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Office Use Only

Monash University

Semester Two Examination Period

2011

Faculty of Business and Economics

EXAM CODES: ECW 2721

TITLE OF PAPER: Trade, Finance and Foreign Exchange

EXAM DURATION: 2 hours writing time

READING TIME: 10 minutes

THIS PAPER IS FOR STUDENTS STUDYING AT:( tick where applicable)

Berwick Clayton Malaysia Off Campus Learning Open LearningCaulfield Gippsland Peninsula Enhancement Studies Sth AfricaPharmacy Other (specify)

During an exam, you must not have in your possession, a book, notes, paper, calculator, pencil case,mobile phone or other material/item which has not been authorised for the exam or specificallypermitted as noted below. Any material or item on your desk, chair or person will be deemed to be in

your possession. You are reminded that possession of unauthorised materials in an exam is adiscipline offence under Monash Statute 4.1.

No examination papers are to be removed from the room.

AUTHORISED MATERIALS

CALCULATORS YES NO

OPEN BOOK YES NO

SPECIFICALLY PERMITTED ITEMS YES NO

if yes, items permitted are:

Candidates must complete this sectionif required to write answerswithin this paper

STUDENT ID __ __ __ __ __ __ __ __ DESK NUMBER __ __ __ __

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INSTRUCTIONS TO STUDENTS

The exam consists of 8 questions. Attempt ANY 6 (SIX) OUT of 8.

Each question is worth 10 marks.

Total marks: 60. The final exam is 60% of the total assessment for this unit.

Draw appropriate, well-labelled diagrams where necessary.

1. Many Asian governments have attempted to promote their export competitiveness by

holding down the value of their currencies through foreign exchange market

intervention.

a.

What is the likely impact of this policy on the countries [5 marks]i. foreign exchange reserves

ii. inflation

iii. export competitiveness

iv. living standards

b. Some Asian countries have attempted to sterilise their foreign exchange market

intervention.

i. What should their central banks do to sterilise their foreign exchange market

intervention? [2 marks]

ii. What are the likely consequences of sterilization on interest rates, exchange

rates in the longer term and export competitiveness? [3 marks]

2. Answer the following questions.

a. Fischer effect asserts that real returns are equalised across countries through

arbitrage. Discuss how and why arbitrage will lead to an equality of real returns.

[6 marks]

b.

Given the information in Table 1and UK as the home country, calculate the

inflation rate in Germany, the expected future spot exchange rate in one years

time (e1) and the forward exchange rate for the transaction in one years time.

[4 marks]

Table 1

UK Germany

Nominal interest rate(%) 10 8

Inflation rate (%) 5 ?

Current spot exchange rate 0.88 (pounds/euro)Expected future spot exchange rate ?

Forward exchange rate ?

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3. Suppose the pound sterling is at US$ = 1.9809 in New York and the CA$ (Canadian

dollar) is offered at US$ = 0.6251 in Toronto. At the same time, London banks are

offering pounds sterling at CA$ = 3.1650.

a.

Is triangular currency arbitrage possible? If so, explain the steps involved inthe triangular arbitrage, and compute the profit from this arbitrage if you had

US$1 million to use. [6 marks]

b. How market forces would eliminate any further possibilities of triangular

arbitrage? [4 marks]

4.

a.

Explain what are future contracts and the advantages and disadvantages ofusing future contracts. [5 marks]

b. If the current spot price is greater than the exercise (strike) price, [5 marks]

i.would the buyer of a call option exercise the option? Why?

ii.would the buyer of a put option exercise the option? Why?

5.

a. A firm with a corporate-wide debt/equity ratio of 1:3, an after-tax cost of debt

of 10 percent, and a cost of equity capital of 17 percent is interested in

pursuing a foreign project. The debt capacity of the project is the same as for

the company as a whole, but its systematic risk is such that the required return

on equity is estimated to be about 20 percent. The after-tax cost of debt is

expected to remain at 17 percent. [4 marks]

i.

What is the project's weighted average cost of capital?

ii. How does it compare with the parent's WACC?

b. Suppose that a foreign project has a beta of 0.95, the risk-free return is 10

percent, and the required return on the market is estimated at 20 percent.

i. What is the cost of capital for the project? [2 marks]

ii. If the beta for this project changes to 0.75? What does that indicate

about the projects risk? Calculate the cost of capital for the projectwith changed beta and compare it with the cost is part (i) above.

[4 marks]

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6. Between 1949 and 1990, the Japanese market rose 25,000 percent. Given these

returns, discuss whether it makes sense for Japanese investors to diversify

internationally?

a. What arguments would you use to persuade a Japanese investor to invest

overseas? [5 marks]

b. Why might Japanese investors still prefer to invest in domestic securities

despite your arguments in part (a) above? [5 marks]

7. What indicators would you look for in assessing the political riskiness of an

investment in a foreign country?

8. Suppose Credit Suisse quotes spot and 90-day forward rates on the Swiss franc of

$0.7955-63, 10-15.

a. What are the outright 90-day forward rates that Credit Suisse is quoting?

[2 marks]

b. What is the forward discount or premium associated with buying 90-day Swiss

francs? [2 marks]

c. Compute the percentage bid-ask spreads on spot and forward Swiss francs. Is

the spread on spot rate different from the spread on forward rates? Explain

why. [6 marks]

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