Barton Wilson, a junior analyst, is a new hire at a money center bank. He has been assigned to help Juanita Chevas, CFA, in the currency trading department. Together, Wilson and Chevas are working on the development of new trading software designed to detect profitable opportunities in the foreign exchange market. Obviously, they are interested in risk-free arbitrage opportunities.However, they have also been instructed to investigate the possibility of longer-term currency exposures that are not necessarily risk-free. To test the logic of their new software, Wilson gathers the following market data:• Spot JPY/USD exchange rate = 120.• Spot EUR/USD exchange rate = 0.7224.• U.S. risk-free interest rate = 7%.• Eurozone risk-free rate = 9.08%.• Japanese risk-free rate = 3.88%.• Yield curves in all three currencies are flat.In addition to in-house currency transactions, the new software program is also intended to provide insight into currency exposure and hedging needs for the bank's major customers. These customers typically include large multinational firms. Essentially, the bank wants to provide consulting services to its clients concerning which currency exposures offer the greatest possibility of appreciation. In this process, the bank will rely on deviations from international parity conditions as an indicator of long-term currency movements.Wilson obtains the following data from the econometrics department:• JPY/USD spot rate one year ago =116.• EUR/USD spot rate one year ago = 0.7200.• Anticipated and historical U.S. annual inflation = 3%.• Anticipated and historical Japanese annual inflation = 0%.• Anticipated and historical Eurozone annual inflation = 5%.One of the bank's major customers has significant portions of its business in Japan, and the Eurozone and has long exposure to both currencies. The customer has traditionally hedged all currency risk. However, the customer's new risk manager has decided to leave some currency exposure unhedged in an attempt to profit from long-term currency exposure.Based on the assumption that international parity conditions will hold in the long run, should the JPY and Euro currency exposures of the bank's major customer be left unhedged?
Answer(s): C
This question requires you to look at deviations from international parity conditions and then determine whether those deviations will tend to work to the advantage of the customer. In this problem, you arc given the necessary information to examine parity conditions using relative purchasing power parity (RPPP). For the JPY, RPPP tells us that, since the spot rate one year ago was 116, the spot rate today should be (JPY is considered the foreign currency):Since the expected spot rate today, based on RPPP (i.e., 112.62), is not equal to the actual spot rate today (i.e., 120), RPPP did not hold over the past year. Since the actual rate is higher than the rate forecast by RPPP, the long-term trend based on deviations from international parity conditions will be for the rate to fall and the JPY to appreciate. Hence, using deviations from parity conditions as indicators of future currency movements, the bank should recommend that the JPY exposure be left unhedged.Using the same RPPP process for the EUR exposure, we can calculate an RPPP spot rate today of 0.7340 (given that the rate was 0.72 one year ago).Again, RPPP did not hold (i.e., the actual rate today, 0.7224, is not equal to the RPPP rate that should exist today given the inflation rates). However, for the EUR case, the RPPP expected spot is higher than the actual spot, indicating that the EUR may be currently overvalued and, thus, more likely to depreciate in the future. EUR exposure should be hedged. (Study Session 4, LOS 19.g,h)
Barton Wilson, a junior analyst, is a new hire at a money center bank. He has been assigned to help Juanita Chevas, CFA, in the currency trading department. Together, Wilson and Chevas are working on the development of new trading software designed to detect profitable opportunities in the foreign exchange market. Obviously, they are interested in risk-free arbitrage opportunities.However, they have also been instructed to investigate the possibility of longer-term currency exposures that are not necessarily risk-free. To test the logic of their new software, Wilson gathers the following market data:• Spot JPY/USD exchange rate = 120.• Spot EUR/USD exchange rate = 0.7224.• U.S. risk-free interest rate = 7%.• Eurozone risk-free rate = 9.08%.• Japanese risk-free rate = 3.88%.• Yield curves in all three currencies are flat.In addition to in-house currency transactions, the new software program is also intended to provide insight into currency exposure and hedging needs for the bank's major customers. These customers typically include large multinational firms. Essentially, the bank wants to provide consulting services to its clients concerning which currency exposures offer the greatest possibility of appreciation. In this process, the bank will rely on deviations from international parity conditions as an indicator of long-term currency movements.Wilson obtains the following data from the econometrics department:• JPY/USD spot rate one year ago =116.• EUR/USD spot rate one year ago = 0.7200.• Anticipated and historical U.S. annual inflation = 3%.• Anticipated and historical Japanese annual inflation = 0%.• Anticipated and historical Eurozone annual inflation = 5%.One of the bank's major customers has significant portions of its business in Japan, and the Eurozone and has long exposure to both currencies. The customer has traditionally hedged all currency risk. However, the customer's new risk manager has decided to leave some currency exposure unhedged in an attempt to profit from long-term currency exposure.An unexpected decline in the growth rate of the USD money supply would most likely cause:
Answer(s): B
If there were an unexpected decline in the growth rate of the money supply, real interest rates would rise, causing an appreciation of the dollar. (Study Session 4, LOS 19.c)
Nigel Holmes, CFA, is an investment manager for a small money management firm in London. All of Holmes' clients are citizens of the U.K. Holmes urges all of his clients to maintain internationally diversified portfolios. In his efforts to find undervalued securities, he is currently analyzing a Canadian company called Slapshot, Inc. Slapshot produces hockey equipment at its Canadian manufacturing facilities. About 85% of Slapshot's sales are to the U.S. market, and the remainder are domestic (i.e., in Canada). Sales have been growing at 12% per year. Last year's sales were C$68,000,000. Holmes has gathered the following market information (inflation is perfectly predictable):• £/$ spot exchange rate = 0.8• £/C$ spot exchange rate = 0.4• U.K. risk-free rate = 6%• U.K. expected inflation rate = 4%• Canadian risk-free rate = 9%• Canadian expected inflation rate = 7%• U.S. risk-free rate = 4%• U.S. expected inflation = 2%Holmes uses the international CAPM (ICAPM) to value international investments. For Slapshot, Holmes believes that the stock's returns are sensitive to the £/C$ exchange rate. In order to apply the model, he estimates the following parameters using the £ as the base currency:• World market risk premium = 6%• Sensitivity of Slapshot to the world market = 1.2• Sensitivity of Slapshot to changes in the £/C$ exchange rate = 1.4• Holmes' expectation for the depreciation of the C$ against the £ = 2%• The ratio of the price of the U.K. consumption basket to the Canadian consumption basket is 0.3.Holmes adds Slapshot stock to several client portfolios at a purchase price of C$ 100. One year later, the stock is trading at C$ 122. There were no dividend payments during the year.The real £/C$ exchange rate is closest to:
The real exchange rate, X, is calculated as follows: S ( / ) S is the spot exchange rate (stated GBP/CAD). Hence, the real exchange rate is 0.4 (1 / 0.3) = 1.33. (Study Session 18, LOS 66.e)
Nigel Holmes, CFA, is an investment manager for a small money management firm in London. All of Holmes' clients are citizens of the U.K. Holmes urges all of his clients to maintain internationally diversified portfolios. In his efforts to find undervalued securities, he is currently analyzing a Canadian company called Slapshot, Inc. Slapshot produces hockey equipment at its Canadian manufacturing facilities. About 85% of Slapshot's sales are to the U.S. market, and the remainder are domestic (i.e., in Canada). Sales have been growing at 12% per year. Last year's sales were C$68,000,000. Holmes has gathered the following market information (inflation is perfectly predictable):• £/$ spot exchange rate = 0.8• £/C$ spot exchange rate = 0.4• U.K. risk-free rate = 6%• U.K. expected inflation rate = 4%• Canadian risk-free rate = 9%• Canadian expected inflation rate = 7%• U.S. risk-free rate = 4%• U.S. expected inflation = 2%Holmes uses the international CAPM (ICAPM) to value international investments. For Slapshot, Holmes believes that the stock's returns are sensitive to the £/C$ exchange rate. In order to apply the model, he estimates the following parameters using the £ as the base currency:• World market risk premium = 6%• Sensitivity of Slapshot to the world market = 1.2• Sensitivity of Slapshot to changes in the £/C$ exchange rate = 1.4• Holmes' expectation for the depreciation of the C$ against the £ = 2%• The ratio of the price of the U.K. consumption basket to the Canadian consumption basket is 0.3.Holmes adds Slapshot stock to several client portfolios at a purchase price of C$ 100. One year later, the stock is trading at C$ 122. There were no dividend payments during the year.If the real exchange rate remained constant, the GBP (£) return on Slapshot for Holmes' clients is closest to:
Answer(s): A
The GBP return is equal to the CAD return, plus appreciation of the CAD. The CAD return is 22% [= (P1-P0) / P0 - (122 - 100) / 100]. Since the real exchange rate remained constant, the change in the nominal rate muse be equal to the inflation differential. Since U.K. inflation is 4% and Canadian inflation is 7%, there is an inflation differential of -3%. This means that the C$ is expected to depreciate by 3% or, equivalently, the £ is expected to appreciate by 3%. Hence, the GBP return is 19% (= 22% minus 3% depreciation of the CAD). (Study Session 18, LOS 66.f)
Nigel Holmes, CFA, is an investment manager for a small money management firm in London. All of Holmes' clients are citizens of the U.K. Holmes urges all of his clients to maintain internationally diversified portfolios. In his efforts to find undervalued securities, he is currently analyzing a Canadian company called Slapshot, Inc. Slapshot produces hockey equipment at its Canadian manufacturing facilities. About 85% of Slapshot's sales are to the U.S. market, and the remainder are domestic (i.e., in Canada). Sales have been growing at 12% per year. Last year's sales were C$68,000,000. Holmes has gathered the following market information (inflation is perfectly predictable):• £/$ spot exchange rate = 0.8• £/C$ spot exchange rate = 0.4• U.K. risk-free rate = 6%• U.K. expected inflation rate = 4%• Canadian risk-free rate = 9%• Canadian expected inflation rate = 7%• U.S. risk-free rate = 4%• U.S. expected inflation = 2%Holmes uses the international CAPM (ICAPM) to value international investments. For Slapshot, Holmes believes that the stock's returns are sensitive to the £/C$ exchange rate. In order to apply the model, he estimates the following parameters using the £ as the base currency:• World market risk premium = 6%• Sensitivity of Slapshot to the world market = 1.2• Sensitivity of Slapshot to changes in the £/C$ exchange rate = 1.4• Holmes' expectation for the depreciation of the C$ against the £ = 2%• The ratio of the price of the U.K. consumption basket to the Canadian consumption basket is 0.3.Holmes adds Slapshot stock to several client portfolios at a purchase price of C$ 100. One year later, the stock is trading at C$ 122. There were no dividend payments during the year.If the real exchange rate at the end of the year was 1.41, the GBP (£) return on Slapshot for Holmes' clients is closest to:
The end-of-period real rate is 1.41. Since inflation is perfectly predictable, we can use the real exchange rate formula to solve for the end-of-period spot rate (i.e., the end-of-period nominal rate). The real rate (X) is calculated as X = S ( where S is stated in GBP per CAD.The end-of-period (inflation adjusted), consumption basket price ratio is 1.07 / 0.312 = 3.4295 ( = 1 x 1.07 = 1.07; - 0.3 x 1-04 = 0.312). Substituting into the real exchange rate equation and solving for S we get:1.41 =S (3.4295)S = 0.41114Now we know that the end-of-period nominal exchange rate is 0.4111 (the £ depreciated when we expected it to appreciate). The CAD appreciation is (P0-P1) /P0 = (0.41114-0.4) / 0.4 = 0.02785 or 2.785%. Now we know both the CAD return on the stock, 22% [= ( - ) / = (122 - 100) / 100] and the CAD appreciation of 2.785%. Therefore, the GBP return must be 24.79% (CAD return plus CAD appreciation). (Study Session 18, LOS 66.f)
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