Foreign/domestic

[wrongsaidfred]

Hi David,

Once again I think I may have found something incorrect on an old practice exam and I was hoping you could help me out because it is driving me crazy.

2007 practice exam #116.

"... the underlying is the AUD/CAD spot exchange rate quoted as 1.35 AUD per 1 CAD. If the AUD and CAD interest rates are 2.4% and 2%, respectively, what would be the inputs for the Merton Model for risk free rate and dividend yield?"

It says that the risk free would 2% (domestic) and the div yield would be 2.4 (foreign)%.

From Hull p 114: The two year interest rates in Australia and the US are 5% and 7%, respectively, and the spot exchange rate between the Australian dollar and the US dollar is 0.62 USD per 1 AUD.

In this it used 7% for r and 5% for dividend yield.

One of these is obviously wrong and from everything else I have read it seems like the test is incorrect.

Any advice you could provide would be greatly appreciated.

Thanks,
Mike

 

[David Harper CFA FRM]

Hi Mike,

Yes, I agree with you. The quote currency uses the risk-free rate and the base currency (CAD above) substitutes its risk-free rate for the dividend yield. An easy way to remember this is:
$0.62 is USD per 1 AUD, which is market parlance is AUD/USD $0.62. The quote is US dollars ($) and so that's going to be the "original" risk free rate; literally you can look at the symbol (!), the currency symbol of the quote will go to the risk-free rate (as in Hull's example). So, if CAD/AUD 1.35 (i.e., 1.35 AUD the quote currency per one unit of the base currency of CAD), the quote currency is AUD and so AUD is risk-free and CAD is the "foreign" that substitutes for the dividend yield. So, I would get, to agree with you, risk-free rate = 2.4% (AUD, the quote) and dividend = 2.0% (CAD, the base).

not that it changes anything w.r.t to these inputs, but "what would be the inputs for the Merton Model for risk free rate and dividend yield?" implies an option price not a forward per interest rate parity. (same substitutes apply)

Thanks, David

 

[David Harper CFA FRM]

Mike, i just searched, actually this came up four years ago http://forum.bionicturtle.com/threads/question-on-practice-exam-q116.84/#post-309

 

[wrongsaidfred]

Thanks. Seems very sloppy on their part. I would hate to have them answer a question like this on the actual exam. I hate to even think about appealing something before I even take the test...if that is even an option.

Take care,
Mike