Questions
1. Exchange Rate Systems. Explain the exchange rate system that existed during the 1950s and 1960s.
How did the Smithsonian Agreement in 1971 revise it? How does today’s exchange rate system
differ?
ANSWER: The 1950s and 1960s were part of the Bretton Woods era, in which currency values were
2. Dirty Float. Explain the difference between a freely floating system and a dirty float. Which type is
more representative of the United States system?
ANSWER: A free float implies that currencies are market determined without government
3. Impact of Quotas. Assume that European countries impose a quota on goods imported from the
United States, and that the United States does not plan to retaliate. How could this affect the value of
the euro? Explain.
4. Impact of Capital Flows. Assume that stocks in the United Kingdom become very attractive to U.S.
investors. How could this affect the value of the British pound? Explain.
5. Impact of Inflation. Assume that Mexico suddenly experiences high and unexpected inflation. How
could this affect the value of the Mexican peso according to purchasing power parity (PPP) theory?
ANSWER: High Mexican inflation would cause an increased Mexican demand for U.S. goods
6. Impact of Economic Conditions. Assume that Switzerland has a very strong economy, placing
upward pressure on both inflation and interest rates. Explain how these conditions could place
pressure on the value of the Swiss franc, and determine whether the franc’s value will rise or fall.
ANSWER: A stronger economy will cause an increased Swiss demand for U.S. goods, which places
Higher Swiss interest rates may attract U.S. funds and place upward pressure on the franc’s value.
7. Central Bank Intervention. The Bank of Japan desires to decrease the value of the Japanese yen
against the U.S. dollar. How could it use direct intervention to do this?
8. Conditions for Speculation. Explain the conditions under which a speculator would like to take a
speculative position in which it will invest in a foreign currency today, even when it has no use for
that currency in the future.
9. Risk from Speculating. Seattle Bank just took speculative positions by borrowing Canadian dollars
and converting the funds to invest in Australian dollars. Explain a possible future scenario that could
adversely affect the bank’s performance.
ANSWER: If the Canadian dollar appreciates against the U.S. dollar, while the Australian dollar
depreciates against the U.S. dollar, this implies that the Canadian dollar is appreciating against the
10. Impact of a Weak Dollar. How does a weak dollar affect U.S. inflation? Explain.
ANSWER: A weak dollar tends to cause higher prices paid by U.S. firms for foreign supplies and
11. Speculating With Foreign Exchange Derivatives. Explain how foreign exchange derivatives could
be used by U.S. speculators to speculate on the expected appreciation of the Japanese yen.
ANSWER: U.S. speculators could attempt to lock in an exchange rate at which they could exchange
Advanced Questions
12. Interaction of Capital Flows and Yield Curve. Assume a horizontal yield curve exists. How do you
think the yield curve would be affected if foreign investors in short-term securities and long-term
securities suddenly anticipate that the value of the dollar will strengthen? (You may find it helpful to
refer back to the discussion of the yield curve in Chapter 3.)
ANSWER: Open-ended. Foreign investors may purchase more U.S. securities than before to benefit
from their expectations. A stronger dollar tends to place downward pressure on inflation and therefore
13. How the Euro’s Value May Respond to Prevailing Conditions. Consider the prevailing conditions
for inflation (including oil prices), the economy, interest rates, and any other factors that could affect
exchange rates. Based on prevailing conditions, do you think the euro’s value will likely appreciate or
depreciate against the dollar for the remainder of this semester? Offer some logic to support your
answer. Which factor do you think will have the biggest impact on the euro’s exchange rate?
ANSWER: This question is open-ended. It requires students to apply the concepts that were presented
14. Obtaining Credit from the European Central Bank. What are the consequences to a government
in the Euroone when it obtains credit from the ECB?
ANSWER: When the ECB provides credit to a country, it imposes austerity conditions that are
15. Impact of Abandoning the Euro on Eurozone Conditions. Explain the possible signal that would
be transmitted to the market if a country abandoned use of the euro.
ANSWER: If a country abandoned use of the euro, it might signal the possible abandonment by other
countries that presently participate in the euro. If MNCs and large institutional investors outside of
Interpreting Financial News
Interpret the following comments made by Wall Street analysts and portfolio managers.
a. “Our use of currency futures has completely changed our risk-return profile.”
b. “Our use of currency options resulted in an upgrade in our credit rating.”
c. “Our strategy to use forward contracts to hedge backfired on us.”
Managing in Financial Markets
You are the manager of a stock portfolio for a financial institution, and about 20 percent of the stock
portfolio that you manage is in British stocks. You expect the British stock market to perform well over
the next year, and you plan to sell the stocks one year from now (and will convert the British pounds
received to dollars at that time). However, you are concerned that the British pound may depreciate
against the dollar over the next year.
a. Explain how you could use a forward contract to hedge the exchange rate risk associated with
your position in British stocks.
b. If interest rate parity holds, does this limit the effectiveness of a forward rate contract as a hedge?
Interest rate parity does not limit the effectiveness of a forward hedge on a portfolio of British
c. Explain how you could use an options contract to hedge the exchange rate risk associated with
your position in stocks.
You could purchase put option contracts on pounds that would allow you to sell pounds at a
specified price (the exercise price). This locks in the minimum exchange rate at which the pounds
d. Assume that while you are concerned about the potential decline in the pound’s value, you also
believe that the pound could appreciate against the dollar over the next year. You would like to
benefit from the potential appreciation of the pound but wish to hedge against the possible
depreciation of the pound. Should you use a forward contract or options contracts to hedge your
position? Explain.
You should purchase put options on pounds so that you have the flexibility to let the options
Problems
1. Currency Futures. Use the following information to determine the probability distribution of per
unit gains from selling Mexican peso futures.
Spot rate of peso is $.10.
Price of peso futures per unit is $.102 per unit.
Your expectation of peso spot rate at maturity of futures contract is:
Possible Outcome for
Future Spot Rate Probability
.09 10%
.095 70%
.11 20%
ANSWER:
Possible Outcome Gain per Unit from
for Future Spot Selling Futures
Rate Contracts Probability
2. Currency Call Options. Use the following information to determine the probability distribution of
net gains per unit from purchasing a call option on British pounds:
Spot rate of the British pound = $1.45
Premium on the British pound option = $.04 per unit
Exercise price of British pound option = $1.46
Your expectation of British pound spot rate prior to the expiration of option is:
Possible Outcome for
Future Spot Rate Probability
$1.48 30%
1.49 40%
1.52 30%
ANSWER:
Gain per Unit from
Possible Outcome Purchasing a Call Option
for Future Spot (After Accounting for
Rate Premium Paid) Probability
3. Locational Arbitrage. Assume the following exchange rate quotes on British pounds:
Bid Ask
Orleans Bank $1.46 $1.47
Kansas Bank 1.48 1.49
Explain how locational arbitrage would occur. Also explain why this arbitrage will realign the
exchange rates.
ANSWER: One could purchase pounds at Orleans Bank for $1.47 and sell them to Kansas Bank for
4. Covered Interest Arbitrage. Assume the following information:
British pound spot rate = $1.58
British pound one-year forward rate = $1.58
British one-year interest rate = 11%
U.S. one-year interest rate = 9%
Explain how U.S. investors could use covered interest arbitrage to lock in a higher yield than 9
percent. What would be their yield? Explain how the spot and forward rates of the pound would
change as covered interest arbitrage occurs.
ANSWER: U.S. investors would purchase pounds for $1.58 in the spot market, invest the pounds at
5. Covered Interest Arbitrage. Assume the following information:
Mexican one-year interest rate = 15%
U.S. one-year interest rate = 11%
If interest rate parity exists, what would be the forward premium or discount on the Mexican peso’s
forward rate? Would covered interest arbitrage be more profitable to U.S. investors than investing at
home? Explain.
a. How could Carson use currency futures to hedge its position?
b. What is the risk of hedging with currency futures?
If Carson does not receive the order, it will still need to sell 3 million euros as of the settlement
date at the exchange rate specified in the futures contract. It can offset this sale of a futures
c. How could Carson use currency options to hedge its position?
d. Explain the advantage and disadvantage to Carson of using currency options instead of currency
futures.
Currency put options do not obligate Carson to sell euros in the future. Therefore, if Carson does
not receive the order and the euro’s value declines over time, it can let the option contract expire.
If it receives the order and the euro’s value is higher at the time it receives payment than the rate
Solution to Integrative Problem for Part V
Choosing Among Derivative Securities
1. The scenario suggests that the United States will rebound from the recession, which should place
upward pressure on interest rates (primarily because of an increase in the demand for loanable funds,
as spending increases). If interest rates rise, the savings institution should hedge. Assuming that
2. Economic conditions will likely improve, so that stock prices will rise. While this is a subjective
3. Since interest rates will likely increase, there is reason to consider hedging the bond portfolio. The
Some people might suggest that hedging the bond portfolio of a pension fund is not necessary
because the income received will ultimately be transferred to participants. The situation is different
4. A short position (selling bond index futures) in a U.S. bond index will not necessarily be an effective
hedge against the interest rate risk of non-U.S. bonds. Interest rates in the United Kingdom will not
Exchange rate risk is also an important risk to consider. If the British pound weakens against the
To hedge against the risk of a stronger dollar (a weaker pound), the manager could sell currency
futures contracts on the pound. If the pound’s value declines, there would be a gain on the currency