bus3026w final 09

8/3/2019 Bus3026w Final 09

1/21

UNIVERSITY OF CAPE TOWNSCHOOL OF MANAGEMENT STUDIES

FINANCE 2 FINAL EXAMBUS3026W

NOVEMBER 2009

Total Marks: 160 Time: 3 hours

INSTRUCTIONS:

DO NOT TURN OVER THE PAGE UNTIL INSTRUCTEDTO DO SO

ANSWER ALL QUESTIONS ANSWER EACH SECTION IN A DIFFERENT BOOK NO QUESTIONS WILL BE ANSWERED DURING THE

EXAM. CLEARLY STATE ANY ASSUMPTIONS MADE INANSWERING EACH QUESTION.

Examiners: R. KrugerK. Hodnett

A. Prayag

8/3/2019 Bus3026w Final 09

2/21

SECTION A: FINANCIAL RISK MANAGEMENT [25 MARKS]

Question 1

Aplexy Bank operates in the South African market and manages an increasingly complexportfolio of assets, including:

A. A number of one-year coupon bonds with a total market value of R150m. Thebonds have a 10% annual coupon payable semi-annually and have an annual yield tomaturity of 8% (EAR).

B. A short position of 250 6-month S&P500 index futures contracts. The contracts arepriced at $2, 220 each with a contract multiplier of 10. The current level of theS&P500 index is 1544.5 and the dividend yield on the index is 0.3%. The expectedweekly return on the S&P500 is 0.45% while the weekly standard deviation is 2.14%.

Given current weaknesses in the US market the rand/dollar exchange rate has demonstratedsignificant instability in recent months. This volatility is expected to persist in future andexperts have estimated that that the annual mean and standard deviation for the R/$exchange rate will be 10.1% and 24.55% respectively. The 6-month US force of interest is0.5% p.a. effective.

The bank is also considering issuing a number of 2-year zero coupon bonds with a face valueof R2m each at par.

Required:

a) Given the information provided, advise Aplexy on how it could manage the risk it isexposed to by its current bond holdings. Support your answer by means of calculations.

[15]

b) Compute what Aplexys current risk exposure is for its futures contracts and brieflydiscuss your method of calculating it. [5]

c) Discuss the impact the anticipated currency volatility will have on both of the aboveholdings if any. Compute the risk exposure(s) anticipated. [5]

--- END FINANCIAL RISK MANAGEMENT SECTION ---

8/3/2019 Bus3026w Final 09

3/21

SECTION B: DERIVATIVE INVESTMENTS [50 MARKS]

Question 2 (30 Marks)

The recent turmoil in JSE Securities Exchange has offered significant profit opportunities.You think that this volatility is likely to continue and derivative instruments are particularlysuitable for short - term risk management and speculation. Use the option and futuresquotations below to answer this question.

BENCOR option contracts: Closing prices on 15 July 2009 (today)

Asset Spot Month Exercise Calls - Last Puts - Last

BEN 14700 September 09 14600 865 438

BEN 14700 September 09 14700 714 482BEN 14700 September 09 14800 659 529

BEN 14700 December 09 14600 1286 625BEN 14700 December 09 14700 1230 666BEN 14700 December 09 14800 1177 780

BEN 14700 March 10 14600 1707 720BEN 14700 March 10 14700 1652 769BEN 14700 March 10 14800 1598 880

Selected terms of the BENCOR option contracts traded:

Quotations: (1) Assets spot price and options exercise price: Actual price (cents per share).(2) Last price of call and put options: Actual price (rands per

contract).

Contract size: 100 shares per option contract.Expiry dates: 15th day of March, June, September and December.

FINANCIAL FUTURES: Closing price 15 July 2009 (today)

Contract Type Spot M-T-M

Sep 09 ALSI 21 840 22 080Dec 09 ALSI 22 530Mar 10 ALSI 23 040 Jun 10 ALSI 23 700

8/3/2019 Bus3026w Final 09

4/21

FINANCIAL FUTURES: Closing prices 12 - 15 July 2009

Date Contract Type Spot M-T-M12 July Sep 09 INDI 24 600 24 90013 July 25 500 26 10014 July 25 200 25 800

Today: 15 July 26 700 27 000

Selected terms of the ALSI and INDI financial futures quoted above:

Quotations: All-Share Index (ALSI) level (no decimal points)

Industrial Index (INDI) level (no decimal points)Contract size: Index level x R10Initial margin: R24 000.00 per contract

Required:

(a) You expect the share price of BENCOR (BEN) to increase above R147.00 by the15thof September 2009 but you are not sure how big the increase will be. Using yourR100,000 savings, you intend to profit from your expectation about the share pricemovement. You are considering two strategies: either (1) buying BENCOR shares, or(2) trading long call options.

(i) How many option contracts can you trade? [2](ii) What would be your net profit/loss from each strategy, if the share price on

15th September is R157.00? If the share price is R140.00? [5]

(iii) Draw a profit/loss diagram for each of your proposed strategies.(Remember to label all relevant points) [5]

(b) Your brother is convinced that BENCOR (BEN) share price will increase, but hethinks the reason is that the share is currently undervalued. He has just purchased 20

000 shares, but he is worried that the general market will decline, causing a drop inBENs share price. He wants to hedge his position until December using either BENoptions or ALSI futures.

(i) Calculate the number of BEN put options that he needs to trade (indicate whether he should buy or sell) in order to fully hedge his position in BENshares. BENCORs standard deviation of returns is 25% and the risk-free rateis 10%.p.a. [6]

8/3/2019 Bus3026w Final 09

5/21

(ii) Calculate the number of ALSI futures contracts that he needs to trade (indicate whether long or short) in order to hedge the systematic risk of BEN shares.BENs beta is 1.4 and the ALSI is expected to drop by 300 points.

(Note: The hedged position will not be closed out before the maturitydate)

[6]

(c) Your sister admits over supper that for the past few days she has been speculating onSeptember 2009 INDI futures contracts. She took a short position on 10 INDI futurecontracts on 12th July 2009 (i.e. F0 = 24 900), and deposited an initial margin withSAFEX the same day. At the close of business today, 15th July 2009, she received amargin call.

(i) What is the net profit/loss on her 10 contract short position as at the close ofbusiness on 15th July 2009? [2]

(ii) Briefly explain what is meant by a margin call and why your sister received it.[2]

(iii) Briefly explain what your sister has to do, if she wants to close out her futuresposition before the futures expiry date in September 2009. [2]

Question 3 (20 Marks)

Mr. Byrne, an investor and analyst, wrote a call option with a premium of R2 and an exerciseprice of R111. He simultaneously wrote a put option on the same stock with a premium ofR3 and an exercise price of R100. Using Table 1 below, Mr. Byrne would like to construct astrategy that will allow him to earn the risk-free rate of return on his investment, irrespectiveof movements in the stock market.

Company Exercise Price Premium (Put) Premium (Call)Everlasting Ltd R 100 R 3 R 10Everlasting Ltd R 111 R 5 R 2All options expire in one years time

Required:

(a) Combine Mr. Byrnes current position (that is, a short call and a short put) with twoadditional options listed in Table 1 which will enable him to achieve the desired risk-free rate of return on his investment (irrespective of any movement in the market).Illustrate your answer by way of option algebra.

[5]

(b) Compute the profit or loss for the strategy constructed in (a) above over thefollowing stock price ranges:

8/3/2019 Bus3026w Final 09

6/21

ST is less than R100 ST is between R100 and R110 ST is greater than R110

[8]

(c) Calculate the rate of return on the strategy in (a) for the one-year holding period.

[2]

(d) Bearing the answers to (a)-(c) in mind, assume that the current risk-free rate of returnis 5% per annum (borrowing and lending rate) explain how an investor could exploitan arbitrage opportunity.

[5]

--- END DERIVATE INSTRUMENTS SECTION ---

8/3/2019 Bus3026w Final 09

7/21

SECTION C: FIXED INCOME INVESTMENTS [35 MARKS]

Question 4 (35 marks)

The ability to forecast interest rates and changes in these rates is critical to successful bondinvesting. Interest rates are the price for loanable funds. Like any price, they are determinedby the supply and demand for these funds.

(Reilly and Brown, 2003)

Assume that the current two-year spot rate is 10 percent, the four-year spot rate is 8 percent,and the two-year liquidity premium is expected to be at a constant 2%.

Required:

Discuss the theories of the term structure of interest rates based on the information givenabove. Your discussion and analysis should incorporate any relevant calculations and graphs.The graphs must be fully labelled.

--- END FIXED INCOME SECTION ---

8/3/2019 Bus3026w Final 09

8/21

SECTION D: INTERNATIONAL FINANCE [50 MARKS]

QUESTION 5 (8 MARKS)

(a) Explain the mechanism which restores the balance of payments equilibrium when it isdisturbed under the gold standard. [3]

(b) Making reference to Yankee stock offerings, name one reason why a firm would want tocross-list its shares on a foreign equity market? [2]

(c) Describe the differences between foreign bonds and Eurobonds. Give a reason why youwould expect to see more Eurobond than foreign bond issues on the international bondmarkets. [3]


Suppose the following exchange rates are quoted:

Barclays.Dollars per Euro = $1.10/HSBCDollars per Pound = $1.60/Natwest.Euros per Pound = 1.55/

(a) Show whether it is possible for a market trader with $1,000,000 to gain an arbitrage.[4]

(b) Given that the three-month forward quote for the dollar at HSBC is $1.40/. Based onyour analysis of the exchange rate, you are confident that the spot exchange rate will be$1.50/ in three months. Assume that you would like to buy or sell $1,000,000 /625,000.

(i) Calculate the forward premium/discount of the dollar ($).[2]

(ii) What actions do you need to take to speculate in the forward market? What isthe expected profit from speculation?

[2]

(iii) What would be your speculative profit if the spot exchange rate actually turnsout to be $1.38/?

[2]

8/3/2019 Bus3026w Final 09

9/21


Currently, the spot exchange rate is R10/ and the six-month forward exchange rate isR11/. The six-month interest rate is 3.0% per annum in the U.K. and 6.0% per annum inSouth Africa. Assume that you can borrow as much as R1,000,000 or 100,000.

(a) Is it possible for a currency trader to carry out a covered interest arbitrage? Show all thesteps and determine the arbitrage profit. [4]

(b) Explain how the IRP will be restored as a result of covered arbitrage activities. [2](c) At what six-month forward exchange rate will an importer by indifferent between a

forward market hedge and a money market hedge? [2]


A currency trader is faced with the following statistics of two countries: South African andJapan.

South Africa JapanInflation (annual rate) 6% 2%One-year interest rate 10% ?Spot exchange rate (ZAR per ) 0.08Expected exchange rate (in one year) ?One-year forward exchange rate (ZAR/) ?

Assuming that all the international parity relationships hold, what would be the mostappropriate answers for the unknown figures (represented by question marks)?

[4]


(a) Suppose MTN is expecting to conclude a merger deal with Bharti Airtel, which willresult in an inflow of $5 billion in three months time. However, this deal which willmake the newly-formed company one of the leading telecommunication companies inthe world will only be concluded if the necessary regulatory approval is obtained from

the domestic government. Explain the type of currency exposure that MTN is facing andhow it can most efficiently hedge the currency risk. [2]

(b)Suppose you are a successful S.African venture capitalist holding a major stake in an e-commerce start-up in Silicon Valley. As a South African, you are concerned with therand value of your U.S. equity position. Assume that if the American economy booms inthe future, your equity stake will be worth $1,000,000, and the exchange rate will beR10/$. If the American economy experiences a recession, on the other hand, yourAmerican equity stake will be worth $500,000, and the exchange rate will be R8/$. You

8/3/2019 Bus3026w Final 09

10/21

assess that the American economy will experience a boom with a 70 percent probabilityand a recession with a 30 percent probability.

(i) Estimate your exposure to the exchange risk. [6]

(ii) How would you hedge this exposure? [1]

(iii) Explain a firms operating exposure to currency risk and list two ways in whichthe firm can hedge its operating exposure. [3]


(a)Why are security returns usually found to be less correlated across countries than withina country. [2]

(b) Arguments against international diversification states that benefits of internationaldiversification are generally overstated. Discuss. [2]

(c) Decomposing the variance of the domestic value of foreign equity investments, it hasbeen found that currency risk only slightly magnifies the volatility of foreign equityinvestments. Give two reasons why this may be the case. [2]

(d) You are a South African citizen who would like to get exposure to the U.K equitymarket. You have the choice of investing in (1) depository receipts of U.K firms thattrade on the JSE, or (2) the Itrix FTSE 100 exchange-traded fund which is also listed onthe JSE. Distinguish between the relative advantages of each alternative. [2]

--- END INTERNATIONAL FINANCE SECTION ---

8/3/2019 Bus3026w Final 09

11/21

Solutions:

Section A: Financial Risk Management

a) Aplexy could make use of duration hedging to reduce its exposure to interest rate risk

from holding its current bonds. Duration hedging attempts to net off our position regardlessof interest changes. In this case, since our current bond holdings are a long position, wewould need a short position of bonds in order to offset this risk since the bank is alreadyconsidering issuing the two-year zero coupon bonds (a short position) the situation is ideal.

[4]

In order to determine the number of the zero-coupon bonds we would need for thispurpose we first need to determine the par value and then the modified duration of ourcurrent bond holdings:

Par Value Calculation:

R150m = 0.05x + 1.05x(1.08)0.5 1.08

Therefore x (par value) = R147.01m[3]

Coupons are thus 0.05 x R147.01m = R7.35m per semi annual payments

Duration Calculation:

Time Payment PV Weight Time x Weight0.5 7.35 7.07 0.047154 0.0235771.0 154.36 142.93 0.952846 0.952846

150 0.976 [4]

The modified duration is therefore: 0.976423/1.04 = 0.94 [1]

Immunized Position Calculation:

Assuming that our zero coupon bonds are quoted as NACC, their duration and modifiedduration is the same = 2. Our value in the new bonds is thus:

[1]

= R150m x (0-0.94)(2-0)

)D(D

)D(DVV

*

V

*

2

*

1

*

V12

=

8/3/2019 Bus3026w Final 09

12/21

= -R70.5m [2]

Or R70.5m of the new zero coupon bonds issued.

b) Students will need to explain that the method for computing the risk exposure for futures

is to map the exposure using the cash-and-carry relationship:

F = e(r-q)T S [2]

The exposure for the short futures position is given by:

= 1544.5 x 10 x 250 x e(0.005-0.003)0.5= $4,037,850 [3]

c) The currency risk will result in added uncertainty regarding the final value of your futuresposition as it is expressed in US $ and will need to be translated back to rands at the end ofthe investment period in 6 months. As such, the appreciation or depreciation of the dollarwill create risk.

This currency risk is equal to 250 x $2 220 = $555,000

There is no currency risk for the bond portfolio as it is traded in rands. [5]

Section B: Derivatives

Part A

(a) Number of options(i) Sep Long Call @ 147 is trading at R714 per contract, so purchase of R100,000 will

mean:R100,000/ R714 per contract = 140 contracts

[2]

(ii) Call value is (ST - X), so (R157 R147) = R10 x 100 sh.x 140 contracts = R140,000Less: cost of purchasing the option contracts (R100,000)Net Profit/Loss R 40,000

Call value is (ST - X), so (R140 - 147) = negative, will not exercise = R 0Less: cost of purchasing the option contracts (R100,000)Net Profit/Loss (R100,000)

With R100,000 you can purchase 680 shares (0.27 fraction cannot be bought)

Profit/Loss: (R157 R147) = R10 per share x 680 shares = R6,800

8/3/2019 Bus3026w Final 09

13/21

Profit/Loss: (R140 R147) = - R7 per share x 680 shares = (R4,760)[5]

(iii) Per 1 option contract or 100 shares

R14,000

Net profit

100 x ST

R700

0

R14,700

Long Asset

R15,700

R1000

Net profit

100 x ST

R714

0

R14,700

R15,414

Long Call

R15,700

R286

[5]

(b) Hedging means eliminate risk completely(i) Long position in shares can be hedged by long puts

Option hedge ratio = 1/ delta and Put options delta = N (d1) - 1

So = X = R147 , risk-free rate = 10%, = 25% T = 5/12 = 0.42

T

/2)T+(r+/X)S(=d

20

1

lnlnlnln= 3402.0

42.025.0

42.0/2)25.0+10.0(+)147/147(

2

=lnlnlnln

8/3/2019 Bus3026w Final 09

14/21

N (d1) = N (0.34) = 0.6331 (Table)

Put delta = 0.6331 - 1 = - 0.3669

20 000 shares / 0.3669 = 54 510 puts must be purchased, or 545 put contracts[6]

(ii) Long position in shares must be hedged by short position in ALSI futuresHR = Change in value of the unprotected position for a given change in the underlying asset

Profit derived from hedge for the same change in the underlying asset

If the ALSI falls by 300 pts, that will be a 1.37 % (300/21 840) drop.

Share position will change by 1.37% * = 1.37 * 1.4 = 1.92%Current share portfolio value is R147.00 x 20,000 = R2,940,000So, 300 pts drop in ALSI will cause R56,448 loss in value (=R2,940,000 *

1.92%)

HR = R56,448 / ((R22530 (F0) 21540 (ST)) * 10) = 5.7 / 6 contracts

(Note: student is told that the hedged position is held until maturity of futurescontract, thus convergence property FT = ST applies in this case)

Since fractions cannot be traded, he should sell 6 contracts to hedge the systematic riskof the share.

[6]

(c) (i) Profit/Loss for a SHORT position in ALSI is F0 - FT(24 900 27 000) = - 2100 pts x R10 x 10 contracts = - R210,000

[2]

(ii) A margin call is a request by the clearing house for a top-up of the marginaccount. The reason such call was received is that losses were realised due toprice movement of the underlying instrument, so the initial deposit must havedropped below the allowed minimum (not surprising, since the funds in themargin account were initially only R240,000).

[2]

(iii) To close out a futures position she needs to take a futures position exactlyopposite to her current one. Since she is short on 10 contracts, she need tonow go long on 10 contracts. The contract price for this transaction will nowbe F0 = 27 000.

[2]

8/3/2019 Bus3026w Final 09

15/21

Part B

(a) SC111 (0; 0; -1)

SP100 (+1; 0; 0)LC100 (0; +1; +1)LP111 (-1; -1; 0)Rf (0; 0; 0)

[5](b) Profit and Loss

St < 100 100

8/3/2019 Bus3026w Final 09

16/21

Section C: Fixed Income Investments

Starting Guideline Points:

Yield Curve: Relationship between YTM (k that equates PV of all future CF with BP) and

Time to Maturity.

Derived Relationship from the Theory: A. F2, 4 and E(S2, 4)B. S4 and ES(2, 4) to predict interest rates movements.

I. The Unbiased Expectations Theorem:

Changes in future spot rates due to change in (real rate) or (inflation). Investors dont know the future rate but have (expectations) Maturity Strategy offer same return as the Rollover Strategy. Demand and Supply ensures that E (S2, 4) = F2, 4

Based on UET: (1 + 0.08)2 = (1 + 0.10)2 * (1 + E(S2, 4) )2

Parity (Must Hold): (1 + S4)4 = (1 + S2)

2 * (1 + f2, 4)2

(1 + 0.08)2 = (1 + 0.10)2 * (1 + 6.04%)2

Therefore: E (S2, 4) = F2, 4 = 6.04%

If E (S2, 4 ) > 6.04%: M < R To restore the equilibrium:Excess Demand for S4 S4 to increaseExcess Supply for S2 S2 to decrease

If E (S2, 4 ) < 6.04%: M > R To restore the equilibrium:Excess Supply for S4 S4 to decreaseExcess Demand for S2 S2 to increase

Because {E(S2,4 ) of 6.04% < S2 of 10% ;Interest rates are expected to decrease:

8/3/2019 Bus3026w Final 09

17/21

IR

10%

8%

6.04%Yield Curve 0

Yield Curve 1

2 4 Maturity

II. The Liquidity Preference Theorem:

(S2) preferred to (S4)S4 has higher liquidity risk To induce investors to supply funds for S4 , M must offer higher return than R:

Based on LPT: (1 + 0.08)2 > (1 + 0.10)2 * (1 + E(S2, 4) )2

Parity (Must Hold): (1 + 0.08)2 = (1 + 0.10)2 * (1 + 6.04%)2

Therefore: F2, 4 = 6.04% > E (S2, 4)F2, 4 = 6.04% = E (S2, 4) + L2, 4.L2, 4 = 2%

As a result, E(S2,4 ) = 4.04%

Because {E(S2,4 ) of 4.04% < S2 of 10% ;Interest rates are expected to decrease substantially compared to the UET:

Magnitude for the drop = 5.96% (Under UET, the drop is only 3.96%).

IR

10%

8%

4.04% Yield Curve 0

Yield Curve 1

2 4 Maturity

8/3/2019 Bus3026w Final 09

18/21

III. The Market Segmentation Theorem:

Various investors and borrowers restricted to their respective markets Spot rates determined by supply and demand conditions in each market Therefore, E(S2, 4) may be higher or lower than f2, 4 of 6.04% In addition, E(S2, 4) may be higher or lower than S2 of 10%

[35]

Section D: International Finance


(a) The adjustment mechanism under the gold standard is referred to as the price-specie-flowmechanism expounded by David Hume. Under the gold standard, a balance of paymentdisequilibrium will be corrected by a counter-flow of gold. Suppose that the U.S. imports morefrom the U.K. than it exports to the latter. Under the classical gold standard, gold, which is theonly means of international payments, will flow from the U.S. to the U.K. As a result, the U.S.

(U.K.) will experience a decrease (increase) in money supply. This means that the price level willtend to fall in the U.S. and rise in the U.K. Consequently, the U.S. products become morecompetitive in the export market, while U.K. products become less competitive. This change willimprove U.S. balance of payments and at the same time hurt the U.K. balance of payments,eventually eliminating the initial BOP disequilibrium.

[3](b)Yankee stock offerings refer to the direct sale of new equity capital to U.S. public investors by

foreign firms. This occurs when foreign firms cross-list their shares on an American equitymarket, in addition to having their shares traded on their domestic equity markets. There are various advantages that accrue to the firm which is cross-listing its shares: Onebenefit from the followings:(1)A company may cross-list its shares on foreign exchanges to broaden its investor base and

therefore to increase the demand for its stock. An increase in demand will generallyincrease the stock price and improve its market liquidity.

(2)A broader investor base may also mitigate the possibility of a hostile takeover.(3) Cross-listing a companys shares establishes name recognition and thus facilitates sourcing

new equity capital in these foreign capital markets.[2]

(c) A foreign bond issue is one offered by a foreign borrower to investors in a national capital marketand denominated in that nations currency. A Eurobond issue is one denominated in a particularcurrency, but sold to investors in national capital markets other than the country which issues thedenominating currency.Two reasons why the Eurobond segment is four times the size of the foreign bond segment: (1)shorter length of time in bringing a Eurodollar bond issue to the market, and (2) lower rate of

interest that borrowers pay for euro bond financing in comparison to foreign bond financing. [3]


(a) First get the cross rate $1.60/ $1.10/ = 1.4545/ therefore arbitrage is possible.Step 1: The market trader with $1,000,000 can sell that sum spot to HSBC for $1,000,000

$1.60/ = 625,000.

8/3/2019 Bus3026w Final 09

19/21

Step 2: These pounds (625,000) can be sold to Natwest for 625,000 1.55/ = 968,750.

Step 3: Then the trader immediately exchanges the Euros for dollars at Barclays Bank for

968,750 $1.10/=$1,065,625. The profit is therefore a risk free $65,625. Such

intermarket arbitrage can continue until the exchange markets re-establish equilibrium.

[4]

(b) Given that S($/) = 1.60 and F90($/) = 1.40, that implies that S(/$) = 0.6250 and F90(/$) =0.7143.

(iv) The three-month forward premium for the dollar is given by:[(0.7143-0.6250)/0.6250]*360/90 = 0.5714 or 57.14%

[2](v) Expected spot rate in three-month time: $1.50/

Action required: Buy 625,000 forward for $1.40/. Your expected profit will be:

625,000 * ($1.50 - $1.40) = 62,500.

[2](vi) If the spot exchange rate actually turns out to be $1.38/ in three months, your loss

from your long position will be:

625,000 * ($1.38 - $1.40) = -12,500.[2]


(d) Lets summarize the given data first:S = R10/; F = R11/; I= 1.5%; IR= 3%, Credit = R1,000,000 or 100,000.

(1+IR) = 1.03(1+I)(F/S) = (1.015)*(11/10) = 1.1165

Thus, IRP is not holding exactly.

- Borrow R1,000,000; repayment will be R1,030,000.- Buy 100,000 spot using R1,000,000.- Invest 100,000 at the pound interest rate of 1.5%; maturity value will be 101,500.- Sell 101,500 forward for R1,116,500. Arbitrage profit will be R86,500 (1,116,500

1,030,000).[4]

(e) Following the arbitrage transactions described above: The rand interest rate will rise; the poundinterest rate will fall; the spot exchange rate will rise; the forward exchange rate will fall.These adjustments will continue until IRP holds.

[2]

(f) An importer will be indifferent between a forward market hedge and a money market hedge,when the IRP holds. This will happen when the six-month forward rate will be:F = (1.03/1.015) x 10 = R10.1478/

[2]


8/3/2019 Bus3026w Final 09

20/21

Using the relative purchasing power parity relationship,

F(ZAR/)/S(ZAR/) = (1+ZAR)/(1+)

F(ZAR/) = (1+06%)/(1+02%) * 0.08 = 0.0831[1]

Using the interest rate parity relationship,

F(ZAR/)/S(ZAR/) = (1+iZAR)/(1+i)

(1+i) = (1+10%) / (0.0831/0.08) = 1.059, or i= 1.059 1 = 0.059 or 5.9%[2]

Using the forward expectation parity relation,

F(ZAR/) = E(S(ZAR/))

E(S(ZAR/)) = 0.0831[1]


(c) MTN is facing a contingent exposure, whereby the firm may or not be subject to exchangeexposure. The most efficient way to hedge such an exposure is to make use of optioncontracts. In our case, MTN should enter into a 3-month put option on $5 billion.

[2]

(d)(i)

Prob = 0.70 P* = $1,000,000 S = R10/$1 P = R10,000,000

Prob = 0.30 P* = $500,000 S = R8/$1 P = R4,000,000

E($) = (0.70)/(10) + (0.30)/(8) = R9.4/$

E(P) = (0.70)*(10,000,000) + (0.30)*(4,000,000) = R8,200,000

Var($) = (0.7)(10-9.4)2 + (0.3)(8-9.4)2 = 0.2520 + 0.5880 = 0.84

Cov(P,$) = [(0.7)(10,000,000-8,200,000)(10-9.4)] + [(0.3)(4,000,000-8,200,000)(8-9.4)] = 2,520,000

b = Cov(P,$)/Var($) = 2,520,000/0.84 = $3,000,000.

[6]

(ii) You would hedge this exposure by selling $3,000,000 forward.[1]

(iii) A firms operating exposure to currency risk is the extent to which the firms operating cashflows are affected by the exchange rate. The firm may manage this operating exposure by: (1)selecting low cost production sites, (2) being flexible with its sourcing policy, (3) by selling in various markets to take advantage of economies of scale and diversify exchange risk, (4)differentiate its product from competition (by investing in R&D), and (5) use financial contractsto partly mitigate the operating exposure. [3]

8/3/2019 Bus3026w Final 09

21/21


(a) Security returns are less correlated probably because countries are different from each other interms of industry structure, resource endowments, macroeconomic policies, and have non-synchronous business cycles. Securities from a same country are subject to the same businesscycle and macroeconomic policies, thus causing high correlations among their returns.

[2]

(b) Basically, the arguments against international investing focus on the diminishing gains to beachieved by diversifying overseas because:- Correlations structure between national financial markets has increased over time.- Correlations among markets increase during periods of increased global volatility.

[2]

(c) Reasons why currency risk only slightly magnifies the volatility of foreign investments are (anytwo):- Currency risk is about half that of foreign stock risk- Foreign asset risk and currency risk are not additive- Currency risk can be hedged using financial derivative contracts- Currency risk will be diversified away in a portfolio of many foreign assets

[2]

(d)The depository receipts are likely going to be denominated and make dividend payments in ZAR.It will also be easily traded from any domestic broker. However, there may be only a few U.Kfirms with depository receipts trading on the JSE, which may not allow the S. African investor toaccess the broad U.K market. So there is firm specific risk as well.

The ETF is an open-end country fund that is designed to closely track a broad market, in thiscase the FTSE 100 index. The fees charged are usually very low cost and it is a convenient wayfor the S.African investor to hold a diversified portfolio of U.K shares.

[2]

bus3026w final 09

Documents