MSc in Economics & Business Administration

Subject Area: Applied Economics and Finance

International Finance
(CAEFO1078U)

Re-Exam
August 2020

General Information

• If you have clarifying questions or suspect an error in the exam assignment, please
contact Peter Feldhütter: pf.fi@cbs.dk directly via CBS email. You will get the answer
as a CANVAS announcement.

• Keep yourself updated on Canvas!!!. To repeat the previous item: If Peter Feldhütter
makes any corrections to the exam set HE WILL DO SO AS A CANVAS ANNOUNCEMENT.

• If you experience problems with upload of your exam hand in, please contact the exam
administrator/Daniel Rotenberg: dar.stu@cbs.dk immediately.

• The exam is open book: You can use any material you want. However, it is strictly
forbidden to communicate with other students or receive any help from other persons.

• You can hand in the exam in Word (or in some other electronic text format) or by
writing in hand and uploading pictures of the hand-written sheets. Handing in an
Excel workbook alone is not acceptable. It is not important in which text-format you
hand in, instead what is important is one can clearly read and understand

– what approach you have used,

– which inputs you have used.

• You are welcome to include screen dumps of figures created in some software. However,
axes should have clear tick-marks with numbers and there should be accompanying text
explaining what the figure shows, potential calculations underlying the graph, and
which question the figure is answering. You are also welcome to submit hand-drawn
figures as long as the figures follow the previously-mentioned requirements.

• The exam consists of 5 problems with a varying number of tasks. Each problem has
a weight. The weights provide rough guidance regarding the amount of time that you
 are expected to spend on each problem. The final grade takes the overall impression
into account.

• Answer all questions, in all tasks, in all problems.

• To avoid any ambiguity, be sure to mark a final answer with two lines under it.

• Unless otherwise specified, you must explain all your answers. The overall assessment
will also be based on your explanations. A correct answer with no explanations will
not give points.

• Irrelevant statements or calculations will weaken the overall impression of your solutions.

• If you are not able to answer a particular question in an exercise, you may still be
able to answer the subsequent questions. If you believe that you lack information to
proceed, you should make – and explicitly state – assumptions that enable you to
proceed.

• Anglo-American punctuation style (e.g. $1,000.05) is used in this assignment.

• The assignment contains 8 (numbered) pages.

Page 2
1. Arbitrage in FX spot and forward markets (20%)

You are an FX dealer and observe the (directly quoted) exchange rates from a competing
FX dealer A as well as market interest rates as given in the table below.

Spot FX 1-year MMkt (p.a.)

(a) How would you set your DKK/USD spot bid and ask quotes if you have excess
inventory of USD? Explain in max 100 words. Only the first 100 words will count.

(b) What are the synthetic bid and ask prices for the one-year JPY/DKK forward rate?
Another dealer B quotes the following bid and ask prices:

Spot FX
bid ask
JPY/USD 111.7044 111.7223
JPY/DKK 16.8080 16.8107

(c) Is there an arbitrage? If so, describe the arbitrage. If not, explain why (max four
sentences).

Page 3
2. Currency trading in practice (20%)

You consider two of Danske Bank’s FX Top Trades 2020. (NB: Danske Bank uses the
indirect quoting convention.)

(a) “Trade #4 2020”

Assume that interest rates are zero. In contrast to Danske Bank, you are able to
bargain a premium of 240 pips.

• Compute and plot the payoffs and profits of this strategy for ST for the range
between 0.8 and 0.9. Be sure to mark x- and y-axes clearly with relevant
numbers.
• What is the range for which the strategy is making a profit? What is the range
for which the strategy is making a loss?
• Explain the motivation behind using such a strategy (max 2 sentences).

Page 4
(b) “Trade #7 2020”’

Assume that interest rates are zero.

• Compute and plot the payoffs and profits of this strategy for ST for the range
between 300 and 400. Be sure to mark x- and y-axes clearly with relevant
numbers.
• What is the range for which the strategy is making a profit? What is the range
for which the strategy is making a loss?
• Assume that the position is closed on August 9, 2020 where the HUF/EUR
exchange rate was 346.20. What is the profit/loss on that date?

Page 5
3. Currency trading strategies using forwards and options (30%)

You are given the following data:

• The current AUD/USD spot rate is 1.40.

• The volatility of the AUD/USD exchange rate volatility is 12% p.a.

• Interest rates in the US are 2.5% p.a. and constant at different horizons

• Interest rates in Australia are 5.5% p.a. and constant at different horizons

The interest rates are quoted using simple compounding and one can convert the rates
to continously compounded rates (as used in the Black-Scholes formula) by the formula
log(1 + r).

You evaluate a “carry-trade” strategy, i.e. borrow money in the low interest rate currency
and invest this money in the high interest rate currency over a horizon of one year.

(a) Explain how to set up this strategy where the money borrowed/lent is AUD 10
millions and compute the payoff in AUD for the following outcomes for ST : 1.15,
1.35, 1.55, 1.75. What is the initial cost of setting up the carry trade strategy?

(b) Explain how the same strategy (i.e. a strategy giving the same payoff) can be set
up using forwards and compute the payoff for the following outcomes for ST : 1.15,
1.35, 1.55, 1.75.

(c) You consider to hedge the payoffs from this carry trade against extreme movements
in the exchange rate using an asymmetric “risk reversal”. One asymmetric risk
reversal is selling a European put option with strike price 1.30 and buying two
European call option with strike 1.60. Plot the payoff profile for one asymmetric
risk reversal for values of ST between 1.00 and 1.80. Be sure to mark x- and y-axes
clearly with relevant numbers.

(d) Use the Black-scholes model to compute the initial price in AUD of one asymmetric
risk reversal.

(e) Plot the profits in AUD of the hedged carry-trade for ST values between 1.00 and
1.80. Be sure to mark x- and y-axes clearly with relevant numbers.

Page 6
4. Exchange rate exposure (15%)

A Danish company considers to invest in the United States. It expects that, at the
relevant horizon, the DKK/USD exchange rate will be either 6 (exchange rate scenario
L) or 8 (exchange rate scenario H) and assesses the two scenarios to be equally likely.
The firm also considers four scenarios with respect to the state of the US economy.
The first scenarios is that the economy is going very well (“boom” [B]) and the Danish
firm will earn USD 4,000. The second scenario is that economy will be slowing down
(“recession” [R]) and the Danish firm will only have a cash flow of USD 2,000. The third
scenario is that the economy will be at its average level (“normal” [N]) and the Danish
firm will have a cash flow of USD 3,000. Finally, there is a disaster scenario where the
economy activity will drop dramatically (“pandemic” [P]) and the cash flows will be 0.

(a) For the following combinations of scenarios compute the firm’s expected DKK cash
flow, the firm’s DKK/USD exposure, explicitly state how you would hedge FX
exposure using forward contracts, and state the value of the expected hedged cash
flows in the L and H states as a function of the forward rate F .

(i) Independent of the exchange rate, the probability is 25% for B, R, N and P.
(ii) Conditional on the FX scenario H, the probability is 90% for R and 10% for P.
Conditional on the FX scenario L, the probability is 80% for B and 20% for N.
(iii) Conditional on the FX scenario H, the probability is 100% for R. Conditional
2 1
on the FX scenario L, the probability is 3
for B and 3
for P.

Page 7
5. International capital budgeting (15%)

Consider the following information for the Peruvian firm Primax’s equity returns:

Correlation Coefficients
Primax Peru World std dev return
Primax 1.00 1.00 0.5 40%
Peru 1.00 0.5 30% 10%
World 1.00 10% 8%

The Peruvian risk-free rate is 0% while the US risk-free rate is 4%. Primax is entirely
equity financed and assume the CAPM holds. Assume that the Peruvian stock market
is segmented from the rest of the world.

(a) Compute the domestic country beta of Primax as well as its world beta.
Primax is considering the following local Peruvian project, named Splat, which has
the same risk as that of the firm:

Project Elektro
year 0 1 2
expected cash flow (in local currency) -100 60 60

(b) Should Primax undertake the project?

(c) Suppose now that Primax has made a surprise decision to make its shares tradable
internationally via cross-listing on NYSE. After the cross-listing might Primax
change its decision to undertake/not undertake the Splat project (explain and/or
document your answer)?

Page 8