Question on Practice Exam Q116

[wang_l]

Hi, David,

Here is the question:

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You are using the Meron model to price an European option on foreign exchange.
The underlying is the AUD/CAD spot exchange rate quoted
as 1.35 AUD per 1.00 CAD (1.35AUD/CAD).
If the AUD and CAD risk free rates are 2.4% and 2%, respectively,
what would the rate inputs be in the Merton model for the risk free rate
and dividend yield?


The answer given is
A. Risk free rate = 2%, Dividend yiedls = 2.4%.

But I think the following is correct:
D. Risk free rate = 2.4%, Dividend yiedls = 2%.
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Could you help me on this?

 

[David Harper CFA FRM]

lan

Maybe not, because I agree with you. I think their answer is incorrect.

Further, I think the answer technically is either (A) or (D) because the question does not actually specify whether it's a call AUD/put CAD or a call CAD/put AUD. To my knowledge, that the quote happens to be expressed 1.35 AUD/CAD instead of 0.74 CAD/AUD, does not necessarily tell us which currency is being put.

I agree that (D) is the literal answer because the Black-Scholes FX takes as the SPOT rate (i.e., the input that is the substitute for the stock price) "domestic currency units per unit (1) of foreign currency." So, in this case 1.35 AUD domestic per 1.00 CAD unit of foreign, if we want to be literal about it, implies CAD is the foreign. And, since the foreign rate is the analogue to the dividend yield, I get (D), also. I have been staring at it for 10 minutes and I can't find a way to disagree with you!

But, on the other hand, if it is a put AUD call CAD, then 0.74 CAD/AUD implies CAD is domestic, so then CAD rate (2%) is the riskfree (2%)....so that's why (D) seems like the literal answer, based on an interpretation of 1.35 per a unit of foreign currency (CAD), but still I believe (A) or (D) could be correct. For this reason, because the question does not actually specify the FX currency option, as i read it, I don't think it can be answered...

David

 

[ajsa]

Hi David,

this really makes me VERY concerned.. I feel one may be disadvantaged to certain degree in FRM exam if he/she has a true understanding (compared with others with less clear understanding)... Apparently GARP has not realized this error or flaw yet and continues publishing it as a sample question in their online library now. (There are other examples as you have noticed...)

"1.35 AUD per 1.00 CAD (1.35AUD/CAD)"
and this is the official explaination:
"We defined the spot exchange rate as the value of one of foreign
currency measured in the domestic currency, thus making the AUD(????) the foreign currency."

Thanks.