1)

IRP, PPP, and Speculating in Currency Derivatives.

The U.S. three-month interest rate (unannualized) is 1%. The Fiji three-month interest rate (unannualized) is 2%. Assume interest rate parity exists. The expected inflation over this period is 3% in the U.S. and 1 % in Fiji. A call option with a three-month expiration date on Fijian dollars is available for a premium of $.02 and a strike price of $.56. The spot rate of the Fijian dollar is $.58. Assume that you believe in purchasing power parity.

Determine the dollar amount of your profit or loss from buying a call option contract specifying $66,000 Fijian dollars. Show all work.

2)

Analysis of Short-term Financing.

Rome Airlines is an Italian based firm that needs $350,000. It has no business in England but is considering one year financing with British pounds, because the annual interest rate would be 5 percent versus 10 percent in Italy. Assume that interest rate parity exists.

Assume that Rome Airlines does not cover its exposure and expects that the British pound will appreciate by 7 percent, 6 percent, or 5 percent, and with an equal probability of each. Use this information to determine the probability distribution of the effective financing rate. What is the probability of financing with the British pound will be less expensive. Show all work.