Graded Homework

1. If the expected inflation rate is 2% and the real required return is 5%, then according to the Fisher Effect, what should be the

nominal interest rate?

2. The inflation rates in the U.S. and UK are expected to be 3% per annum and 5% per annum, respectively. If the current spot rate is ₤1=

$1.3520, then according to the PPP, what should be the expected spot rate in two years?

3. Suppose one-year interest rates on U.S. dollars and euros are 3% and 1%, respectively. If the current spot rate for the euro is

$1.2526, then according to the International Fisher Effect, what should be the spot rate for the euro one year from now?

4. The current one-year interest rate on Japanese yen is -0.166% per annum, the one-year U.S. dollar rate is 2%. What is the implied

forward premium or discount of the yen (over the current spot rate) for a one year forward contract according to Interest Rate Parity?

5. If annualized interest rates in the U.S. and Switzerland are 6% and 3%, respectively, and the 90 day forward rate for the Swiss franc

is SF1=$1.0628, at what current spot rate will interest rate parity hold?

6. You buy a put option on Swiss Francs (SFr) for a premium of $0.01 per SFr, with an exercise price of SFr1= $1.09. If at the maturity

date, the spot rate is SFr1=$1.02,

(a) What is your net profit (or loss) per unit of Krone at the maturity date?

(b). Draw a net profit graph for buying this put option. (The vertical axis of the graph is net profit of buying this put opton, the

horizontal axis is the future spot rate at maturity)

(c). Draw a net profit graph for selling this put option.(The vertical axis of the graph is net profit of selling this put opton, the

horizontal axis is the future spot rate at maturity)

7. You purchase a call option on euro for a premium of $0.01 per euro, with an exercise price of €1 =$1.26. If at the maturity date, the

spot rate is €1=$1.30,

(a) What is your net profit (or loss) per euro at the maturity date?

(b) Draw a net profit graph for buying this call option. (The vertical axis of the graph is net profit of buying this call opton, the

horizontal axis is the future spot rate at maturity.)

8. You have $1000 to invest. Current spot rate of British pound is £1 = $1.45, 1-year forward rate of pound £1= $1.40, 1-year interest

rate in U.S.= 3%, 1-year interest rate in Great Britain = 5%.

(a) If you use covered interest arbitrage strategy for a 1-year investment, what will be the amount of U.S. dollars you will have after 1

year?

(b) Based on your calculation, explain where do you want to invest?

9. Company A and B both require $1 million for a 10-year period.

Company A: a AAA-rated company, would like to borrow at a floating rate.

Company B: a BBB-rated company, would like to borrow at a fixed rate.

Borrower Fixed-rate available Floating-rate available

A: AAA-rated 4.0% LIBOR

B: BBB-rated 6.0% LIBOR + 0.5%

(a) Based on the above information, can Companies A and B use an interest-rate swap to save their borrowing cost? Explain briefly.

(b) Suppose A and B want to split the cost savings equally, how much (i.e., interest rate) would Company A pay for its fixed-rate funds

after the swap? How much (i.e. interest rate) would Company B pay for its floating-rate funds after the swap?