09 Jul FIN31FMS12019 Incompatible Trinity Finance Questions

Question Description
short answers Q&A format

For calculation questions, show all workings.

Question 1

Suppose Mexico is a major export market for your U.S.-based company and the Mexican peso appreciates drastically against the U.S. dollar. Discuss its implications for your company and for Mexican companies that export to the U.S.

Question 2

In the 1850s the French franc was valued by both gold and silver, under the official French ratio which equated a gold franc to a silver franc 15½ times as heavy. At the same time, the gold from newly discovered mines in California poured into the market, depressing the value of gold. Discuss what would happen to the franc in this case.

Question 3

Suppose that the pound is pegged to gold at £20 per ounce and the dollar is pegged to gold at $35 per ounce. This implies an exchange rate of $1.75 per pound. If the current market exchange rate is $1.80 per pound, how would you take advantage of this situation?

Question 4

What is meant by the Incompatible Trinity? Illustrate your answer with an example of a fixed currency exchange regime and an example of a floating currency exchange regime.

Question 5

When a country’s currency depreciates against the currencies of its major trade partners, its trade balance often worsens in the short run before it starts to improve. This leads to a J curve in the trade balance. Illustrate the J curve graphically. Fully label your diagram (note: you are welcome to draw it by hand, take a photo and attach it here). Explain why the J curve happens.

Question 6

Use the table below to answer the following questions:

American Terms

European Terms

Bank A’s Quotations

Bid

Ask

Bid

Ask

British pounds

$

1.9712

$

1.9717

£

0.5072

£

0.5073

Euros

$

1.4738

$

1.4742

€

0.6783

€

0.6785

What is ?
What is ?
Suppose Bank B provides a quote of GBP 0.7462-68 for the EUR. Demonstrate whether and how an arbitrage profit can be made.
Question 7

You are a U.S.-based treasurer with $1,000,000 to invest. The dollar-euro exchange rate is quoted as $1.50 = €1.00 and the dollar-pound exchange rate is quoted at $2.00 = £1.00. If a bank quotes you a cross rate of £1.00 = €1.25, is there an arbitrage opportunity? If so, how much money would you make? Show all workings.

Question 8

A bank is quoting the following exchange rates against the dollar for the Swiss franc and the Australian dollar:

SFr/$ = 1.5958–70

A$/$ = 1.7249–58

An Australian firm asks the bank for an A$/SFr quote.What cross-rate would the bank quote?

Question 9

Explain the differences between a long forward position and a short forward position. In your answer, illustrate the pay-off functions of these positions with graphs. Fully label your graphs. (note: you are welcome to draw them by hand, take a photo and attach it here)

Question 10

Suppose IBM has a liability of £1,000,000, payable in three months. The company wants to hedge foreign exchange risk using forward contracts. The current spot rate for the £ is $1.2415/£, and the three-month forward rate is $1.2492/£.

What forward position should IBM enter into?
Suppose the spot exchange rate in three months’ time is either $1.2342/£ or $1.2547/£. Using this example, demonstrate how the forward contract in part i helps IBM eliminates foreign exchange risk exposure.