3.2 Foreign Exchange Markets&Interest Rate Futures
Question 1
PE2018Q6
An analyst is examining the exchange rate between the US dollar and the euro and is given the following information regarding the EUR/USD exchange rate and the respective risk-free interest rates:
- Current EUR/USD exchange rate: 1.18 1.18 1.18
- Current USD-denominated 1-year risk-free interest rate: 2.5 % 2.5\% 2.5% per year
- Current EUR-denominated 1-year risk-free interest rate: 1.5 % 1.5\% 1.5% per year
According to the interest rate parity theorem, what is the 1-year forward EUR/USD exchange rate?
A.
0.17
0.17
0.17
B.
1.19
1.19
1.19
C.
1.23
1.23
1.23
D.
1.29
1.29
1.29
Answer: B
Learning Objective: Calculate a forward exchange rate using the interest rate parity relationship.
The forward rate, F t F_t Ft, is given by the interest rate parity equation: F t = S 0 × e ( r − r f ) t F_t=S_0\times e^{(r-r_f)t} Ft=S0×e(r−rf)t, where
S
0
S_0
S0 is the spot exchange rate,
r
r
r is the domestic (USD) risk-free rate,
r
f
r_f
rf is the foreign (EUR) risk-free rate,
t
t
t is the time to delivery.
Substituting the values in the equation: F t = 1.18 × e ( 0.025 − 0.015 ) × 1 = 1.19 F_t=1.18\times e^{(0.025-0.015)\times1} =1.19 Ft=1.18×e(0.025−0.015)×1=1.19
Question 2
PE2020Q6 / PE2021Q6 / PE2022Q6
A currency analyst is examining the exchange rate between the US dollar and the euro and is given the following:
- Current USD per EUR 1 1 1 exchange rate: 1.13 1.13 1.13
- Current USD-denominated 1-year risk-free interest rate: 2.7 % 2.7\% 2.7% per year
- Current EUR-denominated 1-year risk-free interest rate: 1.7 % 1.7\% 1.7% per year
According to the interest rate parity theorem, what is the 2-year forward USD per EUR 1 exchange rate?
A.
1.1081
1.1081
1.1081
B.
1.1190
1.1190
1.1190
C.
1.1411
1.1411
1.1411
D.
1.1523
1.1523
1.1523
Answer: D
Learning Objective: Calculate a forward exchange rate using the interest rate parity relationship.
The forward rate,
F
t
F_t
Ft, is given by the interest rate parity equation:
F
=
S
0
(
1
+
R
USD
)
T
(
1
+
R
EUR
)
T
=
1.13
(
1
+
0.027
)
2
(
1
+
0.017
)
2
=
1.1523
F=S_0\frac{(1+R_{\text{USD}})^T}{(1+R_{\text{EUR}})^T}=1.13\frac{(1+0.027)^2}{(1+0.017)^2}=1.1523
F=S0(1+REUR)T(1+RUSD)T=1.13(1+0.017)2(1+0.027)2=1.1523
where:
S
0
S_0
S0 is the spot exchange rate,
R
USD
R_\text{USD}
RUSD is the USD risk-free rate,
R
EUR
R_\text{EUR}
REUR is the EUR risk-free rate,
T
T
T is the time to delivery.
Question 3
PE2022PSQ6
A large international bank has branches in four different countries. The CFO of the bank is considering issuing a bond in one of those countries, and believes that the country with the lowest real interest rate would present the best terms to the bank. Relevant information is in the table below:
Country | Nominal interest rate | Inflation |
---|---|---|
A | 3.9 % 3.9\% 3.9% | 1.9 % 1.9\% 1.9% |
B | 4.1 % 4.1\% 4.1% | 2.0 % 2.0\% 2.0% |
C | 4.2 % 4.2\% 4.2% | $2.3% $ |
D | 4.6 % 4.6\% 4.6% | 2.5 % 2.5\% 2.5% |
Assuming that all other parameters are equal, in which of the four countries should the bank issue the bond?
A. Country A
B. Country B
C. Country C
D. Country D
Answer: C
Learning Objective: Describe the relationship between nominal and real interest rates.
Using the formula, R real = 1 + R nom 1 + R infl − 1 R_{\text{real}}=\cfrac{1+R_{\text{nom}}}{1+R_{\text{infl}}}-1 Rreal=1+Rinfl1+Rnom−1
generates the following results:
Country | Nominal interest rate | Inflation | Real interest rate |
---|---|---|---|
A | 3.9 % 3.9\% 3.9% | 1.9 % 1.9\% 1.9% | 2.0 % 2.0\% 2.0% |
B | 4.1 % 4.1\% 4.1% | 2.0 % 2.0\% 2.0% | 2.1 % 2.1\% 2.1% |
C | 4.2 % 4.2\% 4.2% | $2.3% $ | 1.9 % 1.9\% 1.9% |
D | 4.6 % 4.6\% 4.6% | 2.5 % 2.5\% 2.5% | 2.0 % 2.0\% 2.0% |
Therefore, C has the lowest real interest rate.
Question 4
An American investor holds a portfolio of French stocks. The market value of the portfolio is € 10 10 10 million, with a beta of 1.35 1.35 1.35 relative to the CAC index. In November, the spot value of the CAC index is 4 , 750 4,750 4,750. The exchange rate is USD 1.25 1.25 1.25/€. The dividend yield, euro interest rates, and dollar interest rates are all equal to 4 % 4\% 4%. Which of the following option strategies would be most appropriate to protect the portfolio against a decline of the euro that week? March Euro options (all prices in US dollars per €) strike price is 1.25 1.25 1.25, call euro price is 0.018 0.018 0.018, put euro price is 0.022 0.022 0.022.
A. Buy calls with a premium of USD
180
,
000
180,000
180,000
B. Buy puts with a premium of USD
220
,
000
220,000
220,000
C. Sell calls with a premium of USD
180
,
000
180,000
180,000
D. Sell puts with a premium of USD
220
,
000
220,000
220,000
Answer: B
Buying puts would protect against a decline in the euro and the premium would be:
USD
0.022
×
€
10
million
=
USD
220
,
000
\text{USD}\; 0.022\times€10\;\text{million}=\text{USD}\; 220,000
USD0.022×€10million=USD220,000.
Question 5
PE2022Q31
A quantitative analyst at a foreign exchange (FX) trading company is developing a new factor model to be used for estimating potential risk exposures on FX trades. The analyst is evaluating potential factors to use in the model, and their effects on the performance of the model. Which of the following statements is most likely correct for the analyst to consider when developing the model?
A. Using a large number of underlying factors will allow the model to correctly predict future exchange rates.
B. The most important factor in predicting a country’s interest rates is the political stability of the country.
C. The pair-wise exchange rates for currencies of developed countries can be assumed to be constant for terms shorter than
3
3
3 months.
D. The value of a country’s currency will be negatively correlated with a factor representing changes in that country’s money supply.
Answer: D
Learning Objective: Identify and explain the factors that determine exchange rates.
D is correct. If Country A increases its money supply by 25 % 25\% 25% while Country B keeps its money supply unchanged, the value of Country A’s currency will tend to decline by 25 % 25\% 25% relative to Country B’s currency."
A is incorrect. Future exchange rates cannot be predicted with any precision.
B is incorrect. While political instability would weaken a currency, supply and demand are the most important factors.
C is incorrect. Exchange rates should be assumed to change even in short-term time
horizons.
Question 6
Current spot CHF/USD rate: 1.3680 1.3680 1.3680 ( 1.3680 1.3680 1.3680 CHF = 1 1 1 USD).
- 3-month USD interest rates: 1.05 % 1.05\% 1.05%
- 3-month Swiss interest rates: 0.35 % 0.35\% 0.35%
- Assume continuous compounding)
A currency trader notices that the 3-month future price is USD \text{USD} USD 0.7350 0.7350 0.7350. In order to arbitrage, the trader should investment:
A. Borrow CHF, buy USD spot, go long CHF futures.
B. Borrow CHF, sell CHF spot, go short CHF futures.
C. Borrow USD, buy CHF spot, go short CHF futures.
D. Borrow USD, sell USD spot, go long CHF futures.
Answer: C
Step 1. The spot is quoted in terms of Swiss Francs per USD, theoretical future price of
USD
=
1.368
×
e
(
0.35
%
−
1.05
%
)
×
3
/
12
=
1.368
×
0.99825
=
1.36561
CHF
\text{USD} = 1.368\times e^{(0.35\%-1.05\%)\times3/12} = 1.368\times 0.99825 = 1.36561\;\text{CHF}
USD=1.368×e(0.35%−1.05%)×3/12=1.368×0.99825=1.36561CHF.
Step 2. 3-month future price is USD 0.7350 → 1 / 0.7350 = 1.3605 CHF \text{USD}\;0.7350\to1/0.7350 = 1.3605\;\text{CHF} USD0.7350→1/0.7350=1.3605CHF.
Step 3. 1.36561 CHF > 1.3605 CHF → 1.36561\;\text{CHF}> 1.3605\;\text{CHF} \to 1.36561CHF>1.3605CHF→ USD \text{USD} USD future contract is undervalued.
Step 4. Arbitrage strategies: borrow USD \text{USD} USD (buy CHF \text{CHF} CHF) spot, buy USD \text{USD} USD (short CHF \text{CHF} CHF) future.