International-Financial-Management---Bekaert-2e---Solutions---Ch07.doc

International-Financial-Management---Bekaert-2e---Solutions---Ch07.doc

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15

Chapter7:

SpeculationandRiskintheForeignExchangeMarket

Chapter 7

SpeculationandRiskintheForeignExchangeMarket

QUESTIONS

1.Whataretwowaystospeculateinthecurrencymarketswithoutinvestinganymoneyupfront?

Answer:

Tobelongintheforeigncurrency,onecanborrowdomesticcurrency,converttoforeigncurrencyinthespotforeignexchangemarket,andinvestintheforeignmoneymarketwhileleavingthetransactionexchangeriskunhedged.Thealternativewayistoenterintoaforwardcontracttobuytheforeigncurrencyforward.Tobeshortintheforeigncurrency,onecanborrowforeigncurrency,converttodomesticcurrencyinthespotforeignexchangemarket,andinvestinthedomesticmoneymarketwhileleavingthetransactionexchangeriskunhedged.Thealternativewayistoenterintoaforwardcontracttoselltheforeigncurrencyforward.

2.Whatdofinancialeconomistsmeanwhentheydiscusstheconditionalexpectationofthefuturespotexchangerate?

Answer:

Theconditionalexpectationofthefuturespotexchangerateistheprobabilityweightedaverageofthefuturepossibleexchangerates.Itisthemeanoftheconditionalprobabilitydistributionoffuturespotrates.

3.Whatisthemaindeterminantofthevariabilityofforwardmarketreturns?

Answer:

Themainandonlydeterminantofthevariabilityofforwardmarketreturnsisthevarianceofthefutureexchangerate.

4.Describehowyouconstructtheuncertainyen-denominatedreturnfrominvesting1yenintheSwissfrancmoneymarket.

Answer:

IfyouinvestyenintheSwissmoneymarket,youfirstmustconvertfromyenintoSwissfrancsinthespotforeignexchangemarket.WiththeSwissfrancsthatyouget,youinvestintheSwissmoneymarket,leavingtheinvestmentunhedged.Attheendoftheinvestmenthorizon,youconvertfromSwissfrancsbackintoyenatthefuturespotexchangerate.

5.Whatisahedgedforeigncurrencyinvestment?

WhathappensifyouhedgeyourreturninQuestion4?

Answer:

Ahedgedforeigncurrencyinvestmentsellstheknownforeigncurrencyreturnintheforwardmarketatthetimeoftheinvestment.Thiseliminatesexposuretoforeignexchangerisk,butitalsoelementspossiblegainsfromappreciationoftheforeigncurrency.Byinterestrateparity,weknowthatthedomesticcurrencyreturnfromthehedgedforeigncurrencyinvestmentisjustthedomesticcurrencymoneymarketreturn.

6.Whatdoesitmeanforthe90-dayforwardexchangeratetobeanunbiasedpredictorofthefuturespotexchangerate?

Answer:

Iftheforwardexchangeratefor90daysisanunbiasedpredictorofthefuturespotrate,theforwardrateisequaltotheexpectedfuturespotrate.Whiletherewillbeforecasterrorsthatmaybelarge,therewillnotbesystematicerrorsononesideortheother.Therefore,theexpectedforwardmarketreturniszero.

7.Whyisittruethatthehypothesisthattheforwardexchangerateisanunbiasedpredictorofthefuturespotexchangerateisequivalenttothehypothesisthattheforwardpremium（ordiscount）onaforeigncurrencyisanunbiasedpredictoroftherateofitsappreciation（ordepreciation）?

Answer:

Whentheforwardexchangerateisanunbiasedpredictorofthefuturespotexchangerate,weknowthattheforwardrateequalstheconditionalexpectationofthefuturespotrate.Forexample,atthe90daymaturity,wehave

Becausethecurrentspotrate,S（t）,isintheinformationsetthatisusedtotaketheconditionalexpectation,wecandividebyitonbothsidesoftheaboveequation.Subtractingonefrombothsidesthengives

Thisequationstatesthattheforwardpremiumontheforeigncurrencyequalstheexpectedrateofappreciationoftheforeigncurrency.

8.Itisoftenclaimedthattheforwardexchangerateissetbyarbitragetosatisfy（covered）interestrateparity.Explainhowinterestrateparitycanbesatisfiedandhowtheforwardexchangeratecanbesetbyspeculatorsinreferencetotheexpectedfuturespotexchangerate.

Answer:

Interestrateparityisanoarbitragerelationbetween4variables,thespotandforwardexchangeratesandtheinterestratesonthetwocurrencies.Iftheforwardexchangerateissetbyspeculatorsinreferencetotheexpectedfuturespotexchangerate,thecurrentspotrateorthetwointerestratescanadjusttosatisfyinterestrateparity.Thespeculativedimensionoftradingmustalsobesatisfiedinequilibrium.

9.Itissometimesassertedthatinvestorswhohedgetheirforeigncurrencybondorstockreturnsremovetheforeignexchangeriskassociatedwiththeinvestment,reducethevolatilityoftheirdomesticcurrencyreturns,andthusgeta“freelunch”becausethemeanreturnindomesticcurrencyremainsthesameasthemeanreturnintheforeigncurrency.Isthistrueorfalse?

Why?

Answer:

Ifforwardr