CFA Level 2 - Economics Session 4 - Reading 19 Foreign Exchange Parity Relations - LOS m (Practice Questions, Sample Questions) LOS m: Discuss the foreign exchange expectation relation between theforward exchange rate and the expected exchange rate. 1. The Asian Spec Fund, managed by Jonathan Khamal, CFA, engages in currency speculation for its clients. Based in Paris, Khamal believesthat there is an opportunity to speculate on the Malaysian Ringgit. Thecurrent spot exchange rate is 4.417 Malaysian Ringgit per euro.Assuming the one-year risk-free rate for the European EconomicCommunity is 11.76% and the Malaysian one-year risk-free interest rateis 7.6%, what should the one-year forward rate be for the MalaysianRinggit? A) 4.246 MR/EUR.B) 4.586 MR/EUR. C) 4.253 MR/EUR. Explanation: C) The formula for covered interest rate parity is: F / S0 = (1 + rFC) / (1 + rDC)Forward premium or discount:(F – S0) / S0 = [(1 + rFC) / (1 + rDC)] ? 1 = (rFC – rDC) / (1 + rDC)By substituting:%F = [(1 + 0.076) / (1 + 0.1176)] – 1%F = [1.076 / 1.1176] – 1%F = -0.0372F = 4.417 MR/EUR × (1 – 0.0372) = 4.253 MR/EUR 2. Ronald Lots, CFA, is an international currency portfolio manager seeking speculative opportunities in the euro. While reviewing theforward rates for the euro, he notices that there is a forward premium of4.25% on the euro relative to the U.S. dollar. Which of the followingstatements is correct? The euro is expected to: A) appreciate at least 4.25% against the U.S. dollar.
B) depreciate 4.25% against the U.S. dollar. C) appreciate 4.25% against the U.S. dollar. Explanation: C) According to the foreign exchange expectation relation forward discounts and premiums can be unbiased predictors of expectedchanges in spot exchange rates. With the forward euro rate trading at apremium of 4.25%, the euro is expected to appreciate by the same4.25% against the dollar. 3. According to the foreign exchange expectation relation, which of the following is an unbiased predictor of the expected future spot exchangerate? A) Expected change in spot rates.B) Inflation rate. C) Forward rate. Explanation: C) The foreign exchange expectation relation says that the forward rate is an unbiased predictor of the expected future spot rate: F= E (S1) 4. Which of the following statements best defines the foreign currency risk premium? The foreign currency risk premium is the: A) extra cost of hedging foreign currency denominated assets withforward contracts. B) forward premium on foreign currency forward contracts.C) foreign currency risk of holding all foreign currency denominated assets. Explanation: A) Some investors with foreign currency assets may be willing to pay more than the expected spot rate to hedge the uncertaintyof holding foreign currency assets by taking a short position in theforeign currency. Others will demand more than the expected spot rateto sell the foreign currency forward and bear the uncertainty of the spotrate. That extra amount is the risk premium; think of it as a “cost” ofhedging foreign currency-denominated assets with forward contracts. Ifthere were no risk premium, hedging with forward contracts would becostless.