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

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

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

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%.