MPE707

International Banking and Finance

DEAKIN UNIVERSITY
FACULTY OF BUSINESS AND LAW

MPE707 INTERNATIONAL BANKING AND FINANCE

Trimester 1 2016
(Duration of exam: 2 hours)

Instructions to candidates:

1. This is a closed book exam. Candidates may bring a calculator to the examination.

2. Assessment:

This paper: 60%

Work completed during the trimester: 40%

Total: 100%

3. This paper consists of two sections: Section A and Section B.

All problems and questions in Sections A and B carry equal marks.

Section A consists of two (2) numerical problems.

Section B consists of two (2) descriptive questions.

4. Students are required to attempt all problems and questions.

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 MPE707 International Banking and Finance

SECTION A

This section consists of two problems carrying equal marks. Please answer all problems.
Please show all calculations and relevant steps for solving the problems.

Problem 1

(a) [7.5 marks] Using the double-entry accounting system, show how the following
transactions will generate credits and debits in the Australian Balance of Payments (BoP)
accounts. Please specify clearly which category (and sub-category) within the BoP accounts
each credit or debit will appear. For example, a debit can appear in the Current Account, sub-
category Goods.
(i) A permanent migrant to Australia from India brings Indian rupee funds in the form of a
check drawn on an Indian bank. The check is deposited with a bank in Sydney in exchange
for AUD 25,000.
Funds inflow: Credit in the Capital and Financial Account, sub-category capital transfers.
Check deposit: Debit in the Capital and Financial Account, sub-category other investment.

Notes: Funds inflow gives rise to credit in the Capital and Financial Account. The check
deposit increases foreign assets, which gives rise to debit in the Capital and Financial
Account (this explanation is not required but could well support the answer).

(ii) An Australian resident receives dividends on shares from a firm in the United States. The
dividends are deposited in a bank in New York.
Dividend income: Credit in the Current Account, sub-category primary income.
Change in deposits: Debit in the Capital and Financial Account, sub-category other
investment.

Notes: Dividend income from overseas gives rise to credit in the Current Account, whereas
the increase in foreign assets gives rise to debit in the Capital and Financial Account (this
note could be used to supplement the answer but is not required).

(iii) An Australian firm exports mining products to China. The Chinese importer pays the
Australian firm using deposits it has at a bank in Melbourne.

Exports of mining products: Credit in the Current Account, sub-category goods.

Change in deposits: Debit in the Capital and Financial Account, sub-category other
investment.

Notes: Export of mining products gives rise to credit in the Current Account, whereas the
reduction in liabilities to foreigners gives rise to debit in the Capital and Financial Account
(this note could be used to supplement the answer but is not required).

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 MPE707 International Banking and Finance

(b) [7.5 marks] A trader receives the following quotes for the Australian dollar (AUD),
Singapore dollar (SGD), and the British pound (GBP):

S(SGD/AUD) 1.0250

S(AUD/GBP) 1.6825

S(SGD/GBP) 1.7150

(i) Does the trader have a three-point arbitrage opportunity based on these quotes? If so, what
is the profitable sequence? If the trader has access to AUD 500,000 available for this purpose,
how much profit will he make?
*(*+,/+-.)
The no-arbitrage condition is S(SGD/AUD) = .
*(/0,/+-.)
Check the no-arbitrage condition:
7.879:
1.0250 = 1.0250 = 1.0193, this is not true. Hence:
7.;<=9

*(*+,/+-.)
S(SGD/AUD) .
*(/0,/+-.)

there is a possibility for three point arbitrage.

*(*+,/+-.)
We have that: 1.0250 = S(SGD/AUD) > = 1.0193.
*(/0,/+-.)

The profitable sequence is: SGDGBPAUDSGD.

Convert AUD500,000 into SGD512,500.

Convert SGD512,500 into GBP298,833.82.

Convert GBP298,833.82 into AUD502,787.90.

The profit is AUD502,787.90- AUD500,000=AUD2,787.90.

(ii) How do the three exchange rates as mentioned above change as a result of arbitrage?

Demand to sell AUD, buy SGD exchange rate S(AUD/SGD) increases.

Demand to sell SGD, buy GBP exchange rate S(SGD/GBP) increases.

Demand to sell GBP, buy AUD exchange rate S(GBP/AUD) increases.

Conclusion: S(SGD/AUD) decreases, S(AUD/GBP) decreases, and S(SGD/GBP) increases.

Notes: accept appropriate rounding of figures.

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 MPE707 International Banking and Finance

Problem 2

(a) [5 marks] A speculator holds (or buys) a call option on the Euro (EUR) at an exercise
exchange rate (or strike price) of 1.1125 (USD/EUR). The size of the option contract is EUR
125,000. The premium is USD 0.002 per EUR. Ignore all interest rates.

(i) At which spot exchange rate on the expiration date will the speculator break even?

The speculator will break even if

D = H

where is the strike price, D is the exchange rate at expiration, and H is the premium.
Hence, we have D = + H = 1.1125 + 0.002 = 0.1145.

(ii) Assume that the spot exchange rate on the expiration date is 1.1200 (USD/EUR).
Calculate the value of the call option and the speculators net profit/loss?

Since D > 0, the value of the call option is D = 0.0075 per EUR, or USD
937.50 for the contract.

Since D > 0, the speculator will exercise the option and obtains a net profit

D H = 1.1200 1.1125 0.002 = 0.0055 per EUR or USD 687.50 for the
contract.

(b) [10 marks] A foreign exchange trader obtains the following information for the Canadian
dollar (CAD) and the USD:

Spot exchange rate (CAD/USD) 1.1125

Three-month forward exchange rate (CAD/USD) 1.1215

Three-month interest rate in the United States 2% per annum

Three-month interest rate in Canada 4% per annum

(i) Does Covered Interest Parity (CIP) hold?

Assume that Canada is the domestic country and United States is the foreign country.

The CIP condition is (1+O )=(F/S)(1+P ), where:

- O =4% p.a. = 1% for three months is the Canadian interest rate.

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 MPE707 International Banking and Finance

- P =2% p.a. = 0.5% for three months is the U.S. interest rate.

(1+O )= 1.01.

(F/S)(1+P )=1.0131.

Hence, (1+O )<(F/S)(1+P ), the CIP condition is violated.

(ii) If CIP does not hold, clearly outline the steps the trader would follow in order to make
arbitrage profits in this situation and calculate the profit assuming the trader has access to
CAD 500,000.

To make arbitrage profit, the trader can borrow CAD to invest in USD. The steps are:

- Borrow CAD500,000 at interest rate 1% for three months.

- Convert at the spot rate to obtain CAD500,000/1.1125=USD449,438.20.
- Invest USD449,438.20 at interest rate 0.5% for three months. At maturity, get
USD449,438.20.*1.005=USD451,685.39.
- Sell USD451,685.39 forward to obtain CAD506,565.17.

The repayment is CAD505,000. Hence, the profit is CAD1,565.17.

(iii) Assume that the expected inflation rate in Canada over the next three months is 1% (that
is the price level in Canada is expected to rise by 1% over the next three months). If
Purchasing Power Parity (PPP), Uncovered Interest Parity (UIP), and Real Interest Parity
(RIP) hold, what would you expect the inflation rate in the United States to be over the next
three months?

According to RIP:

OH = O OH =P PH = PH

Where OH and PH are the expected inflation rate in Canada and the U.S, respectively.

Hence, PH = P (O OH )=0.5%-(1%-1%)=0.5%.

The expected inflation rate in the U.S. is 0.5% over the next three months.

Notes: accept appropriate rounding of figures.

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 MPE707 International Banking and Finance

SECTION B
This section consists of two questions carrying equal marks. Please answer all questions.
Where possible, please support your answer with graphs.

Question 1

An online news item carried by the Sydney Morning Herald on 14 April 2015 reported the
following:

Poor Chinese trade data has sent the Australian dollar plummeting in afternoon trade on
the currency markets, taking the currency close to a fresh six-year low. The Aussie went
from US76.7 (i.e., USD 0.7670) at noon to a tad below US76 just after the release of
the data.

Chinese exports were the sore point. In yuan terms, they unexpectedly fell 14.6 per cent
from a year ago in March, against expectations of an 8.2 per cent gain. Chinese imports
were only slightly worse than expectations. In yuan terms, they fell 12.3 per cent from a
year ago despite predictions for an 11.3 per cent fall. The monthly trade balance was
18.16 billion yuan; positive, but the smallest in a 13-month string of surpluses.

(a) [7.5 marks] Using a demand-supply model of exchange rate determination, explain why
the news of poor Chinese trade data as above would lead to an immediate depreciation of the
Australian dollar.

China is a major importer of Australian products. A reduction in Chinas import would imply
a reduction in Australias export and thus the demand for Australian products. A lower
demand for Australian products decreases the demand for AUD. Expectation of the
continuation of this trend (given that Chinese import was worse than expectation) may also
work to decrease the demand for AUD.

Speculative forces make the change in exchange rates AUD/USD immediate following the
news of Chinas trade, as speculators sell AUD and buy other currencies such as USD.

In terms of graph, horizontal/vertical axis and the demand/supply curve must be clearly
labelled, and the following explanations should accompany:

(In the following we assume that the horizontal axis measures quantity of USD and the
vertical axis measures AUD/USD. Students can assume that the horizontal axis measures
quantity of AUD and the vertical axis USD/AUD to generate the answers.)

- The supply curve shifts to the left from S to S (because of a fall in demand for AUD which
means a fall in supply of USD due to news of poor Chinas trade and maybe expectation of
the continuation of the trend.

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 MPE707 International Banking and Finance

- The demand curve shifts to the right from D to D (because of speculative forces and
expectation).

- The equilibrium exchange rate goes up from : to 7 (meaning a depreciation of AUD).

A good structure and presentation of the answer is required.

(AUD/USD)

S S

D D

Quantity of USD

need to mention expectation of trend of Chinas trade. But certainly this is

Notes: There is no
a good point to enrich the answer (without this point students can still get a full score if the
explanation is good enough).

(b) [7.5 marks] Suppose that to support the Australian dollar, the Reserve Bank of Australia
(RBA) undertook a sterilized intervention of the size AUD 500 million. Using the balance
sheet of RBA, explain how such a sterilized intervention would take place. What would be
the outcomes of the intervention?

RBA would have to buy AUD, sell foreign currencies (say, USD) when it undertakes
intervention in the FX market to support the value of the AUD.

For the balance sheet of RBA, the following will appear as a result (students must draw the
balance sheet of RBA by assuming initial value for NFA, NDA, ML, and NW as per topic 4
slides notes numbers can be different):

Intervention: NFA decreases by AUD 500 million; ML decreases by AUD 500

million.

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 MPE707 International Banking and Finance

Sterilization: NDA increases by AUD 500 million; ML increases by AUD 500

million.
Outcomes: S(AUD/USD) decreases (an appreciation of the AUD), RBA holds less
foreign assets and more domestic assets, the public holds more foreign assets and less
domestic assets, and money supply is unchanged.

A good structure/presentation of the answer is required, where the balance sheet must be
consistent with theory, i.e. the sum of assets must equal the sum of liabilities.

Question 2

(a) [7.5 marks] How does direct finance differ from indirect finance? Explain the roles of
international banks through direct and indirect finance.

Differences between direct and indirect finance:

A surplus unit (deficit unit) is an economic unit with total revenue exceeding (falling below)
total expenditure. Under direct finance funds are transferred directly from surplus units to
deficit units, whereas under indirect finance funds are transferred from surplus units to deficit
units through financial intermediaries.

Roles of international banks through direct finance:

Under direct finance, international banks arrange bond issues for their clients (often
Eurobonds) and provide the services through their brokers and underwriters.

Roles of international banks through indirect finance:

Under indirect finance, by functioning as financial intermediaries, international banks create

the following: credit risk intermediation (risk is passed on to banks from surplus units),
maturity intermediation (loans can be made in different maturities fitting customers need),
size/interest rate intermediation (interest rates and sizes change when funds go from one bank
to another) and currency intermediation (lending in different currencies).

(b) [7.5 marks] Define the following concepts. You can use examples to support your
answer:

(i) Indirect quote.

It is an exchange rate quotation method that gives us the price (or value) of one unit of the
domestic currency in terms of foreign currencies.

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 MPE707 International Banking and Finance

(ii) Special Drawing Rights (SDR).

It is the reserve asset created by the International Monetary Fund (IMF). It is priced against a
basket of currencies.

(iii) Gold points (in the Gold Standard).

These are the upper and lower limits within which the exchange rate between two currencies
can fluctuate under the Gold Standard.

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