International Finance Practice Questions And Solutions

Question 1

It is 2010, and the economy of the imaginary country Solovia records the following transactions: Exports of goods and services, euro 1,900 billion; imports of goods and services, euro 2,300 billion; interest payments to the rest of the world, euro 560 billion; interest received from the rest of the world, euro 370 billion; net unilateral transfers are zero; direct investments by Solovian citizens in the rest of the world euro 140 billion; direct investments by foreign citizens in Solovia euro 200 billion; portfolio investments by Solovian citizens in the rest of the world, euro 330 billion; portfolio investments by foreign citizens in Solovia euro 500 billion; net other investments are $0.

1. Calculate the current account balance.

1. Calculate the capital account balance.

A speculator has purchased one European type three-month British pound put option with a strike price of $1.60 per £1. The premium is $0.07 per pound.  The standard size of each option contract is 10,000 pounds. (Please include currency symbols $, £ in your answer)

1. Determine the future spot price after 3 months at which the speculator will only break even.

Strike price in case of put option is a price which an investor would receive for the sale of the investment. The premium is the price that would be paid by the investor to the broker for purchasing the product. In the given question, the strike price is $1.60, while the premium is $0.07. Breakeven point is a point where the investor does not have any profit or loss in the trade of the investment. In this, the price at which the investor would achieve the breakeven point at 0.9$ that is the difference between the strike price and premium.

(b) What would be the speculator’s profit or loss if the pound is worthy $1.40 per £1 at the maturity date of the put?

In the given case the strike price of the put option is same as before that is $1.60, by reducing the amount of premium of 0.7 from the strike price, the related price is 0.9. The worth is $1.40. Hence by analysing the given case, it is said that the investor would be having a loss of 0.5$ which is arrived by the difference in the price and worth price.

Merritt Company, a U.S. multinational company, is considering an investment in the Euro zone. The cash flow of the investment project depends on whether the Euro zone will continue in recession or experience an economic recovery. The probability of remaining in recession is 40%, the probability of recovery is 60%. The table below shows the cash flows in each case.

Question 2

Table: cash flows of the project

Time 0 1 2 3

Recession -€70000 €20000 €24000 €27000

Economic Recovery -€70000 €30000 €35000 €39000

The current exchange rate is $1.50 = €1.00. The inflation rate in the U.S. (p_$) is 2.5 percent and in the euro zone 2 percent(p_€). The appropriate cost of capital of a U.S.-based firm for a foreign project of this risk is 7 percent (i=7%).

(a) Find the dollar cash flows of this project under each scenario.

(b) Find the dollar-denominated expected NPV of this project. Should the firm invest in the Euro zone?

In case of net present value that is NPV, the investor should invest into a particular project if the net present value comes out to be positive. In the given case if a comparative analysis is done between the two economic scenario of recession and recover, it is preferred that company should invest in recession period in euro zone. The reason behind this is increase in the net present value as compare to recovery period.

How is the relative PPP different from the absolute PPP?  (Reminder: you have list of formulas at the end of the exam, you only need to pick up the correct equation from there, when you are asked to write down the equation.)

1. Define Absolute Purchasing Power Parity in words, write down the equation for  Purchasing Power Parity taking as an example the US and the UK

The absolute purchasing power parity describes about a relationship between different stock rates of different countries. It forecasts that the exchange rate should be same among various countries. It mentions that the price should be at same level across the world, all the products and services should be same across the world. It is the assumption of this model that people have same cost of living across the world.

This approach cannot be followed in an exact manner, the reason behind this is, in case of national or local products and services these similarities between the prices cannot be same for longer period. While in case of international products and services, the price can be assumed as standard price, and to be followed across the world at same level. But in case of internationally traded goods and services, the rates cannot be same for a longer period due to high differences in tariffs of countries.

The main objective behind absolute purchasing power parity is that same products should be traded at same prices in different countries. The equation of absolute purchasing power parity is as follows:

Question 3

Here $ and £ describes about the price rates of United States and United Kingdom. It establishes the relationship between the price of United States and United Kingdom with rate of respective country.

1. Define Relative Purchasing Power Parity, and write down the equation.

In case of relative purchasing power parity, it descries about the relationship between the changes in exchange rate of United States and United Kingdom from the change in ratio of price of United States and United Kingdom. The equation of relative purchasing power parity is as follows:                                                                                                                           

1. According to the relative PPP, what is causing the exchange rate to change? If the US and UK inflation rates are expected to be 3% and 5% respectively, how much the British Pound is expected to appreciate or depreciate against the dollar?

The inflation rate of United States is 3%, while inflation rate of United Kingdom is 5%. The change in both the rates is 2% that is 0.02. The price of United Kingdom is 1+0.05 that is 1.05.

Relative purchasing parity = 0.02/1.05

= 1.90%, that is dollar would change 1.90% according to change in the rate of United Kingdom.

1. European quotes of euro are euro0.88/US$ in Paris and euro0.90/US$ in NYC.  In which location is the euro cheap, and in which location is the euro expensive? How much of an arbitrage profit you can make, if you have $1,000 to invest?

In case of comparison between the currency rates of Euros and dollars, it has been found that investing in Paris would be cheaper as in comparison to NYC. The reason behind this is, to invest in Paris; the company would be requiring paying 0.88 Euros for 1 dollar, while in case of NYC, the investor would be requiring paying 0.90 Euros for 1 dollar. Hence by analysing this it can be concluded that investing in Paris would be requiring lesser Euros as in comparison to investing in NYC. Investing in Paris would be cheaper and investing in NYC would be expensive to the investor by 0.02 Euros.

The arbitrage profit would be earned by the investor is:

It has been assumed that investor is rational; he has invested at cheaper rate and sold the investment at expensive rates. Hence by analysing the given financial data the profit earned by the investor would be the difference in the currency rates * amount to be invested, that is 0.02*1000$= 20$.

1. Quotes of the euro and the Swiss Franc (SF) are euro0.87/US$ and SF1.17/US$ respectively. And, the direct market quote between the euro and the SF is euro 0.78/SF.  Show how you can make a triangular arbitrage profit with $1,000 investment.

To do selection between the SF and Euros, the investor has to determine about the US exchange rates. In the given case, if the investor has selected to invest in euro, he need to require currency rate of $/euro in two different markets. Hence 1^st $/euro can be calculated as 1/.87 that would be 1.149, while the 2^nd currency rate of $/euro can be calculated by ($/euro)*(SF/euro) that is (1/1.17)* (1/0.78) that would be 1.095.

If the expected inflation rate is 2% and the real required return is 3%, what is the nominal interest rate?

Question 4

Nominal interest rate is a rate that does not consider the inflation rate. It defines the relationship between the real required rate of return and inflation rate. The required rate of return includes inflation rate into itself, hence to arrive at nominal rate of interest, inflation rate has to be subtracted.

Nominal rate= real required rate of return – inflation rate

Nominal rate= 3%-2%

Nominal rate= 1%

Use the following information to answer the next two questions. Assume you have $10,000 to invest; the current spot rate of British pounds is $1.800/£; the 90-day forward rate of the pound is $1.780/£; the annual interest rate in the US is 4%; the annual interest rate in the UK is 6%. (For the answer to be acceptable you need to show the calculation.)

1. Where would you invest your $10,000 to maximize your return with no foreign exchange risk? (Show how many USD you will have for sure if you invest in the US versus if you invest in the UK? Look up the Formulas, be careful11 here, the interest rates quoted are per annum, i.e., per 360 days, the forward is for 90 days. I.e., the forward is for ¼ of a year.)

The investments would be purchased now at spot rate that is 1.8*$10000, this would be equals to £5555. By investing this amount into UK, the investor would be requiring amount of £5555*1.015 that is £5638. If the investment would be sold after the 90days, at £5638*1.78, the amount would become $10036. Hence by analysing the above scenario it has been analysed that the investor is getting $64 by investing in United States. Therefore it is advisable for the investor to invest in United States at $10000* 1.01 that would be $10100.

1. Given the US interest rate, the UK interest rate, and the spot rate, what would be an equilibrium forward exchange quotation? (Look up the Formulas, be careful here, the interest rates quoted are per annum, i.e., per 360 days, the forward is for 90 days. I.e., the forward is for ¼ of a year.)

By using the above equation, the equilibrium forward exchange quotation would be [(F – 1.800)/1.800 x (360/90)] = 0.04 – 0.06.

By solving the above equation, the forward exchange quotation has come out to be £1.809.

Two companies, bank A and company B can borrow at the terms given in the following table (LIBOR is the London Interbank Offer Rate, Fixed/Floating Rate says at what Fixed or Floating rate they can borrow) :

1. Calculate the Quality Spread Differential

Quality spread differential is the difference between the interest rate offered by both the companies. Swap is preferable between both the companies if the quality spread differentials comes out to be positive.

1. Does it make sense for those two companies to enter into an interest rate swap agreement?

In case of analyzing the quality spread differential between both the countries:

Change in fixed rate of both the companies= 0.60%

Change in the floating rate of both the companies= 0.5%

Hence, quality spread differential is equal to subtraction of change in fixed rate and change in floating rate. Hence in the question, quality spread differential is equal to 0.1%. Since the quality spread differential is positive, swap is preferable between both the companies.

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