Financial instruments (Essay Sample)

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Questions
Why do we say a fixed exchange rate system is subject to speculative attacks?
A speculative attack is where market speculators attempt to gain profits by creating significant short term demand for foreign currency which cannot be sustained by the Central Bank, and as a result earn profits from the depreciation of the domestic currency. A fixed exchange rate regime is where a currency is matched to another single currency or to another measure of value with aim of stabilizing the value of that currency against the matched currency. (Garber and Flood, p.1-13). A fixed exchange rate regime is susceptible to speculative attacks courtesy of the large amount of reserves required to keep it in place.
In a pure flexible exchange rate system, how much are Central Banks reserve and why?
A purely flexible exchange rate regime is where the market forces of supply and demand determine a currency’s exchange rate. In this system, a country does not need to maintain a large reserve of the foreign currency like in the fixed exchange rate system; instead, it can even deplete its reserves since the market forces play the role of exchange rate determination.
Using the one step binomial tree calculate the option price (assuming risk neutral probability) with an initial long position in a stock and a short position in a 3 month call. Assume the spot price is 20, strike price is 20, and discount rate is 5% (continuous compounds) and the stock price can end up at either 25 or 15.
To get the option price, we assume p to be the probability that the stock price would move up in a risk-neutral world. The expected return of stock in a risk-neutral world is the risk-free rate of 5%. Therefore, p must satisfy,
 Stock price =$25, option price= 1
Stock price= $20
Stock price=15, option price=0
25p+15(1-p) =20e0.05*3/12
10p=20e0.05*3/12 -15
p=0.5252
At the end of three months, the call option has a 0.5252 probability of being 1 and 0.4748 of being equal to zero.
Its expected value is therefore,
0.5252*1 + 0.4748*0= 0.5252.
This should be discounted at the risk-free arte in a risk-neutral world. The value of the option today is therefore,
0.5252e-0.05*3/12
= $0.5187
Question 4.
Hedging is the process used to mitigate the impact of negative outcomes of fluctuations in the stock market. The multinational US Corporation can decide either to use a futures contract or a call option contract. The futures contract is where the Corporation enters into a contract to with another party to buy a specified amount of Euros at a given price at specified dates, and the parties have an obligation to execute at the maturity and that is the delivery. With the call option, where the Corporation enters into a contract to buy a specified amount of securities at a predetermined price and date, the buyer has the right but not an obligation to execute the contract.
I would recommend the use of a call option. This gives the multinational corporation a chance to make gains in case the Euro weakens against the dollar. However, since the current movement shows that the Euro is gaining strength against the dollar, i.e. 1.48 to 1.39 in the past year, it would be imperative to use a call option in hedging the risk. The multinational US Corporation should enter into a call option contract to purchase 2.5 billion Euros at December 2011.
Question 5
Financial crisis is a phenomenon where a recession is experienced as a result of the collapse of large financial institutions and the downturn of the banking system. A countries economy is...