Homework # 2

Econ. 316; Prof. Ramirez

1. Using the data provided in Problem 3 of Homework 1, suppose that the investor faces transactions costs that reduce the gains from investing abroad by 1.5 % . Would there now be net gains or losses from covered interest arbitrage? Explain.

2. Suppose that you are the treasurer of a firm importing VCRs from Japan. You have a 62,500,000 yen payable due in 90 days. The current spot rate is $0.0050 per yen, but you expect the yen to appreciate against the dollar over the next 90 days and buy a call option contract on yen. The premium on the option is $0.0002 and the striking price is $0.0055. What is the dollar cost of the contract? If the spot rate in 90 days is $0.0052, do you exercise the option or let it expire? What was the dollar gain or loss from holding the contract? If the spot rate in 90 days is $0.0058, do you exercise the option or let it expire? What was your dollar gain or loss from holding the option contract?

3. Consider an U.S. investor who is deciding whether to invest dollars locally or to undertake covered investments in Canada. Suppose that the Canadian dollar is worth $0.70 spot, the 1-year forward rate is $0.75, and the U.S. and Canadian annual interest rates are 12% and 6%, respectively. The applicable tax rate on interest income is 40%, while that on foreign exchange gains is 20% . Compute the post-tax returns on U.S. and Canadian investments. Which alternative offers the highest post-tax return?