30.3 Exchange Rate Risk
For the following problems, please include a copy of the cumulative standard normal tables.
1) Suppose the current exchange rate is $1.62/£, the interest rate in the united states is 5.25%, the
interest rate in the United Kingdom is 4%, and the volatility of the $/£ exchange rate is 18%.
Using the Black-Scholes formula, the price of a six-month European call option on the British
pound with a strike price of $1.60/£ will be closest to:
A) $0.040/£
B) $0.059/£
C) $0.078/£
D) $0.097/£
2) Suppose the current exchange rate is $1.42/€, the interest rate in the United States is 4.0%, the
interest rate in the EU is 6%, and the volatility of the $/€ exchange rate is 20%. Using the
Black-Scholes formula, the price of a three-month European call option on the Euro with a strike
price of $1.45/€ will be closest to:
A) $0.040/€
B) $0.059/€
C) $0.078/€
D) $0.097/€
3) Like most foreign exchange rates, the dollar/euro rate is a floating rate, which means it
changes constantly depending on the quantity supplied and demanded for each currency in the
market. The supply and demand for each currency is driven directly by all of the following
factors EXCEPT:
A) relative inflation.
B) firms trading goods.
C) investors trading securities.
D) the actions of central banks in each country.
4) A currency forward contract specifies all of the following EXCEPT:
A) the amount of currency to exchange.
B) the spot exchange rate.
C) the delivery date on which the exchange will take place.
D) the currencies to be exchanged.
5) The cash-and-carry strategy consists of all of the following simultaneous trades EXCEPT:
A) borrow euros today using a one-year loan with the interest rate r€.
B) exchange the euros for dollars today at the spot exchange rate S $/€.
C) purchase a forward contract to convert $ to €.
D) invest the dollars today for one year at the interest rate r$.
6) Which of the following statements is FALSE?
A) The most common method firms use to reduce the risk that results from changes in exchange
rates is to hedge the transaction using currency forward contracts.
B) Fluctuating exchanges rates cause a problem known as the importer—exporter dilemma for
firms doing business in international markets.
C) Exchange rate risk naturally arises whenever transacting parties use different currencies: Both
of the parties will be at risk if exchange rates fluctuate.
D) Because the supply and demand for currencies varies with global economic conditions,
exchange rates are volatile.
7) Which of the following statements is FALSE?
A) The covered interest parity equation states that the difference between the forward and spot
exchange rates is related to the interest rate differential between the currencies.
B) By entering into a currency forward contract, a firm can lock in an exchange rate in advance
and reduce or eliminate its exposure to fluctuations in a currency’s value.
C) When the interest rate differs across countries, investors have an incentive to borrow in the
low-interest rate currency and invest in the high interest rate currency.
D) A currency forward is usually written between two firms, and it fixes a currency exchange
rate for a transaction that will occur at a future date.
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8) Which of the following statements is FALSE?
A) Currency options allow firms to lock in a future exchange rate; currency forward contracts
allow firms to insure themselves against the exchange rate moving beyond a certain level.
B) Generally speaking, cash-and-carry strategies are used primarily by large banks, which can
borrow easily and face low transaction costs.
C) Currency options, like the stock options, give the holder the right–but not the obligation–to
exchange currency at a given exchange rate.
D) Many managers want the firm to benefit if the exchange rate moves in their favor, rather than
being stuck paying an above-market rate.
9) Which of the following statements regarding currency options is FALSE?
A) Firms often prefer forward contracts to currency options if the transaction they are hedging
might not take place.
B) Currency options are another method that firms commonly use to manage exchange rate risk.
Currency options, like the stock options, give the holder the right–but not the obligation–to
exchange currency at a given exchange rate.
C) Currency forward contracts allow firms to lock in a future exchange rate; currency options
allow firms to insure themselves against the exchange rate moving beyond a certain level.
D) Many managers want the firm to benefit if the exchange rate moves in their favor, rather than
being stuck paying an above-market rate.
10) In December 2005, the spot exchange rate for the British Pound was $1.7188/£. Suppose
that at the same time the on-year interest rate in the United States was 4.85% and the one-year
interest rate in Great Britain was 3.15%. Based on these rates, what forward exchange rate is
consistent with no arbitrage.
11) In December 2005, the spot exchange rate for the British Pound was $1.7188/£ and the one-
year forward rate was $1.8675/£. Suppose that at the same time Luther Industries entered into a
contract to purchase goods with a price of £375,000 to be delivered in one year. Simultaneously
Luther entered into a one-year forward contract to purchase £375,000. What is the amount of the
payment in U.S. dollars that Luther Industries will have to make in one year to pay for their
goods?
30.4 Interest Rate Risk
Use the following information to answer the question(s) below.
You are a risk manager for Security First Trust Savings and Loan (SFTSL). SFTSL’s balance
sheet is as follows (in millions of dollars):
The duration of the auto loans is three years and the duration of the mortgages is eight years.
Both cash reserves and checking and savings have zero duration. The CDs have a duration of
two years and the long-term financing has a ten year duration.
1) The duration of SFTSL’s equity is closest to:
A) 6 years
B) 8 years
C) 10 years
D) 14 years
2) Because of a new program called Kash for Klunkers, SFTSL experiences a rash of auto loan
prepayments, reducing the size of the auto loan portfolio from $200 million to $100 million and
increasing the cash reserves to $200 million. After these prepayments, the duration of SFTSL’s
equity is closest to:
A) 6 years
B) 8 years
C) 10 years
D) 14 years
3) If interest rates are currently 5%, but fall to 4%, your estimate of the approximate change in
SFTSL equity is closest to:
A) 8% decrease
B) 12% decrease
C) 8% increase
D) 14% increase
4) Which of the following statements is FALSE?
A) We can measure a firm’s sensitivity to interest rates by computing the duration of its balance
sheet.
B) Just as the interest rate sensitivity of a single cash flow increases with its maturity, the interest
rate sensitivity of a stream of cash flows increases with its duration.
C) By restructuring the balance sheet to increase its duration, we can hedge the firm’s interest
rate risk.
D) A firm’s market capitalization is determined by the difference in the market value of its assets
and its liabilities.
5) Which of the following statements is FALSE?
A) As interest rates change, the market values of the securities and cash flows in the portfolio
change as well, which in turn alters the weights used when computing the duration as the value-
weighted average maturity.
B) The duration of a portfolio of investments is the simple average of the durations of each
investment in the portfolio.
C) Adjusting a portfolio to make its duration neutral is sometimes referred to as immunizing the
portfolio, a term that indicates it is being protected against interest rate changes.
D) When the durations of a firm’s assets and liabilities are significantly different, the firm has a
duration mismatch.
6) Which of the following statements is FALSE?
A) Interest rate swaps are an alternative means of modifying the firm’s interest rate risk exposure
without buying or selling assets.
B) A portfolio with a negative duration is called a duration-neutral portfolio or an immunized
portfolio, which means that for small interest rate fluctuations, the value of equity should remain
unchanged.
C) Maintaining a duration-neutral portfolio will require constant adjustment as interest rates
change.
D) A duration-neutral portfolio is only protected against interest rate changes that affect all
yields identically.
7) Which of the following statements is FALSE?
A) The swap contract—like forward and futures contracts—is typically structured as a “zero-
cost” security.
B) An interest rate swap is a contract entered into with a bank, much like a forward contract, in
which the firm and the bank agree to exchange the coupons from two different types of loans.
C) In a standard interest rate swap, one party agrees to pay coupons based on a fixed interest rate
in exchange for receiving coupons based on the prevailing market interest rate during each
coupon period.
D) If short-term interest rates were to fall while long-term rates remained stable, then short-term
securities would fall in value relative to long-term securities, despite their shorter duration.
8) Which of the following statements is FALSE?
A) Corporations use interest rate swaps routinely to alter their exposure to interest rate
fluctuations.
Firms can use interest rate swaps with duration-hedging strategies.
B) The value of a swap, while initially zero, will fluctuate over time as interest rates change.
C) An interest rate that adjusts to current market conditions is called a floating rate.
D) When interest rates rise, the swap’s value will rise for the party receiving the fixed rate;
conversely, it will fall for the party paying the fixed rate.
9) What is the duration of a five-year zero-coupon bond?
A) 2.5 Years
B) 1 Year
C) 5 Years
D) 0 Years
10) The duration of a five-year bond with 8% annual coupons trading at par is closest to:
A) 2.5 Years
B) 4.3 Years
C) 5.0 Years
D) 6.2 Years
11) The Century 22 fund has invested in a portfolio of mortgaged backed securities that has a
current market value of $245 million. The duration of this portfolio of mortgaged back securities
is 14.7 years. The fund has borrowed to purchase these securities, and the current value of its
liabilities (i.e., the current value of the bonds Century 22 has issued) is $160 million. The
duration of these liabilities is 5.4 years. What is the initial duration of the equity for the Century
22 fund?
12) Luther Industries needs to borrow $50 million in cash. Currently long-term AAA rates are
9%. Luther can borrow at 9.75% given its current credit rating. Luther is expecting interest rates
to fall over the next few years, so it would prefer to borrow at the short-term rates and refinance
after rates have dropped. Luther management is afraid, however, that its credit rating may fall
which could greatly increase the spread the firm must pay on new borrowings. How can Luther
benefit from the expected decline in future interest rates without exposure to the risk of the
potential future changes to its credit ratings bring?