BUS3026W Finance 2 Objective Test 8 16 October 2007

Total marks: 30 Time: 40 minutes

All questions are to be completed on this worksheet. For each question, please circle
the appropriate answer (where provided) clearly or answer in the provided ‘Workings’
sections.

Multiple Choice Questions (Q 1 to 10): 1 marks each.

Incorrect answers: -1/4 mark each.
No answers: 0 marks each.

1. Gresham’s Law states that:

a. Exchange Rates between currencies must equal the ratio of the price of gold in
the two countries.
b. Good money drives bad money out of circulation.
c. Bad money drives good out of circulation.
d. The Price-Specie Flow mechanism will automatically adjust exchange rates to
their correct level.

2. Suppose that the pound is pegged to gold at £20 per ounce and the dollar is pegged to
gold at $35 per ounce. This implies an exchange rate of $1.75 per pound. If the current
market exchange rate is $1.80 per pound, how would you take advantage of this
situation?

a. Start with $350. Buy 10 ounces of gold with dollars at $35 per ounce.
Convert the gold to £200 at £20 per ounce. Exchange the £200 for dollars at
the current rate of $1.80 per pound.
b. Start with £350. Buy 17.5 ounces of gold at £20 per ounce. Convert the gold to
dollars at $35 per ounce. Exchange the dollars for pounds at the current market
exchange rate is $1.80 per pound.
c. Both of the above are correct
d. None of the above are correct

3. Suppose you observe the following exchange rates: €1 = $.85; £1 = $1.60; and €2.00 =
£1.00. Starting with $1,000,000, how can you make money?

a. Start with dollars, exchange for pounds at £1 = $1.60. Buy euros at €2 =

£1.00; trade for dollars at €1 = $.85.
b. Start with dollars, exchange for euros at €1 = $.85; exchange for pounds at €2.00
= £1.00; exchange for dollars at £1 = $1.60.
c. Start with euros; exchange for pounds; exchange for dollars; exchange for euros
d. There is no arbitrage opportunity.

4. Consider the following exchange rate quotation from Wall Street Journal.

U.S.$ equiv. Currency per U.S. $

Friday Thursday Friday Thursday
Britain (Pound) 1.5760 1.5720 0.6345 0.6361
1 Month Forward 1.5726 1.5686 0.6359 0.6375
3 Months Forward 1.5661 1.5621 0.6385 0.6402
6 Months Forward 1.5564 1.5523 0.6425 0.6442

Judging by the exchange rates quoted above, which country has the higher rate of
inflation?

a. There is not enough information to say.

b. The United States
c. Britain
d. Both should have the same expected rate of inflation.
5. Suppose you observe the following exchange rates: S($/€) = 0.85 (i.e. €1 = $.85) The
one-year forward rate is F1($/€) = 0.935 (i.e. €1 = $.935) The risk-free interest rate in the
U.S. is 5% and in Germany it is 2%. How can a dollar-based investor make money?

a. There are no profitable arbitrage opportunities.

b. Borrow dollars in the U.S., exchange for euros, invest in Germany, enter
into a on-year forward contract; in one year, translate the euros back into
dollars at the forward rate.
c. Borrow euros, translate into dollars at the spot, invest in the U.S. at 5% for one
year. At the end of the year, translate part of your dollar investment back into
euros at the forward rate to repay your euro debt.
d. By forming a forward market hedge.

6. Consider a trader who opens a short futures position. The contract size is £62,500, the
maturity is six months, and the initial price is $1.50 = £1. The next day, the settlement
price is $1.60 = £1. What is the amount of his gain or loss?

a. $6,250 gain
b. $6,250 loss
c. No loss or no gain since maturity has not arrived.
d. $2,604.17 gain

7. Consider an investor who has short a PUT option on €100,000. The strike price is $0.80 =
€1.00 and the option premium is $0.02 per euro. What is the theoretical maximum gain on
this position?

a. There is unlimited upside potential.

b. $80,000
c. $78,000
d. $2,000

8. Other things equal, investors will generally ______________ on bearer bonds than on
registered bonds of comparable terms.

a. demand a higher credit rating

b. demand a higher yield
c. accept a lower yield
d. a) and b) are both correct

9. An ADR
a. Is a mechanism for the avoidance of taxes, especially capital gains taxes, on
shares of foreign stocks.
b. Are bearer securities, not registered securities.
c. Is a receipt representing a number of foreign shares that are deposited in a
U.S. bank.
d. None of the above is true.

10. Changes in exchange rates

a. Generally explain a larger portion of the variability of foreign bond indexes
than foreign equity indexes.
b. Generally explain a larger portion of the variability of foreign equity indexes than
foreign bond indexes.
c. Do not affect the variability of foreign equity indexes or foreign bond indexes.
d. Affect all foreign stock markets equally.
11. You are a S.African importer of nuts from Seychelles. You have just ordered next year’s
inventory. Payment of SR10,000,000 is due in one year. You want to hedge against the
exchange risk that this future payment represents, but are disappointed to note that your
bank does not make a forward market in SR (Seychelles Rupee). You are provided with
the following information:

Spot exchange rate S(SR/R) = SR2/R

S.A discount rate iR = 5%
Seychelles discount rate iSR = 10%

a. Assuming that IRP holds, show the steps to form a forward market hedge to achieve
your objective.

b. If your bank were to offer a 1-year forward quote on the Seychelles Rupee, what
would it be?

[4,1]
Answer:

a. To form a forward market hedge:

1. Borrow R4,545,455 in South Africa (in one year you will owe
R4,772,727).
2. Translate R4,545,455 into Seychelles rupees at the spot rate S(SR/R)
= SR2/R to receive SR9,090,909.
3. Invest SR9,090,909 in the Seychelles at iSR = 10% for one year.
4. In one year, your investment will be worth SR10,000,000 – exactly
enough to pay your supplier.

b. The 1-year forward rate would be:

1-year forward rate = (1.10/1.05)*2 = SR2.0952/R

12. Consider 8.5 percent Swiss franc/U.S. dollar dual-currency bonds that pay $666.67 at
maturity per SF1,000 of par value. What is the implicit SF/$ exchange rate at maturity?
Will the investor be better or worse off at maturity if the actual SF/$ exchange rate is
SF1.35/$1.00?
[1,1]
Answer:
Implicitly, the dual currency bonds call for the exchange of SF1,000 of face value for
$666.67. Therefore, the implicit exchange rate built into the dual currency bond
issue is SF1,000/$666.67, or SF1.50/$1.00. If the exchange rate at maturity is
SF1.35/$1.00, SF1,000 would buy $740.74 = SF1,000/SF1.35. Thus, the dual
currency bond investor is worse off with $666.67 because the dollar is at a
depreciated level in comparison to the implicit exchange rate of SF1.50/$1.00.

13. As an investor, what factors would you consider before investing in the emerging stock
market of a developing country?
[3]
Answer:
An investor in emerging market stocks needs to be concerned with the depth of the
market (market concentration) and the market’s liquidity.

Depth of the market refers to the opportunities to invest in the country. One
measure of the depth of the market is the concentration ratio of a country’s stock
market. The concentration ratio frequently is calculated to show the market value
of the ten largest stocks traded as a fraction of the total market capitalization of all
equities traded. The higher the concentration ratio, the less deep is the market.
That is, most value is concentrated in only a few companies. While this does not
necessarily imply that the largest stocks in the emerging market are not good
 investments, it does, however, suggest that there are few opportunities for investment
in that country and that proper diversification within the country may be difficult.

In terms of liquidity, an investor would be wise to examine the market turnover ratio
of the country’s stock market. High market turnover suggests that the market is
liquid, or that there are opportunities for purchasing or selling the stock quickly at
close to the current market price. This is important because liquidity means you can
get in or out of a stock position quickly without spending more than you intended on
purchase or receiving less than you expected on sale.

14. You are a UK-based trader with the following derivatives positions. A long position of
250 FTSE 100 index futures contracts traded on the London International Financial
Futures Exchange (LIFFE) maturing in 6 months time. The contract multiplier on the
LIFFE contract is £10 and the current value of the index is 4841.6.

200 long put options on the S&P 500 Index. The contracts are each currently worth $24
560 each, and have a delta of -0.66 to the S&P 500 index. The index level is 1240.3 and
the contract multiplier is 10.

The 6-month UK interest rate is 3.6% and that of the US is 4.55%. The dividend yield on
the S&P 500 index is 1.4% and that on the FTSE 100 is 1.6% per annum. All dividend
yields & interest rates are per annum NACC.

What would your exposures be if you wished to perform a VaR calculation? [6]

The FTSE 100 position is calculated as follows:

250 x 10 x 4841.6 x e(0.036-0.016)*0.5 = £12,225,647.22

The S&P 500 position is calculated as follows:

-0.66 x 1240.3 x 10 x 200 = -$1,637,196

Lastly, the currency exposure is:

200 x 24 560 = $4,912,000

15. Bond A is a coupon bond with a modified duration of 11.5 year. Bond B is also a zero
coupon bond with a modified duration of 4 years. A bond portfolio manager has R145m
invested in Bond A.

How much worth of Bond B should the manager go long/short in order to

a) Reduce the modified duration of his net portfolio to 7 years?

V1 × (D*V − D1* )
V2 =
(D2* − D *V )

V2 = 145 x (7 – 11.5)
(4-7)

= R217.5m long position

b) Reduce the modified duration of his net portfolio to 0 years?

V2 = 145 x (0 – 11.5)
(4-0)

= -R416.88m