International-Financial-Management---Bekaert-2e---

©2012PearsonEducation,Inc.Chapter7SpeculationandRiskintheForeignExchangeMarketQUESTIONS1.Whataretwowaystospeculateinthecurrencymarketswithoutinvestinganymoneyupfront?Answer:Tobelongintheforeigncurrency,onecanborrowdomesticcurrency,converttoforeigncurrencyinthespotforeignexchangemarket,andinvestintheforeignmoneymarketwhileleavingthetransactionexchangeriskunhedged.Thealternativewayistoenterintoaforwardcontracttobuytheforeigncurrencyforward.Tobeshortintheforeigncurrency,onecanborrowforeigncurrency,converttodomesticcurrencyinthespotforeignexchangemarket,andinvestinthedomesticmoneymarketwhileleavingthetransactionexchangeriskunhedged.Thealternativewayistoenterintoaforwardcontracttoselltheforeigncurrencyforward.2.Whatdofinancialeconomistsmeanwhentheydiscusstheconditionalexpectationofthefuturespotexchangerate?Answer:Theconditionalexpectationofthefuturespotexchangerateistheprobabilityweightedaverageofthefuturepossibleexchangerates.Itisthemeanoftheconditionalprobabilitydistributionoffuturespotrates.3.Whatisthemaindeterminantofthevariabilityofforwardmarketreturns?Answer:Themainandonlydeterminantofthevariabilityofforwardmarketreturnsisthevarianceofthefutureexchangerate.4.Describehowyouconstructtheuncertainyen-denominatedreturnfrominvesting1yenintheSwissfrancmoneymarket.Answer:IfyouinvestyenintheSwissmoneymarket,youfirstmustconvertfromyenintoSwissfrancsinthespotforeignexchangemarket.WiththeSwissfrancsthatyouget,youinvestintheSwissmoneymarket,leavingtheinvestmentunhedged.AttheendoftheChapter7:SpeculationandRiskintheForeignExchangeMarket©2012PearsonEducation,Inc.2investmenthorizon,youconvertfromSwissfrancsbackintoyenatthefuturespotexchangerate.5.Whatisahedgedforeigncurrencyinvestment?WhathappensifyouhedgeyourreturninQuestion4?Answer:Ahedgedforeigncurrencyinvestmentsellstheknownforeigncurrencyreturnintheforwardmarketatthetimeoftheinvestment.Thiseliminatesexposuretoforeignexchangerisk,butitalsoelementspossiblegainsfromappreciationoftheforeigncurrency.Byinterestrateparity,weknowthatthedomesticcurrencyreturnfromthehedgedforeigncurrencyinvestmentisjustthedomesticcurrencymoneymarketreturn.6.Whatdoesitmeanforthe90-dayforwardexchangeratetobeanunbiasedpredictorofthefuturespotexchangerate?Answer:Iftheforwardexchangeratefor90daysisanunbiasedpredictorofthefuturespotrate,theforwardrateisequaltotheexpectedfuturespotrate.Whiletherewillbeforecasterrorsthatmaybelarge,therewillnotbesystematicerrorsononesideortheother.Therefore,theexpectedforwardmarketreturniszero.7.Whyisittruethatthehypothesisthattheforwardexchangerateisanunbiasedpredictorofthefuturespotexchangerateisequivalenttothehypothesisthattheforwardpremium(ordiscount)onaforeigncurrencyisanunbiasedpredictoroftherateofitsappreciation(ordepreciation)?Answer:Whentheforwardexchangerateisanunbiasedpredictorofthefuturespotexchangerate,weknowthattheforwardrateequalstheconditionalexpectationofthefuturespotrate.Forexample,atthe90daymaturity,wehavetF(t,90)=ES(t+90)Becausethecurrentspotrate,S(t),isintheinformationsetthatisusedtotaketheconditionalexpectation,wecandividebyitonbothsidesoftheaboveequation.SubtractingonefrombothsidesthengivestF(t,90)-S(t)S(t+90)-S(t)=ES(t)S(t)Thisequationstatesthattheforwardpremiumontheforeigncurrencyequalstheexpectedrateofappreciationoftheforeigncurrency.8.Itisoftenclaimedthattheforwardexchangerateissetbyarbitragetosatisfy(covered)interestrateparity.ExplainhowinterestrateparitycanbesatisfiedandhowtheChapter7:SpeculationandRiskintheForeignExchangeMarket©2012PearsonEducation,Inc.3forwardexchangeratecanbesetbyspeculatorsinreferencetotheexpectedfuturespotexchangerate.Answer:Interestrateparityisanoarbitragerelationbetween4variables,thespotandforwardexchangeratesandtheinterestratesonthetwocurrencies.Iftheforwardexchangerateissetbyspeculatorsinreferencetotheexpectedfuturespotexchangerate,thecurrentspotrateorthetwointerestratescanadjusttosatisfyinterestrateparity.Thespeculativedimensionoftradingmustalsobesatisfiedinequilibrium.9.Itissometimesassertedthatinvestorswhohedgetheirforeigncurrencybondorstockreturnsremovetheforeignexchangeriskassociatedwiththeinvestment,reducethevolatilityoftheirdomesticcurrencyreturns,andthusgeta“freelunch”becausethemeanreturnindomesticcurrencyremainsthesameasthemeanreturnintheforeigncurrency.Isthistrueorfalse?Why?Answer:Ifforwardratesareunbiasedpredictorsoffuturespotrates,hedgingforeigncurrencyinvestmentsdoesnotchangetheirexpectedreturnsandeffectivelyremovesasourceofvolatility.Somewouldsaythatthisprovidesa“freelunch”becausevolatilityisreducedwithoutareductioninmean.Byhedgingforeigninvestments,youcanincreaseyourSharperatioforthisparticularassetclass,whichallowsyoutoleverthereturntothesamevolatilityandgetmorereturn.But,thereisno“freelunch”becauseinthiscasetheforeignexchangeriskisnotapricedrisk.Ifthereisariskpremiumintheforeignexchangemarket,thestatementiswrong.Hedgedforeignbondandequityinvestmentswouldhavedifferentexpectedreturnsthanunhedgedinvestments.10.Itisoftenarguedthatforwardexchangeratesshouldbeunbiasedpredictorsoffuturespotexchange