BUS 426_Exam 2 Study Guide

BUS 426_Exam 2 Study Guide - Parity Conditions:...

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Unformatted text preview: Parity Conditions: IRP(Interest Rate Parity) including covered interest arbitrage in the event that IRP does not hold. An arbitrage condition that must hold when international financial markets are in equilibrium. When IRP doesnt hold, the situation gives rise to covered interest arbitrage opportunities. CIA activities will increase the interest rate differential and at the same time, lower the forward premium/discount. IFE(International Fisher Effect) including uncovered interest arbitrage in the event that IFE/FEP does not hold. It is known as:E(e)=(i$-i)/ (1+i)~i$-i. It suggests that the nominal interest rate differential reflects the expected change in exchange rate. Fisher Effect- 1+nominal=(1+inflation)(1+real). FEP(Forward Expectations Parity)-When the international Fisher effect is combined with IRP (F-S)/S=($-i)/ (1+i),we obtain (F-S)/S=E(e). Forward parity states that any forward premium or discount is equal to the expected change in the exchange rate. When investors are risk-neutral, forward parity will hold as long as the foreign exchange market is informationally efficient. Otherwise, it need not hold even if the market is efficient. Options: (1)Definitions: Call- an option to buy an underlying asset at a specified price. The right, but not an obligation to BUY an asset at a pre-specified strike price. Put-an option to sell an underlying asset at a prespecified price. The right, but not an obligation to SELL an asset a a pre-specified strike price. American-allow the buyer to exercise at any time thru the expiration date/end of business. American owner can do everything he can do with a European option. European-these options can ONLY be exercised on the expiration date. (2)Payout maps(?) (3)Option valuation: the relation between input variables (standard deviation, spot exchange rate- price at which foreign exchange can be sold or purchased for immediate (within two business days) delivery , strike exchange rate, and US and foreign interest rates) and the value of a call- American call and put premiums will be at least as large as the immediate exercise value (intrinsic value) of the call or put option. A call option with St> E (E>St) is referred to as trading in the money. If St=E the option is trading at the money. If St<E(E<St) the call option is trading out of the money. The difference between the option premium and the options intrinsic value is nonnegative and sometimes referred to as the options time value. Hedging using forward markets-a method of hedging exchange risk exposure in which a foreign currency contract is sold or bought forward. money markets- an example is when the net cash flow is zero at the present time, implies that, apart from possible transaction costs, it is fully self-financing. A method of hedging transaction exposure by borrowing and lending in the domestic and foreign money markets. options Ex post gains or losses from using these hedging alternatives. Swaps; Why are they used and options Ex post gains or losses from using these hedging alternatives....
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BUS 426_Exam 2 Study Guide - Parity Conditions:...

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