MOCK EXAM May 2010

Please answer only 3 questions. Notice that where descriptive answers are asked, these are only meant to provide a guidance, you are not expected to replicate them exactly.

1)
The following are the Balance of Payments records for Australia:
In millions of AU$ Balance of Trade Services Balance Balance of Goods & Services Net income Current transfers Current Account Capital Account Financial Account Net errors and omissions Official Reserves 2000 2001 2008

12,955 -1,396

182 -22,273 1,027 765

19,346 19,750 -48,780 -4,407 -4,408 -5,608 1,053 -1,118 -2,622 1,075 2,167

344 1,238 -8,880 44,292

a) Complete the table b) Explain the meaning of each entry in the above table. c) What are the likely economic explanations for the figures recorded at the end of 2008? d) Knowing that the current account deficit as a ratio to GDP was 2.4% in 2000, 2.8% in 2001 and 6.5% in 2008, do you think this trend is sustainable given that Australia was hit by the global recession immediately thereafter?

ANSWER
a) Balance on goods and services: -14 351; 1 209;-21 508. Obtained by summing the balance of trade in goods with the services balance. The current account balance are: -33,479; -18,496; -70,632. Obtained by summing through the balance of goods and services + net income + current transfers The total of the Balance of Payments must be zero, which means that current account + capital account + financial account + errors and omissions +official reserves=0 The value of the financial account is found therefore by calculating:

financial account = current account-capital account- official reserves -errors and omissions Therefore for 2000 the financial account =33,479-1,053+1,118+2,622=36,166 For 2001 is 25,957; and for 2008 is 22,935 b) The Balance of Trade refers to the difference between what Australia receives for exports (credits, or receipts for goods sold overseas) and what is paid for imports (debits, payments for goods purchased from overseas). When export credits are more than import debits a surplus exists, or, if export credits are less than import debits, a deficit occurs. Although 2001 shows a positive small value, we can see that both in 2000 and in 2008 Australia has a large balance of trade deficit, particularly in 2008, we can therefore assume that over time this situation is getting worse. The services balance involves the balance of service exports and imports such as tourism, education, insurance, shipping and finance. Services imported are debits and services exported are credits. This over time has improved, particularly between 2000 and 2001, going from a deficit to a surplus, and remaining a surplus (although) smaller also in 2008. It means that Australia has become more competitive in the provision of international services. Net income refers to the income received from Australian owned assets overseas (credits) less any payment of income to overseas on foreign owned assets in Australia (debits). These include interest payments on borrowings of the private (companies), and public (government) sectors and the return on investments in the form of rent, profits and dividends. It is clear that here debits are bigger than credits for all three periods, meaning that Australia is paying more income abroad than what it receives. Net current transfers refer to unearned payments and receipts of money used for short-term purposes. A net current transfer occurs when no specific good or service has been supplied. This includes foreign aid to developing countries in the form of money for food or famine relief (if these funds are being used for capital investment they will be included in the capital and financial account), insurance claims and pensions. This item is also steadily negative. Then we have balance on current account = balance on goods and services + net income + net current transfers. The capital account contains the following components. Capital transfers brought in by permanent migrants coming to Australia; capital transfers of foreign aid to help build developing countries infrastructure, such as roads and clean water; entries for the purchase and sale of non-produced, nonfinancial assets such as the sale of patents, copyrights, trademarks, intellectual property rights and franchises (eg.from American companies such as Burger King). The capital account is usually small in relation to the financial account, and in the case of Australia it shows a persistent surplus. The major items in the financial account are outlined as follows: Direct investment includes the purchase or sale of assets or the takeover of companies (more than 10% of share acquisition) overseas and in Australia. Portfolio Investment is the purchase and sale of land, shares, debentures and other securities between Australian and foreign individuals and companies. This is the largest item in the capital and financial account.

Financial derivatives such as futures contracts and forward contracts. Other investments, including non-tradable loans and deposits with banks, and trade credit provided by businesses to their customers. Australia shows a positive balance on the financial account, although it appears that the trend is indicating a progressive reduction. Official reserves include the Reserve Bank of Australias holdings of foreign currencies, gold and special drawing Rights (SDRs) position with the International Monetary Fund. Finally, net errors and omissions refer to statistical adjustments to allow the capital and financial account, and the current account and official reserves to total under a floating exchange rate system. Under a floating exchange rate system in fact the official reserves should fluctuate around zero, as it appears in the case of Australia. It is important to understand that the deficit indicated by the current account is financed through activities recorded on the capital and financial account, or the official reserves. The deficit on the current account must be exactly offset by the surplus on the capital and financial account, and reserves (if it is not, net errors and omissions will correct it). c) Historically Australia has recorded large CADs which have had implications for foreign investors. The net income deficit is the major factor behind the current account deficits Australia has experienced over the years. These CADs have led to an increase in net foreign liabilities (debt and equity), largely the outcome of private sector transactions rather than actions by the public sector (government). By 2008 the Current Account Deficit had grown substantially. Since the CAD corresponded, in early 2008, to 6.5% of GDP, many economists believed that in this situation the CAD to GDP ratio was too high and becoming unsustainable. Others believed that this deficit in the current account is the result of rational decisions made by businesses in the pursuit of profit and so is not of such concern. The CAD rose in 2008 because the economy was booming and consumers were increasing their purchase of imported goods. d) However, the global financial crisis caused economic growth to slow down, imports fell and the current account fell rapidly. By the end of 2009 the Current Account Deficit (CAD) had fallen to around 3.4 % of GDP (no need to know this ratio!) which means that the trend has been interrupted thanks to the recession. However it remains to be seen whether the recovery will lead to further increases of CADs, a problem which has been common among many industrialized economies like the UK and the US, mainly due to the rise of Chinas power as a producing and exporting country. Something which doesnt seem to be reversible.

2)

Use the following spot and forward bid-ask rates for the Japanese yen/U.S. dollar (/ $) exchange rate to answer the following questions: Period spot 1 month 2 months 3 months 6 months 12 months 24 months /$ Bid Rate 114.23 113.82 113.49 113.05 112.05 110.20 106.83 /$ Ask Rate 114.27 113.87 113.52 113.11 112.11 110.27 106.98

a) Can you tell for which maturities the yen is at premium (and the dollar is at discount) and for which maturities the yen is at discount (hence the dollar is at premium) without calculating the forward rates? b) Using the formulae to calculate the forward bid-ask exchange rates, and assuming that no arbitrage is possible, calculate the bid-ask interest rates on a eurodollar deposit at 12 months maturity knowing that the bid-ask oneyear rates of interest on a euroyen are 12/5 141/100 ANSWER a) Exchange rates /$. The dollar is the reference currency
forward bid rate - spot forward ask rate - spot difference between the bid rate ask rate two 0.41 0.74 1.18 2.18 4.03 7.40 0.40 0.75 1.16 2.16 4.00 7.29 0.01 0.01 0.02 0.02 0.03 0.11 dollar at premium, yen at discount dollar at discount, yen at premium dollar at premium, yen at discount dollar at premium, yen at discount dollar at premium, yen at discount dollar at premium, yen at discount

If [Fb - Sb ] < [Fa-Sa], reference currency at a premium (the difference is negative)

If [Fb-Sb ] > [Fa - Sa], reference currency at a discount (the difference is positive) b)
bid Spot /$ 114.23 12-month forward 110.2 Interest on euroyen 1.4 ask 114.27 110.27 1.41

Using the formula for the forward bid exchange rate (assuming 1-year period) Fb / $ = Sb (1 + ib ) $ 1 + ia

Then we can obtain the ask interest on a Eurodollar: Ask interest rate on euro-dollar = (114.23 x 0.014/110.2)-1 = 0.051082 Given the forward ask exchange rate formula (assuming 1-year period) Fa / $ = Sa (1 + ia ) $ 1 + ib

Then we can obtain the bid interest on a Eurodollar: Bid interest rate on euro-dollar = (114.27 x 0.0141/110.27)-1 = 0.050886

3)
The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In January 2002 the Argentine peso was floated. On January 29, 2003 it was trading at Ps3.20/$. During that one year period Argentina's inflation rate was 20% on an annualized basis. Inflation in the United States during that same period was 2.2% annualized. a) What should have been the exchange rate in January 2003 if PPP held? b) By what percentage was the Argentine peso undervalued? c) What were the probable causes of undervaluation?

ANSWER
We calculate the PPP exchange rate taking into account the rate of inflation in Argentine and the US: a) Ps1/$ x 1.20 / 1.022 = Ps1.1742/$ PPP exchange rate b) Actual exchange rate (Ps/$) 3.20 PPP exchange rate (Ps/$) 1.1742 % undervaluation = (PPP exchange rate actual rate) / actual rate

(1.1742 3.20)/3.20 = 0.63307 Hence 63.307% c) The rapid decline in the value of the Argentine peso was a result of not only inflation, but also a severe crisis in the balance of payments

4)
A speculator is considering the purchase of five three-month Japanese yen call options with a striking price of 96 cents per 100 yen. The premium is 1.35 cents per 100 yen. The spot price is 95.28 cents per 100 yen and the 90-day forward rate is 95.71 cents. The speculator believes the yen will appreciate to $1.00 per 100 yen over the next three months. As the speculators assistant, you have been asked: a) Determine the speculators profit if the yen appreciates to $1.00/100 yen. b) Determine the speculators profit if the yen only appreciates to the forward rate. c) Determine the future spot price at which the speculator will only break even. d) What is the theoretical maximum gain that the above call option can generate? ANSWER a) In the spot market the speculator needs 100 cents to buy 100. Thanks to the call option she
can buy the same amount of yen at 96 cents (the exercise price E), bought she saves [(100 - 96) 1.35] = 2.65 cents. The gain made for each 100 yen is therefore 2.65 cents. The total amount of yen that the speculator wants to buy is (5 x 6,250,000). It follows that the gain on the total amount is [(5 x 6,250,000)/100]*[2.65]= 828,125 cents. therefore for each 100

b) Since the option expires out-of-the-money, the speculator will let the option expire worthless.
She will only lose the option premium.

c) 96 + 1.35 = 97.35 cents per 100 yen

d) There is unlimited upside potential gain.

5)
a) Explain the concepts of credit risk and repricing risk. b) Define what is a fixed-for-floating interest rate swap and explain how they are employed in financial markets. c) What is the necessary condition for a fixed-for-floating interest rate swap to be possible? d) Xerox and Unilever Companies can borrow for a five-year term at the following rates:

S&Ps credit rating Fixed-rate borrowing cost Floating-rate borrowing cost

Xerox AA 8.5% LIBOR

Unilever BAA 10.0% LIBOR + 1%

Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixedrate debt. No swap bank is involved in this transaction. e) Assume now that a swap bank is involved as a intermediary. Briefly describe how this would change the cost savings in the borrowing costs of both Xerox and Unilever Companies.

ANSWER
a) Credit risk, sometimes termed roll-over risk, is the possibility that a borrowers creditworthiness, at the time of renewing a credit, is reclassified by the lender. This can result in changing fees, changing interest rates, altered credit lines commitments, or even denial. Repricing risk is the risk of changes in interest rates charged (earned) at the time a financial contracts rate is reset. b) In interest rate swap financing, two parties, called counterparties, make a contractual agreement to exchange cash flow at periodic intervals. In a fixed-for-floating interest rate swap (or Plain Vanilla Swap) one counterparty exchange the interest payments of a floating-rate debt obligation for a fixed-interest rate payments of the other counterparty. Both debt obligations are denominated in the same currency. Some reasons for using an interest rate swap are to better match cash inflows and outflows, and to obtain cost saving. The cost saving originates from the fact that the different credit rating of the counterparties involved in the swap transaction. This makes possible for the counterparties to gain from entering a swap contract. Ideally, the cost advantage of interest rate swaps would likely be arbitraged away in competitive markets. However, even in this case there are some other explanations which can explain the development of the interest rate swap market. One possible explanation is that all types of debt instruments are not always available to all borrowers. Interest rate swaps can assist in market completeness. That is, a borrower may use a swap to get out of one type of financing and to obtain a more desirable type of credit that is more suitable for its asset maturity structure. An important role in swap contracts is played by the swap bank. The swap bank acts as a swap broker or as a swap dealer. A swap broker arranges a swap between two counterparties for a fee without taking a risk position in the swap. A swap dealer is a market maker of swaps and assumes a risk position in matching opposite sides of a swap and in assuring that each counterparty fulfils its contractual obligation to the other.

c) For a fixed-for-floating interest rate swap to be possible it is necessary for a quality spread differential to exist. The QSD is the difference between the default-risk premium differential on the fixed-rate debt and the default-risk premium differential on the floating-rate debt. In general, the default-risk premium of the fixed-rate debt will be larger than the default-risk premium of the floating-rate debt. In this case the QSD = (10.0% - 8.5%) minus (LIBOR + 1% - LIBOR) = 0.5%. d) Xerox needs to issue fixed-rate debt at 8.5% and Unilever needs to issue floating ratedebt at LIBOR + 1%. Xerox has an absolute advantage in both fixed and floating rates, but decides to go for the fixed rate because this is where lies its competitive advantage, given that the default-risk premium differential on the fixed-rate debt is higher. Xerox needs to pay LIBOR to Unilever. Unilever needs to pay 8.75% to Xerox. If this is done, Xeroxs floating-rate all-in-cost is: 8.5% + LIBOR - 8.75% = LIBOR - .25%, a . 25% savings over issuing floating-rate debt on its own. Unilevers fixed-rate all-in-cost is: LIBOR+ 1% + 8.75% - LIBOR = 9.75%, a .25% savings over issuing fixed-rate debt. e). When a swap bank is involved as a intermediary then cost savings of Xerox and Unilever Companies will diminish as the potential saving (quantified by the QSD) must be shared among Xerox, Unilever and the swap bank. The swap bank, in fact, requires a reward (a positive margin) for its activity of intermediation (remember that the swap bank can act either as a dealer or as a broker). How the QSD is shared among the three parties depends on how the swap contract is arranged by the parties.

6)
Mattel is a U.S.-based company whose sales are roughly two-thirds in dollars (Asia and the Americas) and one-third in euros (Europe). In September Mattel delivers a large shipment of toys (primarily Barbies and Hot Wheels) to a major distributor in Antwerp. The receivable, 30 million, is due in 90 days, standard terms for the toy industry in Europe. Mattels treasury team has collected the following currency and market quotes. The companys foreign exchange advisors believe the euro will be at about $1.4200/ in 90 days. Mattels management does not use currency options in currency risk management activities. Advise Mattel on which hedging alternative is probably preferable.
90-day A/R () Current spot rate ($/) Credit Suisse 90-day forward rate ($/) Barclays 90-day forward rate ($/) Expected spot rate in 90 days ($/) 90-day eurodollar interest rate 90-day euro interest rate Implied 90-day forward rate (calculated, $/) 90-day eurodollar borrowing rate 30,000,000.00 $1.4158 $1.4172 $1.4195 $1.4200 4.000% 3.885% $1.4162 5.000%

90-day euro borrowing rate Mattel Toys weighted average cost of capital ($)

5.000% 9.600%

ANSWER
Hedging Alternatives 1. Remain Uncovered, settling A/R in 90 days at market rate (20 million euros / future spot rate) If spot rate in 90 days is same as current If spot rate in 90 days is same as Credit Suisse forward rate If spot rate in 90 days is same as Barclays forward rate If spot rate in 90 days is expected spot rate 2. Sell euros forward 90 days Settlement amount at Credit Suisse forward rate Settlement amount at Barclays forward rate 3. Money Market Hedge Principal A/R in euros discount factor for euro borrowing rate for 90 days Borrow euros against 90-day A/R Current spot rate, $/euro US dollar current value Mattel's WACC carry-forward factor for 90 days Future value of money market hedge Evaluation of Alternatives The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate (carry-forward rate). 0 $42,956,420.74 7 29,629,629.63 $1.4158 $41,949,629.63 1.024 1 + (.0960 x 90/360) Certain 30,000,000.00 0.987 1/(1 + (.05 x 90/360)) $42,516,000.00 $42,585,000.00 Certain Certain $42,474,000.00 $42,516,000.00 $42,585,000.00 $42,600,000.00 Risky Risky Risky Risky Values Risk Assessment