3 PERCENT (7.3 PERCENT + 200 BASIS POINTS) CAN BE LOCKED IN IF THE H...

9.3 percent (7.3 percent + 200 basis points) can be locked in if the hedge is correctly

implemented.

A rise in the rate to 7.8 percent represents a 50 basis point (bp) increase over the implied LIBOR

rate. For a 50 basis point increase in LIBOR, the cash flow on the short futures position is:

= ($25 per basis point per contract) × 50 bp × 100 contracts

= $125,000.

However, the cash flow on the floating rate liability is:

= –0.098 × ($100,000,000 / 4)

= –$2,450,000.

Combining the cash flow from the hedge with the cash flow from the loan results in a net

outflow of $2,325,000, which translates into an annual rate of 9.3 percent:

= ($2,325,000 × 4) / $100,000,000 = 0.093

This is precisely the implied borrowing rate that Johnson locked in on September 20. Regardless

of the LIBOR rate on December 20, the net cash outflow will be $2,325,000, which translates

into an annualized rate of 9.3 percent. Consequently, the floating rate liability has been

converted to a fixed rate liability in the sense that the interest rate uncertainty associated with

the March 20 payment (using the December 20 contract) has been removed as of September 20.

B. In a strip hedge, Johnson would sell 100 December futures (for the March payment), 100 March

futures (for the June payment), and 100 June futures (for the September payment). The objective

is to hedge each interest rate payment separately using the appropriate number of contracts. The

problem is the same as in Part A except here three cash flows are subject to rising rates and a

strip of futures is used to hedge this interest rate risk. This problem is simplified somewhat

because the cash flow mismatch between the futures and the loan payment is ignored.

Therefore, in order to hedge each cash flow, Johnson simply sells 100 contracts for each

payment. The strip hedge transforms the floating rate loan into a strip of fixed rate payments. As

was done in Part A, the fixed rates are found by adding 200 basis points to the implied forward

LIBOR rate indicated by the discount yield of the three different Eurodollar futures contracts.

The fixed payments will be equal when the LIBOR term structure is flat for the first year.

Level III: Question 8

Topic: Economic Inputs and Portfolio Management

Minutes: 12

Reading References:

“Is Purchasing Power Parity a Useful Guide to the Dollar?” Craig S. Hakkio, Economic Review

(Federal Reserve Bank of Kansas City, Third Quarter 1992)

Purpose:

To test the candidate’s ability to compare and contrast absolute PPP and relative PPP and evaluate

the extent to which PPP is useful in forecasting exchange rate movements.

LOS: The candidate should be able to

“Is Purchasing Power Parity a Useful Guide to the Dollar?” (Session 6)

• contrast the performance of relative purchasing power parity (PPP) as a guide in forecasting

short-term movements and as a guide in forecasting long-term movements in foreign exchange

rates;

• appraise the usefulness of PPP in forming expectations about future movements in exchange

rates and in making judgments about managing portfolio exposure to currency risks.

Guideline Answer

A. Purchasing power parity (PPP) is a measure of a currency’s equilibrium value (the exchange

rate to which the currency moves over time). In PPP equilibrium, any asset or service purchased

with a certain amount of currency in one country will cost the same in any other country, after

conversion into the base currency. PPP is grounded in the law of one price, which states that, in

the absence of transport costs and trade impediments, identical goods should cost the same

across all countries and currencies.

Absolute PPP states that exchange rates depend on differences in absolute price levels in

different countries. Under absolute PPP, exchange rates move to equalize the prices of identical

market baskets in different countries. That is, the exchange rate between two currencies will

tend to rise or fall toward the ratio of the two countries’ overall price levels.

Relative PPP states that exchange rates depend on differences in inflation rates in different

countries. Under relative PPP, exchange rates move to offset inflation differentials in different

countries. That is, the exchange rate between two currencies will tend to rise or fall at a rate

equal to the difference between the two countries’ inflation rates.

Because relative PPP extends directly from absolute PPP, relative PPP holds if absolute PPP

holds. But relative PPP may hold even if absolute PPP does not. Although the exchange rate is

not likely to strictly equal the ratio of foreign and domestic price levels, as absolute PPP

requires, the exchange rate may be proportional to the ratio. If the proportion is fixed, a less

restrictive condition than precise equality, relative PPP holds. Thus, relative PPP is more likely

to hold than absolute PPP.

Both absolute and relative PPP are subject to criticism. Absolute PPP is criticized because the

law of one price does not always hold and because price levels in different countries are

calculated using different price indexes. Relative PPP is criticized because different theories of

exchange rate determination can generate non-PPP equilibrium rates and because price levels

adjust at different speeds than exchange rates.

B. For several reasons, PPP has limited usefulness in predicting short-term foreign exchange rate

movements. First, because exchange rates change rapidly while price levels adjust more slowly,

deviations from PPP are likely to disappear only over longer periods of time as prices adjust.

Second, evidence suggests that:

• market exchange rates and PPP rates do not tend to move together from month to month;

• the time required for exchange rates to equal their PPP rates ranges from several months to

several years;

• trade and capital flows create long-run pressures toward PPP, but observed exchange rates

often show large and prolonged deviations from PPP levels;

• only when deviations from PPP are unusually large is it likely that exchange rates will move

toward their PPP rates in the short run;

• major political and economic events can dominate short-run exchange rate movements;

• explicit government intervention can cause exchange rates to deviate from PPP levels.

Level III: Question 9

Topic: Global Markets/Instruments and Analysis of Alternative Investments

Minutes: 18