FM Chapter 23 Questions – Foreign exchange risk management
33 Comments
D
David·
According to my understainding of question 2 my answer is the following. What am I doing incorrect? Thanks in advance for your explanation.
To calculate the 6-month forward exchange rate, we can use the interest rate parity formula:
F = S * (1 + r_h)^n / (1 + r_f)^n
where F is the forward exchange rate, S is the spot exchange rate, r_h is the home country interest rate, r_f is the foreign country interest rate, and n is the time until the forward exchange rate.
Plugging in the given information, we get:
S = 20 dinar/$
r_h = 3%
r_f = 7%
n = 6 months = 0.5 years
Now, we can use the interest rate parity formula to calculate the forward exchange rate:
Therefore, the 6-month forward exchange rate is 19.6489 dinar/$.
J
John MoffatTutor·
For this formula, if the interest is 3% per annum, then for six months it is 3/2 = 1.5%.
(You can see workings for all the questions if you click 'review quiz' after submitting your answers.)
D
David·
Why is in question 2 the foreign country divided by the home country, and in question 1 the home country divided by the foreign country?
J
John MoffatTutor·
The base currency in both cases is the $ and both questions have been done the same way.
Did you watch the free lectures before attempting this quiz?
P
PratibhaSupporter·
Hi Sir,
I am unable to understand the question 1. Could you please explain what exactly do we need to understand in this?
Thanks alot in advance:)
J
John MoffatTutor·
You need to calculate the forward rate for 1 years time.
P
PratibhaSupporter·
So the information given in the first para about getting the currency exchanged and again converting it is of no relevance ?
J
John MoffatTutor·
It is relevant. They are going to exchange money now, then invest it, then convert it back in a years time. For there to be no gain or loss they will effectively be converting it back at the forward rate in one years time.
T
Truc·
Hi Sir,
For question 1, I calculated 12 month forward exchange rate is 1.418 euro per 1$ by using the formula. But I don't understand the question clearly. The Q is "Compared to making a dollar investment for 12 months, at what 12 month Forward exchange rate will the investor make neither a loss or a gain?". I am wondering if 12 month forward exchange rate (resulted in as 1.418 Eu per 1$) is the Spot rate on the date of the end of 12 month period? How can we predict the spot rate on a specific date in 12 months? How can we know we don't make neither a loss nor a gain when we use this 12 month forward exchange rate? Please advise!!! Thank you so much!!!
J
John MoffatTutor·
The forward rate is the rate quoted now for converting in 12 months time. It is not the spot rate in 12 months time.
I do explain this in my lectures.
S
SOLANKAR·
80percent
P
Pratim·
In Q.5,
Euro Has Strengthened. Doesn't It Mean That Just The Way €1 = $2.4, It Can Be Interpreted As €0.8 = $2 Also ?
G
goddish·
Hello Mr. Moffat,
Could you please clarify this for me. On question 5, I get your POV that says if the euro has strengthened, it means you get more dollars for 1 Euro.
But is it also not the case that if the Euro has strengthened by 20%, you only need 80% of it to get a dollar. That is currently the spot is equivalent to €/$ 0.5. So 20% stronger gives €/$ 0.4, hence the total receivable becomes 1000*0.4=$400?
Thanks
G
goddish·
Correction: €400 rather.
J
John MoffatTutor·
You cannot have both of them strengthening!!
Currently €1 buys $2.
If the € strengthens by 20%, then 1 € will buy 20% more $'s. Therefore the new exchange rate will be such that €1 buys $2.40.
N
Njabulo·
Hello Sir.
I am asking if is there a difference between the exchange rate of R13.50/$,becasue if i appreciate the rand,say to R10.30/$,the rules that the export must be expensive in foreign country(as in your example) does not hold,please help.maybe I appreciate it in a wrong way.
J
John MoffatTutor·
Assuming we are in the country that uses the Rand and are exporting to a country using the $, then exports certainly do become more expensive.
Suppose you export something for R100 to America. At the moment, the cost in $'s is 100/13.50 = $7.41.
If the exchange rate changes to R10.30/$, then the cost in $'s increases and becomes 100/10.30 = $9.71
P
Poonam·
Hi John, Just a doubt in q2 why we are using the interest rate parity to calculate the forward rate rather than purchasing power parity since both interest and inflatin rates are mentioned in the question. Thank You
J
John MoffatTutor·
As I explain in my free lectures, forward rates are always calculated using interest rate parity. Purchasing power parity is only used for estimating future spot rates.
P
priya·
Hi sir
Q1
shouldn't the ans be 1.415*((1.018)/(1.02))
= 1.412
as base is 2%
J
John MoffatTutor·
No - the answer is correct. The exchange rate is quoted against the $, so $ is the 'base' currency.
Do watch my free lectures on this :-)
I
Irina·
Dear sir, could you please explain the logic of 1st question? The question said that investor should have the same fin.result (getting from conversion to euro, invest them and then convert back) as he could make dollars investment at 1,8%...
J
John MoffatTutor·
It is using the interest rate parity formula (which, as I explain in my free lectures, gives the forward rate and is equivalent to money market hedging).
J
Jatin·
Hello Sir, based on your above reply for Q.1, in Q.2 why is Dinar selected as the base currency and not the $?
J
John MoffatTutor·
The $ has been used as the base currency (and is the currency used by the company).
Z
zahidzafar·
sir may you explain question 2??
Why we are using both interest rate rather then one inflation of foreign country and interest of foriegn country.??
We are using both interest rate.??
J
John MoffatTutor·
Forward rates are always calculated using the interest rate parity formula.
It would make no sense to use inflation rates and interest rates.
Have you watched the free lectures on this?
K
khanhhoangvu·
Dear Teacher,
Could you please to make my problem more clear that the interest rate quoted in question 1 is the deposit rate or borrowing rate?
Thank you Teacher very much
J
John MoffatTutor·
This is exactly how the question appeared in the real exam - with only one rate of interest it is only that rate that you can use in the formula!
M
madiha·
i got all the questions right. what an amazing teacher. god bless you Mr. Moffat
J
John MoffatTutor·
Congratulations (and thank you :-) )
H
haidershah·
could you please explain this point that if euro is getting stronger by 20% then how come its becoming 1euro = $2.4
my answer is coming $2.5
= euro 2 / .8 = 2.5 which gives answer of 400euros
J
John MoffatTutor·
At the moment, 1 euro buys $2
If the euro is 20% stronger, then it buys 20% more $'s. 20% x $2 = $0.4. So it now buys $2.40
To calculate the 6-month forward exchange rate, we can use the interest rate parity formula:
F = S * (1 + r_h)^n / (1 + r_f)^n
where F is the forward exchange rate, S is the spot exchange rate, r_h is the home country interest rate, r_f is the foreign country interest rate, and n is the time until the forward exchange rate.
Plugging in the given information, we get:
S = 20 dinar/$
r_h = 3%
r_f = 7%
n = 6 months = 0.5 years
Now, we can use the interest rate parity formula to calculate the forward exchange rate:
F = S * (1 + r_h)^n / (1 + r_f)^n
= 20 * (1 + 0.03)^0.5 / (1 + 0.07)^0.5
= 19.6489 dinar/$
Therefore, the 6-month forward exchange rate is 19.6489 dinar/$.
(You can see workings for all the questions if you click 'review quiz' after submitting your answers.)
Did you watch the free lectures before attempting this quiz?
I am unable to understand the question 1. Could you please explain what exactly do we need to understand in this?
Thanks alot in advance:)
For question 1, I calculated 12 month forward exchange rate is 1.418 euro per 1$ by using the formula. But I don't understand the question clearly. The Q is "Compared to making a dollar investment for 12 months, at what 12 month Forward exchange rate will the investor make neither a loss or a gain?". I am wondering if 12 month forward exchange rate (resulted in as 1.418 Eu per 1$) is the Spot rate on the date of the end of 12 month period? How can we predict the spot rate on a specific date in 12 months? How can we know we don't make neither a loss nor a gain when we use this 12 month forward exchange rate? Please advise!!! Thank you so much!!!
I do explain this in my lectures.
Euro Has Strengthened. Doesn't It Mean That Just The Way €1 = $2.4, It Can Be Interpreted As €0.8 = $2 Also ?
Could you please clarify this for me. On question 5, I get your POV that says if the euro has strengthened, it means you get more dollars for 1 Euro.
But is it also not the case that if the Euro has strengthened by 20%, you only need 80% of it to get a dollar. That is currently the spot is equivalent to €/$ 0.5. So 20% stronger gives €/$ 0.4, hence the total receivable becomes 1000*0.4=$400?
Thanks
Currently €1 buys $2.
If the € strengthens by 20%, then 1 € will buy 20% more $'s. Therefore the new exchange rate will be such that €1 buys $2.40.
I am asking if is there a difference between the exchange rate of R13.50/$,becasue if i appreciate the rand,say to R10.30/$,the rules that the export must be expensive in foreign country(as in your example) does not hold,please help.maybe I appreciate it in a wrong way.
Suppose you export something for R100 to America. At the moment, the cost in $'s is 100/13.50 = $7.41.
If the exchange rate changes to R10.30/$, then the cost in $'s increases and becomes 100/10.30 = $9.71
Q1
shouldn't the ans be 1.415*((1.018)/(1.02))
= 1.412
as base is 2%
Do watch my free lectures on this :-)
Why we are using both interest rate rather then one inflation of foreign country and interest of foriegn country.??
We are using both interest rate.??
It would make no sense to use inflation rates and interest rates.
Have you watched the free lectures on this?
Could you please to make my problem more clear that the interest rate quoted in question 1 is the deposit rate or borrowing rate?
Thank you Teacher very much
my answer is coming $2.5
= euro 2 / .8 = 2.5 which gives answer of 400euros
If the euro is 20% stronger, then it buys 20% more $'s. 20% x $2 = $0.4. So it now buys $2.40