Question 1 (40 marks) a) Explain the concepts of arbitrage and speculation in the context of FOREX market. Use illustrative and numerical examples. [15 marks] b) Discuss the theoretical link between interest rate and exchange rate. Derive and explain the Interest Rate Parity theorem. [12 marks] c) One year borrowing and deposit interest rates are 10% and 8% respectively in the US and 7% and 6.5% respectively in France. The spot exchange rate for the US dollar is $1.2 to the EURO. The 12-month forward rate is $1.35 i) Using the Interest Rate Parity formula, show that there is a breakdown in the parity conditions. [2 marks] ii) Suggest a way an investor might profit from any pricing inconsistency present above, assuming you have no initial investment funds. [8 marks] iii) Will the situation in ii) above last forever? Discuss your answer. [3 marks]

Question 2 (30 marks) a) Differentiate between transaction and translation risks, using illustrative examples. [10 marks] b) OGS Co, A US company, expects to receive 300,000 from export sales at the end of six months. A forward rate of 268 per $1 has been offered by the companys bank and the spot rate is 266 per $1. OGS Co can borrow short term at 10% per year and the rate of interest on $ is 6% Required: Calculate the dollar income from a forward market hedge and a money market hedge, and indicate which hedge would be financially preferred by OGS Co. [10 marks] c) How can FOREX risks be managed in the context of uncertain settlement dates? Illustrate with examples. [10 marks]

Question 3 (30 marks) a) Differentiate carefully between Call and Put Options and discuss their payoff profiles. [8 marks] b) Write down and explain intuitively the Black-Scholes European call option pricing formula. Discuss fully how call prices it delivers change with each of the inputs to the calculation. [7 marks] c) Consider a stock, with a price of $50 and a standard deviation of 0.5. The current risk free rate of interest is 10%. A European call and put on this stock have an exercise price of $56 and expire in four months. Required: Calculate the call option and the put option price and discuss the results. [10 marks] d) How and why are Straddles constructed? Discuss their respective payoff profiles and the implications for speculators. [5 marks]

Question 4 (30 marks) a) What are interest rate swaps? Discuss their uses, using illustrative examples as far as possible. [15 marks] b) You are the corporate treasurer of Baba International Inc. Your firm, rated as AAA, is able to raise capital in US dollars at a floating rate of LIBOR+0.5% or EURO at 5% flat. However, Momo International ltd, with a rating of AA is only able to receive the capital in US dollar at floating rate of LIBOR +1% or in EURO at a fixed rate of 6.5%. Assume that Baba International Inc wants to borrow US dollars at a floating rate of interest and Momo International ltd wants to borrow EURO at a fixed rate of interest. A financial institution is planning to arrange a swap and requires a 20- basis-point spread (0.2). If the swap is equally attractive to Baba International Inc and Momo International Inc, construct a swap and show the rates of interest they will end up paying. [10 marks] c) What are the risks associated with swap contracts? [5 marks]

Question 5 (30 marks) Write on any three (3) of the following. Make use of illustrative examples where appropriate. [3 x 10 marks] - Eurobonds - Marking to market - Letter of Credit and Forfaiting - Government intervention and FOREX - Heckscher-Ohlin Theory & Leontief Paradox - Purchasing Power Parity