Jill Surratt, CFA, and Elizabeth Castillo, CFA, are analysts for Summit Consulting. Summit provides investment advice to hedge funds and actively managed investment funds throughout the United States and Canada.Surratt and Castillo have a client, Tom Carr, who is interested in increasing his returns from foreign currency positions. Carr currently has a position in Japanese yen (¥) that he wishes to convert to Taiwanese dollars (NTS) because he thinks the Taiwanese currency will appreciate in the near term. He docs not have a quote for yen in terms of the NTS, but has received quotes for both currencies in terms of the U.S. dollar The quotes are $0.008852-56 for the yen and $0.02874-6 for the Taiwanese dollar. He would like to purchase NTS10 million.Discussing these quotes, Surratt notes that the bid-ask spread is affected by many factors. She states that if an economic crisis were expected in the Asian markets, then the bid-ask spread of the currency quotes should widen. Castillo states that if a dealer wished to unload an excess inventor}' of yen, the typical response would be to lower her ask for the yen, thereby narrowing the bid-ask spread.In regards to changes in currency values, Surratt states that if the U.S. Federal Reserve unexpectedly restricts the growth of the money supply and foreign interest rates remain constant, then the U.S. interest rate differential should increase, thereby increasing the value of the dollar. She states that this change may occur without a change in the quantity of dollars traded. Surratt also mentions that in addition to monetary policy having an impact on exchange rates, governments sometimes intervene directly into the foreign currency markets. She states that if a country was defending its currency value, it would buy up its currency for as long as needed in the foreign currency markets.In addition to using monetary policy, Summit Consulting uses anticipated changes in fiscal policy to forecast exchange rates and the balance of payments for a country. Castillo states that if the U.S. Congress were to unexpectedly reduce the budget deficit, then this should have a positive impact on the value of the dollar in the short-run because foreigners would have more confidence in the U.S. economy. Castillo adds that this change would result in changes in the balance of payments components, with the trade deficit and the capital account surplus decreasing.Another of Summit's clients is Jack Ponder. Ponder would like to investigate the possibility of using covered interest arbitrage to earn risk free profits over the next three months, assuming initial capital of $1 million. He asks Surratt to gather information on the inflation rates, interest rates, spot rates, and forward rates for the U.S. dollar and the Swiss franc (SF). Surratt has also used technical analysis to obtain a projection of the future spot rate for the two countries' currencies. The information is presented below:Spot rate $0.85 /SFThree month forward rate (as of today) for SF $0.80 / SF Expected spot rate three months from now $0.60/SF Three month inflation rate in Switzerland (annualized) 2.0% Three month inflation rate in the US (annualized) 6.0%Three month interest rate for SF (annualized) 12.0%Three month interest rate for U.S. dollars (annualized) 18.0%At a training session for new employees, Surratt and Castillo lecture on international trade and finance issues. To illustrate the concept of comparative advantage, Castillo uses two countries, Country A and Country B. Both produce computers and food but have different opportunity costs for producing them. A's opportunity cost of producing another pallet of computers is two bushels of food. B*s opportunity cost of producing another pallet of computers is five bushels of food. The table below provides the output from each country before international trade takes place;Evaluate Castillo's statements concerning the effect of fiscal policy on currency values and the balance of payments components? Castillo is:
Answer(s): B
Castillo is incorrect with respect to the impact of unanticipated restrictive fiscal policies on the value of the dollar. There are two opposing forces here. An unanticipated shift to a more restrictive fiscal policy (a reduction the budget deficit) could result in an economic slowdown and lower inflation. These factors discourage imports and encourage exports, resulting in a higher value of the dollar.On the other hand, a reduction the budget deficit means that government borrowing will decline, which reduces real interest rates and causes investment funds to flow out of the country. As a result, the value of the dollar tends to decline.Thus, the influences are conflicting. However, since financial capital is mobile, the effect of the interest rate change generally dominates in the short run, leading to short-run devaluation.Castillo is correct with respect to the impact of unanticipated restrictive fiscal policies on the balance of payments accounts. An unanticipated shift to a smaller budget deficit will cause a decrease in aggregate demand and a decrease in domestic interest rates (due to less government borrowing). The decreased aggregate demand reduces imports, which reduces the current account deficit. Meanwhile, the lower interest rates result in lower foreign investment and in domestic capital leaving the country. Thus, the capital account surplus will be reduced. (Study Session 4, LOS 19.c,d,e)
Jill Surratt, CFA, and Elizabeth Castillo, CFA, are analysts for Summit Consulting. Summit provides investment advice to hedge funds and actively managed investment funds throughout the United States and Canada.Surratt and Castillo have a client, Tom Carr, who is interested in increasing his returns from foreign currency positions. Carr currently has a position in Japanese yen (¥) that he wishes to convert to Taiwanese dollars (NTS) because he thinks the Taiwanese currency will appreciate in the near term. He docs not have a quote for yen in terms of the NTS, but has received quotes for both currencies in terms of the U.S. dollar The quotes are $0.008852-56 for the yen and $0.02874-6 for the Taiwanese dollar. He would like to purchase NTS10 million.Discussing these quotes, Surratt notes that the bid-ask spread is affected by many factors. She states that if an economic crisis were expected in the Asian markets, then the bid-ask spread of the currency quotes should widen. Castillo states that if a dealer wished to unload an excess inventor}' of yen, the typical response would be to lower her ask for the yen, thereby narrowing the bid-ask spread.In regards to changes in currency values, Surratt states that if the U.S. Federal Reserve unexpectedly restricts the growth of the money supply and foreign interest rates remain constant, then the U.S. interest rate differential should increase, thereby increasing the value of the dollar. She states that this change may occur without a change in the quantity of dollars traded. Surratt also mentions that in addition to monetary policy having an impact on exchange rates, governments sometimes intervene directly into the foreign currency markets. She states that if a country was defending its currency value, it would buy up its currency for as long as needed in the foreign currency markets.In addition to using monetary policy, Summit Consulting uses anticipated changes in fiscal policy to forecast exchange rates and the balance of payments for a country. Castillo states that if the U.S. Congress were to unexpectedly reduce the budget deficit, then this should have a positive impact on the value of the dollar in the short-run because foreigners would have more confidence in the U.S. economy. Castillo adds that this change would result in changes in the balance of payments components, with the trade deficit and the capital account surplus decreasing.Another of Summit's clients is Jack Ponder. Ponder would like to investigate the possibility of using covered interest arbitrage to earn risk free profits over the next three months, assuming initial capital of $1 million. He asks Surratt to gather information on the inflation rates, interest rates, spot rates, and forward rates for the U.S. dollar and the Swiss franc (SF). Surratt has also used technical analysis to obtain a projection of the future spot rate for the two countries' currencies. The information is presented below:Spot rate $0.85 /SFThree month forward rate (as of today) for SF $0.80 / SF Expected spot rate three months from now $0.60/SF Three month inflation rate in Switzerland (annualized) 2.0% Three month inflation rate in the US (annualized) 6.0%Three month interest rate for SF (annualized) 12.0%Three month interest rate for U.S. dollars (annualized) 18.0%At a training session for new employees, Surratt and Castillo lecture on international trade and finance issues. To illustrate the concept of comparative advantage, Castillo uses two countries, Country A and Country B. Both produce computers and food but have different opportunity costs for producing them. A's opportunity cost of producing another pallet of computers is two bushels of food. B*s opportunity cost of producing another pallet of computers is five bushels of food. The table below provides the output from each country before international trade takes place;Which of the following best describes the covered interest arbitrage that Ponder should execute? Borrow in:
Answer(s): C
The relevant information here is the spot rate, the forward rate, and the interest rates in the two countries. The first step in covered interest arbitrage is to determine in which currency funds will be borrowed and in which currency funds will be invested. The three month interest rate in the United States is 18%/4 = 4.5% and 12%/4 = 3% in Switzerland.In covered interest rate parity, the hedged foreign return (combining the foreign interest rate (SF) with the forward-spot rare differential) should equal to the domestic (USD) return:If we insert the data from the example into this relationship, we get the following:Because the effective rate is lower in Switzerland, Ponder will borrow in Switzerland and invest in the United States. Assuming that Ponder will utilize $1,000,000, we convert this amount to SF at the spot rate to determine the amount of the Swiss franc loan:$1,000,000 x SF/$0.85 = SF1,176,470.59.The amount of the Swiss franc loan to be paid back in three months uses the Swiss interest rate of 3%SF1.176,470.59 x 1.03 = SF1.211,764.71At inception of the arbitrage, Ponder will have entered into a forward contract where he buys Swiss franc and sells U.S. dollars. Using this forward contract and rate, the cost of the loan in U.S. dollars is:SF1,211,764.71 x $0.80/SF = $969,411.76.In the United States, Ponder will have invested the $1,000,000 at 4.5% and will have in three months:$1,000,000 x 1.045 = $1,045,000.The covered interest arbitrage profit is thus:$1,045,000 - $969,411.76 = $75,588.24.Professor's Note: If you are asked to calculate a covered interest arbitrage profit on the exam, the quickest way to arrive at your answer would be to multiply the return differential calculated at the beginning of this problem by the $1,000,000:$1,000,000 x (1.045 - 0.9694) = $75,600.Using six decimal places for the Swiss return to get 0.969412 (or carrying the calculation in your calculators memory) will give you the more precise $75,588.Also note that the expected spot rate and inflation rates are not necessary in this problem. Do not confuse covered interest rate parity with purchasing power parity.(Study Session 4, LOS 18.h)
Jill Surratt, CFA, and Elizabeth Castillo, CFA, are analysts for Summit Consulting. Summit provides investment advice to hedge funds and actively managed investment funds throughout the United States and Canada.Surratt and Castillo have a client, Tom Carr, who is interested in increasing his returns from foreign currency positions. Carr currently has a position in Japanese yen (¥) that he wishes to convert to Taiwanese dollars (NTS) because he thinks the Taiwanese currency will appreciate in the near term. He docs not have a quote for yen in terms of the NTS, but has received quotes for both currencies in terms of the U.S. dollar The quotes are $0.008852-56 for the yen and $0.02874-6 for the Taiwanese dollar. He would like to purchase NTS10 million.Discussing these quotes, Surratt notes that the bid-ask spread is affected by many factors. She states that if an economic crisis were expected in the Asian markets, then the bid-ask spread of the currency quotes should widen. Castillo states that if a dealer wished to unload an excess inventor}' of yen, the typical response would be to lower her ask for the yen, thereby narrowing the bid-ask spread.In regards to changes in currency values, Surratt states that if the U.S. Federal Reserve unexpectedly restricts the growth of the money supply and foreign interest rates remain constant, then the U.S. interest rate differential should increase, thereby increasing the value of the dollar. She states that this change may occur without a change in the quantity of dollars traded. Surratt also mentions that in addition to monetary policy having an impact on exchange rates, governments sometimes intervene directly into the foreign currency markets. She states that if a country was defending its currency value, it would buy up its currency for as long as needed in the foreign currency markets.In addition to using monetary policy, Summit Consulting uses anticipated changes in fiscal policy to forecast exchange rates and the balance of payments for a country. Castillo states that if the U.S. Congress were to unexpectedly reduce the budget deficit, then this should have a positive impact on the value of the dollar in the short-run because foreigners would have more confidence in the U.S. economy. Castillo adds that this change would result in changes in the balance of payments components, with the trade deficit and the capital account surplus decreasing.Another of Summit's clients is Jack Ponder. Ponder would like to investigate the possibility of using covered interest arbitrage to earn risk free profits over the next three months, assuming initial capital of $1 million. He asks Surratt to gather information on the inflation rates, interest rates, spot rates, and forward rates for the U.S. dollar and the Swiss franc (SF). Surratt has also used technical analysis to obtain a projection of the future spot rate for the two countries' currencies. The information is presented below:Spot rate $0.85 /SFThree month forward rate (as of today) for SF $0.80 / SF Expected spot rate three months from now $0.60/SF Three month inflation rate in Switzerland (annualized) 2.0% Three month inflation rate in the US (annualized) 6.0%Three month interest rate for SF (annualized) 12.0%Three month interest rate for U.S. dollars (annualized) 18.0%At a training session for new employees, Surratt and Castillo lecture on international trade and finance issues. To illustrate the concept of comparative advantage, Castillo uses two countries, Country A and Country B. Both produce computers and food but have different opportunity costs for producing them. A's opportunity cost of producing another pallet of computers is two bushels of food. B*s opportunity cost of producing another pallet of computers is five bushels of food. The table below provides the output from each country before international trade takes place;Which of the following best describes potential gains from international trade in Castillo's example?Potential gains:
If As opportunity cost of producing another pallet of computers is 2 bushels of food while B's is 5, then it does not cost A much to make more computers. A is thus more efficient in the production of computers and A should increase production of computers.It costs Country B 1/5 (the reciprocal of 5) a pallet of computers to make a bushel of food while it costs A 1/2 a pallet. Thus B is more efficient in their production of food and B should increase production of food.There is the potential for gains from international trade because both A and B will shift more of their production to the good each country makes more efficiently. The size of the international production pie will increase and both countries will benefit to varying degrees.For example, assume that A produces 2 more pallets of computers. It will forfeit 4 (2 x 2) bushels of food. This worldwide loss in food will be compensated for by B.B will make 4 more bushels of food. As a result, B will produce 0.8 (4 x 1/5) less pallets of computers. In total, the world will be better off because the same amount of food will be produced (16) while more computers are produced (24.2). The result of international trade is summarized in the "After Trade" table below:(Study Session 4, LOS l6.a)
William Rogers, a fixed-income portfolio manager, needs to eliminate a large cash position in his portfolio. He would like to purchase some corporate bonds. Two bonds that he is evaluating are shown in Exhibit I. These two bonds are from the same issuer, and the current call price for the callable bond is 100. Assume that the issuer will call if the bond price exceeds the call price.Rogers is also concerned about increases in interest rates and is considering the purchase of a putable bond. He wants to determine how assumed increases or decreases in interest rate volatility affect the value of the straight bonds and bonds with embedded options. After Rogers performs some analysis, he and his supervisor, Sigourney Walters, discuss the relative price movement between the two bonds in Exhibit 1 when interest rates change significantlyDuring the discussions, Rogers makes the following statements:Statement 1: If the volatility of interest rates decreases, the value of the callable bond will increase.Statement 2: The noncallable bond will not be affected by a change in the volatility or level of interest rates.Statement 3: When interest rates decrease, the value of the noncallable bond increases by more than the callable bond.Statement 4: If the volatility of interest rates increases, the value of the putable bond will increase.Walters mentors Rogers on bond concepts and then asks him to consider the pricing of a third bond. The third bond has five years to maturity, a 6% annual coupon, and pays interest semiannually. The bond is both callable and putable at 100 at any time. Walters indicates that the holders of the bond's embedded options will exercise if the option is in-the-money.Rogers obtained the prices shown in Exhibit b using software that generates an interest rate lattice. He uses his software to generate the interest rate lattice shown in Exhibit 2.Exhibit 2: Interest Rate Lattice (Annualized Interest Rates)Evaluate Rogers' statements.
Statement 1 is correct. If the volatility of interest rates decreases, the call option is less valuable, which increases the value of the callable bond. Recall that V^y^ = Vno uah|e — V «. Statement 3 is also correct. The value of the noncallable bond increases by more than the callable bond because as yield falls, the value of the call goes up. As the call value increases, the callable value (noncall value - call option value) goes up by less than the noncall value. (Study Session 14, LOS 54.e,f)
Statement 2 is incorrect because the noncallal in the level of interest rates.Statement 4 is correct because higher interest embedded put option and increase the value i LOS 54.0 >lc bond value will be affected by a change rate volatility will increase the value of the >f the puttable bond. (Study Session 14,
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