Vignette: Ichi Yamamoto is a foreign exchange trader for a large Japanese bank. Ichi takes advantage of short-term currency arbitrage opportunities by using large amounts of leverage to exploit small differences in currency spreads.
Currently, the following market rates for three currencies are displayed:
Bid
Ask
¥/$
104.69
104.72
$/€
1.3262
1.3265
Ichi has also gathered data on three other currencies, as follows:
₤/CAD
0.44579
CAD/AUD
0.98256
₤/AUD
0.40895
Question: Calculate the widest interval between the euro and the yen that will not allow arbitrage to occur if the midpoint is 138.87 and transaction costs are 0.03%.
Select an Answer: 0.00043 0.0043 0.0000043 0.000043
Rationale:
The largest interval is found through the following equation:
X = -(1 / Direct exchange rate in foreign) + 1 / ((1 − Transaction cost)2 × Direct exchange rate in foreign)
= -(1 / 138.87) + 1 / ((1 − 0.03%)2 × 138.87)
= -(1 / 138.87) + 1 / (0.99972 × 138.87)
= 0.0000043225
2023-11-28
Vignette: Karen Maas works as a foreign exchange trader for a U.S.-based foreign exchange dealer.
She has gathered the following details on the two most commonly traded securities that she deals in, the euro and the U.S. dollar.
Eurozone expected inflation
2.5%
U.S. expected inflation
3.25%
$/€ spot exchange rate
1.2256
$/€ one-year forward rate
1.2447
Eurozone risk-free rate
4.25%
U.S. risk-free rate
5.50%
Question: Calculate the approximate forward premium (discount) implied by interest rate parity.
Rationale:
Note that since our exchange rate is in direct terms:
Approximate forward premium = RfD − RfF
= 5.50% − 4.25%
= 1.25% premium
2023-11-27
Vignette: Karen Maas works as a foreign exchange trader for a U.S.-based foreign exchange dealer.
She has gathered the following details on the two most commonly traded securities that she deals in, the euro and the U.S. dollar.
Eurozone expected inflation
2.5%
U.S. expected inflation
3.25%
$/€ spot exchange rate
1.2256
$/€ one-year forward rate
1.2447
Eurozone risk-free rate
4.25%
U.S. risk-free rate
5.50%
Question: Which of the following approaches to determining short-run exchange rate movements would compare the price of a hamburger across all countries?
Select an Answer: Balance of Payments Relative PPP Absolute PPP Asset Market
Rationale:
By comparing the real value of a single good across countries, one is trying to determine the under/overvaluation of the exchange rate between countries using Absolute PPP. If a basket of goods were measured between countries over a period of time, relative PPP would have been correct.
2023-11-26
Vignette: Gerald White has been researching foreign exchange arbitrage opportunities between the U.S. and Canadian dollars, the pound, and Swiss francs.
Gerald has determined that he can trade foreign exchange for a transaction cost of 0.02%.
Gerald has obtained the following quotes:
CAD/USD
1.2251
CAD/₤
2.3634
₤/SF
0.44860
SF/CAD
0.94313
Question: Calculate the midpoint cross rate for the SF/USD.
Select an Answer: 1.1452 0.76984 1.1554 1.1785
Rationale:
In order to calculate the SF/USD cross rate, we need to use the CAD/USD and SF/CAD exchange rates and combine them in such a way that we are left with just SF/USD.
Thus:
CAD/USD × SF/CAD will yield SF/USD
= 1.2251 × 0.94315
= 1.1554
2023-11-25
Vignette: Elliot Schultz is excited about beginning a summer internship with the finance division of Luxury Cars, an auto manufacturer. Schultz is being mentored by Jason Billups, who is equally eager to share his knowledge and experience with the young intern.
Billups explains that Luxury Cars needs to raise $200 million for an expansion project that has been researched and planned for several months and makes the following statement:
"Rather than issuing bonds to raise the money we need, Luxury will take $200 million of its receivables and have them securitized." This means that Luxury will sell some of its receivables to an SPV called Safety First Trust.
Schultz wonders how the newly-formed ABS will be rated. Billups says that the credit rating agencies use the same standards to rate an ABS as they would use to value a corporate bond and that these standards have always been accepted by finance professionals.
One year later, Schultz is now a paid employee of Luxury Cars. He discovers that some scheduled debt payments had not been made to Safety First and wonders whether his estimation of the probability of default had been too low. The credit rating agencies had given the ABS an AA rating.
Question: How does the structure of the debt for Safety First Trust compare to the structure of corporate debt for Luxury Cars?
Select an Answer: The corporate bonds for Luxury Cars have a stated coupon payment, whereas the debt for Safety First does not. The corporate bonds for Luxury Cars have a stated maturity and face value, whereas the debt for Safety first does not. The debt for Safety First is divided into tranches, whereas the corporate debt for Luxury Cars is not. The debt structures are identical.
Rationale:
Even though the debt structure for both Luxury Cars and its SPV, Safety First Trust, both have a stated maturity, face value, and coupon payments, only Safety First has its debt divided into tranches.
