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- July 29, 2019 at 2:13 am #525153
QUESTION 50 CASASOPHIA
In the case of currency option we see the spot rate at the time of receipt that is in four months time. We see the difference between spot rate and exercise price to see if we want to exercise option or not and then calculate gain or loss (difference of spot rate and exercise price of option). In this question solution they exercised at both options, though 1.38 is not favorable as compared to spot rate (which in exam they assume future rate 1.3698)
Calculation for 1.36 is right.(i do get alternative method) we exercise at 1.36 because spot rate movement is not favorable that is 1.3689)Lets say if four month spot rates are not given can we use forward rates as an alternative?provided PPP info is not given.
The second thing is why they don’t use purchasing power parity to calculate spot rate?
Which is
s1=1.3618*1.097/1.012=1.476
(1.476-1.3618)*4/12For four months it will be 1.3618+.0380=1.3998
In question b)
Analysis they write the forward rate are calculated based on purchasing power parity …..but we calculate it using interest rate parity…am I missing on some thing…or I’m interpreting it wrong..
QUESTION 48 ASTERIOD
Here they asked about the impact of hedging on cost of equity
Solution write this way (which I am not getting)
“The extent of the impact will depend on the size and importance of the potential foreign currency exposure and the correlation of the currency with the market. If currency and company have same correlation with the market then the removal of risk will have little or no effect.”
This correlation thing I am not getting.
If we take casasophia question 50 above example
In which they hedged the income with forward rate. As inflation will fluctuate the forward rate so the income and NPV. And increase in inflation depreciate currency and remittance of income decreases.(how we will see the currency and company correlation with market.??General question:
one more thing does the calculation of annual swap rate in currency swap based on the quarterly reset is included in syllabus?
July 29, 2019 at 12:03 pm #525205Q50:
Since the spot rate is not given at the date of the transaction, you have two choices. The best (and the way the current examiner deals with it) is to use the lock-in rate and this is shown at the top of the second page of the answer.
Otherwise (but not as good an approach even though the previous examiner used to use it) is to assume a spot rate as at the date of the transaction. It does not matter what rate you use because you will end up with the same answer regardless (it would always give the same answer apart from any over or under hedging because of the contract size).In section (b) it is all worded rather badly. As the answer does say, forward rates are calculated using interest rate parity. They only mention purchasing power parity because in theory it would give the same as interest rate parity but in practice it does not give the same in the short term.
Q48
Two things affect the cost of equity. One is the beta factor which will reduce if the risk due to exchange rate fluctuations is reduced. The other is the overall return on the market. They are not related and we do not know how the overall market return will change in the future, but if the market return were to increase in line with the reduction in the beta then there would be no effect on the cost of equity.
As far as currency swaps with quarterly resets is concerned, it is not specifically excluded from the syllabus. However it has never been examined and I would be very surprised if it ever was examined (currency swaps have only been asked a few times anyway).
July 29, 2019 at 10:59 pm #525292Thank you very much Sir for addressing my concerns, you are just one in a million! devoting all your time, effort helping students, just simply unique.
one more thing. we cannot calculate spot rate by using purchasing power parity as inflation rate in Mazabia is uncertain and we cannot take average of 5% and 15%. Am i right?
July 30, 2019 at 1:05 am #525296QUESTION 57 Part B BPP
if in the same question if they ask to calculate current value of SWAP will it be like this
19.4*0.964(based on spot yield)+19.4*0.9201+19.4*0.8713+19.4*0.8195=69.34
as the principle amount of loan will be paid after 10 years so we will not account for it.
July 30, 2019 at 9:14 am #525446In future please start a new thread when you are asking about a different question.
(The reason is that our answers are for the benefit of everyone – we do not give free private tuition – and many students use the search facility to find previous answers to their problems.)Q 57. Yes – what you have written is correct 🙂
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