Define covered interest parity. You may use a diagram to assist youranswer.
1(a)Suppose a Canadian investor has CAD 1 million to invest for 90 days. The currentspot rate between CAD and USD is that 1 USD = 1.1239 CAD. He is considering twooptions:
Option 1: He can invest this money in a local bank in Toronto, and earn annualisedreturn of 0.75%.
Option 2: Alternatively, he could sell his Canadian dollars for US dollars and place aUSD deposit in Chicago and earn 0.4% annualised return.
(i)Assuming that the borrowing and lending rate is the same within each country,what is theoretical 90-day forward rate between Canadian dollar and US dollar thatmakes the investor indifferent between the two options (ignoring transaction costsand taxes)?
Define covered interest parity. You may use a diagram to assist youranswer.[40%]
(ii)Assuming the actual 90-day forward rate is 1.1200.
Explain how the investor couldmake a profit without risk and without investing any of his own money (ignoringtransaction costs and taxes).[30%]
(b)In Germany, financial institutions hold significant equity interests in the borrowingfirms. How does this affect the cost of financial distress and bankruptcy?[30%]Question
2(a)Explain how debt could distort a firm’s investment strategies.[70%]
(b)Explain why you agree or disagree with this statement: “Buying a put isjust like shortselling the underlying asset. You gain the same thing from either position, if theunderlying asset’s price falls. If the price goes up, you have the same loss.”[30%]
3(a)Discuss the S&L crisis. Focusing your discussion upon the funding problem of lendinglong and borrowing short.[70%]
(b)Explain theory of information cascade. Focus on the information asymmetry betweeninvestors, and show how the theory explains IPO underpricing.[30%]Question
4(a)The Fed changed its monetary policy from targeting fed funds rate to nonborrowedreserves between 1979 and 1982.
Explain the rationale behind such change in policyand how the new policy was supposed to affect the economy.[70%]
(b)Explain the reinvestment risk of fixed-income bonds, and whether zero coupon bondshave this type of risk.[30%]Question
5(a)Explain the similarity and difference in the risk-reward characteristics of futures andoptions contracts.
Explain how call options allow investors to protect or hedge againsta rise in the price of the underlying instrument; use a graph to illustratethe hedgeoutcome.[70%]
(b)What keeps the Fed from being able to achieve its goals in a direct way?[30%]
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