# International FinanceExamination 3

These questions are from the test bank. Some questions have multiple parts.

## Short Answer Essay

1. The data in the table below is from the Big Mac Index from The Economist. Please evaluate the PPP in terms of the foreign currency per \$1. Then appraise whether the exchange rate is overvalued or undervalued relative to the PPP.

 Country (1997) Big Mac Price Exchange Rate PPP Under/Overvalued United States \$2.42 - Argentina 2.50 pesos 1.00 p / \$1 Brazil 2.97 reals 1.06 r / \$1 Chile 1,200.00 pesos 417.00 p / \$1 Mexico 14.90 pesos 7.90 p / \$1

2. You are trader and have access to \$4 million U.S. dollars. You noticed the following information for the U.S. and Norway. The currency of Norway is the krone (kr). Appraise whether international arbitrage is possible, and your possible rate of return on this investment.

Spot Exchange rate: kr 6.5520 / \$1
3-month forward rate: kr 6.5264 /\$1
U.S. 3-month Treasury Bill rate: 5.625% APR
Norwegian 3-month Treasury Bill rate 4.250% APR

3. You are trader and have access to \$1 million U.S. dollars. You noticed the following information for the U.S. and Switzerland. The currency of Switzerland is the franc (SF). Appraise whether international arbitrage is possible, and the possible annual rate of return for this investment.

Spot Exchange rate: SF 1.12810 / \$1
3-month forward rate: SF 1.12740 /\$1
U.S. 3-month interest rate: 4.800% APR
Swiss 3-month interest rate 3.200% APR

4. The interest rate is 5% in the Eurozone and 1% in the United States. If the spot exchange rate is 1.5 euros / \$1, what is the price of a 3-month forward contract? You may use the approximation. Furthermore, the U.S. dollar is in denominator and thus the foreign interest rate.

5. Distinguish between Purchasing Power Parity (PPP), and relative Purchasing Power Parity.

(a) What is the Law of One Price?

(b) Does the PPP Theory hold in the long run? Please explain.

6. What is Relative Purchasing Power Parity (PPP)?

(a) If the Eurozone experiences an annual inflation rate of 2%, while the United States has an inflation rate of 3%, what is your prediction for the change in the exchange rate? Make sure you identify which currency appreciates and which one depreciates.

(b) Which currencies do international investors prefer to hold?

7. What is the Fisher Effect (also called Fisher Equation)?

(a) What is the International Fisher Effect?

(b) If the interest rate is 7% in Europe, 1% in the United States, and the time period is 180 days, what is your prediction for the euro-U.S. dollar exchange rate? Make sure you identify which currency appreciates, and which one depreciates.

8. What is the difference between a speculator and hedger?

(a) Which three cases could an investor or hedger use a derivatives contract?

(b) Who is Nick Leeson?

9. What is the difference between a Futures and a Forward?

(a) What is the difference between a “short” and a “long?”

(b) Which three things do every futures/forward contract possesses?

10. What is the difference between a call and put option?

(a) Distinguish between an American and European option? Is there a real difference?

(b) What is an option premium?

11. Which five factors influence the size of the option’s premium?

12. What is the Interbank (OTC) Market?

(a) Where are these banks located?

(b) What is OTC and how does it differ from a traditional organized exchange?

13. What is securitization?

(a) What is a tranche?

(b) How did securitization contribute to the 2008 Financial Crisis (or housing crisis)?

(c) How do banks earn profits from securitization?

14. Explain the function of Collateralized Debt Obligations (CDOs).

(a) What is a tranche?

(b) Identify the credit-rating agencies' role with the CDOs?

(c) Identify CDOs contribution to the U.S. housing market crisis in 2008.

15. Identify the problems with Collateralized Debt Obligations (CDOs) and Securitization for the U.S. mortgage market?

(a) How could a company use CDOs to convert debt to assets on a firm’s balance sheet?

(b) What is a subprime (or toxic) mortgage?

16. What are Credit Default Swaps (CDSs)?

(a) How could multiple contracts insure (or cover) the same debt?

(b) What happened with CDSs when the U.S. economy entered a recession in December 2007?

(c) What is a potential flaw with CDS (that your professor told you)?

17. This example is a margin call example. A person bought 5 Futures contracts for gold. The contract size is 10 ounces; the maturity is one year from now, and the contract price is 1,000 euros per ounce.

(a) If the spot gold price rises to 1,200 euros per ounce, what is the margin? Who deposits money with the dealer?

(b) If the spot gold price falls to 900 euros per ounce, what is the margin? Who deposits money with the dealer?

18. This example is a margin call example. A person bought 10 Futures contracts for Euros. The contract size is 10,000 euros; the maturity is one year from now, and the contract price is \$1.40 / 1 euro.

(a) If the spot exchanges changes to \$2 / 1 euro, what is the margin? Who deposits money with the dealer?

(b) If the spot exchange rate changes to \$1 / 1 euro, what is the margin? Who deposits money with the dealer?

19. This example is a European call option. A person bought 10 call contracts for Bosnian convertible marks (KM). The contract size is 1,000 KMs; the maturity is one year from now; the premium is euros 0.001 / 1 KM, and the contract price is euros 1 / 2 KM.

(a) How much is this person’s premium for the contracts?

(b) What happens on the maturity date if the spot exchange rate is euros 1 / 1.5 KM?

(c) What happens on the maturity date if the spot exchange rate is euros 1 / 2.5 KM?

20. This example is a European put option. A person buys 10 put contracts for Serbian dinars. The contract size is 10,000 dinars; the maturity is one year from now; the premium is euros 0.0001 / 1 dinar, and the contract price is euros 1 / 1,000 dinars.

(a) How much is this person’s premium for the contracts?

(b) What happens on the maturity date if the spot exchange rate is euros 1 / 1,500 dinars?

(c) What happens on the maturity date is the spot exchange rate is euros 1 / 500 dinars?