Ch13Sols - 13-1CHAPTER 13: FOREIGN CURRENCY...

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Unformatted text preview: 13-1CHAPTER 13: FOREIGN CURRENCY DERIVATIVESEND-OF-CHAPTER QUESTIONS AND PROBLEMS1.The answer to this question is essentially the answer to the question of the difference between forward andfutures markets in general. The currency forward market is an informal network of large financial institutions that make forwardcommitments to buy and sell foreign currencies. There is no formal organization or rules and regulations.The contract terms and conditions are tailored to the needs of the two parties, and the contracts are notgenerally liquidated prior to expiration; that is, delivery is usually made on the commitments. As we haveemphasized throughout this book, any forward market is subject to default risk.The futures market is a formal organization operating within a futures exchange--the InternationalMonetary Market of the Chicago Mercantile Exchange. Futures contracts are standardized and can beeasily traded. Thus, holding until delivery is unnecessary, and most contracts are liquidated beforeexpiration. Of course, futures contracts are marked-to-market while forward contracts are not. 2.Both instruments can be used to hedge the risk of foreign currency fluctuations. Options, however, allowthe holder to choose not to execute the purchase or sale of the currency. This can be quite useful inhedging situations in which it is not known for certain whether the hedger will have a position in thecurrency. This type of contingency is often faced when bidding on contracts in foreign countries. If thebid is lost, the firm will not receive the currency; thus, if the firm uses a futures contract, it would finditself with an open position in the futures. This would not be a problem if the bid were won, because thenthe currency would be received and would offset the open position in the currency. The option allows thehedger either to let the option expire unexercised or to exercise it and dispose of the currency for a profit. The option hedge requires the payment of a premium up front, whereas the futures hedge requires only thesmall initial margin deposit but at the expense of giving up upside gains.3.The following relationship must hold:($/DM)(DM/SF)(SF/$) = 1This means that the price of German marks in dollars times the price of Swiss francs in German markstimes the price of dollars in Swiss francs should equal one. In this problem, to get the price of dollars inSwiss francs, we have to invert the Swiss franc exchange rate of $.4710. This gives 1/.4710, which is2.1231. That is, one dollar is worth 2.1231 Swiss francs. Then we plug the appropriate numbers into theequation(.3937)(1.21)(2.1231) = 1.0114It is impossible to determine which of the exchange rates is mispriced, and it does not really matter, butwe do need to make an assumption in order to identify the appropriate arbitrage. Suppose we assume thatthe ratio of Swiss francs to one dollar is too high, i.e., it should be less than 2.1231. The Swiss franc isundervalued relative to the dollar. This means that we need to convert a dollar to another currency,...
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Ch13Sols - 13-1CHAPTER 13: FOREIGN CURRENCY...

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