Economics【Reading 18】Sample 2012

bapswarrior

If the exchange rate value of the euro goes from $0.95 to $1.10, then the euro has:

A) depreciated and the Dutch will find U.S. goods more expensive.

B) depreciated and the Dutch will find U.S. goods cheaper.

C) appreciated and the Dutch will find U.S. goods cheaper.

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An exchange rate is a ratio that describes how many units of one currency you can buy per unit of another currency. The numerator will be in the currency in which the quote is made, and the denominator is the other unit of the currency you are comparing. A currency appreciates when it rises in value relative to another foreign currency. Likewise, a currency depreciates when it falls in value relative to another foreign currency. An appreciation in value of a currency makes that country's goods more expensive to residents of other countries. The depreciation of the value of a currency makes a country's goods more attractive to foreign buyers.

MarginofSafety

Chao Wang, CFA, is a portfolio manager considering a currency position on the Chinese yuan. The current spot rate is 8.2781 yuan per U.S. dollar, while the one-year forward rate is 8.9817. Wang calculates the expected percentage change in the exchange rate over the next year to be:

A) -7.83%.

B) -8.50%.

C) 6.50%.

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Using the foreign exchange parity relation allows for the calculation of the expected percentage change in the exchange over the next year:

(F - S0 ) / S0 = E (%ΔS)

By substituting:

(8.9817–8.2781) / 8.2781 = E (%ΔS)
8.50% = E (%ΔS)

The yuan can be expected to depreciate by 8.50%.

MarginofSafety

Which of the following statements best defines the foreign currency risk premium? The foreign currency risk premium is the:

A) forward premium on foreign currency forward contracts.

B) extra cost of hedging foreign currency denominated assets with forward contracts.

C) foreign currency risk of holding all foreign currency denominated assets.

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Some investors with foreign currency assets may be willing to pay more than the expected spot rate to hedge the uncertainty of holding foreign currency assets by taking a short position in the foreign currency. Others will demand more than the expected spot rate to sell the foreign currency forward and bear the uncertainty of the spot rate. That extra amount is the risk premium; think of it as a “cost” of hedging foreign currency-denominated assets with forward contracts. If there were no risk premium, hedging with forward contracts would be costless.

MarginofSafety

Jonathan Smith, CFA, is a currency trader and is reviewing forward foreign exchange rates. His investors have made several statements regarding foreign exchange rates. Which of the following statements is correct and can help Jonathan predict future spot exchange rates? According to the foreign exchange expectation relation forward:

A) discounts and premiums can be unbiased predictors of expected changes in spot exchange rates.

B) rates are unbiased predictors of interest and inflation rates.

C) discounts and premiums can be effective predictors of expected spot exchange rates.

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The forward discount or premium is an unbiased predictor of the expected change in the spot exchange rate: (F – S0) / S0 = E (%ΔS)

MarginofSafety

According to the foreign exchange expectation relation, which of the following is an unbiased predictor of the expected future spot exchange rate?

A) Expected change in spot rates.

B) Inflation rate.

C) Forward rate.

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The foreign exchange expectation relation says that the forward rate is an unbiased predictor of the expected future spot rate: F = E (S1)

MarginofSafety

Ronald Lots, CFA, is an international currency portfolio manager seeking speculative opportunities in the euro. While reviewing the forward rates for the euro, he notices that there is a forward premium of 4.25% on the euro relative to the U.S. dollar. Which of the following statements is correct? The euro is expected to:

A) appreciate at least 4.25% against the U.S. dollar.

B) depreciate 4.25% against the U.S. dollar.

C) appreciate 4.25% against the U.S. dollar.

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According to the foreign exchange expectation relation forward discounts and premiums can be unbiased predictors of expected changes in spot exchange rates. With the forward euro rate trading at a premium of 4.25%, the euro is expected to appreciate by the same 4.25% against the dollar.

MarginofSafety

Chao Wang, CFA, is a portfolio manager looking to take a currency position on the Chinese yuan. The current spot rate is 8.2781 yuan per U.S. dollar, while the two-year forward rate is 9.3336. Wang’s expected holding period is one year. Wang calculates the average expected percentage change in the exchange rate over the next year to be:

A) −6.18%.

B) −12.75%.

C) 5.68%.

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Using the foreign exchange parity relation allows for the calculation of the expected percentage change in the exchange over the next two years:

(F − S0) / S0 = E(%ΔS)

By substituting:

(9.3336 − 8.2781) / 8.2781 = E(%ΔS) for 2 years
12.75% = E(%ΔS) for 2 years

In order to convert the expected change over the next one-year period, use the standard effective interest rate formula:

[(1 + 0.1275)1/2] − 1 = E (%ΔS) for 1 year
[1.12751/2] − 1 = E(%ΔS)
6.18% = E(%ΔS)

The Chinese yuan can be expected to depreciate at an average of approximately 6.18% over the next year based on the two-year forward premium of 12.75% of the U.S. dollar.

MarginofSafety

The Asian Spec Fund, managed by Jonathan Khamal, CFA, engages in currency speculation for its clients. Based in Paris, Khamal believes that there is an opportunity to speculate on the Malaysian Ringgit. The current spot exchange rate is 4.417 Malaysian Ringgit per euro. Assuming the one-year risk-free rate for the European Economic Community is 11.76% and the Malaysian one-year risk-free interest rate is 7.6%, what should the one-year forward rate be for the Malaysian Ringgit?

A) 4.253 MR/EUR.

B) 4.246 MR/EUR.

C) 4.586 MR/EUR.

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The formula for covered interest rate parity is: F / S0 = (1 + rFC) / (1 + rDC)

Forward premium or discount:

(F – S0) / S0 = [(1 + rFC) / (1 + rDC)] − 1 = (rFC – rDC) / (1 + rDC)

By substituting:

%F = [(1 + 0.076) / (1 + 0.1176)] – 1
%F = [1.076 / 1.1176] – 1
%F = -0.0372
F = 4.417 MR/EUR × (1 – 0.0372) = 4.253 MR/EUR

MarginofSafety

The Asian Spec Fund, managed by Jonathan Khamal, CFA, engages in currency speculation for its clients. Based in Paris, Khamal believes that there is an opportunity to speculate on the Malaysian Ringgit. The current spot exchange rate is 4.417 Malaysian Ringgit per euro. Khamal wants to determine an expected exchange price one year from today. Assuming the one-year nominal interest rate for the European Economic Community is 11.76% and the Malaysian one-year nominal interest rate is 7.6%, what would be the expected exchange rate for the Malaysian Ringgit one year from today?

A) 4.586 MR/EUR.

B) 4.253 MR/EUR.

C) 4.246 MR/EUR.

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The formula for uncovered interest rate parity is:

E (S1) / S0 = (1 + rFC) / (1 + rDC) or (E (S1) – S0) / S0 = %ΔS = [(1 + rFC) / (1 + rDC)] – 1

where:
E (S1) = expected spot rate in one period, quoted in FC per unit of DC
S0 = spot rate today, quoted in FC per unit of DC
rFC = interest rate on the FC
rDC = interest rate on the DC
%ΔS = percentage change in the spot rate

By substituting:

%ΔS = [(1 + 0.076) / (1 + 0.1176)] – 1
= [ 1.076 / 1.1176 ] – 1
= - 0.0372
E (S1) = 4.417 MR/EUR × (1 – 0.0372) = 4.253 MR/EUR

The Malaysian Ringgit is expected to appreciate 3.72% against the euro over the next year. It will require less Malaysian Ringgits to convert into euro by next year. This is the case because of lower inflation expectations for Malaysia that are implied in its nominal interest rate.

MarginofSafety

Chao Wong, CFA, is the portfolio manager for the China Current Fund in Germany. The current spot exchange rate is 9.6246 Chinese yuan per euro. Wong believes that there is an opportunity to speculate on the Chinese yuan. Wong wants to determine an expected exchange price one year from today. Assuming the one-year nominal interest rate for the European Economic Community is 11.76% and the Chinese one-year nominal interest rate is 10.2%, what would be the expected exchange rate for the Chinese yuan one year from today?

A) 9.7608 CY/EUR.

B) 9.4903 CY/EUR.

C) 9.4884 CY/EUR.

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The formula for uncovered interest rate parity (IRP) is:

Exact methodology: E (S1) / S0 = (1 + rFC) / (1 + rDC) or (E (S1) – S0) / S0 = %ΔS = [(1 + rFC) / (1 + rDC)] – 1

where:
E(S1) = expected spot rate in one period, quoted in FC per unit of DC
S0 = spot rate today, quoted in FC per unit of DC
rFC = interest rate on the FC
rDC = interest rate on the DC
%ΔS = percentage change in the spot rate

By substitution:

%ΔS = [(1 + 0.102) / (1 + 0.1176)] − 1
= [1.102 / 1.1176] − 1
= −0.013958
E(S1) = 9.6246 CY/EUR × (1 − 0.013958) = 9.4903 CY/EUR

The Chinese yuan is expected to appreciate 1.3958% against the euro over the next year. It will require less Chinese yuan to convert into euro by next year. This is the case because of the lower inflation expectations for China that are implied in its nominal interest rate.