Chapter 22 Solutions
1.
Exchange Rate Risk - the gain or loss experienced by an investor in foreign
securities due to changes in the value of currencies.
Segmented Markets - markets which are isolated or unconnected with each other
due to some sort of barriers. It would be possible for the same good to sell at a
different price in each market because of the lack of arbitrage due to the barriers.
Integrated Market - markets which are connected to each other, in the sense that
arbitrage will cause the same good to sell at one price in both markets.
Fisher Effect - for every country the nominal interest rate is connected to its own
real rate and inflation and the real rate and inflation in other countries .
Spot Rate - today the price of currencies can be bought or sold for delivery today.
Forward Rate - today the price that currencies can be bought or sold for delivery
at some future time.
Direct Foreign Investment - the purchase of real asset (plant, equipment, land etc.)
in a foreign country with the expressed aim of managing the assets.
Portfolio Investment - the purchase of stock, bonds or other financial claims with
the expressed aim of not managing the assets.
ADR - American Depository Receipt, A financial claim issued in the U.S. which
represents the ownership of stock in a foreign country.
2.
Total Return = (degree of return) (change in exchange rate)
A.
14.24% = (1 + .12)(1.02) − 1
B.
4.5% = (1 + .10) ( 1 − . 05) − 1
C.
7% = (1 + .07)(1 + 0) − 1
D.
−12% = (l. + .1) (1 − .2) − 1
3. Some but not all of the currency risk can be diversified away for the U.S. investor.
The dollar being the world standard to which most other currencies are compared
makes it difficult for the U.S. investor to totally eliminate risk. Currency
variations consist of two components; random fluctuations of all currencies with
each other and equal fluctuations of all non-dollar currencies with the dollar. For
the U.S, investor, the first risk can be diversified completely, the second risk can
only be modified by adjusting the total portion of the investors portfolio into
non-dollar assets.
4.
R
International
Domestic
risk
This relationship exists because:
1. the returns internationally are higher than domestically
2. the correlations between securities are lower internationally.
5.
Segmented markets exist because of barriers. Barriers such as: legal restrictions;
transaction costs; lack of information; unfamiliarity with foreign markets;
currency risks, and controls; political risks; government rules and regulation for
foreign investors etc.
6.
The country with the higher rate of inflation will eventually have to devalue its
currency in order for the Purchasing Power Parity Theory to hold. The degree of
devaluation depends on the amount of trade between countries, the governments
monetary policy, relative interest rates between countries, and government
intervention in the foreign exchange markets.
7.
E S1d
f
 S
S0d
E S1d
f
f
  61ff
1
6 ff
E S1d
f
d f
0

E(I d )  E(I f )
1  E(I d )

.05  .10
1.05
  1 6 ff  $1 6 ff (.05 1.05)
 $1 6 ff  $.047619 6 ff
 .166  .0079365
E S1d
f
  $.1587301
ff  6.30 ff $
8.
The evidence of the efficiency of world capital markets is mixed. What is needed
is a simultaneous evaluation of financial markets, currency markets, and real
markets.
9.
ADR's are financial instruments issued by American banks against shares
deposited with the banks overseas brinks of a custodian, ADR's allow U.S,
investors to buy and sell foreign securities. The return of ADR's is denominated
in dollars and also reflects the movement of exchange rates as well as security
price movements. They avoid foreign taxes, provide dividend collection services,
avoid foreign regulation against foreigners and home liquidity.
10. A Eurobond is a long term debt instrument issued by a corporation of one
rationality to an investor of a different rationality in an unregulated market,
denominated in a currency which is different from the currency of the country of
the issuing company.
Advantages: 1. low risk, 2. higher yields on a risk adjusted basis then comparable
U.S. bonds ,and 3. no taxes.
11. The valuation model for the European type of currency call option can be defined as
C  Se
 rf t
N (d1 )  Xert N (d2 ) ,
Where S = spot exchange rate, r = domestic risk-free rate, rf = foreign
risk free rate, X = exercise price, σ = standard deviation of spot
S
ln 
X
exchange rate, t = time to expiration, d1  

2 t
   r  rf  t  
2

,
 t
S
ln 
X
and d 2  

2 t
   r  rf  t  
2

 d1   t .
 t
S=80, X=85, r=3%, rf =2%, σ =15%, t=1
(0.15)
 80 
ln     0.03  0.02  
85
2
d1   
 0.2625
0.15
2
d 2  d1   t  0.2625  0.15  0.4125
The value of the currency call option on the Japanese yen is
N (d1 )  N (0.2625)  0.3965, N (d 2 )  N (0.4125)  0.3400
C  80e0.02 (0.3965)  85e0.03 (0.3400)  3.0446
12. The European style of index call options can be evaluated as
C  S N (d1 )  Xe  rt N (d 2 ) ,
where S   Se  qt , S = spot exchange rate, q = dividend yield per year, r = risk-free
rate, X = exercise price, σ = standard deviation of spot exchange rate, t = time to
1
expiration, d1  [ln( S X )  (r  q   2 )t ]  t , and d2  d1   t .
2
S=1000, X=950, r= 6%,σ =15%, t=3/12=0.25, Total dividend yield during 3 months is
1%, so dividend yield per annum is 4% (that is, q =4%).
1
d1  [ln(1000 950)  (0.06  0.04  (0.15)2 )(0.25)] (0.15) 0.25  0.7881
2
d 2  d1   t  0.7881  (0.15) 0.25  0.7131
N (d1 )  N (0.7881)  0.7847, N (d 2 )  N (0.7131)  0.7621
C  1000e0.04(0.25) (0.7847)  950e0.06(0.25) (0.7621)  63.6495
13. The rate of return on ABC in terms of Japanese Yen is [(250+20)-200]/200=0.35
or 35%.
The rate of return in terms of U.S. dollar is
100(250  20)
 1  0.5 or 50%
90(200)