3、Renaud Blanc Case Scenario

Renaud Blanc is an analyst in the risk management department of De Luca Corporation, a U.S. company that processes fruit and vegetables bought on the world market. Production and sales of packaged fruit juices and condiments occur in the United States, South America, and Europe. Blanc is responsible for making assessments of the relative strength of the U.S. dollar against other relevant currencies. Blanc knows that relative rates of inflation will influence the dollar value of a currency, so he forecasts inflation for the United States and its trading partners.

De Luca buys fruit from Brazil. For the coming year Blanc forecasts annual U.S. inflation of 2% and annual Brazilian inflation of 10%. The current exchange rate is BRL3/USD (BRL = Brazilian real, USD = U.S. dollar). The one-year risk-free interest rates in the United States and Brazil are 2.25% and 18%, respectively.

One of Blanc’s colleagues, Paula Smith, makes the following statements:

1."The theory of uncovered interest rate parity allows me to calculate E(S₁)/S₀ as being equal to the ratio of "one plus the one-year Brazilian interest rate” to "one plus the one-year U.S. interest rate,” when the expected ending exchange rate, E(S₁), and the beginning of period exchange rate, S₀, are quoted as BRL/USD.” 

2."Exchange rate risk reduces to inflation uncertainty if all parity relationships hold perfectly.”

Smith questions Blanc about whether forward markets for the Brazilian real give any indication about the expected exchange rate in one year. Blanc responds:

"If the forward rate equals the expected spot rate, then using forward currency contracts to hedge exchange risk would be costless (aside from commissions) in terms of the expected dollar price that De Luca would pay for fruit in Brazil.”

De Luca also purchases fruit and packaging materials in Europe. Blanc is considering various ways to hedge against the cost of future material purchases in Europe. For the coming year, he forecasts annual inflation of 4% for Europe and 2% for the United States. He believes that uncovered and covered interest parity hold for the United States and Europe.

Question 1

Based on purchasing power parity, Blanc's estimate of the exchange rate (BRL / USD) in one year should be closest to:

A. 2.60.

B. 2.78.

C. 3.24.

D. 3.46.

Question 2

Based on interest rate parity, Blanc's estimate of the one-year forward exchange rate for the Brazilian real (BRL / USD) should be closest to:

A. 2.60.

B. 2.78.

C. 3.47.

D. 3.62.

Question 3

Is Smith's statement about the theory of uncovered interest rate parity correct?

A. Yes.

B. No, because the relationship is covered interest parity.

C. No, because the relationship is relative purchasing power parity.

D. No, because the relationship is absolute purchasing power parity.

Question 4

Blanc's best response to Smith's statement about exchange rate risk is that the statement is:

A. correct.

B. incorrect, because exchange rate risk reduces to real rate uncertainty.

C. incorrect, because exchange rate risk reduces to interest rate uncertainty.

D. incorrect, because exchange rate risk is eliminated if all parity relationships hold.

Question 5

Is Blanc's response to Smith about the forward rate and using forward currency contracts correct?

A. Yes.

B. No, because uncovered interest parity must also hold.

C. No, because the international Fisher effect must also hold.

D. No, because relative purchasing power parity must also hold.

Question 1

Based on purchasing power parity, Blanc's estimate of the exchange rate (BRL / USD) in one year should be closest to:

A. 2.60.

B. 2.78.

C. 3.24.

D. 3.46.

 
Correct answer = C

"Foreign Exchange Parity Relations," Bruno Solnik and Dennis McLeavey
2008 Modular Level II, Vol. 1, pp. 562-564
Study Session 4-19-g
discuss absolute purchasing power parity and relative purchasing power parity and calculate the end-of-period exchange rate implied by purchasing power parity, given the beginning-of-period exchange rate and the inflation rates
Based on relative PPP we have S₁ = S₀ x (1+ I_BRL) / (1+I_US) where the exchange rate, S, is quoted as BRL / USD, and I is inflation. We have e₁ = BRL3 / USD x (1.10) / (1.02) = 3.235 = 3.24. The approximate version of PPP would indicate that the percentage change in the exchange rate would be 10% - 2% = 8% for a new exchange rate of 3 x 1.08 = BRL3.24 / USD. 

Question 2

Based on interest rate parity, Blanc's estimate of the one-year forward exchange rate for the Brazilian real (BRL / USD) should be closest to:

A. 2.60.

B. 2.78.

C. 3.47.

D. 3.62.

 
Correct answer = C

"Foreign Exchange Parity Relations," Bruno Solnik and Dennis McLeavey
2008 Modular Level II, Vol. 1, pp. 561-562
Study Session 4-19-k
calculate the forward exchange rate, given the spot exchange rate and risk-free interest rates, using 1) interest rate parity, and 2) its linear approximation
The correct use of interest rate parity is as follows:
F = S₀ x (1+ r_BRL) / (1+ r_US), where r is the interest rate, and the exchange rate, S₀, and the forward rate, F, are quoted as BRL / USD. We have F = 3 x (1.18) / (1.0225) = 3.462. The approximate forward premium / discount (equation 19.1) is equal to 18% - 2.25% = 15.75% for a forward rate of 3 x (1+ 0.1575) = 3.4725. 

Question 3

Is Smith's statement about the theory of uncovered interest rate parity correct?

A. Yes.

B. No, because the relationship is covered interest parity.

C. No, because the relationship is relative purchasing power parity.

D. No, because the relationship is absolute purchasing power parity.

 
Correct answer = A

"Foreign Exchange Parity Relations," Bruno Solnik and Dennis McLeavey
2008 Modular Level II, Vol. 1, pp. 566-568
Study Session 4-19-h, i
discuss the international Fisher relation and calculate and interpret 1) interest rates exactly and by linear approximation, given expected inflation rates and the assumption that the international Fisher relation holds, 2) the real interest rate, given interest rates and inflation rates and the assumption that the international Fisher relation holds, and 3) the international Fisher relation, and its linear approximation, between interest rates and expected inflation rates;
discuss the theory of uncovered interest rate parity, and explain the theory's relationship to other exchange rate parity theories and calculate and interpret the expected change in the exchange rate, given interest rates and the assumption that uncovered interest rate parity holds
In the vignette, note 1 indicates that E(S₁) / S₀ is equal to the ratio of "one plus the Brazilian rate" to "one plus the U.S. rate" (with S quoted at BRL / USD). This is a correct statement of uncovered interest rate parity. 

Question 4

Blanc's best response to Smith's statement about exchange rate risk is that the statement is:

A. correct.

B. incorrect, because exchange rate risk reduces to real rate uncertainty.

C. incorrect, because exchange rate risk reduces to interest rate uncertainty.

D. incorrect, because exchange rate risk is eliminated if all parity relationships hold.

 
Correct answer = A

"Foreign Exchange Parity Relations," Bruno Solnik and Dennis McLeavey
2008 Modular Level II, Vol. 1, pp. 569-571
Study Session 4-19-l
discuss the implication of the parity relationships combined
If all parity conditions hold simultaneously, then nominal exchange risk will be eliminated but we are still confronted with inflation uncertainty. 

Question 5

Is Blanc's response to Smith about the forward rate and using forward currency contracts correct?

A. Yes.

B. No, because uncovered interest parity must also hold.

C. No, because the international Fisher effect must also hold.

D. No, because relative purchasing power parity must also hold.

 
Correct answer = A

"Foreign Exchange Parity Relations," Bruno Solnik and Dennis McLeavey
2008 Modular Level II, Vol. 1, pp. 568-569
Study Session 4-19-j
discuss the foreign exchange expectation relation between the forward exchange rate and the expected spot exchange rate and calculate and interpret the expected change in the exchange rate, given the forward exchange rate discount or premium, and discuss the implications of a foreign currency risk premium
If the forward rate is equal to the expected spot exchange rate, then there is a zero risk premium and forward contracting would lock in the expected exchange rate. If De Luca were a net buyer of currency forward, they would give up nothing in terms of the expected price paid for fruit. 

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