Question

1. In the context of investments in securities (stocks and bonds), portfolio risk

diversification refers to (2 points)

A. the time-honored adage "Don't put all your eggs in one basket".

B. investors' ability to reduce portfolio risk by holding securities that are less than perfectly positively correlated.

C. the fact that the less correlated the securities in a portfolio, the lower the portfolio risk.

D. all of the above

2. The following questions are based on the case provided below

Able Inc. and Baker Inc. face the following borrowing costs in the fixed and floating rate markets:

__Fixed‑Rate Market__ __Floating Rate Market__

Baker T + 1. 90% L + 0.20%

Able T + 0.75% L ‑ 0.15%

**Each firm desires the rate other than that for which it has comparative advantage.**

A dealer stands ready to enter into a swap as either a fixed‑rate payer or floating-rate receiver (or vice versa). The dealer will pay a fixed T+1.22% against LIBOR or receive T+1.30% against LIBOR. Assume that each firm borrows in the market in which it has __comparative advantage__ and enters into a swap agreement. Analyze the potential gains from swapping for all parties under the following headlines:

a. What does the swap dealer earn? (2 point)

Answer D

b. Obtain the effective loan rate for Able. List all loans Able deals with. (4 points)

Aer

c. By how much is Baker better-off from the swap agreement? (6 points)

d. What is the overall benefit of the three parties: Able, Baker and the Dealer? (2 points)

3. Volusia, Inc. is a U.S.-based firm that expects to receive payment from its Canadian customers and delivery payment to its German suppliers. Based on today's spot rates, the dollar value of the funds of Canadian dollars received is estimated at $200,000, and the dollar value of the funds of Euros paid is estimated at $300,000. Based on data for the last fifty months, Volusia estimates the standard deviation of monthly percentage changes to be 7 percent for the euro and 4 percent for the Canadian dollar. The correlation coefficient between the euro and the Canadian dollar is -0.30. (8 points)

4. Based on the information in the table below, what is the proper financial hedging strategy with forwards? (10 points)

*State*

*Probability*

*P**

*S*

*1*

1/3

€900

$1.35/€

*2*

1/3

€1,000

$1.50/€

*3*

1/3

€1,100

$1.65/€

We sell €_________ forward at the 1-year forward rate of ________

a. $ net cash flow when the French assets is worth €900, and the exchange rate is $1.35/€ (2 points)

b. $ net cash flow when the French assets is worth €1,000, and the exchange rate is $1.50/€ (2 points)

c. $ net cash flow when the French assets is worth €1,100, and the exchange rate is $1.65/€ (2 points)

5. A project in France yields a series of Euro cash flows as the following:

Please solve for the project IRR in Euros (4 points)

Solve for the equivalent USD IRR. The exchange rate of Euro today is $1.25 per Euro. The inflation rate in the euro zone is p_{€} = 3%, the inflation rate in dollars is p_{$}* = *6%. Assume that international fisher effect and purchasing power parity holds. (6 points)

6. Boeing imported a Rolls-Royce jet engine for £5 mil payable in one year (10 points)

· The US interest rate 6.00% per annum

· The UK interest rate 6.50% per annum

· The Spot exchange rate $ 1.80/£ today

How to utilize the money market tools to hedge the risk of pound exchange one year later? In particular, answer which loan (US or UK) to borrow and to lend? How much is the dollar cost one year later (a number you would know today)?

7. Based on the table below (Decomposition of the Variance of International Security Returns in USD), please tell which international security is the safest investment when converted to USD? Which international security has the highest risk in the exchange rate? Which security has the lowest risk when measured in local currency? Note Ri denotes the return in local currency, Ri$ denotes the return in USD; ei denotes the change of exchange risk

8. Please list at least 3 types of investment instruments for international diversification and briefly describe the difference among them. (5points)

9. The mean and standard deviation (SD) of monthly returns, over a given period of time, for the stock markets of two countries, X and Y are (4 points)

Assuming that the monthly risk-free interest rate is 0.25%, the Sharpe performance measures, SHP(X) and SHP(Y), and the performance ranks, respectively, for X and Y are:

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