BFN3104

Chapter 12
Questions
1.

Define uncertainty analysis and risk analysis.

Uncertainly analysis is an unquantified approach that takes a view about how much
actual outcomes may be better or worse than rational estimates.
Risk analysis is quantified approach about how future outcomes may vary expressed
as probabilities.

2.

Cite and briefly discuss the exchange rate equivalency model.

The exchange rate equivalency model may be defined as a hypothetical relationship
in which the nominal interest rate differential between two countries is assumed to be
equal to the expected inflation rate differential between those two countries, the
differential between the forward rate and spot rate of currencies over a given period,
and any potential future change in the spot exchange rate.

3.

Cite and discuss the theories and hypotheses related to the exchange rate
equivalency model.
The exchange rate equivalency model may be considered as a combination of the
following theories and hypotheses.
Expectation Theory of exchange rate: The expectation theory of exchange rates
regards todays forward foreign currency exchange rate as reasonable expectation of
the future spot rate.
Fisher effect (closed hypothesis): The fisher effect describes the long-run relationship
between expectations about a countrys future inflation and interest rates. Normally, a
rise in a countrys expected inflation rate should eventually cause an equal rise in the
interest rate (and vice versa).
International Fisher effect (opened hypothesis): The international Fisher effect states
that an expected change in a foreign currency spot exchange rate between two
countries is approximately equivalent to the difference between the nominal interest
rates of the two countries for that time.
Interest Rate Parity Theory: The theory that lending and borrowing interest rate
differential between two countries is equal to the differential between the forward
foreign currency exchange rate of the two countries and the spot exchange rate.
Purchasing Power Parity: The theory that foreign currency exchange rates are in
equilibrium when their purchasing power is the same in each of the two countries at
the prevailing exchange rates. This means that the exchange rates between two
countries should equal the rate of the two countries price level of fixed basket of
goods and services. When a country experiences inflation and its domestic price level
is increasing, its exchange rate must depreciate in order to return to purchasing power
parity.

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Problems
4. On 1 May 2007 Cookies Plc needed to make a payment of US$730,000 in three
months time. The company considered three different ways in which it may hedge its
transaction exposure foreign exchange forward contract; money market; currency
option based on the following foreign currency exchange rate and interest rate data:
Exchange rates:
US$/ sterling spot rate
Three month US$/ forward rate

1.8188-1.8199
1.8109-1.8120

Interest rates:
US$
sterling

Borrowing
%
3.15
5

Lending
%
2.85
4.5

Foreign currency option prices in cents per US$ for a contract size of 25,000:
Exercise price
Call option (July 2007)
Put option (July 2007)
US$1.90/
2.5
7.5
Calculate the cost of the transaction using each of the three different methods considered
by Cookies Plc to determine which is the cheapest for the company.
Solution:
Foreign exchange forward contract
Forward contract fixed at 1 Aug 2007

Total cost of the payment of

Money Market
Assuming it has sufficient sterling Cookies Plc could buy US$ and lend it in the money
market.
Three months US$ lending rate = 2.85% / 4 = 0.7125%
The amount today required to become US $730,000 in the three month time.

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Cost of buying US $724,836 at the currency spot rate is

The three month sterling lending rate = 4.5% / 4 = 1.125%

Three months interest lost on 398,524
398,524 * 0.01125 = 4,483
Total cost of the payment US $730,000 = 398,524 + 4,483 = 430,007
Currency option
Put option may be used and each contract would deliver US $47,500 (US $1.90/ *
25,000)
The number of contracts required is

Cost of the put option contracts = 0.075 * US $47,500 * 15 = US $53,438

sterling cost of the options:

sterling required to deliver US $712,500 (15 * US $47,500) is 375,000 (15 * 25,000)

Shortfall = US $730,000 US $712,500 = US $17,500
Cost of shortfall in sterling using the US $ / three month forward rate

Total cost of using options = 29,381 + 375,000 + 9,664 = 414,045

The foreign exchange fixed forward contract is the cheapest method in this example for
cookies plc to use to hedge its US $730,000 transaction exposure at cost of 403,114.

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