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

1、15Chapter 7: Speculation and Risk in the Foreign Exchange MarketChapter 7Speculation and Risk in the Foreign Exchange MarketQUESTIONS1. What are two ways to speculate in the currency markets without investing any money up front?Answer: To be long in the foreign currency, one can borrow domestic curr

2、ency, convert to foreign currency in the spot foreign exchange market, and invest in the foreign money market while leaving the transaction exchange risk unhedged. The alternative way is to enter into a forward contract to buy the foreign currency forward. To be short in the foreign currency, one ca

3、n borrow foreign currency, convert to domestic currency in the spot foreign exchange market, and invest in the domestic money market while leaving the transaction exchange risk unhedged. The alternative way is to enter into a forward contract to sell the foreign currency forward.2. What do financial

4、 economists mean when they discuss the conditional expectation of the future spot exchange rate?Answer: The conditional expectation of the future spot exchange rate is the probability weighted average of the future possible exchange rates. It is the mean of the conditional probability distribution o

5、f future spot rates.3. What is the main determinant of the variability of forward market returns?Answer: The main and only determinant of the variability of forward market returns is the variance of the future exchange rate.4. Describe how you construct the uncertain yen-denominated return from inve

6、sting 1 yen in the Swiss franc money market.Answer: If you invest yen in the Swiss money market, you first must convert from yen into Swiss francs in the spot foreign exchange market. With the Swiss francs that you get, you invest in the Swiss money market, leaving the investment unhedged. At the en

7、d of the investment horizon, you convert from Swiss francs back into yen at the future spot exchange rate. 5. What is a hedged foreign currency investment? What happens if you hedge your return in Question 4?Answer: A hedged foreign currency investment sells the known foreign currency return in the

8、forward market at the time of the investment. This eliminates exposure to foreign exchange risk, but it also elements possible gains from appreciation of the foreign currency. By interest rate parity, we know that the domestic currency return from the hedged foreign currency investment is just the d

9、omestic currency money market return.6. What does it mean for the 90-day forward exchange rate to be an unbiased predictor of the future spot exchange rate?Answer: If the forward exchange rate for 90 days is an unbiased predictor of the future spot rate, the forward rate is equal to the expected fut

10、ure spot rate. While there will be forecast errors that may be large, there will not be systematic errors on one side or the other. Therefore, the expected forward market return is zero.7. Why is it true that the hypothesis that the forward exchange rate is an unbiased predictor of the future spot e

11、xchange rate is equivalent to the hypothesis that the forward premium (or discount) on a foreign currency is an unbiased predictor of the rate of its appreciation (or depreciation)?Answer: When the forward exchange rate is an unbiased predictor of the future spot exchange rate, we know that the forw

12、ard rate equals the conditional expectation of the future spot rate. For example, at the 90 day maturity, we haveBecause the current spot rate, S(t), is in the information set that is used to take the conditional expectation, we can divide by it on both sides of the above equation. Subtracting one f

13、rom both sides then givesThis equation states that the forward premium on the foreign currency equals the expected rate of appreciation of the foreign currency. 8. It is often claimed that the forward exchange rate is set by arbitrage to satisfy (covered) interest rate parity. Explain how interest r

14、ate parity can be satisfied and how the forward exchange rate can be set by speculators in reference to the expected future spot exchange rate.Answer: Interest rate parity is a no arbitrage relation between 4 variables, the spot and forward exchange rates and the interest rates on the two currencies

15、. If the forward exchange rate is set by speculators in reference to the expected future spot exchange rate, the current spot rate or the two interest rates can adjust to satisfy interest rate parity. The speculative dimension of trading must also be satisfied in equilibrium.9. It is sometimes asser

16、ted that investors who hedge their foreign currency bond or stock returns remove the foreign exchange risk associated with the investment, reduce the volatility of their domestic currency returns, and thus get a “free lunch” because the mean return in domestic currency remains the same as the mean return in the foreign currency. Is this true or false? Why?Answer: If forward r