Problem Set 3 of EF 4331 Instructor: Dr.

Du Du

Select the best answers for questions 1-12 (2 pts each) 1. Which of the following is/are the benefits of quantitative easing in terms of stimulating the economy?
i) QE drives down the home currency valuation which facilitates export ii) QE drives down price levels of domestic products and services which encourages consumption. iii) QE provides corporations with easy access to bank loans which encourages investment.

A) i) and ii) only B) i) and iii) only C) ii) and iii) only D) none of the above

2. In the US, which of the following belong to monetary base but NOT to money supply?
i) cash in circulation ii) bank reserves with Fed iii) vault cash A) i) only B) i) and ii) only C) i) and iii) only D) none of the above

3. Which of the following belong to the M0 measure of money supplyi) vault cash and cash in circulation
ii) funds held in checking account iii) funds held in savings account

A) i) and ii) only B) i) and iii) only C) ii) and iii) only

D) none of the above

4. Which of the following statements related to money creation is/are correct?

i) In the U.S., the Fed has the sole sovereignty to print out USD by crediting commercial banks with extra reserves ii) To balance the expanded liability due to money creation, the US Fed can add to the asset category of its balance sheet by purchasing either government bonds from treasury department or toxic assets from commercial banks iii) In Hong Kong, HKMA has the sole sovereignty to print out HKD by crediting note issuing banks with extra certificates of indebtedness

A) i) and ii) only B) i) and iii) only C) ii) and iii) only D) none of the above

5. Which of the following is/are correct about moral hazard and adverse selection when it comes to deposit insurance?
i) Moral hazard is when those without prudent banking practices will choose to be insured whereas those who are strong will choose not to be insured. ii) Adverse selection is when the insured bank takes on more risk at the presence of deposit insurance than when there is no insurance. iii) An effective way to deal with moral hazard is to make deposit insurance mandatory to all banks.

A) i) and ii) only B) i) and iii) only C) ii) and iii) only D) none of the above

6. Under Basel II agreement, which of the following does NOT belong to Tier I capital for bank?
A) Common stock B) Qualifying subordinated debts C) Retained earning

D) Preferred stock

7. According to Basel II agreement, the minimum of Tier I capital is 4% of the risk-weighted bank assets. Consider bank A whose assets consist of i) AAA rated debt of $1 million with a risk weight of 20%; ii) CCC+ rated debt of $2 million with a risk weight of 150%. The minimum Tier I capital required for bank A is
A) $0.2 million B) $3.2 million C) $0.128 million D) $0.256 million

8. An Offshore banking center is A) a country whose banking system is organized to permit external accounts beyond the normal economic activity of the county. B) is external to any government, frequently located on old oil drilling platforms located in international waters. C) a country like North Korea D) none of the above

9. Suppose you enter into the long position of a Eurodollar interest rate futures with the futures price of 96. At the expiration date of the futures contract, the spot rate of the three month LIBOR is 6%. What is your profit/loss from holding this futures position?
A) you lose $50 B) you gain $50 C) you lose $5,000 D) you gain $5,000

10. Which of the following is true about forward and the futures contracts?
i) both forward and futures contracts specify today a certain amount of the underlying at a certain price which is to be transacted at some future date

ii) both forward and futures contracts are marked-to-market on a daily basis iii) both forward and futures contracts have standardized contract size and maturity date

A) i) and ii) B) i) and iii) C) ii) and iii) D) none of A), B) or C) is correct

11. Consider both a call option and a put option written on euro. When the euro exchange rate becomes less volatile, which of the following statements is correct?
A) the call option becomes cheaper whereas the put option becomes more expensive B) the put option becomes cheaper whereas the call option becomes more expensive C) both the call and the put become cheaper D) both the call and the put become more expensive.

12. Consider a put futures option written on one euro futures contract, and each euro futures contract is written on 12,500. Suppose the option premium and the strike price are $0.15/ and $1.5/, respectively. At expiration of the option contract, the spot and the futures exchange rate are 1.405$/ and 1.4$/, respectively. The total profit/loss for the option writer is thus
A) $1875 B) $687.5 C) $625 D) $-625

Questions 13-17 are quantitative problems: you need to show both the final results and the procedure with which you obtain the final results.

13. (6pts) Assume todays settlement price on a CME EUR futures contract is $1.3140/EUR. You have a short position in one contract, and the contract size is EUR125,000. Your margin account currently has a balance of $1,700, and the maintenance performance bond level is $1000. Suppose the next three days settlement prices are $1.3126, $1.3133, and $1.3049. Calculate the balance of your performance bond account from daily marking-to-market for each of the next three days

14. (8pts) Suppose today the (annualized) interest rates on USD and AUD are 0% and 4%, respectively, and the exchange rate is $1/AU$. Consider the following two strategies. In strategy A, you borrow one million USD and use the proceeds to buy one million AUD. In strategy B, you long a one-year forward contract which is written on one million AUD. The investment horizon is one year and interests are only paid at the end of the one-year horizon. Suppose the exchange rate changes to $1.1/AU$ in one year.
a) (2 points) Calculate your profit/loss (quoted in USD) from strategy A.

b) (3 points) Calculate your profit/loss (quoted in USD) from strategy B. (Hint: first determine the forward rate using the strict form of IRP)

c) (3 points) Repeat b) when a forward contract is written on AUD 1,000,000/F instead, where F denotes the forward exchange rate calculated in b). Compare your result with that in a): what conclusion can you draw?

15. (10 pts)

Use the European option pricing formula to find the value of a six-

month at-the-money (ATM) call option on Japanese yen. The strike price is $1 = 100. The volatility is 25 percent per annum; r$ = 5.5% and r = 6%. (please round the numbers in the final results to three significant digits only) (hint: convert all exchange rates in American terms before using the Black-Scholes formula)

16. (10.5 pts) Suppose firm A can issue fixed-rate debt of the same maturity at 10.3% or floating-rate debt at LIBOR+0.5%. Firm B can issue fixed-rate debt at 9.3% or floating-rate debt at LIBOR+0.3%. A Fixed Floating 10.3% LIBOR+0.5% B 9.3% LIBOR+0.3%

Suppose that A prefers to issue fixed-rate debt whereas B prefers to issue floating-rate debt. If you were an investment banker, how could you arrange an interest rate swap between A and B to make everybody happy? Write in the figure the cash flows with arrows to describe your answers. In addition, compute the net borrowing position for both firms and the percentage returns for the international banker. (Hint: you may use the following numbers: 9.7%, 9.6%, LIBOR+0.1%, and LIBOR+0.2%)

Investment banker

Market/public

17. (8 pts) Suppose you buy a call option with C0 =$0.03/ and X = $1.5/, and buy a put option with P0 =$0.02/ and X = $1.5/ at the same time. Both options are written on pounds and will expire in one year. In addition, suppose that contract sizes are 1m
a) (3.5 pts) draw the profit profile on this portfolio one year later b) (1.5 pt each) what is your profit (loss) when the pound exchange rate one year later is i) $1.5/; ii) $1.6/; iii) $1.3/