Individual Assignment
EFIC 698
This Individual Assignment is worth 20% of your final grade and should be done after you have completed all the eight lessons of the course. Read the requirements for each question and plan your responses carefully. Answer all five questions. Each Question is 20 marks.
Although your responses should be concise, ensure that you answer all portions of each question completely. The objective of this assignment is for you to synthesize the material presented in the course, and to consider each question rationally and logically.
1. Suppose that Bell Aliant (a Canadian firm) expects to receive 1 million euros in one year. The existing spot rate of the euro is CAD 1.50. The one-year forward rate of the euro is CAD1.52. Bell Aliant expects the spot rate of the euro to be CAD 1.51 in one year.
Assume that one-year put options on euros are available, with a strike price of CAD1.53 and a premium of CAD 0.06 per unit. Assume the following money market rates:
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Canada
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Eurozone
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Deposit rate
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1.55%
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0.25%
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Borrowing rate
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2.50%
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0.50%
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a. Determine the dollar cash flows to be received if Bell Aliant uses a money market hedge (i.e. foreign exchange swap). (Assume the firm does not have any cash on hand.)
b. Determine the dollar cash flows to be received if Bell Aliant uses a put option hedge. What conclusion would you draw between the money market hedge and the put option hedge in the case of Bell Aliant?
2. Suppose that the USD – CAD spot exchange rate is USD = CAD 1.34 and the 180-day forward rate is USD = CAD 1.30. Suppose the 180-day U.S. interest rate is 1.15% and Canada’s 180-day interest rate is 1.75%. Based on this information:
a. Is covered interest parity arbitrage by Canadian investors feasible (assuming that the investment is CAD 1 million and that Canadian investors use their own funds? Explain.
b. Does interest parity exist? Explain.
c. Explain in general terms how various forms of arbitrage can remove any discrepancies in the pricing of currencies.
3. Use the purchasing power parity (PPP) theory to answer the following.
a. A Canadian importer of American car parts pays for the components in USD. The importer is not concerned about a possible increase in U.S. prices (charged in USD) because of the likely offsetting effect caused by PPP. Explain what this means.
b. In (a), from what you have learned about the tests of PPP, explain why the Canadian importer of American car components should be concerned about its future payments.
c. (i) Explain how the USD to CAD exchange rate might change if Canada experiences high inflation, while the U.S. experiences low inflation.
(ii). Assume that the spot rate is CAD = USD 0.75 and Canadian and U.S. inflation rates are similar. Suppose that Canada experiences 2% inflation, while the U.S. experiences 1.5% inflation. What will be the new value of the CAD after it adjusts to the inflationary changes? (You may use the approximate formula to answer this question.)
4. One Canadian executive commented that the United Sates was not considered as a location for foreign direct investment because the U.S. dollar value was too strong. Interpret this statement.
Explain any two reasons why Canadian firms might prefer to engage in foreign direct investment in Mexico rather than in the U.S.
5. Explain how the declining international reserves could be a prelude to a financial crisis.
How did high levels of leverage in financial institutions contribute to the Great Recession of 2007-2009? What other factor or factors could have also contributed to the Great Recession and how?