sets are as following:
S&P 500 is 1.38; DAX is 1.77; NFTY is 1.52; SSE is 1.12 and C20 1.27.
(b) Root mean squared pricing error is 1.188.
(c) Cross sectional R square 1.412.
Requirement 4:
(a) Yes, USD/EUR risk price is in subsample as can be seen from the calculation below:
60.89% / 0.058% : 70.73% /0.137%.
No, the risk priced is not in subsample 2.
(b) It is clear from the risk premia in each of the two sub samples that the USD is expected to strengthen against EURO.
Requirement 5:
(a) A lot of work has been identified with resource estimating models focusing on the financial specialist soul and inspiration to get to the normal estimation of incomes at various danger levels. The most conspicuous examinations as far as clarification of danger return relationship are CAPM created by Sharpe (1964) and Lintner (1965). Both CAPM considers utilize the market arrangement of all economy resources estimated through beta of incomes and build up a straight connection between resource returns and market returns. The different examinations research the cross sectional danger return relationship on customary adaptation of CAPM over most recent forty. The major exact disadvantage of the standard CAPM examines is facing just one challenge factor, which is vulnerability (market returns) about future costs. The majority of the writing demonstrates that standard CAPM has neglected to anticipate the cross sectional anticipated returns. The CAPM may in any case be enduring in light of the fact that no other resource estimating model is strong; CAPM has natural call while different models need it, or maybe absence of observational financial significance against) set that the disappointment of static CAPM in anticipating expected returns is monetarily more significant.
(b) Based on the empirical evidence obtained above it would recommended to use conditional version of International APM in equation to enhance the credibility of the formula.
Requirement 6:
(a) Economic motivation of CAPM model is to find out the effective cost of capital to discount the future cash flows from a project to appraise investment projects. Taking correct decisions in relation to investments is the main economic motivation behind using the CAPM model.
(b) The factors including risk free rate of return, beta, market risk premium are determined firstly on the basis of information collected from the market to enter these in order to factor in the model constructed.