Solution Manual For International Financial Management, 9th Edition by Cheol Eun Chapter 1-21

Solution Manual For International Financial Management, 9th Edition, Cheol Eun Chapter 1-21 CHAPTER 1

GLOBALIZATION AND THE MULTINATIONAL FIRM

ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS

1. Why is it important to study international financial management?

Answer:

We are now living in a world where all the major economic functions, such as

consumption, production, investment, and financing, are highly globalized. It is thus essential for financial managers to fully understand vital international dimensions of financial management. This global shift is in marked contrast to a situation that existed when the authors of this book were learning finance a few decades ago. At that time, most professors customarily (and safely, to some extent) ignored international aspects of finance. This mode of operation has become untenable since then.

2. How is international financial management different from domestic financial management?

Answer: There are three major dimensions that set apart international finance from domestic finance. They are: 1. foreign exchange and political risks, 2. market imperfections, and 3. expanded opportunity set.

3. Discuss the major trends that have prevailed in international business during the last two decades.

Answer: The 2000s brought a rapid integration of international capital and financial markets.

Impetus for globalized financial markets initially came from the governments of major countries that had begun to deregulate their foreign exchange and capital markets.

The economic

integration and globalization that began in the eighties and nineties are picking up speed in the 2000s. Trade liberalization and economic integration continued to proceed at both the regional

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and global levels. Despite sovereign debt crisis in Europe, more EU member countries have adopted the common currency, the euro, that effectively became the second global currency after the U.S. dollar. In the last few years, however, economic nationalism has been gaining some popularity, as exemplified by the Brexit decision of the United Kingdom and the so-called ―America First‖ policies of the Trump Administration. To the extent that economic nationalism is a populist response to the global financial crisis and Great Recession, it may subside as the world economy continues to recover.

4. How is a country‘s economic well-being enhanced through free international trade in goods and services?

Answer: According to David Ricardo, with free international trade, it is mutually beneficial for two countries to each specialize in the production of the goods that it can produce relatively most efficiently and then trade those goods. By doing so, the two countries can increase their combined production, which allows both countries to consume more of both goods.

This

argument remains valid even if a country can produce both goods more efficiently in absolute terms than the other country. International trade is not a ‗zero-sum‘ game in which one country benefits at the expense of another country. Rather, international trade could be an ‗increasingsum‘ game from which all players become winners.

5. What considerations might limit the extent to which the theory of comparative advantage is realistic?

Answer:

The theory of comparative advantage was originally advanced by the nineteenth

century economist David Ricardo as an explanation for why nations trade with one another.

The theory claims that economic well-being is enhanced if each country produces what it has a comparative advantage in producing relative to other countries, and then trade products.

Underlying the theory are the assumptions of free trade between nations and that the factors of production (labor, technological know-how, and capital) are relatively immobile. To the extent that these assumptions do not hold, the theory of comparative advantage may not realistically describe international trade. In addition, free trade produces winners and losers and if the losers are not compensated, free trade may faces political opposition from them.

6. What are multinational corporations (MNCs) and what economic roles do they play?

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Answer: A multinational corporation (MNC) can be defined as a business firm incorporated in one country that has production and sales operations in many other countries. Indeed, some MNCs have operations in a few dozens of different countries. MNCs obtain financing from major money centers around the world in many different currencies to finance their operations.

Global operations force the treasurer‘s office to establish international banking relationships, to place short-term funds in several currency denominations, and to effectively manage foreign exchange risk. By circumventing and also taking advantage of various market imperfections, such as barriers to trade and barriers to flow of people and capital across countries, MNCs contribute to greater integration of the world economy and ing more perfect functioning of global markets.

7. Ross Perot, a former Presidential candidate of the Reform Party, which was a third political party in the United States, had strongly objected to the creation of the North American Trade Agreement (NAFTA), which nonetheless was inaugurated in 1994. Perot feared the loss of American jobs to Mexico where it is much cheaper to hire workers. What are the merits and demerits of Perot‘s position on NAFTA? Considering the recent economic developments in North America, how would you assess Perot‘s position on NAFTA?

Answer: Since the inception of NAFTA, many American companies indeed have invested heavily in Mexico, sometimes relocating production from the United States to Mexico. Although this might have temporarily caused unemployment of some American workers, they were eventually rehired by other industries often for higher wages. At the same time, Mexico has been experiencing a major economic boom. It seems clear that both Mexico and the U.S. have benefited from NAFTA. Perot‘s concern appears to have been ill founded.

8. In 1995, a working group of French chief executive officers was set up by the Confederation of French Industry (CNPF) and the French Association of Private Companies (AFEP) to study the French corporate governance structure. The group reported the following, among other things: ―The board of directors should not simply aim at maximizing share values as in the U.K. and the U.S. Rather, its goal should be to serve the company, whose interests should be clearly distinguished from those of its shareholders, employees, creditors, suppliers and clients but still equated with their general common interest, which is to safeguard the prosperity and continuity of the company‖. Evaluate the above recommendation of the working group.

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Answer: The recommendations of the French working group clearly show that shareholder wealth maximization is not a universally accepted goal of corporate management, especially outside the United States and possibly a few other Anglo-Saxon countries including the United Kingdom and Canada. To some extent, this may reflect the fact that share ownership is not wide spread in most other countries.

9. Emphasizing the importance of voluntary compliance, as opposed to enforcement, in the aftermath of such corporate scandals as those involving Enron and WorldCom, U.S. President George W. Bush stated that while tougher laws might help, ―ultimately, the ethics of American business depends on the conscience of America‘s business leaders.‖ Describe your view on this statement.

Answer: There can be different answers to this question. If business leaders always behave with a high ethical standard, many of the corporate scandals we have seen lately might not have happened. Since we cannot fully depend on the ethical behavior on the part of individual business leaders, the society should protect itself by adopting the rules/regulations and governance structure that would induce business leaders to behave in the interest of the society at large. But at the same time, we need to make sure that excessive regulations do not stymy free enterprises, an important engine of economic growth. It is important to strike the right balance.

10. Suppose you are interested in investing in shares of Samsung Electronics of Korea, which is a world leader in mobile phones, TVs, and home appliances. But before you make investment decision, you would like to learn about the company. Visit the website of Yahoo (http://finance.yahoo.com) and collect information about Samsung Electronics, including the recent stock price history and analysts‘ views of the company. Discuss what you learn about the company. Also discuss how the instantaneous access to information via internet would affect the nature and workings of financial markets.

Answer: As students might have learned from visiting the website, information is readily available even for foreign companies like Samsung Electronics. Ready access to international information helps integrate financial markets, dismantling barriers to international investment and financing. Integration, however, may help a financial shock in one market to be quickly

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transmitted to other markets.

MINI CASE: NIKE AND SWEATSHOP LABOR

Nike, a company headquartered in Beaverton, Oregon, is a major force in the sports footwear and fashion industry, with annual sales exceeding $ 30 billions, more than half of which now come from outside the United States. The company was co-founded in 1964 by Phil Knight, a CPA at Price Waterhouse, and Bill Bowerman, college track coach, each investing $ 500 to start. The company, initially called Blue Ribbon Sports, changed its name to Nike in 1971 and adopted the ―Swoosh‖ logo—recognizable around the world—originally designed by a college student for $35. Nike became highly successful in designing and marketing massappealing products such as the Air Jordan, the best selling athletic shoe of all time.

Nike has no production facilities in the United States. Rather, the company manufactures athletic shoes and garments in such Asian countries as India, Indonesia, and Vietnam using subcontractors, and sells the products in the U.S. and international markets. In each of those Asian countries where Nike has production facilities, the rates of unemployment and underemployment are relatively high. The wage rate is very low in those countries by U.S. standards—the hourly wage rate in the manufacturing sector is less than $ 2 in each of those countries, compared with about $ 38 in the United States. In addition, workers in those countries often operate in poor and unhealthy environments and their rights are not particularly well protected. Understandably, host countries are eager to attract foreign investments like Nike‘s to develop their economies and raise the living standards of their citizens. Recently, however, Nike came under worldwide criticism for its practice of hiring workers for such a low rate of pay— ―next to nothing‖ in the words of critics—and overlooking poor working conditions in host countries.

Initially, Nike denied the sweatshop charges and lashed out at critics. But later, the company began monitoring the labor practice at its overseas factories and grading the factories in order to improve labor standards. Nike also agreed to random factory inspections by disinterested parties.

Discussion points 1.

Do you think the criticism of Nike is fair, considering that the host countries are in dire needs of creating jobs?

2.

What do you think Nike‘s executives might have done differently to prevent the sensitive charges of sweatshop labor in overseas factories?

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3.

Do firms need to consider the so-called corporate social responsibilities in making investment decisions?

Suggested Solution to Nike and Sweatshop Labor Obviously, Nike‘s investments in such Asian countries as China, Indonesia, and Vietnam were motivated to take advantage of low labor costs in those countries. While Nike was criticized for the poor working conditions for its workers, the company has recognized the problem and has substantially improved the working environments recently. Although Nike‘s workers get paid very low wages by the Western standard, they probably are making substantially more than their local compatriots who are either under- or unemployed. While Nike‘s detractors may have valid points, one should not downplay the fact that the company is making contributions to the economic welfare of those Asian countries by creating job opportunities and also helping earn hard currencies that can be used to fund economic growth of those countries.

APPENDIX 1A. GAIN FROM TRADE: THE THEORY OF COMPARATIVE ADVANTAGE

PROBLEMS

1. Country C can produce seven pounds of food or four yards of textiles per unit of input.

Compute the opportunity cost of producing food instead of textiles. Similarly, compute the opportunity cost of producing textiles instead of food.

Solution: The opportunity cost of producing food instead of textiles is one yard of textiles per 7/4 = 1.75 pounds of food. A pound of food has an opportunity cost of 4/7 = .57 yards of textiles.

2. Consider the no-trade input/output situation presented in the following table for Countries X and Y. Assuming that free trade is allowed, develop a scenario that will benefit the citizens of both countries.

INPUT/OUTPUT WITHOUT TRADE _______________________________________________________________________

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Country X

Y

Total

________________________________________________________________________ I. Units of Input (000,000) _______________________ ______________________________ Food

70

60

Textiles

40

30

________________________________________________________________________ II. Output per Unit of Input (lbs or yards) ____________________________________________________ Food

17

5

Textiles

5

2

________________________________________________________________________ III. Total Output (lbs or yards) (000,000) ____________________________________________________ Food

1,190

300

1,490

Textiles

200

60

260

________________________________________________________________________ IV. Consumption (lbs or yards) (000,000) ___________________________________________________ Food

1,190

300

1,490

Textiles

200

60

260

________________________________________________________________________

Solution: Examination of the no-trade input/output table indicates that Country X has an absolute advantage in the production of food and textiles.

Country X can ―trade off‖ one unit of

production needed to produce 17 pounds of food for five yards of textiles. Thus, a yard of textiles has an opportunity cost of 17/5 = 3.40 pounds of food, or a pound of food has an opportunity cost of 5/17 = .29 yards of textiles. Analogously, Country Y has an opportunity cost of 5/2 = 2.50 pounds of food per yard of textiles, or 2/5 = .40 yards of textiles per pound of food.

In terms of opportunity cost, it is clear that Country X is relatively more efficient in producing food and Country Y is relatively more efficient in producing textiles. Thus, Country X (Y) has a

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comparative advantage in producing food (textile) is comparison to Country Y (X).

When there are no restrictions or impediments to free trade the economic-well being of the citizens of both countries is enhanced through trade.

Suppose that Country X shifts

20,000,000 units from the production of textiles to the production of food where it has a comparative advantage and that Country Y shifts 60,000,000 units from the production of food to the production of textiles where it has a comparative advantage. Total output will now be (90,000,000 x 17 =) 1,530,000,000 pounds of food and [(20,000,000 x 5 =100,000,000) + (90,000,000 x 2 =180,000,000) =] 280,000,000 yards of textiles. Further suppose that Country X and Country Y agree on a price of 3.00 pounds of food for one yard of textiles, and that Country X sells Country Y 330,000,000 pounds of food for 110,000,000 yards of textiles. Under free trade, the following table shows that the citizens of Country X (Y) have increased their consumption of food by 10,000,000 (30,000,000) pounds and textiles by 10,000,000 (10,000,000) yards.

INPUT/OUTPUT WITH FREE TRADE __________________________________________________________________________

Country X

Y

Total

__________________________________________________________________________ I. Units of Input (000,000) _______________________________________________________ Food

90

0

Textiles

20

90

__________________________________________________________________________ II. Output per Unit of Input (lbs or yards) ______________________________________________________ Food

17

5

Textiles

5

2

__________________________________________________________________________ III. Total Output (lbs or yards) (000,000) _____________________________________________________ Food

1,530

0

1,530

Textiles

100

180

280

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__________________________________________________________________________ IV. Consumption (lbs or yards) (000,000) _____________________________________________________ Food

1,200

330

1,530

Textiles

210

70

280

__________________________________________________________________________

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CHAPTER 2 INTERNATIONAL MONETARY SYSTEM ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS 1. Explain Gresham‘s Law. Answer: Gresham‘s law refers to the phenomenon that bad (abundant) money drives good (scarce) money out of circulation. This kind of phenomenon was often observed under the bimetallic standard under which both gold and silver were used as means of payments, with the exchange rate between the two fixed.

2.

Explain the mechanism which restores the balance of payments equilibrium when it is

disturbed under the gold standard.

Answer: The adjustment mechanism under the gold standard is referred to as the price-specieflow mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium will be corrected by a counter-flow of gold. Suppose that the U.S. imports more from the U.K. than it exports to the latter. Under the classical gold standard, gold, which is the only means of international payments, will flow from the U.S. to the U.K. As a result, the U.S. (U.K.) will experience a decrease (increase) in money supply. This means that the price level will tend to fall in the U.S. and rise in the U.K. Consequently, the U.S. products become more competitive in the export market, while U.K. products become less competitive. This change will improve U.S. balance of payments and at the same time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium.

3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to gold at 12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be two francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take advantage of this situation? What would be the effect of shipping costs?

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Answer: Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds directly in the foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of gold for 12 francs in France and then ship it to England and sell it for 6 pounds.

In this case, it only costs you 12 francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the pound. Of course, you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign exchange market. The arbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not exist. If it costs more than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit.

4. Discuss the advantages and disadvantages of the gold standard.

Answer: The advantages of the gold standard include: (I) since the supply of gold is restricted, countries cannot have high inflation; (2) any BOP disequilibrium can be corrected automatically through cross-border flows of gold. On the other hand, the main disadvantages of the gold standard are: (I) the world economy can be subject to deflationary pressure due to restricted supply of gold; (ii) the gold standard itself has no mechanism to enforce the rules of the game, and, as a result, countries may pursue economic policies (like de-monetization of gold) that are incompatible with the gold standard.

5. What were the main objectives of the Bretton Woods system?

Answer:

The main objectives of the Bretton Woods system are to achieve exchange rate

stability and promote international trade and development.

6. Comment on the proposition that the Bretton Woods system was programmed to an eventual demise.

Answer: The answer to this question is related to the Triffin paradox. Under the gold-exchange system, the reserve-currency country should run BOP deficits to supply reserves to the world economy, but if the deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself, eventually causing the downfall of the system.

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7. Explain how special drawing rights (SDR) are constructed. Also, discuss the circumstances under which the SDR was created.

Answer: SDR was created by the IMF in 1970 as a new reserve asset, partially to alleviate the pressure on the U.S. dollar as the key reserve currency. The SDR is a basket currency currently comprised of five major currencies, i.e., the U.S. dollar, euro, Chinese yuan, Japanese yen, and British pound. Currently, the dollar receives a 41.73% weight, euro 30.93%, yuan 10.92, yen 8.33%, and pound 8.09%. The weights for different currencies tend to change over time, reflecting the relative importance of each currency in international trade and finance.

8. Explain the arrangements and workings of the European Monetary System (EMS).

Answer:

EMS was launched in 1979 in order to (i) establish a zone of monetary stability in

Europe, (ii) coordinate exchange rate policies against the non-EMS currencies, and (iii) pave the way for the eventual European monetary union. The main instruments of EMS are the European Currency Unit (ECU) and the Exchange Rate Mechanism (ERM). Like SDR, the ECU is a basket currency constructed as a weighted average of currencies of EU member countries. The ECU works as the accounting unit of EMS and plays an important role in the workings of the ERM. The ERM is the procedure by which EMS member countries manage their exchange rates. The ERM is based on a parity grid system, with parity grids first computed by defining the par values of EMS currencies in terms of the ECU. If a country‘s ECU market exchange rate diverges from the central rate by as much as the maximum allowable deviation, the country has to adjust its policies to maintain its par values relative to other currencies. EMS achieved a complete monetary union in 1999 when the common European currency, the euro, was adopted.

9. There are arguments for and against the alternative exchange rate regimes. a. List the advantages of the flexible exchange rate regime. b. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed exchange rate regime. c. Rebut the above criticism from the viewpoint of the proponents of the flexible exchange rate regime.

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Answer:

a. The advantages of the flexible exchange rate system include: (I) automatic

achievement of balance of payments equilibrium and (ii) maintenance of national policy autonomy. b. If exchange rates are fluctuating randomly, that may discourage international trade and encourage market segmentation. This, in turn, may lead to suboptimal allocation of resources. c. Economic agents can hedge exchange risk by means of forward contracts and other techniques. They don‘t have to bear it if they choose not to. In addition, under a fixed exchange rate regime, governments often restrict international trade in order to maintain the exchange rate. This is a self-defeating measure. What‘s good about having the fixed exchange rate if international trade need to be restricted?

10.

In an integrated world financial market, a financial crisis in a country can be quickly

transmitted to other countries, causing a global crisis. What kind of measures would you propose to prevent the recurrence of an Asia-type crisis.

Answer: First, there should be a multinational safety net to safeguard the world financial system from the Asia-type crisis. Second, international institutions like IMF and the World Bank should monitor problematic countries more closely and provide timely advice to those countries.

Countries should be required to fully disclose economic and financial information so that devaluation surprises can be prevented. Third, countries should depend more on domestic savings and long-term foreign investments, rather than short-term portfolio capital. There can be other suggestions.

11. Discuss the criteria for a ‗good‘ international monetary system.

Answer: A good international monetary system should provide (i) sufficient liquidity to the world economy, (ii) smooth adjustments to BOP disequilibrium as it arises, and (iii) safeguard against the crisis of confidence in the system.

12. Once capital markets are integrated, it is difficult for a country to maintain a fixed exchange rate. Explain why this may be so.

Answer: Once capital markets are integrated internationally, vast amounts of money may flow in and out of a country in a short time period. This will make it very difficult for the country to

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maintain a fixed exchange rate.

13. Assess the possibility for the euro to become another global currency rivaling the U.S. dollar. If the euro really becomes a global currency, what impact will it have on the U.S. dollar and the world economy?

Answer: In light of the large transactions domain of the euro, which is comparable to that of the U.S. dollar, and the mandate for the European Central Bank (ECB) to guarantee the monetary stability in Europe, the euro may potentially become another global currency over time. A major uncertainty about this prospect is the lack of political and fiscal integration of Europe. If Europe becomes politically more integrated, the euro is more likely to become a global currency. If the euro becomes a global currency, it will come at the expense of the dollar. Currently, the U.S. derives substantial benefits from the dollar‘s status as the dominant global currency – for instance, the U.S. can run trade deficits without having to maintain substantial foreign exchange reserves, can carry out international commercial and financial transactions in dollars without bearing exchange risk, etc. If the euro is to be used as a major denomination, reserve, and invoice currency in the world economy, dollar-based agents will start to bear more exchange risk, among other things.

MINI CASE: Grexit or Not? When the euro was introduced in 1999, Greece was conspicuously absent from the list of the European Union member countries adopting the common currency. The country was not ready. In a few short years, however, European leaders, probably motivated by their political agenda, allowed Greece to join the euro club in 2001 although it was not entirely clear if the country satisfied the entry conditions. In any case, joining the euro club allowed the Greek government, households, and firms to gain easy access to plentiful funds at historically low interest rates, ushering in a period of robust credit growth. For a while, Greeks enjoyed what seemed to be the fruits of becoming a fullfledged member of Europe. In December 2009, however, the new Greek government revealed that the government budget deficit would be 12.7% for 2009, not 3.7% as previously announced by the outgoing government, far exceeding the EU’s convergence guideline of keeping the budget deficit below 3.0% of the GDP. As the true picture of the government finance became known, the prices of Greek government bonds began to fall sharply, prompting panic selling among international investors, threatening the sovereign defaults.

Several years into the crisis, the Greek government debt stands at around 180% of GDP and the jobless rate among youth is above 50%. The country’s GDP declined by about

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25%. Severe austerity measures, such as sharply raised taxes and much reduced pension benefits, were imposed on Greece as conditions for the bailouts arranged by the EU, IMF, and the European Central Bank. In addition, people were allowed to have only restricted access to their bank deposits, to prevent bank runs. Opinion polls indicate that the majority of people in Germany, the main creditor nation for Greece, prefer the Greek exit from the euro-zone, popularly called Grexit, while some people in Greece are demanding Grexit themselves and restoration of the national currency, the drachma.

Discussion points: (i) the root causes of the Greek predicaments; (ii) the costs and benefits of staying in the euro-zone for Greece, (iii) the measures that need to be taken to keep Greece in the euro-zone in the long run if that is desirable, (iv) If you were a disinterested outside advisor for the Greek government, would you advise Grexit or not?

Why or why not ?

Suggested Solution to Grexit or Not? As is often the case with many sovereign debt crises in history, the Greek sovereign debt crisis, which raises the possibility of Grexit from the euro-zone, is attributable to the excessive borrowing and spending on the part of the government which cannot be adequately financed by the government revenues. As is well known, tax evasion is widely spread in Greece while pension benefits and other welfare services are lavish compared with the country’s economic resources. And the lack of transparency of the government finance also contributed to the steep decline in the Greek government bond prices in late 2009 and 2010. Greece is still not completely out of crisis in part because the country now doesn’t have its own monetary policy that can be tailored to address its dire economic conditions, like easy monetary policy and depreciation of the national currency to help the country recover from the crisis quickly. The lack of policy independence thus is a very major cost of remaining in the euro-zone. If Greece is to remain in the euro-zone in the long run, it has to reduce the government expenditures, cut business costs, and boost labor productivity, among other things. If it is difficult to implement the above and other measures to strengthen the competitiveness of the Greek economy, the country then may seriously consider getting out of the euro-zone and recovering national policy autonomy with its own currency.

CHAPTER 3 BALANCE OF PAYMENTS

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ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Define balance of payments.

Answer: The balance of payments (BOP) can be defined as the statistical record of a country‘s international transactions over a certain period of time presented in the form of double-entry bookkeeping.

2. Why would it be useful to examine a country‘s balance of payments data?

Answer: It would be useful to examine a country‘s BOP for at least two reasons. First, BOP provides detailed information about the supply and demand of the country‘s currency. Second, BOP data can be used to evaluate the performance of the country in international economic competition. For example, if a country is experiencing perennial BOP deficits, it may signal that the country‘s industries lack competitiveness.

3.

The United States has experienced continuous current account deficits since the early

1980s. What do you think are the main causes for the deficits? What would be the consequences of continuous U.S. current account deficits?

Answer: The current account deficits of U.S. may be attributable to (i) the strong dollar and undervalued currencies of trading partners such as China, Japan, and euro-zone (ii) high consumption and low savings in the U.S. and low consumption and high savings in major trading partners, (iii) weak competitiveness of U.S. industries, especially manufacturing sector. If U.S. deficits continue, the dollar may eventually depreciate substantially and the confidence in dollar may suffer.

4. In contrast to the United States, Japan has realized continuous current account surpluses.

What could be the main causes for these surpluses? Is it desirable to have continuous current account surpluses?

Answer: Japan‘s continuous current account surpluses may have reflected a weak yen and

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high competitiveness of Japanese industries. Massive capital exports by Japan prevented yen from appreciating more than it did. At the same time, foreigners‘ exports to Japan were hampered by closed nature of Japanese markets. Continuous current account surpluses disrupt free trade by promoting protectionist sentiment in the deficit country. It is not desirable especially when it is brought about by the mercantilist policies.

5. Comment on the following statement: ―Since the United States imports more than it exports, it is necessary for the United States to import capital from foreign countries to finance its current account deficits.‖

Answer: The statement presupposes that the U.S. current account deficit causes its financial account surplus. In reality, the causality can be running in the opposite direction: U.S. financial account surplus may cause the country‘s current account deficit. Suppose foreigners find the U.S. a great place to invest and send their capital to the U.S., resulting in U.S. financial account surplus. This capital inflow will strengthen the dollar, hurting the U.S. export and encouraging imports from foreign countries, causing current account deficits.

6. Explain how a country can run an overall deficit or surplus on its balance of payments.

Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve transactions. For example, an overall BOP deficit can be supported by drawing down the central bank‘s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central bank‘s reserve holdings.

7. Explain official reserve assets and its major components.

Answer: Official reserve assets are those financial assets that can be used as international means of payments. Currently, official reserve assets comprise: (i) gold, (ii) foreign exchanges, (iii) special drawing rights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges are by far the most important official reserves.

8. Explain how to compute the overall balance and discuss its significance.

Answer: The overall balance is determined by computing the cumulative balance of payments

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including the current account, capital account, financial account, and the statistical discrepancies. The overall balance is significant because it indicates a country‘s international payment gap that must be financed by the government‘s official reserve transactions.

9. Since the early 1980s, foreign portfolio investors have purchased a significant portion of U.S. treasury bond issues.

Discuss the short-term and long-term effects of foreigners‘ portfolio

investment on the U.S. balance of payments.

Answer: As foreigners purchase U.S. Treasury bonds, U.S. BOP will improve in the short run. But in the long run, U.S. BOP may deteriorate because the U.S. should pay interests and principals to foreigners. If foreign funds are used productively and contributes to the competitiveness of U.S. industries, however, U.S. BOP may improve in the long run.

10. Describe the balance of payments identity and discuss its implications under the fixed and flexible exchange rate regimes.

Answer: The balance of payments identity holds that the combined balance on the current, capital, and financial accounts should be equal in size, but opposite in sign, to the change in the official reserves: BCA + BKA + BFA = - BRA. Under the pure flexible exchange rate regime, central banks do not engage in official reserve transactions and, as a result, BRA would be close to zero. Thus, the overall balance must balance, i.e., BCA + BFA = - BKA. Under the fixed exchange rate regime, however, a country can have an overall BOP surplus or deficit as the central bank will accommodate it via official reserve transactions.

11. Exhibit 3.6 indicates that in 2013, China had a current account surplus and at the same time a financial account surplus. Explain how this can happen?

Answer: In 2013, China experienced a current account surplus since it exported more to the rest of the world than it imported from the rest of the world. At the same time, China also attracted financial inflows that exceed its financial outflows. As a result, China experienced an overall surplus on its BOP in 2013, which must have increased its reserve holdings.

12. Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments:

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(1) A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank account kept in New York City.

(2) A U.S. citizen consumes a meal at a restaurant in Paris and pays with her American Express card.

(3) A Indian immigrant living in Los Angeles sends a check drawn on his L.A. bank account as a gift to his parents living in Mumbai.

(4) A U.S. computer programmer is hired by a British company for consulting and gets paid from the U.S. bank account maintained by the British company.

Answer: _________________________________________________________________ Transactions

Credit

Debit

_________________________________________________________________

Japanese purchase of U.S. T bonds



Japanese payment using NYC account



U.S. citizen having a meal in Paris



Paying the meal with American Express

 

Gift to parents in Bombay Receipts of the check by parents (goodwill)



Export of programming service



British payment out of its account in U.S.



_________________________________________________________________

13. Construct the balance of payment table for Germany for year 2018 which is comparable in format to Exhibit 3.1, and interpret the numerical data. You may consult International Financial Statistics published by IMF or search for useful websites for the data yourself.

Answer: A summary of the German Balance of Payments for 2018 (in $ billion)

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Credits Current Account [1] Exports [1.1] Goods [1.2] Services [2] Imports [2.1] Goods [2.2] Services [3] Primary income [4] Secondary income Balance on current account [[1]+[2]+[3]+[4]] Capital Account Balance on capital account Financial Account [5] Direct investment [6] Portfolio investment [6.1] Equity securities [6.2] Debt securities [6.3] Derivatives, net [7] Other investment Balance on financial account [[5]+[6]+[7]] [8] Statistical discrepancies Overall balance Official Reserve Account

Debits

1,869.9 1,527.1 342.8 -1,630.3 -1,264.6 -365.7 -149.5 -136.9

257.3 80.8 291.3

51.3 2.4

-48.9

105.3 -51.4

-159.1 -110.0 -34.0 -48.5 -27.5 -154.7 -270.5

1.1 -52.5 99.4

-22.7 0.5 -0.5

Source: Balance of Payments and International Investment Position Statistics, IMF

Note: It is noted that Germany experienced ‗divestment‘ by foreigners in portfolio investment in 2018. It is also noted that the above numbers may be affected somewhat by the government updating of the economic data. One salient feature of the above table is that Germany realized a significant merchandise trade surplus but a deficit in service trade, suggesting that Germany‘s comparative advantage may be in the manufacturing sector, not in service sector.

14. Discuss the possible strengths and weaknesses of SDRs versus the dollar as the main reserve currency. Do you think the SDR should or could replace the U.S. dollar as the main global reserve currency?

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Answer: Being a basket currency, SDR has a relatively stable exchange value. However, IMF, that issues SDRs, has no mandate to function as the world central bank. In addition, there is no liquid bond market for SDR. The U.S. dollar, on the other hand, has deep, liquid markets and is backed by the most powerful country in the world. The dollar‘s credibility as the dominant global currency, however, is being hurt by fiscal and trade deficits and the declining share of the U.S. in the world output.

PROBLEMS

1. The U.S. Balance of Payments for year 2017.

Solution: Goods -2,360.9 Balance on current account -449.2 Balance on financial account 330.2 Statistical discrepancies 92.5 MINI CASE: MEXICO‘S BALANCE OF PAYMENTS PROBLEM

Recently, Mexico experienced large-scale trade deficits, depletion of foreign reserve holdings and a major currency devaluation in December 1994, followed by the decision to freely float the peso. These events also brought about a severe recession and higher unemployment in Mexico. Since the devaluation, however, the trade balance has improved.

Investigate the Mexican experiences in detail and write a report on the subject. In the report, you may: (a) document the trend in Mexico‘s key economic indicators, such as the balance of payments, the exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12.; (b) investigate the causes of Mexico‘s balance of payments difficulties prior to the peso devaluation; (c) discuss what policy actions might have prevented or mitigated the balance of payments problem and the subsequent collapse of the peso; and (d) derive lessons from the Mexican experience that may be useful for other developing countries.

In your report, you may identify and address any other relevant issues concerning Mexico‘s balance of payment problem. International Financial Statistics published by IMF provides basic

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macroeconomic data on Mexico.

Suggested Solution to Mexico‘s Balance of payments Problem

To solve this case, it is useful to review Chapter 2, especially the section on the Mexican peso crisis. Despite the fact that Mexico had experienced continuous trade deficits until December 1994, the country‘s currency was not allowed to depreciate for political reasons. The Mexican government did not want the peso devaluation before the Presidential election held in 1994. If the Mexican peso had been allowed to gradually depreciate against the major currencies, the peso crisis could have been prevented.

The key lessons that can be derived from the peso crisis are: First, Mexico depended too much on short-term foreign portfolio capital (which is easily reversible) for its economic growth.

The country perhaps should have saved more domestically and depended more on long-term foreign capital. This can be a valuable lesson for many developing countries. Second, the lack of reliable economic information was another contributing factor to the peso crisis. The Salinas administration was reluctant to fully disclose the true state of the Mexican economy. If investors had known that Mexico was experiencing serious trade deficits and rapid depletion of foreign exchange reserves, the peso might have been gradually depreciating, rather than suddenly collapsed as it did. The transparent disclosure of economic data can help prevent the peso-type crisis. Third, it is important to safeguard the world financial system from the peso-type crisis. To this end, a multinational safety net needs to be in place to contain the peso-type crisis in the early stage.

CHAPTER 4 CORPORATE GOVERNANCE AROUND THE WORLD SUGGESTED ANSWERS TO END-OF-CHAPTERQUESTIONS AND PROBLEMS

Questions

1. The majority of major corporations are franchised as public corporations. Discuss the key strength and weakness of the ‗public corporation‘. When do you think the public corporation as an organizational form is unsuitable?

Answer: The key strength of the public corporation lies in that it allows for efficient risk sharing among investors. As a result, the public corporation may raise a large sum of capital at a relatively low cost. The main weakness of the public corporation stems from the conflicts of

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interest between managers and shareholders. If this problem, known as the agency problem, becomes severe with the entrenched management, resulting in misallocation of resources and destruction of shareholder wealth, the public corporation becomes unviable.

2. The public corporation is owned by multitude of shareholders but managed by professional managers. Managers can take self-interested actions at the expense of shareholders.

Discuss the conditions under which the so-called agency problem arises.

Answer: The agency problem arises when managers have control rights but insignificant cash flow rights. This wedge between control and cash flow rights motivates managers to engage in self-dealings at the expense of shareholders.

3. Following corporate scandals and failures in the U.S. and abroad, there is a growing demand for corporate governance reform. What should be the key objectives of corporate governance reform? What kind of obstacles can there be thwarting reform efforts?

Answer: The key objectives of corporate governance reform should be to strengthen shareholder rights and protect shareholders from expropriation by corporate insiders, whether managers or dominant shareholders. Controlling shareholders or managers do not wish to lose their control rights and thus resist reform efforts.

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4. Studies show that the legal protection of shareholder rights varies a great deal across countries. Discuss the possible reasons why the English common law tradition provides the strongest and the French civil law tradition the weakest protection of investors.

Answer: In civil law countries, the state historically has played an active role in regulating economic activities and has been less protective of property rights. In England, control of the court passed from the crown to the parliament and property owners in seventeenth century.

English common law thus became more protective of property owners, and this protection was extended to investors over time.

5. Explain ‗the wedge‘ between the control and cash flow rights and discuss its implications for corporate governance.

Answer: When there is a separation of ownership and control, managers have control rights with insignificant cash flow rights, whereas shareholders have cash flow rights but no control rights.

This wedge gives rise to the conflicts of interest between managers and shareholders. The wedge is the source of the agency problem.

6. Discuss different ways that dominant investors use to establish and maintain the control of the company with relatively small investments.

Answer:

Dominant investors may use: (i) shares with superior voting rights, (ii) pyramidal

ownership structure, and (iii) inter-firm cross-holdings.

7. The Cadbury Code of the Best Practice adopted in the United Kingdom led to a successful reform of corporate governance in the country. Explain the key requirements of the Code and discuss how it may have contributed to the success of reform.

Answer: The Code requires that chairman of the board and CEO be held by two different individuals, and that there should be at least three outside board members. The recommended

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board structure helped to strengthen the monitoring function of the board and reduce the agency problem.

8. Many companies grant stocks or stock options to the managers. Discuss the benefits and possible costs of using this kind of incentive compensation scheme.

Answer: Stock options can be useful for aligning the interest of managers with that of shareholders and reduce the wedge between managerial control rights and cash flow rights. But at the same time, stock options may induce managers to distort investment decisions and manipulate financial statements so that they can maximize their benefits in the short run.

9. It has been shown that foreign companies listed in the U.S. stock exchanges are valued more than those from the same countries that are not listed in the U.S. Explain the reasons why U.S.-listed foreign firms are valued more than those which are not. Also explain why not every foreign firm wants to list stocks in the United States.

Answer: Foreign companies domiciled in countries with weak investor protection can bond themselves credibly to better investor protection by listing their stocks in U.S. exchanges that are known to provide a strong investor protection. Managers of some companies may not wish to list shares in U.S. exchanges, subjecting themselves to stringent disclosure and monitoring, for fear of losing their control rights and private benefits.

10. Explain ―free cash flows.‖

Why do managers like to retain free cash flows instead of

distributing it to shareholders? Discuss what mechanisms may be used to solve this problem?

Answer: Free cash flow represents a firm‘s internally generated fund in excess of the amount needed to undertake all profitable investment projects. Managers may want to keep free cash flows to undertake unprofitable projects at the expense of shareholders to benefit themselves.

Having some debt can impose disciplining effect on the managers and induce them to reduce waste of firm‘s resources.

11. Epic bribe scandal at Petrobras, a major oil company controlled by the Brazilian government, that broke out in 2015 shocked the economic and political system of Brazil. Put simply, the company insiders, outside suppliers and contractors, and politicians colluded and

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stole billions of dollars from the company via kickbacks, bid riggings, overcharging for construction projects, etc. The Petrobras scandal led to a sharp drop of the company share price, laying off thousands of workers, and tilting the national economy toward recession.

The scandal also seriously tarnished the image of Brazil as one of the promising emerging markets. Document in detail what happened at Petrobras and then investigate how the company’s governance and the country’s political culture may have contributed to the scandal.

Answer: According to the 2018 Corruption Perceptions Index compiled by Transparency International, a global civil organization, Brazil ranks 105th in the world much below countries like Romania and Senegal. There has been wide-spread discontent in Brazil about the rampant corruption in the highest echelons of business and politics. Since March 2014, Brazil has been shaken by the news exposing the largest scandal involving the state-controlled Petrobras, the largest company in Brazil. Even Brazil’s former President Luiz Inacio Lula da Silva was detained and interrogated for possible wrongdoings. The Petrobras corruption scheme involves multiple companies colluding to win over-priced contracts from Petrobras and paying a part of those contracts back to high-level employees of Petrobras as bribes. In return for the bribes, Petrobras executives condone the cartel scheme of the contracting companies. High-level government officials and politicians responsible for overseeing Petrobras also take bribes for condoning the corruption schemes. In Brazil, it is difficult to prosecute those suspects with high government positions due to the privileged status they enjoy. But prosecutors managed to successfully prosecute corrupt businessmen, bankers, and politicians.

MINI CASE: Parmalat: Europe‘s Enron

Discussion points.

1. How was it possible for Parmalat managers to ―cook the books‖ and hide it for so long?

2. Investigate and discuss the role that international banks and auditors might have played in Parmalat‘s collapse.

3. Study and discuss Italy‘s corporate governance regime and its role in the failure of Parmalat.

Suggested Answers:

1. Parmalat was able to cook the books mainly due to the fact that Italy has a low level of accounting transparency.

2. Apparently, international banks and auditors failed to do the due diligence, perhaps unintentionally contributing to the failure of Parmalat.

3. Italy has a weak corporate governance regime that does not provide a strong protection of outside shareholders. The majority of public firms are dominated by large controlling shareholders who are often the founding families. The lack of independent board of directors

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also contributed to the implosion of Parmalat.

CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGE ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Give a full definition of the market for foreign exchange.

Answer:

Broadly defined, the foreign exchange (FX) market encompasses the conversion of

purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts.

2. What is the difference between the retail or client market and the wholesale or interbank market for foreign exchange?

Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the wholesale or interbank market and the other tier is the retail or client market. International banks provide the core of the FX market. They stand willing to buy or sell foreign currency for their own account.

These international banks serve their retail clients, corporations or

individuals, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Retail transactions account for only about 14 percent of FX trades. The other 86 percent is interbank trades between international banks, or non-bank dealers large enough to transact in the interbank market.

3. Who are the market participants in the foreign exchange market?

Answer: The market participants that comprise the FX market can be categorized into five groups: international banks, bank customers, non-bank dealers, FX brokers, and central banks.

International banks provide the core of the FX market.

Approximately 100 to 200 banks

worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange.

Non-bank dealers are large non-bank financial

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institutions, such as investment banks, mutual funds, pension funds, and hedge

funds, whose size and frequency of trades make it cost- effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs.

Most interbank trades are speculative or arbitrage transactions where market participants attempt to correctly judge the future direction of price movements in one currency versus another or attempt to profit from temporary price discrepancies in currencies between competing dealers.

FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers.

Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price of its currency against that of a major trading partner, or a country that it ―fixes‖ or ―pegs‖ its currency against. Intervention is the process of using foreign currency reserves to buy one‘s own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively, selling one‘s own currency for foreign currency in order to increase its supply and lower its price.

4. How are foreign exchange transactions between international banks settled?

Answer: The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining

demand deposit

accounts with

one another,

called

correspondent bank accounts. The correspondent bank account network allows for the efficient functioning of the foreign exchange market.

As an example of how the network of

correspondent bank accounts facilities international foreign exchange transactions, consider a U.S. importer desiring to purchase merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his bank and inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the bank will debit the U.S. importer‘s account for the purchase of the Dutch guilders. The bank will instruct its correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount of guilders and to credit the Dutch exporter‘s bank account. The importer‘s bank will then debit its books to offset the debit of U.S. importer‘s account, reflecting the decrease in its correspondent bank account balance.

5. What is meant by a currency trading at a discount or at a premium in the forward market?

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Answer:

The forward market involves contracting today for the future purchase or sale of

foreign exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower (at a discount) than the spot price.

6. Why does most interbank currency trading worldwide involve the U.S. dollar?

Answer: Trading in currencies worldwide is against a common currency that has international appeal. That currency has been the U.S. dollar since the end of World War II. However, the euro and Japanese yen have started to be used much more as international currencies in recent years. More importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a market against all other currencies.

7. Banks find it necessary to accommodate their clients‘ needs to buy or sell FX forward, in many instances for hedging purposes. How can the bank eliminate the currency exposure it has created for itself by accommodating a client‘s forward transaction?

Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To illustrate, suppose a bank customer wants to buy dollars three months forward against British pound sterling.

The bank can handle this trade for its customer and

simultaneously neutralize the exchange rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will lend the dollars for three months until they are needed to deliver against the dollars it has sold forward. The British pounds received will be used to liquidate the sterling loan.

8.

A CAD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of

the market is trading at CAD1.3436-CAD1.3441. What is implied about the trader‘s beliefs by his prices?

Answer: The trader must think the Canadian dollar is going to appreciate against the U.S. dollar and therefore he is trying to increase his inventory of Canadian dollars by discouraging purchases of U.S. dollars by standing willing to buy $ at only CAD1.3435/$1.00 and offering to

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sell from inventory at the slightly lower than market price of CAD1.3440/$1.00.

9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?

Answer: Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate.

Most, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread.

Nevertheless, the implied cross-rate bid-ask quotations impose a

discipline on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit is possible.

10. Over the past five years, the exchange rate between British pound and U.S. dollar, $/£, has changed from about 1.69 to about 1.31. Would you agree that over this five-year period that British goods have become cheaper for buyers in the United States?

CFA Guideline Answer:

The value of the British pound in U.S. dollars has gone down from about 1.69 to about 1.31.

Therefore, the dollar has appreciated relative to the British pound, and the dollars needed by Americans to purchase British goods have decreased. Thus, the statement is correct.

PROBLEMS

1. Using the American term quotes from Exhibit 5.7, calculate a cross-rate matrix for the euro, Swiss franc, Japanese yen, and the British pound so that the resulting triangular matrix is similar to the portion above the diagonal in Exhibit 5.8.

Solution: Because we are using the American term quotes, the cross-rate formula we want to use is:

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S(j/k) = S($/k)/S($/j).

The triangular matrix will contain 4 x (4-1)/2 = 6 cross-rates among these currencies in addition to their USD exchange rates in European terms copied from Exhibit 5.7 in the first column. $

SF

¥

£

Euro

0.8903

0.8918

0.00799

1.1714

Switzerland

0.9982

0.00895

1.3134

Japan

111.49

U.K

0.7600

146.69

2. Using the American term quotes from Exhibit 5.7, calculate the one-, three-, and six-month forward cross-exchange rates between the Australian dollar and the Swiss franc. State the forward cross-rates in ―Australian‖ terms.

Solution: The formulas we want to use are: FN(AUD/SFr) = FN($/SFr)/FN($/AUD) or FN(AUD/SFr) = FN(AUD/$)/FN(SFr/$).

We will use the top formula that uses American term forward exchange rates.

F1(AUD/SFr) = 1.0047/.7117 = 1.4117 F3(AUD/SFr) = 1.0104/.7125 = 1.4181 F6(AUD/SFr) = 1.0193/.7139 = 1.4278 3. A foreign exchange trader with a U.S. bank took a short position of £5,000,000 when the $/£ exchange rate was 1.55.

Subsequently, the exchange rate has changed to 1.61.

Is this

movement in the exchange rate good from the point of view of the position taken by the trader?

By how much has the bank‘s liability changed because of the change in the exchange rate?

CFA Guideline Answer:

The increase in the $/£ exchange rate implies that the pound has appreciated with respect to the dollar. This is unfavorable to the trader since the trader has a short position in pounds.

Bank‘s liability in dollars initially was 5,000,000 x 1.55 = $7,750,000

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Bank‘s liability in dollars now is 5,000,000 x 1.61 = $8,050,000

4. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in forward points.

Spot

1.3431-1.3436

One-Month

1.3432-1.3442

Three-Month

1.3448-1.3463

Six-Month

1.3488-1.3508

Solution: One-Month

01-06

Three-Month

17-27

Six-Month

57-72

5. Using the spot and outright forward quotes in problem 4, determine the corresponding bidask spreads in points.

Solution: Spot

5

One-Month

10

Three-Month

15

Six-Month

20

6. Using Exhibit 5.7, calculate the one-, three-, and six-month forward premium or discount for the Japanese yen versus the U.S. dollar using American term quotations.

For simplicity,

assume each month has 30 days. What is the interpretation of your results?

Solution: The formula we want to use is: fN,JPY

= [(FN($/¥) - S($/¥)/S($/¥)] x 360/N

f1,JPY = [(.00899 - .00897)/.00897] x 360/30 = .02676 f3,JPY = [(.00903 - .00897)/.00897] x 360/90 = .02676 f6,JPY = [(.00910 - .00897)/.00897] x 360/180 = .02899 The pattern of forward premiums indicates that the Japanese yen is trading at a premium versus the U.S. dollar. That is, it becomes more expensive to buy a Japanese yen forward for U.S.

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dollars (in absolute and percentage terms) the further into the future one contracts.

7. Using Exhibit 5.7, calculate the one-, three-, and six-month forward premium or discount for the U.S. dollar versus the British pound using European term quotations. For simplicity, assume each month has 30 days. What is the interpretation of your results?

Solution: The formula we want to use is: fN,$

= [(FN (£/$) - S(£/$))/S(£/$)] x 360/N

f1,$ = [(.7588 - .7600)/.7600] x 360/30 = -.01895 f3,$ = [(.7565 - .7600)/.7600] x 360/90 = -.01842 f6,$ = [(.7532 - .7600)/.7600] x 360/180 = -.01789 The pattern of forward premiums indicates that the dollar is trading at a discount versus the British pound. That is, it becomes less expensive to buy a dollar forward for British pounds (in absolute and percentage terms). However, the forward discount decreases slightly as one contracts further into the future.

8.

A bank is quoting the following exchange rates against the dollar for the Swiss franc and

the Australian dollar:

SFr/$ = 1.5960--70 A$/$ = 1.7225--35

An Australian firm asks the bank for an A$/SFr quote. What cross-rate would the bank quote?

CFA Guideline Answer:

The SFr/A$ quotation is obtained as follows. In obtaining this quotation, we keep in mind that SFr/A$ = SFr/$/A$/$, and that the price (bid or ask) for each transaction is the one that is more advantageous to the bank.

The SFr/A$ bid price is the number of SFr the bank is willing to pay to buy one A$. This transaction (buy A$—sell SFr) is equivalent to selling SFr to buy dollars (at the bid rate of 1.5960 and the selling those dollars to buy A$ (at an ask rate of 1.7235). Mathematically, the transaction is as follows:

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bid SFr/A$ = (bid SFr/$)/(ask A$/$) = 1.5960/1.7235 = 0.9260

The SFr/A$ ask price is the number of SFr the bank is asking for one A$. This transaction (sell A$—buy SFr) is equivalent to buying SFr with dollars (at the ask rate of 1.5970 and then simultaneously purchasing these dollars against A$ (at a bid rate of 1.7225). This may be expressed as follows:

ask SFr/A$ = (ask SFr/$)/(bid A$/$) = 1.5970/1.7225 = 0.9271

The resulting quotation by the bank is

SFr/A$ = 0.9260—0.9271

9. Given the following information, what are the NZD/SGD currency against currency bid-ask quotations?

American Terms

European Terms

Bank Quotations

Bid

Bid

New Zealand dollar

.7265 .7272

1.3751 1.3765

Singapore dollar

.6135 .6140

1.6287 1.6300

Ask

Ask

Solution: Equation 5.12 from the text implies Sb(NZD/SGD) = Sb($/SGD) x Sb(NZD/$) = .6135 x 1.3751 = .8436. The reciprocal, 1/Sb(NZD/SGD) = Sa(SGD/NZD) = 1.1854. Analogously, it is implied that Sa(NZD/SGD) = Sa($/SGD) x Sa(NZD/$) = .6140 x 1.3765 = .8452. The reciprocal, 1/Sa(NZD/SGD) = Sb(SGD/NZD) = 1.1832. Thus, the NZD/SGD bid-ask spread is NZD0.8436NZD0.8452 and the SGD/NZD spread is SGD1.1832-SGD1.1854.

10. Doug Bernard specializes in cross-rate arbitrage. He notices the following quotes:

Swiss franc/dollar = SFr1.5971?$ Australian dollar/U.S. dollar = A$1.8215/$ Australian dollar/Swiss franc = A$1.1440/SFr

Ignoring transaction costs, does Doug Bernard have an arbitrage opportunity based on

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these quotes?

If there is an arbitrage opportunity, what steps would he take to make an

arbitrage profit, and how would he profit if he has $1,000,000 available for this purpose.

CFA Guideline Answer:

A.

The implicit cross-rate between Australian dollars and Swiss franc is A$/SFr = A$/$ x $/SFr

= (A$/$)/(SFr/$) = 1.8215/1.5971 = 1.1405.

However, the quoted cross-rate is higher at

A$1.1.1440/SFr. So, triangular arbitrage is possible.

B.

In the quoted cross-rate of A$1.1440/SFr, one Swiss franc is worth A$1.1440, whereas the

cross-rate based on the direct rates implies that one Swiss franc is worth A$1.1405. Thus, the Swiss franc is overvalued relative to the A$ in the quoted cross-rate, and Doug Bernard‘s strategy for triangular arbitrage should be based on selling Swiss francs to buy A$ as per the quoted cross-rate. Accordingly, the steps Doug Bernard would take for an arbitrage profit is as follows: i.

Sell dollars to get Swiss francs: Sell $1,000,000 to get $1,000,000 x SFr1.5971/$ = SFr1,597,100.

ii.

Sell Swiss francs to buy Australian dollars: Sell SFr1,597,100 to buy SFr1,597,100 x A$1.1440/SFr = A$1,827,082.40.

iii.

Sell

Australian

dollars

for

dollars:

Sell

A$1,827,082.40

for

A$1,827,082.40/A$1.8215/$ = $1,003,064.73.

Thus, your arbitrage profit is $1,003,064.73 - $1,000,000 = $3,064.73.

11. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal, you notice that Dresdner Bank is quoting €0.7627/$1.00 and Credit Suisse is offering SFr1.1806/$1.00. You learn that UBS is making a direct market between the Swiss franc and the euro, with a current €/SFr quote of .6395. Show how you can make a triangular arbitrage profit by trading at these prices. (Ignore bid-ask spreads for this problem.) Assume you have $5,000,000 with which to conduct the arbitrage. What happens if you initially sell dollars for Swiss francs? What €/SFr price will eliminate triangular arbitrage?

Solution: To make a triangular arbitrage profit the Deutsche Bank trader would sell $5,000,000 to Dresdner Bank at €0.7627/$1.00. This trade would yield €3,813,500= $5,000,000 x .7627.

The Deutsche Bank trader would then sell the euros for Swiss francs to Union Bank of Switzerland at a price of €0.6395/SFr1.00, yielding SFr5,963,253 = €3,813,500/.6395. The

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Deutsche Bank trader will resell the Swiss francs to Credit Suisse for $5,051,036 = SFr5,963,253/1.1806, yielding a triangular arbitrage profit of $51,036.

If the Deutsche Bank trader initially sold $5,000,000 for Swiss francs, instead of euros, the trade would yield SFr5,903,000 = $5,000,000 x 1.1806. The Swiss francs would in turn be traded for euros to UBS for €3,774,969= SFr5,903,000 x .6395. The euros would be resold to Dresdner Bank for $4,949,481 = €3,774,969/.7627, or a loss of $50,519. Thus, it is necessary to conduct the triangular arbitrage in the correct order.

The S(€/SFr) cross exchange rate should be .7627/1.1806 = .6460. This is an equilibrium rate at which a triangular arbitrage profit will not exist. (The student can determine this for himself.)

A profit results from the triangular arbitrage when dollars are first sold for euros

because Swiss francs are purchased for euros at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss francs are purchased for only €0.6395/SFr1.00 instead of the no-arbitrage rate of €0.6460/SFr1.00. Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs are sold for euros at too low a rate, resulting in too few euros.

That is, each Swiss franc is sold for €0.6395/SFr1.00 instead of the higher no-arbitrage rate of €0.6460/SFr1.00.

12. The current spot exchange rate is $1.95/£ and the three-month forward rate is $1.90/£.

Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/£ in three months. Assume that you would like to buy or sell £1,000,000.

a.

What actions do you need to take to speculate in the forward market?

What is the

expected dollar profit from speculation?

b.

What would be your speculative profit in dollar terms if the spot exchange rate actually

turns out to be $1.86/£.

Solution:

a.

If you believe the spot exchange rate will be $1.92/£ in three months, you should buy

£1,000,000 forward for $1.90/£. Your expected profit will be: $20,000 = £1,000,000 x ($1.92 -$1.90).

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b.

If the spot exchange rate actually turns out to be $1.86/£ in three months, your loss from

the long position will be: -$40,000 = £1,000,000 x ($1.86 -$1.90).

13. Omni Advisors, an international pension fund manager, plans to sell equities denominated in Swiss Francs (CHF) and purchase an equivalent amount of equities denominated in South African rands (ZAR).

Omni will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate the risk that the ZAR will appreciate relative to the CHF during this 30-day period. The following exhibit shows current exchange rates between the ZAR, CHF, and the U.S. dollar (USD).

Currency Exchange Rates ZAR/US

ZAR/US

CHF/US

CHF/US

D

D

D

D

Bid

Ask

Bid

Ask

Spot

6.2681

6.2789

1.5282

1.5343

30-day

6.2538

6.2641

1.5226

1.5285

90-day

6.2104

6.2200

1.5058

1.5115

Maturit y

a.

Describe the currency transaction that Omni should undertake to eliminate currency risk over the 30-day period.

b.

Calculate the following: • The CHF/ZAR cross-currency rate Omni would use in valuing the Swiss equity portfolio.

• The current value of Omni‘s Swiss equity portfolio in ZAR. •

The annualized forward premium or discount at which the ZAR is trading

versus the CHF. CFA Guideline Answer:

a.

To eliminate the currency risk arising from the possibility that ZAR will appreciate against the CHF over the next 30-day period, Omni should sell 30-day forward

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CHF against 30-day forward ZAR delivery (sell 30-day forward CHF against USD and buy 30-day forward ZAR against USD).

b.

The calculations are as follows:

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• Using the currency cross rates of two forward foreign currencies and three currencies (CHF, ZAR, USD), the exchange would be as follows: --30 day forward CHF are sold for USD. Dollars are bought at the forward selling price of CHF1.5285 = $1 (done at ask side because going from currency into dollars) --30 day forward ZAR are purchased for USD. Dollars are simultaneously sold to purchase ZAR at the rate of 6.2538 = $1 (done at the bid side because going from dollars into currency) --For every 1.5285 CHF held, 6.2538 ZAR are received; thus the cross currency rate is 1.5285 CHF/6.2538 ZAR = 0.244411398.

• At the time of execution of the forward contracts, the value of the 3 million CHF equity portfolio would be 3,000,000 CHF/0.244411398 = 12,274,386.65 ZAR. • To calculate the annualized premium or discount of the ZAR against the CHF requires comparison of the spot selling exchange rate to the forward selling price of CHF for ZAR.

Spot rate = 1.5343 CHF/6.2681 ZAR = 0.244779120 30 day forward ask rate 1.5285 CHF/6.2538 ZAR = 0.244411398 The premium/discount formula is: [(forward rate – spot rate) / spot rate] x (360 / # day contract) = [(0.244411398 – 0.24477912) / 0.24477912] x (360 / 30) = -1.8027126 % = -1.80% discount ZAR to CHF

MINI CASE: SHREWSBURY HERBAL PRODUCTS, LTD.

Shrewsbury Herbal Products, located in central England close to the Welsh border, is an old-line producer of herbal teas, seasonings, and medicines. Its products are marketed all over the United Kingdom and in many parts of continental Europe as well.

Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign customers in order to guard against adverse exchange rate changes. Nevertheless, it has just received an order from a large wholesaler in central France for £320,000 of its products, conditional upon delivery being made in three months‘ time and the order invoiced in euros.

Shrewsbury‘s controller, Elton Peters, is concerned with whether the pound will appreciate

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versus the euro over the next three months, thus eliminating all or most of the profit when the euro receivable is paid. He thinks this is an unlikely possibility, but he decides to contact the firm‘s banker for suggestions about hedging the exchange rate exposure.

Mr. Peters learns from the banker that the current spot exchange rate is €/£ is €1.4537, thus the invoice amount should be €465,184. Mr. Peters also learns that the three-month forward rates for the pound and the euro versus the U.S. dollar are $1.8990/£1.00 and $1.3154/€1.00, respectively. The banker offers to set up a forward hedge for selling the euro receivable for pound sterling based on the €/£ forward cross-exchange rate implicit in the forward rates against the dollar.

What would you do if you were Mr. Peters?

Suggested Solution to Shrewsbury Herbal Products, Ltd.

(Note to Instructor: This elementary case provides an intuitive look at hedging exchange rate exposure. Students should not have difficulty with it even though hedging will not be formally discussed until Chapter 8. The case is consistent with the discussion that accompanies Exhibit 5.9 of the text.

Professor of Finance, Banikanta Mishra, of Xavier Institute of

Management – Bhubaneswar, India contributed to this solution.)

Suppose Shrewsbury sells at a twenty percent markup. Thus the cost to the firm of the £320,000 order is £256,000.

Thus, the pound could appreciate to €465,184/£256,000 =

€1.8171/1.00 before all profit was eliminated. This seems rather unlikely. Nevertheless, a ten percent appreciation of the pound (€1.4537 x 1.10) to €1.5991/£1.00 would only yield a profit of £34,904 (= €465,184/1.5991 - £256,000). Shrewsbury can hedge the exposure by selling the euros forward for British pounds at F3(€/£) = F3($/£) ’ F3($/€) = 1.8990 ÷ 1.3154 = 1.4437. At this forward exchange rate, Shrewsbury can ―lock-in‖ a price of £322,217 (= €465,184/1.4437) for the sale. The forward exchange rate indicates that the euro is trading at a premium to the British pound in the forward market. Thus, the forward hedge allows Shrewsbury to lock-in a greater amount (£2,217) than if the euro receivable was converted into pounds at the current spot If the euro was trading at a forward discount, Shrewsbury would end up locking-in an amount less than £320,000. Whether that would lead to a loss for the company would depend upon the extent of the discount and the amount of profit built into the price of £320,000. Only if the forward exchange rate is even with the spot rate will Shrewsbury receive exactly £320,000.

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Obviously, Shrewsbury could ensure that it receives exactly £320,000 at the end of threemonth accounts receivable period if it could invoice in £. That, however, is not acceptable to the French wholesaler.

When invoicing in euros, Shrewsbury could establish the euro invoice

amount by use of the forward exchange rate instead of the current spot rate. The invoice amount in that case would be €461,984 = £320,000 x 1.4437. Shrewsbury can now lock-in a receipt of £320,000 if it simultaneously hedges its euro exposure by selling €461,984 at the forward rate of 1.4437. That is, £320,000 = €461,984/1.4437.

CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS AND FORECASTING FOREIGN EXCHANGE RATES ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Give a full definition of arbitrage.

Answer: Arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.

2. Discuss the implications of the interest rate parity for the exchange rate determination.

Answer: Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be written as: S = [(1 + i£)/(1 + i$)]E[St+1It].

The exchange rate is thus determined by the relative interest rates, and the expected future spot rate, conditional on all the available information, It, as of the present time. One thus can say that expectation is self-fulfilling. Since the information set will be continuously updated as news hit the market, the exchange rate will exhibit a highly dynamic, random behavior.

3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate.

Answer: The forward exchange rate will be an unbiased predictor of the future spot rate if (i) the forward risk premium is insignificant and (ii) foreign exchange markets are informationally efficient.

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4. Explain the purchasing power parity, both the absolute and relative versions. What causes the deviations from the purchasing power parity?

Answer: The absolute version of purchasing power parity (PPP): S = P$/P£.

The relative version is: e = $ - £.

PPP can be violated if there are barriers to international trade or if people in different countries have different consumption taste. PPP is the law of one price applied to a standard consumption basket.

5. Discuss the implications of the deviations from the purchasing power parity for countries‘ competitive positions in the world market.

Answer: If exchange rate changes satisfy PPP, competitive positions of countries will remain unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative competitiveness of countries. If a country‘s currency appreciates (depreciates) by more than is warranted by PPP, that will hurt (strengthen) the country‘s competitive position in the world market.

6. Explain and derive the international Fisher effect.

Answer: The international Fisher effect can be obtained by combining the Fisher effect and the relative version of PPP in its expectational form. Specifically, the Fisher effect holds that E($) = i$ - $, E(£) = i£ - £.

Assuming that the real interest rate is the same between the two countries, i.e., $ = £, and substituting the above results into the PPP, i.e., E(e) = E($)- E(£), we obtain the international Fisher effect: E(e) = i$ - i£.

7.

Researchers found that it is very difficult to forecast the future exchange rates more

accurately than the forward exchange rate or the current spot exchange rate. How would you interpret this finding?

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Answer: This implies that exchange markets are informationally efficient. Thus, unless one has private information that is not yet reflected in the current market rates, it would be difficult to beat the market.

8. Explain the random walk model for exchange rate forecasting. Can it be consistent with the technical analysis?

Answer:

The random walk model predicts that the current exchange rate will be the best

predictor of the future exchange rate. An implication of the model is that past history of the exchange rate is of no value in predicting future exchange rate. The model thus is inconsistent with the technical analysis which tries to utilize past history in predicting the future exchange rate.

*9. Derive and explain the monetary approach to exchange rate determination.

Answer: The monetary approach is associated with the Chicago School of Economics. It is based on two tenets: purchasing power parity and the quantity theory of money. Combing these two theories allows for stating, say, the $/£ spot exchange rate as: S($/£) = (M$/M£)(V$/V£)(y£/y$), where M denotes the money supply, V the velocity of money, and y the national aggregate output. The theory holds that what matters in exchange rate determination are: 1. The relative money supply, 2. The relative velocities of monies, and 3. The relative national outputs.

10. Explain the following three concepts of purchasing power parity (PPP): a. The law of one price. b. Absolute PPP. c. Relative PPP.

Answer: a. The law of one price (LOP) refers to the international arbitrage condition for the standard consumption basket. LOP requires that the consumption basket should be selling for the same

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price in a given currency across countries. b. Absolute PPP holds that the price level in a country is equal to the price level in another country times the exchange rate between the two countries. c. Relative PPP holds that the rate of exchange rate change between a pair of countries is about equal to the difference in inflation rates of the two countries.

11. Evaluate the usefulness of relative PPP in predicting movements in foreign exchange rates on: a. Short-term basis (for example, three months) b. Long-term basis (for example, six years) Answer. a. PPP is not useful for predicting exchange rates on the short-term basis mainly because international commodity arbitrage is a time-consuming and costly process. b. PPP is more useful for predicting exchange rates on the long-term basis.

PROBLEMS

1. Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months. The six-month interest rate is 8 percent per annum in the United States and 7 percent per annum in Germany. Currently, the spot exchange rate is €1.01 per dollar and the six-month forward exchange rate is €0.99 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return?

Solution: The market conditions are summarized as follows: i$ = 4%; i€ = 3.5%; S = €1.01/$; F = €0.99/$.

If $100,000,000 is invested in the U.S., the maturity value in six months will be $104,000,000 = $100,000,000 (1 + .04).

Alternatively, $100,000,000 can be converted into euros and invested at the German interest rate, with the euro maturity value sold forward. In this case the dollar maturity value will be $105,590,909 = ($100,000,000 x 1.01)(1 + .035)(1/0.99) Clearly, it is better to invest $100,000,000 in Germany with exchange risk hedging.

2. While you were visiting London, you purchased a Jaguar for £35,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35% interest per

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month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£ and the three-month forward exchange rate is $1.40/£. In London, the money market interest rate is 2.0% for a three-month investment. There are two alternative ways of paying for your Jaguar. (a) Keep the funds at your bank in the U.S. and buy £35,000 forward. (b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity value becomes equal to £35,000.

Evaluate each payment method. Which method would you prefer? Why?

Solution: The problem situation is summarized as follows: A/P = £35,000 payable in three months iNY = 0.35%/month, compounding monthly iLD = 2.0% for three months S = $1.45/£;

F = $1.40/£.

Option a: When you buy £35,000 forward, you will need $49,000 in three months to fulfill the forward contract. The present value of $49,000 is computed as follows: $49,000/(1.0035)3 = $48,489.

Thus, the cost of Jaguar as of today is $48,489.

Option b: The present value of £35,000 is £34,314 = £35,000/(1.02). To buy £34,314 today, it will cost $49,755 = 34,314x1.45. Thus the cost of Jaguar as of today is $49,755.

You should definitely choose to use ―option a‖, and save $1,266, which is the difference between $49,755 and $48489.

3. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000. a. Determine whether the interest rate parity is currently holding. b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit. c. Explain how the IRP will be restored as a result of covered arbitrage activities.

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Solution: Let‘s summarize the given data first: S = $1.5/£; F = $1.52/£; i$ = 2.0%; i£ = 1.45% Credit = $1,500,000 or £1,000,000. a. (1+i$) = 1.02 (1+i£)(F/S) = (1.0145)(1.52/1.50) = 1.0280 Thus, IRP is not holding exactly. b. (1) Borrow $1,500,000; repayment will be $1,530,000.

(2) Buy £1,000,000 spot using $1,500,000.

(3) Invest £1,000,000 at the pound interest rate of 1.45%; maturity value will be £1,014,500.

(4) Sell £1,014,500 forward for $1,542,040 Arbitrage profit will be $12,040 (=$1,542,040 - $1,530,000). c. Following the arbitrage transactions described above, The dollar interest rate will rise; The pound interest rate will fall; The spot exchange rate will rise; The forward exchange rate will fall.

These adjustments will continue until IRP is restored.

4. Currently, the spot exchange rate is $0.85/A$ and the one-year forward exchange rate is $0.81/A$. One-year interest is 3.5% in the United States and 4.2% in Australia.

You may borrow up to $1,000,000 or A$1,176,471, which is equivalent to $1,000,000 at the current spot rate. a. Determine if IRP is holding between Australia and the United States. b. If IRP is not holding, explain in detail how you would realize certain profit in U.S. dollar terms. c. Explain how IRP will be restored as a result of arbitrage transactions you carry out above.

Solution: a. (1+i$) = 1.035 (1+iA$)(F/S) = (1.042)(0.81/0.85) = 0.9930 Thus, IRP is not holding exactly. b. (1) Borrow A$1,176,471 and repay A$1,225,883 in one year.

(2) Sell spot A$1,176,471 for $1,000,000.

(3) Invest $1,000,000 in the US. The maturity value will be $1,035,000.

(4) Buy A$1,225,883 forward for $992,965.

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Arbitrage profit = $1,035,000 - $992,965 = $42,035.

5.

Suppose that the current spot exchange rate is €0.80/$ and the three-month forward

exchange rate is €0.7813/$. The three-month interest rate is 5.60 percent per annum in the United States and 5.40 percent per annum in France. Assume that you can borrow up to $1,000,000 or €800,000. a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit. b. Assume that you want to realize profit in terms of euros. Show the covered arbitrage process and determine the arbitrage profit in euros.

Solution: a. (1+ i$) = 1.014 < (F/S) (1+ i €) = 1.0378. Thus, one has to borrow dollars and invest in euros to make arbitrage profit.

1. Borrow $1,000,000 and repay $1,014,000 in three months.

2. Sell $1,000,000 spot for €800,000.

3. Invest €800,000 at the euro interest rate of 1.35 % for three months and receive €810,800 at maturity.

4. Sell €810,800 forward for $1,037,758.

Arbitrage profit = $1,037,758 - $1,014,000 = $23,758. b. Follow the first three steps above. But the last step, involving exchange risk hedging, will be different. Specifically, for the euro-based investor, the source of currency risk is the dollar payable, $1,014,000. Thus, he/she needs to buy $1,014,000 forward for €792,238.

Arbitrage profit = €810,800 - €792,238 = €18,562.

6. In the October 23, 1999 issue, the Economist reports that the interest rate per annum is 5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based on the reported interest rates, how would you predict the change of the exchange rate between the U.S. dollar and the Turkish lira?

Solution: A high Turkish interest rate must reflect a high expected inflation in Turkey. According to international Fisher effect (IFE), we have E(e) = i$ - iLira = 5.93% - 70.0% = -64.07% The Turkish lira thus is expected to depreciate against the U.S. dollar by about 64%.

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7. As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is R$1.95/$. The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6% and 20.0%, respectively. What would you forecast the exchange rate to be at around November 1, 2000?

Solution: Since the inflation rate is quite high in Brazil, we may use the purchasing power parity to forecast the exchange rate.

E(e) = E($) - E(R$) = 2.6% - 20.0% = -17.4% R$ is expected to depreciate by about 17.4% against the US dollar. Thus, the expected exchange rate would be E(ST) = So(1 + E(e)) = (R$1.95/$) (1 + 0.174) = R$2.29/$

8. (CFA question) Omni Advisors, an international pension fund manager, uses the concepts of purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates. Omni gathers the financial information as follows: Base price level

100

Current U.S. price level

105

Current South African price level

111

Base rand spot exchange rate

$0.175

Current rand spot exchange rate

$0.158

Expected annual U.S. inflation

7%

Expected annual South African inflation

5%

Expected U.S. one-year interest rate

10%

Expected South African one-year interest rate

8%

Calculate the following exchange rates (ZAR and USD refer to the South African rand and U.S. dollar, respectively). a. The current ZAR spot rate in USD that would have been forecast by PPP. b. Using the IFE, the expected ZAR spot rate in USD one year from now.

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c. Using PPP, the expected ZAR spot rate in USD four years from now.

Solution: a. ZAR spot rate under PPP = [1.05/1.11](0.175) = $0.1655/rand. b. Expected ZAR spot rate = [1.10/1.08] (0.158) = $0.1609/rand. c. Expected ZAR under PPP = [(1.07)4/(1.05)4] (0.158) = $0.1704/rand.

9. Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate is €1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot exchange rate. a. Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are a euro-based investor. Also determine the size of the arbitrage profit. b. Discuss how the interest rate parity may be restored as a result of the above transactions. c. Suppose you are a pound-based investor. Show the covered arbitrage process and determine the pound profit amount.

Solution: a. First, note that (1+i €) = 1.054 is less than (F/S)(1+i €) = (1.60/1.50)(1.052) = 1.1221.

You should thus borrow in euros and lend in pounds.

1) Borrow €1,000,000 and promise to repay €1,054,000 in one year.

2) Buy ₤666,667 spot for €1,000,000.

3) Invest ₤666,667 at the pound interest rate of 5.2%; the maturity value will be ₤701,334.

4) To hedge exchange risk, sell the maturity value ₤701,334 forward in exchange for €1,122,134.

The arbitrage profit will be the difference between €1,122,134 and

€1,054,000, i.e., €68,134. b. As a result of the above arbitrage transactions, the euro interest rate will rise, the pound interest rate will fall. In addition, the spot exchange rate (euros per pound) will rise and the forward rate will fall. These adjustments will continue until the interest rate parity is restored. c. The pound-based investor will carry out the same transactions 1), 2), and 3) in a. But to hedge, he/she will buy €1,054,000 forward in exchange for ₤658,750. The arbitrage profit will then be ₤42,584 = ₤701,334 - ₤658,750.

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10. Due to the integrated nature of their capital markets, investors in both the U.S. and U.K. require the same real interest rate, 2.5%, on their lending. There is a consensus in capital markets that the annual inflation rate is likely to be 3.5% in the U.S. and 1.5% in the U.K. for the next three years. The spot exchange rate is currently $1.50/£.

a. Compute the nominal interest rate per annum in both the U.S. and U.K., assuming that the Fisher effect holds. b. What is your expected future spot dollar-pound exchange rate in three years from now? c. Can you infer the forward dollar-pound exchange rate for one-year maturity?

Solution. a. Nominal rate in US = (1+ρ) (1+E(π$)) – 1 = (1.025)(1.035) – 1 = 0.0609 or 6.09%.

Nominal rate in UK= (1+ρ) (1+E(π₤)) – 1 = (1.025)(1.015) – 1 = 0.0404 or 4.04%. b. E(ST) = [(1.0609)3/(1.0404)3] (1.50) = $1.5904/₤. c. F = [1.0609/1.0404](1.50) = $1.5296/₤.

11. After studying Iris Hamson‘s credit analysis, George Davies is considering whether he can increase the holding period return on Yucatan Resort‘s excess cash holdings (which are held in pesos) by investing those cash holdings in the Mexican bond market. Although Davies would be investing in a peso-denominated bond, the investment goal is to achieve the highest holding period return, measured in U.S. dollars, on the investment.

Davies finds the higher yield on the Mexican one-year bond, which is considered to be free of credit risk, to be attractive but he is concerned that depreciation of the peso will reduce the holding period return, measured in U.S. dollars. Hamson has prepared selected economic and financial data, given in Exhibit 3-1, to help Davies make the decision.

Selected Economic and Financial Data for U.S. and Mexico Expected U.S. Inflation Rate 2.0% per year Expected Mexican Inflation Rate 6.0% per year U.S. One-year Treasury Bond Yield 2.5% Mexican One-year Bond Yield 6.5%

Spot One-year Forward

Nominal Exchange Rates 9.5000 Pesos = U.S. $ 1.00 9.8707 Pesos = U.S. $ 1.00

Hamson recommends buying the Mexican one-year bond and hedging the foreign currency exposure using the one-year forward exchange rate. She concludes: ―This transaction will result

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in a U.S. dollar holding period return that is equal to the holding period return of the U.S. oneyear bond.‖

a. Calculate the U.S. dollar holding period return that would result from the transaction recommended by Hamson. Show your calculations. State whether Hamson‘s conclusion about the U.S. dollar holding period return resulting from the transaction is correct or incorrect. After conducting his own analysis of the U.S. and Mexican economies, Davies expects that both the U.S. inflation rate and the real exchange rate will remain constant over the coming year. Because of favorable political developments in Mexico, however, he expects that the Mexican inflation rate (in annual terms) will fall from 6.0 percent to 3.0 percent before the end of the year. As a result, Davies decides to invest Yucatan Resorts‘ cash holdings in the Mexican one-year bond but not to hedge the currency exposure. b. Calculate the expected exchange rate (pesos per dollar) one year from now. Show your calculations. Note: Your calculations should assume that Davies is correct in his expectations about the real exchange rate and the Mexican and U.S. inflation rates. c. Calculate the expected U.S. dollar holding period return on the Mexican one-year bond.

Show your calculations. Note: Your calculations should assume that Davies is correct in his expectations about the real exchange rate and the Mexican and U.S. inflation rates.

Solution: a. The U.S. dollar holding period return that would result from the transaction recommended by Hamson is 2.5%. The investor can buy ―x‖ amount of pesos at the (indirect) spot exchange rate, invest these ―x‖ pesos in the Mexican bond market and have ―x × (1 + Y MEX)‖ pesos in one year, and convert these pesos back into dollars using the (indirect) forward exchange rate. Interest rate parity asserts that the two holding period returns must be equal, which can be represented by the formula: (1 + YUS) = Spot × (1 + YMEX) × (1 / Forward) where ―Spot‖ and ―Forward‖ are in indirect terms. The left side of the equation represents the holding period return for a U.S. dollar-denominated bond. If interest rate parity holds, the ―YUS‖ term also corresponds to the U.S. dollar holding period return for the currency-hedged Mexican one-year bond. The right side of the equation is the holding period return, in dollar terms, for a currency-hedged peso-denominated bond.

Solving for YUS:

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(1 + YUS) = 9.5000 × (1 + 0.065) × (1 / 9.8707) (1 + YUS) = 9.5000 × 1.065 × 0.1013 (1 + YUS) = 1.0249 YUS = 1.0249 – 1.0000 = 0.0249 = 2.5% Thus YUS = 2.5%, which is the same yield as on the one-year U.S. bond. Hamson‘s conclusion about the U.S. dollar holding period return is correct. b. The expected exchange rate one year from now is 9.5931. The rate can be calculated by using the formula: (1 + %Δ RUS) = (1 + %Δ SUS) × [(1 + %Δ PUS) / (1 + %Δ PMEX)] = (S1 / S0) × [(1 + %Δ PUS) / (1 + %Δ PMEX)] where RUS is the real U.S. dollar exchange rate, Si is the nominal spot exchange rate in period i, and %Δ P is the inflation rate. Note that the currency quotes are in indirect form.

Solving for S1 (the expected exchange rate one year from now): (1 + 0.0000) = (S1 / 9.5000) × [(1 + 0.02) / (1 + 0.03)] 1.0000 = (S1 / 9.5000) × 0.9903 1.0098 = S1 / 9.5000 S1 = 9.5931 c. The expected U.S. dollar holding period return on the Mexican one-year bond is 5.47%. The return can be calculated as shown below, using the formula in Part A and the current spot exchange rate and expected one-year spot exchange rate calculated in Part B. Holding period return = [(1 + YMEX) × (1 + %Δ peso‘s value)] – 1 = [(1 + YMEX) × (S0 / S1)] – 1 = [(1 + 0.065) × (9.5000 / 9.5931)] – 1 = (1.065 × 0.9903) – 1 = 5.47%

12. James Clark is a foreign exchange trader with Citibank. He notices the following quotes.

Spot exchange rate

SFr1.2051/$

Six-month forward exchange rate

SFr1.1922/$

Six-month $ interest rate

2.5% per year

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Six-month SFr interest rate

2.0% per year

a. Is the interest rate parity holding? You may ignore transaction costs. b. Is there an arbitrage opportunity? If yes, show what steps need to be taken to make arbitrage profit. Assuming that James Clark is authorized to work with $1,000,000, compute the arbitrage profit in dollars.

Solution: a.

For six months, iSFr = 1.0% and i$ = 1.25%. the spot exchange rate is $0.8298/SFr and the forward rate is $0.8388/SFr. Thus, (1+ i$ ) = 1.0125 and (F/s) (1 + iSFr) = (0.8388/0.8298) (1.01) = 1.02095 Because the left and right sides of IRP are not equal, IRP is not holding.

b. Because IRP is not holding, there is an arbitrage possibility: Because 1.0125 < 1.02095, we can say that the SFr interest rate quote is more than what it should be as per the quotes for the other three variables. Equivalently, we can also say that the $ interest rate quote is less than what it should be as per the quotes for the other three variables. Therefore, the arbitrage strategy should be based on borrowing in the $ market and lending in the SFr market. The steps would be as follows:  Borrow $1,000,000 for six months at 1.25%. Need to pay back $1,000,000 × (1 + 0.0125) = $1,012,500 six months later.  Convert $1,000,000 to SFr at the spot rate to get SFr 1,205,100.  Lend SFr 1,205,100 for six months at 1.0%. Will get back SFr 1,205,100 × (1 + 0.01) = SFr 1,217,151 six months later.  Sell SFr 1,217,151 six months forward. The transaction will be contracted as of the current date but delivery and settlement will only take place six months later. So, six months later, exchange SFr 1,217,151 for SFr 1,217,151/SFr 1.1922/$ = $1,020,929.

The arbitrage profit six months later is $1,020,929 – $1,012,500 = $8,429.

13. Suppose you conduct currency carry trade by borrowing $1 million at the start of each year and investing in New Zealand dollar for one year. One-year interest rates and the exchange rate between the U.S. dollar ($) and New Zealand dollar (NZ$) are provided below for the period 2000 – 2009. Note that interest rates are one-year interbank rates on January 1st each year, and that the exchange rate is the amount of New Zealand dollar per U.S. dollar on December 31 each year. The exchange rate was NZ$1.9088/$ on January 1, 2000. Fill out the columns (4) –

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(7) and compute the total dollar profits from this carry trade over the ten-year period. Also, assess the validity of uncovered interest rate parity based on your solution of this problem. You are encouraged to use Excel program to tackle this problem.

(1) Year iNZ$ 2000 6.53 2001 6.70 2002 4.91 2003 5.94 2004 5.88 2005 6.67 2006 7.28 2007 8.03 2008 9.10 2009 5.10 Data source: Datastream.

(2) i$ 6.50 6.00 2.44 1.45 1.46 3.10 4.84 5.33 4.22 2.00

(3) SNZ$/$ 2.2599 2.4015 1.9117 1.5230 1.3845 1.4682 1.4182 1.2994 1.7112 1.3742

(4) iNZ$ - i$

(5) eNZ$/$

(6) (4)-(5)

(7) $ Profit

(2) i$ 6.50 6.00 2.44 1.45 1.46 3.10 4.84 5.33 4.22 2.00

(3) SNZ$/$ 2.2599 2.4015 1.9117 1.5230 1.3845 1.4682 1.4182 1.2994 1.7112 1.3742

(4) iNZ$ - i$ 0.03 0.7 2.47 4.49 4.42 3.57 2.44 2.7 4.88 3.1

(5) eNZ$/$ 18.40 6.27 -20.40 -20.33 -9.10 6.05 -3.40 -8.38 31.69 -19.69

(6) (4)-(5) -18.37 -5.57 22.87 24.82 13.52 -2.48 5.84 11.08 -26.81 22.79

(7) $ Profit -183655 -55680 228676 248220 135159 -24790 58438 110810 -268106 227922

Solution: (1) iNZ$ 6.53 6.70 4.91 5.94 5.88 6.67 7.28 8.03 9.10 5.10

Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Notes: 1. Interest rates are interbank 1-year rates on January 1st of each year and measured in percent terms.

2. Spot exchange rates, SNZ$/$, are measured on December 31st of each year and spot exchange rates was NZ$1.9088 per US$ on January 1, 2000.

3. All data are from Datastream.

If uncovered interest rate parity holds, profit from carry trade should be insignificantly different from zero. But since the profit in column (7) substantially differs from zero each year, uncovered IRP does not appear to hold.

Mini Case: Turkish Lira and the Purchasing Power Parity

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Veritas Emerging Market Fund specializes in investing in emerging stock markets of the world.

Mr. Henry Mobaus, an experienced hand in international investment and your boss, is currently interested in Turkish stock markets. He thinks that Turkey will eventually be invited to negotiate its membership in the European Union. If this happens, it will boost the stock prices in Turkey.

But, at the same time, he is quite concerned with the volatile exchange rates of the Turkish currency. He would like to understand what drives the Turkish exchange rates. Since the inflation rate is much higher in Turkey than in the U.S., he thinks that the purchasing power parity may be holding at least to some extent. As a research assistant for him, you were assigned to check this out. In other words, you have to study and prepare a report on the following question: Does the purchasing power parity hold for the Turkish lira-U.S. dollar exchange rate? Among other things, Mr. Mobaus would like you to do the following:

1. Plot past annual exchange rate changes against the differential inflation rates between Turkey and the U.S. for the last 20 years.

2. Regress the annual rate of exchange rate changes on the annual inflation rate differential to estimate the intercept and the slope coefficient, and interpret the regression results.

Data source: You may download the annual inflation rates for Turkey and the U.S., as well as the exchange rate between the Turkish lira and US dollar from the following source: http://data.un.org. For the exchange rate, you are advised to use the variable code 186 AE ZF.

Solution: Data obtained from http://data.un.org Inf_TK (%) (1)

Inf_US (%) (2)

∆Inf (1)-(2)

1989

S(TL/$) End-of-year rate

∆St/St-1 (%) := et

0.0023

1990

60.3127

5.3980

54.9147

0.0029

26.6406

1991

65.9694

4.2350

61.7344

0.0051

73.3720

1992

70.0728

3.0288

67.0440

0.0086

68.5938

1993

66.0971

2.9517

63.1454

0.0145

68.9838

1994

106.2630

2.6074

103.6556

0.0387

167.5833

1995

88.1077

2.8054

85.3023

0.0597

54.0309

1996

80.3469

2.9312

77.4157

0.1078

80.6790

1997

85.7332

2.3377

83.3955

0.2056

90.7724

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1998

84.6413

1.5523

83.0890

0.3145

52.9457

1999

64.8675

2.1880

62.6795

0.5414

72.1660

2000

54.9154

3.3769

51.5385

0.6734

24.3785

2001

54.4002

2.8262

51.5740

1.4501

115.3493

2002

44.9641

1.5860

43.3781

1.6437

13.3485

2003

25.2964

2.2701

23.0263

1.3966

-15.0307

2004

10.5842

2.6772

7.9070

1.3395

-4.0912

2005

10.1384

3.3928

6.7457

1.3451

0.4143

2006

10.5110

3.2259

7.2851

1.4090

4.7545

2007

8.7562

2.8527

5.9035

1.1708

-16.9056

2008

10.4441

3.8391

6.6050

1.5255

30.2913

2009

6.2510

-0.3555

6.6065

1.4909

-2.2649

Solution: 1. In the current solution, we use the annual data from 1990 to 2009.

2. We regress the rate of exchange rate changes (e) on the inflation rate differential and estimate the intercept ( ) and slope coefficient ( ):

= −12.760 (Standard Error=11.555; t=−1.10)

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= 1.219 (Standard Error=0.203; t=6.02) The estimated intercept is insignificantly different from zero, whereas the slope coefficient is positive and significantly different from zero. In fact, the slope coefficient is insignificantly different from unity. [Note that t-statistics for

=1 is 1.08=(1.219-1)/0.203] In other words, we

cannot reject the hypothesis that the intercept is zero and the slope coefficient is one. The results are thus supportive of purchasing power parity.

CHAPTER 7 FUTURES AND OPTIONS ON FOREIGN EXCHANGE ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Explain the basic differences between the operation of a currency forward market and a futures market.

Answer: The forward market is an OTC market where the forward contract for purchase or sale of foreign currency is tailor-made between the client and its international bank. No money changes hands until the maturity date of the contract when delivery and receipt are typically made.

A futures contract is an exchange-traded instrument with standardized features

specifying contract size and delivery date. Futures contracts are marked-to-market daily to reflect changes in the settlement price. Delivery is seldom made in a futures market. Rather a reversing trade is made to close out a long or short position.

2. In order for a derivatives market to function most efficiently, two types of economic agents are needed: hedgers and speculators. Explain.

Answer:

Two types of market participants are necessary for the efficient operation of a

derivatives market: speculators and hedgers. A speculator attempts to profit from a change in the futures price. To do this, the speculator will take a long or short position in a futures contract depending upon his expectations of future price movement.

A hedger, on-the-other-hand,

desires to avoid price variation by locking in a purchase price of the underlying asset through a long position in a futures contract or a sales price through a short position. In effect, the hedger passes off the risk of price variation to the speculator who is better able, or at least more willing, to bear this risk.

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3. Why are most futures positions closed out through a reversing trade rather than held to delivery?

Answer: In forward markets, approximately 90 percent of all contracts that are initially established result in the short making delivery to the long of the asset underlying the contract. This is natural because the terms of forward contracts are tailor-made between the long and short. By contrast, only about one percent of currency futures contracts result in delivery. While futures contracts are useful for speculation and hedging, their standardized delivery dates make them unlikely to correspond to the actual future dates when foreign exchange transactions will occur. Thus, they are generally closed out in a reversing trade. In fact, the commission that buyers and sellers pay to transact in the futures market is a single amount that covers the round-trip transactions of initiating and closing out the position.

4. How can the FX futures market be used for price discovery?

Answer: To the extent that FX forward prices are an unbiased predictor of future spot exchange rates, the market anticipates whether one currency will appreciate or depreciate versus another.

Because FX futures contracts trade in an expiration cycle, different contracts expire at different periodic dates into the future. The pattern of the prices of these contracts provides information as to the market‘s current belief about the relative future value of one currency versus another at the scheduled expiration dates of the contracts.

One will generally see a steadily

appreciating or depreciating pattern; however, it may be mixed at times. Thus, the futures market is useful for price discovery, i.e., obtaining the market‘s forecast of the spot exchange rate at different future dates.

5. What is the major difference in the obligation of one with a long position in a futures (or forward) contract in comparison to an options contract?

Answer: A futures (or forward) contract is a vehicle for buying or selling a stated amount of foreign exchange at a stated price per unit at a specified time in the future. If the long holds the contract to the delivery date, he pays the effective contractual futures (or forward) price, regardless of whether it is an advantageous price in comparison to the spot price at the delivery date. By contrast, an option is a contract giving the long the right to buy or sell a given quantity of an asset at a specified price at some time in the future, but not enforcing any obligation on

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him if the spot price is more favorable than the exercise price. Because the option owner does not have to exercise the option if it is to his disadvantage, the option has a price, or premium, whereas no price is paid at inception to enter into a futures (or forward) contract.

6. What is meant by the terminology that an option is in-, at-, or out-of-the-money?

Answer: A call (put) option with St > E (E > St) is referred to as trading in-the-money. If St  E the option is trading at-the-money. If St < E (E < St) the call (put) option is trading out-of-themoney.

7. List the arguments (variables) of which an FX call or put option model price is a function.

How does the call and put premium change with respect to a change in the arguments?

Answer: Both call and put options are functions of only six variables: St, E, if, i$, T and .

When all else remains the same, the price of a European FX call (put) option will increase: 1. the larger (smaller) is S, 2. the smaller (larger) is E, 3. the smaller (larger) is if, 4. the larger (smaller) is i$, 5. the larger (smaller) i$ is relative to if, and 6. the greater is .

When i$ and if are not too much different in size, a European FX call and put will increase in price when the option term-to-maturity increases. However, when i$ is very much larger than if, a European FX call will increase in price, but the put premium will decrease, when the option term-to-maturity increases. The opposite is true when if is very much greater than i$. For American FX options the analysis is less complicated. Since a longer term American option can be exercised on any date that a shorter term option can be exercised, or a some later date, it follows that the all else remaining the same, the longer term American option will sell at a price at least as large as the shorter term option.

PROBLEMS 1. Assume today‘s settlement price on a CME EUR futures contract is $1.3140/EUR. You have

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a short position in one contract. Your performance bond account currently has a balance of $1,700. The next three days‘ settlement prices are $1.3126, $1.3133, and $1.3049. Calculate the changes in the performance bond account from daily marking-to-market and the balance of the performance bond account after the third day.

Solution: $1,700 + [($1.3140 - $1.3126) + ($1.3126 - $1.3133) + ($1.3133 - $1.3049)] x EUR125,000 = $2,837.50, where EUR125,000 is the contract size of one EUR contract.

2. Do problem 1 again assuming you have a long position in the futures contract.

Solution:

$1,700 + [($1.3126 - $1.3140) + ($1.3133 - $1.3126) + ($1.3049 - $1.3133)] x

EUR125,000 = $562.50, where EUR125,000 is the contract size of one EUR contract.

With only $562.50 in your performance bond account, you would experience a margin call requesting that additional funds be added to your performance bond account to bring the balance back up to the initial performance bond level.

3. Using the quotations in Exhibit 7.3, calculate the face value of the open interest in the September 2019 Swiss franc futures contract.

Solution:

42 contracts x SF125,000 = SF5,500,000, where SF125,000 is the contract size of

one SF contract. Note: By comparison the face value of the open interest in the 73,541 June 2019 contracts is SF9,192,625,000.

4. Using the quotations in Exhibit 7.3, note that the June 2019 Mexican peso futures contract has a price of $0.05143 per MXN. You believe the spot price in June will be $0.05795 per MXN. What speculative position would you enter into to attempt to profit from your beliefs? Calculate your anticipated profits, assuming you take a position in three contracts. What is the size of your profit (loss) if the futures price is indeed an unbiased predictor of the future spot price and this price materializes?

Solution: If you expect the Mexican peso to appreciate from $0.05143 to $0.05795 per MXN, you would take a long position in futures since the futures price of $0.05143 is less than your expected spot price.

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Your anticipated profit from a long position in three contracts is: 3 x ($0.05795 - $0.05143) x MXN500,000 = $9,780 where MXN500,000 is the contract size of one MXN contract.

If the futures price is an unbiased predictor of the expected spot price, the expected spot price is the futures price of $0.05143 per MXN. If this spot price materializes, you will not have any profits or losses from your short position in three futures contracts:

3 x ($0.05143 -

$0.05143) x MXN500,000 = 0.

5. Do problem 4 again assuming you believe the June 2019 spot price will be $0.04491 per MXN.

Solution: If you expect the Mexican peso to depreciate from $0.05143 to $0.04491 per MXN, you would take a short position in futures since the futures price of $0.05143 is greater than your expected spot price.

Your anticipated profit from a short position in three contracts is: 3 x ($0.05143 - $0.04491) x MXN500,000 = $9,780, where MXN500,000 is the contract size of one MXN contract.

If the futures price is an unbiased predictor of the future spot price and this price materializes, you will not profit or lose from your long futures position.

6. Using the market data in Exhibit 7.6, show the net terminal value of a long position in one 110 Sep Japanese yen European call contract at the following terminal spot prices (stated in U.S. cents per 100 yen): 101, 105, 110, 115, and 119. Ignore any time value of money effect.

Solution: The net terminal value of one call contract is: [Max[ST – E, 0] – Ce] x JPY1,000,000/100 ÷ 100¢, where JPY1,000,000 is the contract size of one JPY contract.

At 101: [Max[101 – 110, 0] – 1.40] x JPY1,000,000/100 ÷ 100¢ = -$140 At 105: [Max[105 – 110, 0] – 1.40] x JPY1,000,000/100 ÷ 100¢ = -$140 At 110: [Max[110 – 110, 0] – 1.40] x JPY1,000,000/100 ÷ 100¢ = -$140 At 115: [Max[115 – 110, 0] – 1.40] x JPY1,000,000/100 ÷ 100¢ = $360 At 119: [Max [119 – 110, 0] – 1.40] x JPY1,000,000/100 ÷ 100¢ = $760

7. Using the market data in Exhibit 7.6, show the net terminal value of a long position in one 110 Sep Japanese yen European put contract at the following terminal spot prices (stated in U.S. cents per 100 yen): 101, 105, 110, 115, and 119. Ignore any time value of money effect.

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Solution: The net terminal value of one put contract is: [Max[E –ST, 0] – Pe x JPY1,000,000/100 ÷ 100¢, where JPY1,000,000 is the contract size of one JPY contract.

At 101: [Max[110 – 101, 0] – 2.89] x JPY1,000,000/100 ÷ 100¢ = $611 At 105: [Max[110 – 105, 0] – 2.89] x JPY1,000,000/100 ÷ 100¢ = $211 At 110: [Max[110 – 110, 0] – 2.89] x JPY1,000,000/100 ÷ 100¢ = -$289 At 115: [Max[110 – 115, 0] – 2.89] x JPY1,000,000/100 ÷ 100¢ = -$289 At 119: [Max[110 – 119, 0] – 2.89] x JPY1,000,000/100 ÷ 100¢ = -$289

8. Assume that the Japanese yen is trading at a spot price of 92.04 cents per 100 yen. Further assume that the premium of an American call (put) option with a striking price of 93 is 2.10 (2.20) cents. Calculate the intrinsic value and the time value of the call and put options.

Solution: Premium - Intrinsic Value = Time Value Call: 2.10 - Max[92.04 – 93.00 = - .96, 0] = 2.10 cents per 100 yen Put: 2.20 - Max[93.00 – 92.04 = .96, 0] = 1.24 cents per 100 yen

9. Assume spot Swiss franc is $0.7000 and the six-month forward rate is $0.6950. What is the minimum price that a six-month American call option with a striking price of $0.6800 should sell for in a rational market? Assume the annualized six-month Eurodollar rate is 3 ½ percent.

Solution: Note to Instructor: A complete solution to this problem relies on the boundary expressions presented in footnote 3 of the text of Chapter 7.

Ca  Max[(70 - 68), (69.50 - 68)/(1.0175), 0]  Max[ 2, 1.47, 0] = 2 cents

10. Do problem 9 again assuming an American put option instead of a call option.

Solution: Pa  Max[(68 - 70), (68 - 69.50)/(1.0175), 0]  Max[ -2, -1.47, 0] = 0 cents

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11. Use the European option-pricing models developed in the chapter to value the call of problem 9 and the put of problem 10. Assume the annualized volatility of the Swiss franc is 14.2 percent. This problem can be solved using the FXOPM.xls spreadsheet.

Solution: d1 = [ln(69.50/68) + .5(.142)2(.50)]/(.142).50 = .2675 d2 = d1 - .142.50 = .2765 - .1004 = .1671 N(d1) = .6055 N(d2) = .5664 N(-d1) = .3945 N(-d2) = .4336 Ce = [69.50(.6055) - 68(.5664)]e-(.035)(.50) = 3.51 cents Pe = [68(.4336) - 69.50(.3945)]e-(.035)(.50) = 2.03 cents 12. Use the binomial option-pricing model developed in the chapter to value the call of problem 9.

The volatility of the Swiss franc is 14.2 percent.

Solution: The spot rate at T will be either 77.39¢ = 70.00¢(1.1056) or 63.32¢ = 70.00¢(.9045), where u = e.142.50 = 1.1056 and d = 1/u = .9045. At the exercise price of E = 68, the option will only be exercised at time T if the Swiss franc appreciates; its exercise value would be CuT = 9.39¢ = 77.39¢ - 68. If the Swiss franc depreciates it would not be rational to exercise the option; its value would be CdT = 0.

The hedge ratio is h = (9.39 – 0)/(77.39 – 63.32) = .6674.

Thus, the call premium is: C0 = Max{[69.50(.6674) – 68((77.39/68)(.6674 – 1) +1)]/(1.0175), 70 – 68} = Max[4.05, 2] = 4.05 cents per SF. MINI CASE: THE OPTIONS SPECULATOR

A speculator is considering the purchase of five three-month Japanese yen call options with a striking price of 96 cents per 100 yen. The premium is 1.35 cents per 100 yen. The spot price

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is 95.28 cents per 100 yen and the 90-day forward rate is 95.71 cents. The speculator believes the yen will appreciate to $1.00 per 100 yen over the next three months. As the speculator‘s assistant, you have been asked to prepare the following: 1. Graph the call option cash flow schedule.

2. Determine the speculator‘s profit if the yen appreciates to $1.00/100 yen.

3. Determine the speculator‘s profit if the yen only appreciates to the forward rate.

4. Determine the future spot price at which the speculator will only break even.

Suggested Solution to the Options Speculator:

1.

+

-

2. (5 x ¥1,000,000) x [(100 - 96) - 1.35]/10000 = $1,325.00.

3. Since the option expires out-of-the-money, the speculator will let the option expire worthless.

He will only lose the option premium.

4. ST = E + C = 96 + 1.35 = 97.35 cents per 100 yen.

CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. How would you define transaction exposure? How is it different from economic exposure?

Answer: Transaction exposure is the sensitivity of realized domestic currency values of the firm‘s contractual cash flows denominated in foreign currencies to unexpected changes in

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exchange rates. Unlike economic exposure, transaction exposure is well-defined and shortterm.

2. Discuss and compare hedging transaction exposure using the forward contract vs. money market instruments. When do the alternative hedging approaches produce the same result?

Answer: Hedging transaction exposure by a forward contract is achieved by selling or buying foreign currency receivables or payables forward. On the other hand, money market hedge is achieved by borrowing or lending the present value of foreign currency receivables or payables, thereby creating offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are equivalent.

3. Discuss and compare the costs of hedging via the forward contract and the options contract.

Answer: There is no up-front cost of hedging by forward contracts. In the case of options hedging, however, hedgers should pay the premiums for the contracts up-front. The cost of forward hedging, however, may be realized ex post when the hedger regrets his/her hedging decision.

4. What are the advantages of a currency options contract as a hedging tool compared with the forward contract?

Answer: The main advantage of using options contracts for hedging is that the hedger can decide whether to exercise options upon observing the realized future exchange rate. Options thus provide a hedge against ex post regret that forward hedger might have to suffer. Hedgers can only eliminate the downside risk while retaining the upside potential.

5. Suppose your company has purchased a put option on the euro to manage exchange exposure associated with an account receivable denominated in that currency. In this case, your company can be said to have an ‗insurance‘ policy on its receivable. Explain in what sense this is so.

Answer: Your company in this case knows in advance that it will receive a certain minimum dollar amount no matter what might happen to the $/€ exchange rate. Furthermore, if the euro

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appreciates, your company will benefit from the rising euro.

6. Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. How would you explain this result?

Answer: There can be many possible reasons for this. First, many firms may feel that they are not really exposed to exchange risk due to product diversification, diversified markets for their products, etc. Second, firms may be using self-insurance against exchange risk. Third, firms may feel that shareholders can diversify exchange risk themselves, rendering corporate risk management unnecessary.

7. Should a firm hedge? Why or why not?

Answer: In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to their value by hedging if markets are imperfect. First, if management knows about the firm‘s exposure better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to hedge at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable because it reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce tax obligations by hedging which stabilizes corporate earnings.

8. Using an example, discuss the possible effect of hedging on a firm‘s tax obligations.

Answer: One can use an example similar to the one presented in the chapter.

9. Explain contingent exposure and discuss the advantages of using currency options to manage this type of currency exposure.

Answer: Companies may encounter a situation where they may or may not face currency exposure. In this situation, companies need options, not obligations, to buy or sell a given amount of foreign exchange they may or may not receive or have to pay. If companies either hedge using forward contracts or do not hedge at all, they may face definite currency exposure.

10. Explain cross-hedging and discuss the factors determining its effectiveness.

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Answer: Cross-hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging would depend on the strength and stability of the relationship between the two assets.

PROBLEMS

1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced €10 million payable in six months. Currently, the six-month forward exchange rate is $1.10/€ and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/€ in six months. (a) What is the expected gain/loss from the forward hedging? (b) If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? Why or why not? (c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not? (d) Suppose now that the future spot exchange rate is forecast to be $1.17/€. Would you recommend hedging? Why or why not?

Solution: (a) Expected gain($) = 10,000,000(1.10 – 1.05) = 10,000,000(.05) = $500,000.

Note that for each euro sold forward, Cray Research will receive $1.10 for sure and has to deliver one euro that is expected to cost $1.05.

(b) I would recommend hedging because Cray Research can increase the expected dollar receipt by $500,000 and also eliminate the exchange risk.

(c) Since Cray Research can eliminate risk without sacrificing dollar receipt, I still would recommend hedging. (d) Now, hedging via forward contract involves an expected loss: -$700,000 = 10,000,000 (1.10 -1.17). Hedging thus becomes much less attractive. But if Cray Research is highly risk averse, it may still decide to hedge. The decision to hedge then critically depends on the firm‘s degree of

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risk aversion.

2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million payable in three months. Currently, the spot exchange rate is ¥105/$ and the three-month forward rate is ¥100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen account payable. (a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation. (b) Conduct the cash flow analysis of the money market hedge.

Solution: (a). Let‘s first compute the PV of ¥250 million, i.e., 250m/1.0175 = ¥245,700,245.70 So if the above yen amount is invested today at the Japanese interest rate for three months, the maturity value will be exactly equal to ¥25 million which is the amount of payable.

To buy the above yen amount today, it will cost: $2,340,002.34 = ¥245,700,245.70/105.

The dollar cost of meeting this yen obligation is $2,340,002.34 as of today. (b) __________________________________________________________________ Transaction CF0 CF1 __________________________________________________________________ 1. Buy yens spot

-$2,340,002.34

with dollars

¥245,700,245.70

2. Invest in Japan

- ¥245,700,245.70

3. Pay yens Net cash flow

¥250,000,000 - ¥250,000,000

- $2,340,002.34

__________________________________________________________________

3. You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with the exercise rate of

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$0.64/SF for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland. (a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF. (b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract. (c) At what future spot exchange rate will you be indifferent between the forward and option market hedges? (d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.

Solution: (a) Total option premium = (.05)(5000) = $250. In three months, $250 is worth $253.75 = $250(1.015). At the expected future spot rate of $0.63/SF, which is less than the exercise price, you don‘t expect to exercise options. Rather, you expect to buy Swiss franc at $0.63/SF. Since you are going to buy SF5,000, you expect to spend $3,150 (=.63x5,000). Thus, the total expected cost of buying SF5,000 will be the sum of $3,150 and $253.75, i.e., $3,403.75.

(b) $3,150 = (.63)(5,000).

(c) $3,150 = 5,000x + 253.75, where x represents the break-even future spot rate. Solving for x, we obtain x = $0.57925/SF. Note that at the break-even future spot rate, options will not be exercised.

(d) If the Swiss franc appreciates beyond $0.64/SF, which is the exercise price of call option, you will exercise the option and buy SF5,000 for $3,200. The total cost of buying SF5,000 will be $3,453.75 = $3,200 + $253.75. This is the maximum you will pay for SF5,000.

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$ Cost $3,453.75

Options hedge

$3,150

Forward hedge

$253.75 0

$/SF 0.579

0.64 (strike price)

4. Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. Air France will be billed €20 million which is payable in one year. The current spot exchange rate is $1.05/€ and the one-year forward rate is $1.10/€. The annual interest rate is 6.0% in the U.S. and 5.0% in France. Boeing is concerned with the volatile exchange rate between the dollar and the euro and would like to hedge exchange exposure. (a) It is considering two hedging alternatives: sell the euro proceeds from the sale forward or borrow euros from Credit Lyonnaise against the euro receivable. Which alternative would you recommend? Why? (b) Other things being equal, at what forward exchange rate would Boeing be indifferent between the two hedging methods?

Solution: (a) In the case of forward hedge, the future dollar proceeds will be (20,000,000)(1.10) = $22,000,000. In the case of money market hedge (MMH), the firm has to first borrow the PV of its euro receivable, i.e., 20,000,000/1.05 =€19,047,619. Then the firm should exchange this euro amount into dollars at the current spot rate to receive: (€19,047,619)($1.05/€) = $20,000,000, which can be invested at the dollar interest rate for one year to yield: $20,000,000(1.06) = $21,200,000. Clearly, the firm can receive $800,000

more by using

forward hedging. (b) According to IRP, F = S(1+i$)/(1+iF). Thus the ―indifferent‖ forward rate will be: F = 1.05(1.06)/1.05 = $1.06/€.

5. Suppose that Baltimore Machinery sold a drilling machine to a Swiss firm and gave the Swiss client a choice of paying either $10,000 or SF 15,000 in three months. (a) In the above example, Baltimore Machinery effectively gave the Swiss client a free option to buy up to $10,000 dollars using Swiss franc. What is the ‗implied‘ exercise exchange rate? (b) If the spot exchange rate turns out to be $0.62/SF, which currency do you think the Swiss

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client will choose to use for payment? What is the value of this free option for the Swiss client? (c) What is the best way for Baltimore Machinery to deal with the exchange exposure?

Solution: (a) The implied exercise (price) rate is: 10,000/15,000 = $0.6667/SF. (b) If the Swiss client chooses to pay $10,000, it will cost SF16,129 (=10,000/.62). Since the Swiss client has an option to pay SF15,000, it will choose to do so. The value of this option is obviously SF1,129 (=SF16,129-SF15,000).

(c) Baltimore Machinery faces a contingent exposure in the sense that it may or may not receive SF15,000 in the future. The firm thus can hedge this exposure by buying a put option on SF15,000.

6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the U.S. PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of .014 cents per yen. (a) Compute the future dollar costs of meeting this obligation using the money market hedge and the forward hedges. (b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used. (c) At what future spot rate do you think PCC may be indifferent between the option and forward hedge?

Solution: (a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In the case of money market hedge, the future dollar cost will be: 500,000,000(1.08)/(1.05)(124) = $4,147,465.

(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000(1.08) = $75,600.

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At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC will exercise its call option and buy ¥500,000,000 for $4,050,000 (=500,000,000x.0081).

The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000. (c) When the option hedge is used, PCC will spend ―at most‖ $4,125,000. On the other hand, when the forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate.

This means that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between forward and options hedges.

7. Consider a U.S.-based company that exports goods to Switzerland. The U.S. Company expects to receive payment on a shipment of goods in three months. Because the payment will be in Swiss francs, the U.S. Company wants to hedge against a decline in the value of the Swiss franc over the next three months. The U.S. risk-free rate is 2 percent, and the Swiss riskfree rate is 5 percent. Assume that interest rates are expected to remain fixed over the next six months. The current spot rate is $0.5974 a. Indicate whether the U.S. Company should use a long or short forward contract to hedge currency risk. b. Calculate the no-arbitrage price at which the U.S. Company could enter into a forward contract that expires in three months. c. It is now 30 days since the U.S. Company entered into the forward contract. The spot rate is $0.55. Interest rates are the same as before. Calculate the value of the U.S. Company‘s forward position.

Solution: a. The risk to the U.S. company is that the value of the Swiss franc will decline and it will receive fewer U.S. dollars on conversion. To hedge this risk, the company should enter into a contract to sell Swiss francs forward.

b. S0 = $0.5974 T = 90/365 r = 0.02 rf = 0.05  0.5974  F (0, T )   (1.02) 90 / 365  $0.5931 90 / 365  ( 1 .

05 )  

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c. St = $0.55 T = 90/365 t = 30/365 T – t = 60/365 r = 0.02 rf = 0.05 Vt (0, T ) 

$0.55 $0.5931   $0.0456 60 / 365 (1.05) (1.02) 60 / 365

This represents a gain to the short position of $0.0456 per Swiss franc. In this problem, the U.S. company holds the short forward position.

8. Suppose that you are a U.S.-based importer of goods from the United Kingdom. You expect the value of the pound to increase against the U.S. dollar over the next 30 days. You will be making payment on a shipment of imported goods in 30 days and want to hedge your currency exposure. The U.S. risk-free rate is 5.5 percent, and the U.K. risk-free rate is 4.5 percent. These rates are expected to remain unchanged over the next month. The current spot rate is $1.50. a. Indicate whether you should use a long or short forward contract to hedge currency risk. b. Calculate the no-arbitrage price at which you could enter into a forward contract that expires in three months. c. Move forward 10 days. The spot rate is $1.53. Interest rates are unchanged. Calculate the value of your forward position. d. Using the text software spreadsheet TRANSEXP, replicate the analysis in Exhibit 8.8.

Solution: a. The risk to you is that the value of the British pound will rise over the next 30 days and it will require more U.S. dollars to buy the necessary pounds to make payment. To hedge this risk, you should enter a forward contract to buy British pounds.

b. S0 = $1.50 T = 30/365 r = 0.055 rf = 0.045

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 $1.50  F (0, T )   (1.055) 30 / 365  $1.5018 30 / 365   (1.045) 

c. St = $1.53 T = 30/365 t = 10/365 T – t = 20/365 r = 0.055 rf = 0.045 Vt (0, T ) 

$1.53 $1.5012   $0.0295 20 / 365 (1.045) (1.055) 20 / 365

Because you are long, this is a gain of $0.0295 per British pound.

d. The answer is provided in Exhibit 8.8 of the textbook.

MINICASE: AIRBUS‘ DOLLAR EXPOSURE Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company, and billed $30 million payable in six months. Airbus is concerned with the euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $1.05/€ and six-month forward exchange rate is $1.10/€ at the moment. Airbus can buy a six-month put option on U.S. dollars with a strike price of €0.95/$ for a premium of €0.02 per U.S. dollar. Currently, six-month interest rate is 2.5% in the euro zone and 3.0% in the U.S. a. Compute the guaranteed euro proceeds from the American sale if Airbus decides to hedge using a forward contract. b. If Airbus decides to hedge using money market instruments, what action does Airbus need to take? What would be the guaranteed euro proceeds from the American sale in this case? c. If Airbus decides to hedge using put options on U.S. dollars, what would be the ‗expected‘ euro proceeds from the American sale? Assume that Airbus regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate. d. At what future spot exchange rate do you think Airbus will be indifferent between the option and money market hedge?

Solution: a. Airbus will sell $30 million forward for €27,272,727 = ($30,000,000) / ($1.10/€).

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b. Airbus will borrow the present value of the dollar receivable, i.e., $29,126,214 = $30,000,000/1.03, and then sell the dollar proceeds spot for euros:

€27,739,251

(=$29,126,214/$1.05/€). This is the euro amount that Airbus is going to keep. c. Since the expected future spot rate is less than the strike price of the put option, i.e., €0.9091< €0.95, Airbus expects to exercise the put option on $ and receive €28,500,000 = ($30,000,000)(€0.95/$). This is gross proceeds. Airbus spent €600,000 (=0.02x30,000,000) upfront for the option and its future cost is equal to €615,000 = €600,000 x 1.025. Thus the net euro proceeds from the American sale is €27,885,000, which is the difference between the gross proceeds and the option costs. d. At the indifferent future spot rate, the following will hold: €28,432,732 = ST (30,000,000) - €615,000.

Solving for ST , we obtain the ―indifference‖ future spot exchange rate, i.e., €0.9683/$, or $1.0327/€. Note that €28,432,732 is the future value of the proceeds under money market hedging: €28,432,732 = (€27,739,251) (1.025).

Case Application: Richard May‘s Options

It is Tuesday afternoon, February 14, 2012.

Richard May, Assistant Treasurer at

American Digital Graphics (ADG), sits in his office on the thirty-fourth floor of the building that dominates Rockefeller Plaza‘s west perimeter. Its Valentine‘s Day and Richard and his wife have dinner reservations with another couple at Balthazar at 7:30. ―I must get this hedging memo done,‖ thinks May, ―and get out of here. Foreign exchange options? I had better get the story straight before someone in the Finance Committee starts asking questions. Let‘s see, there are two ways in which I can envisage us using options now. One is to hedge a dividend due on September 15th from ADG Germany. The other is to hedge our upcoming payment to Matsumerda for their spring RAM chip statement. With the yen at 78 and increasing I‘m glad we haven‘t covered the payment so far, but now I‘m getting nervous and I would like to protect my posterior. An option to buy yen on June 10 might be just the thing.

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Before we delve any further into Richard May‘s musings, let us learn a bit about ADG, and about foreign exchange options. American Digital Graphics is a $12 billion sales company engaged in, among other things, the development, manufacture, and marketing of microprocessor-based equipment. Although 30 percent of the firm‘s sales are currently abroad, the firm has full-fledged manufacturing facilities in only three foreign countries, Germany, Canada, and Brazil.

An assembly plant in Singapore exists primarily to solder Japanese

semiconductor chips onto circuit boards and to screw these into Brazilian-made boxes for shipment to the United States, Canada, and Germany. The German subsidiary has developed half of its sales to France, the Netherlands, and the United Kingdom, billing in euros. ADG Germany has accumulated a cash reserve of €900,000, worth $1,178,100 at today‘s exchange rate. While the Hamburg office has automatic permission to repatriate €3 million, they have been urged to seek authorization to convert another €1 million by September 15th. The firm has an agreement to buy three hundred thousand RAM chips at ¥8000 each semi-annually, and it is this payment that will fall due on June 10th.

The conventional means of hedging exchange risk are forward or future contracts.

These, however, are fixed and inviolable agreements. In many practical instances the hedger is uncertain whether foreign currency cash inflow or outflow will materialize. In such cases, what is needed is the right, but not the obligation, to buy or sell a designated quantity of a foreign currency at a specified price (exchange rate). This is precisely what a foreign exchange option provides.

A foreign exchange option gives the holder the right to buy or sell a designated quantity of a foreign currency at a specified exchange rate up to or at a stipulated date.

The terminal date of the contract is called the expiration date (or maturity date). If the option may be exercised before the expiration date, it is called an American option; if only at the expiration date, a European option.

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The party retaining the option is the option buyer; the party giving the option is the option seller (or writer). The exchange rate at which the option can be exercised is called the exercise price or strike price. The buyer of the option must pay the seller some amount, called the option price or the premium, for the rights involved.

The important feature of a foreign exchange option is that the holder of the option has the right, but not the obligation, to exercise it. He will only exercise it if the currency moves in a favorable direction. Thus, once you have paid for an option you cannot lose, unlike a forward contract, where you are obliged to exchange the currencies and therefore will lose if the movement is unfavorable.

The disadvantage of an option contract, compared to a forward or futures contract is that you have to pay a price for the option, and this price or premium tends to be quite high for certain options. In general, the option‘s price will be higher the greater the risk to the seller (and the greater the value to the buyer because this is a zero-sum game). The risk of a call option will be greater, and the premium higher, the higher the forward rate relative to the exercise price; after all, one can always lock in a profit by buying at the exercise price and selling at the forward rate. The chance that the option will be exercised profitably is also higher, the more volatile is the currency, and the longer the option has to run before it expires.

Returning to Richard May in his Rockefeller Center office, we find that he has been printing spot, forward and currency options and futures quotations from the company‘s Bloomberg terminal.

The option prices are quoted in U.S. cents per euro. Yen are quoted in hundredths of a cent. Looking at these prices, Richard realizes that he can work out how much the euro or yen would have to change to make the option worthwhile. Richard makes a mental note that ADG can typically borrow in the Eurocurrency market at LIBOR + 1% and lend at LIBID. ―I‘ll attach these numbers to my memo,‖ mutters May, but the truth is he has yet to come to grips with the real question, which is when, if ever, are currency options a better means of

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hedging exchange risk for an international firm than traditional forward exchange contracts or future‘s contracts. Please assist Mr. May in his analysis of currency hedging for his report to ADG‘s Finance Committee. In doing so, you may consult the highlighted market quotes in the following attachments.

Solution ADG’s euro receivable ADG has a €3,000,000 receivable in 214 days on September 15th. To assess alternative ways of hedging, the following data are relevant: The current spot exchange rate (S)=$1.3088/€, 7-month forward exchange rate (F)=$1.3090, the dollar interest rate (bid)=0.78% and euro interest rate (ask)=1.40%. The put option on the euro with the strike (exercise) price of $1.31 selling for a premium of 5.09 cents per euro. Here we consider and compare three alternative hedging methods as in our discussions in the textbook: Forward, money market, and option hedges. Hedging with futures is often inconvenient due to the standardized maturities and contract size and also possibly thin trading.

▪ Forward hedge If ADG chooses to use forward contract, it just needs to sell its euro receivable at today’s forward exchange. ADG then is assured of receiving a guaranteed dollar amount of $3,927,000 on September 15th: (€3,000,000) ($1.3090/€) = $3,927,000.

▪ Money market hedge If ADG decides to use money market hedging, it first needs to borrow the present value (PV) of its euro receivable at 2.40% interest rate (=1.40%+1.0%): PV = (€3,000,000) / (1+0.024(214/360)) = 3,000,000 / 1.01427 = €2,957,802.

It then would convert €2,957,802 at today’s spot exchange rate of $1.3088/€ into Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

$3,871,171. If ADG invests this dollar amount at the dollar interest rate till September 15th, the future value (FV) of the investment will be: FV = ($3,871,171) (1+0.0078 (214/360) ) = $3,889,121.

▪ Option hedge If ADG chooses to hedge its euro receivable using currency options, it can purchase put options on three million euros with a $1.31 strike price at the premium of 5.09 cents per euro. This means that the firm has to spend the option cost upfront. The option costs, including the time value of money, would be: 153,408 = (€3,000,000) ($0.0509) [1+0.0078 (214/360) ]. If the future spot exchange rate turns out to be less than the strike price, i.e., if the euro becomes cheaper than the option strike price ($1.31), ADG will simply exercise its put option and exchange its euro receivable at the strike price, collect $3,776,592 (net of option costs), which is the guaranteed minimum net dollar proceeds: (€3,000,000) ($1.31) - $153,408 = $3,776,592. If the euro becomes stronger than the strike price, the firm will simply let its put option expire and convert its euro receivable at the future spot exchange rate.

As can be seen from the following graph, forward hedging dominates money market hedging. If the future spot rate exceeds the indifference rate, S* = $1.36, option hedging becomes preferable; otherwise, forward hedging is preferable.

ADG’s yen payable ADG has a ¥2,400 million payable in 4 months. The relevant market data include: The current spot exchange rate of $0.01274/¥, four-month forward exchange rate of $0.01274/¥, four-month call option on yen with the strike price set at 127 cents for 100 yen that is selling for 3.11 cents per 100 yen. ADG’s borrowing interest rate in dollars is

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0.62%, while lending interest rate in yen is 0.18%.

▪ Forward hedge If ADG decides to use forward contract to hedge its yen payable, it just needs to purchase the yen payable amount forward at today forward exchange rate. The dollar cost of doing so will be $30,576,000 = (¥2,400,000,000) ($0.01274/¥).

▪ Money market hedge Money market hedging would require borrowing the PV of the yen pable in dollars, $30,558,123.50 = [(¥2,400,000,000)/(1+0.0018(117/360)] ($0.01274), and converting the dollar amount borrowed into yen and invest for four months at the yen interest rate to receive, ¥2,400,000,000 = ($30,558,123.50/$0.01274/¥)(1+0.0018(117/360)).

When ADG receives the maturity value of the yen investment, it will use the yen amount to make payment to Matsumerda. Lastly, in four month, ADG will pay back the dollar loan: $30,719,012 = ($30,558,123.50) (1+0.0162(117/360)).

▪ Option hedge In the case of hedging with option, ADG will need to buy call option on its yen payable. If ADG decides to buy ontions with strike price set at $0.0127 per dollar trading for 3.11 cents per 100 yens, the option cost (including the time value of money) will be, $747,783 = (¥2,400,000,000)($0.000311)[1+0.0057(117/360)] = ($746,400)(1.0018525) If the yen appreciates beyond the strike price of the call optopn, K=$0.0127/¥, ADG will simply exercise its option and the max dollar cost of securing the yen payable amount will be, $31,227,783 = (¥2,400,000,000)($0.0127/¥) + $747,783.

As can be seen from the graph, forward hedge dominates money market hedge as the dollar cost will be always lower with forward hedge than with money market hedge. If the exchange rate becomes lower than the indifference rate, S*=$0.0124, call option hedge would be preferable; otherwise, forward hedge would be preferrable. Thje indifference rate can be identified from solving the following equation for S*: 30,576,000 = (2,400,000,000) S* +747,783.

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CHAPTER 9 MANAGEMENT OF ECONOMIC EXPOSURE ANSWERS & SOLUTIONS TO END OF CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. How would you define economic exposure to exchange risk?

Answer: Economic exposure can be defined as the possibility that the firm‘s cash flows and thus its market value may be affected by the unexpected exchange rate changes.

2. Explain the following statement: ―Exposure is the regression coefficient.‖

Answer: Exposure to currency risk can be appropriately measured by the sensitivity of the firm‘s future cash flows and the market value to random changes in exchange rates.

Statistically, this sensitivity can be estimated by the regression coefficient. Thus, exposure can be said to be the regression coefficient.

3. Suppose that your company has an equity position in a French firm. Discuss the condition under which the dollar/euro exchange rate uncertainty does not constitute exchange exposure for your company.

Answer: Mere changes in exchange rates do not necessarily constitute currency exposure. If the euro value of the equity moves in the opposite direction as much as the dollar value of the euro changes, then the dollar value of the equity position will be insensitive to exchange rate Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

movements. As a result, your company will not be exposed to currency risk.

4.

Explain the competitive and conversion effects of exchange rate changes on the firm‘s

operating cash flow.

Answer: The competitive effect: exchange rate changes may affect operating cash flows by altering the firm‘s competitive position.

The conversion effect: A given operating cash flows in terms of a foreign currency will be converted into higher or lower dollar (home currency)amounts as the exchange rate changes.

5. Discuss the determinants of operating exposure.

Answer: The main determinants of a firm‘s operating exposure are (i) the structure of the markets in which the firm sources its inputs, such as labor and materials, and sells its products, and (ii) the firm‘s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing.

6. Discuss the implications of purchasing power parity for operating exposure.

Answer: If the exchange rate changes are matched by the inflation rate differential between countries, firms‘ competitive positions will not be altered by exchange rate changes. Firms are not subject to operating exposure.

7. General Motors exports cars to Spain but the strong dollar against the euro hurts sales of GM cars in Spain. In the Spanish market, GM faces competition from the Italian and French car makers, such as Fiat and Renault, whose operating currencies are the euro. What kind of measures would you recommend so that GM can maintain its market share in Spain.

Answer: Possible measures that GM can take include: (1) diversify the market; try to market the cars not just in Spain and other European countries but also in, say, Asia; (2) locate production facilities in Spain and source inputs locally; (3) locate production facilities, say, in Morocco where production costs are low and export to Spain from Morocco.

8. What are the advantages and disadvantages of financial hedging of the firm‘s operating

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exposure vis-à-vis operational hedges (such as relocating manufacturing site)?

Answer: Financial hedging can be implemented quickly with relatively low costs, but it is difficult to hedge against long-term, real exposure with financial contracts. On the other hand, operational hedges are costly, time-consuming, and not easily reversible.

9. Discuss the advantages and disadvantages of maintaining multiple manufacturing sites as a hedge against exchange rate exposure.

Answer: To establish multiple manufacturing sites can be effective in managing exchange risk exposure, but it can be costly because the firm may not be able to take advantage of the economy of scale.

10. Evaluate the following statement: ―A firm can reduce its currency exposure by diversifying across different business lines.‖

Answer: Conglomerate expansion may be too costly as a means of hedging exchange risk exposure. Investment in a different line of business must be made based on its own merit.

11. The exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure. Explain why this may be the case.

Answer: A firm can have a natural hedging position due to, for example, diversified markets, flexible sourcing capabilities, etc. In addition, to the extent that the PPP holds, nominal exchange rate changes do not influence firms‘ competitive positions. Under these circumstances, firms do not need to worry about exchange risk exposure.

PROBLEMS

1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will

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experience a boom with a 60% probability and a slow-down with a 40% probability. (a) Estimate your exposure b to the exchange risk. (b) Compute the variance of the dollar value of your property that is attributable to the exchange rate uncertainty. (c) Discuss how you can hedge your exchange risk exposure and also examine the consequences of hedging.

Solution: (a) Let us compute the necessary parameter values: E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580 E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44 Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2 = .00096+.00144 = .0024.

Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44) = -5.28-7.92 = -13.20 b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.

You have a negative exposure! As the pound gets stronger (weaker) against the dollar, the dollar value of your British holding goes down (up). (b) b2Var(S) = (-5500)2(.0024) =72,600($)2 (c) Buy £5,500 forward. By doing so, you can eliminate the volatility of the dollar value of your British asset that is due to the exchange rate volatility.

2. A U.S. firm holds an asset in France and faces the following scenario:

State 1

State 2

State 3

State 4

Probability

25%

25%

25%

25%

Spot rate

$1.20/€

$1.10/€

$1.00/€

$0.90/€

P*

€1500

€1400

€1300

€1200

P

$1,800

$1,540

$1,300

$1,080

In the above table, P* is the euro price of the asset held by the U.S. firm and P is the dollar price of the asset. (a) Compute the exchange exposure faced by the U.S. firm.

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(b) What is the variance of the dollar price of this asset if the U.S. firm remains unhedged against this exposure? (c) If the U.S. firm hedges against this exposure using the forward contract, what is the variance of the dollar value of the hedged position?

Solution: (a) E(S) = .25(1.20 +1.10+1.00+0.90) = $1.05/€ E(P) = .25(1,800+1,540+1,300 +1,080) = $1,430 Var(S) = .25[(1.20-1.05)2 +(1.10-1.05)2+(1.00-1.05)2+(0.90-1.05)2] = .0125 Cov(P,S) = .25[(1,800-1,430)(1.20-1.05) + (1,540-1,430)(1.10-1.05) (1,300-1,430)(1.00-1.05) + (1,080-1,430)(0.90-1.05)] = 30 b = Cov(P,S)/Var(S) = 30/0.0125 = €2,400. (b) Var(P) = .25[(1,800-1,430)2+(1,540-1,430)2+(1,300-1,430)2+(1,080-1,430)2] = 72,100($)2. (c) Var(P) - b2Var(S) = 72,100 - (2,400)2(0.0125) = 100($)2.

This means that most of the volatility of the dollar value of the French asset can be removed by hedging exchange risk. The hedging can be achieved by selling €2,400 forward.

3. Suppose you are a British venture capitalist holding a major stake in an e-commerce start-up in Silicon Valley. As a British resident, you are concerned with the pound value of your U.S. equity position. Assume that if the American economy booms in the future, your equity stake will be worth $1,000,000, and the exchange rate will be $1.40/£. If the American economy experiences a recession, on the other hand, your American equity stake will be worth $500,000, and the exchange rate will be $1.60/£. You assess that the American economy will experience a boom with a 70 percent probability and a recession with a 30 percent probability. (a) Estimate your exposure to the exchange risk. (b) Compute the variance of the pound value of your American equity position that is attributable to the exchange rate uncertainty. (c) How would you hedge this exposure? If you hedge, what is the variance of the pound value of the hedged position?

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Solution: Prob = 0.70 Prob = 0.30

P* = $1,000,000 *

P = $500,000

S = $1.40 S = $1.60

P = £714,300

P = £312,500

E(S) = (0.70)/(1.40) + (0.30)/(1.60) = £0.688/$ E(P) = (0.70)*(714,300) + (0.30)*(312,500) = £593,760/$ Var(S) = 0.00167 Cov(P,S) = 7,535

(a) b = Cov(P,S)/Var(S) = 7,535/0.00167 = 4,511,976 ($) (b) b2Var(S) = (4,511,976)2*(0.00167) = 33,997,738,800 (c) Var(e) = Var(P) - b2Var(S) = 33,903,080,400 - 33,997,738,800 ≈ 0

You can hedge this exposure by selling $4,511,976 forward.

MINI CASE: ECONOMIC EXPOSURE OF ALBION COMPUTERS PLC

Consider Case 3 of Albion Computers PLC discussed in the chapter. Now, assume that the pound is expected to depreciate to $1.50 from the current level of $1.60 per pound. This implies that the pound

cost of the imported part, i.e., Intel‘s microprocessors, is £341

(=$512/$1.50). Other variables, such as the unit sales volume and the U.K.

inflation rate,

remain the same as in Case 3. (a) Compute the projected annual cash flow in dollars. (b) Compute the projected operating gains/losses over the four-year horizon as the discounted present value of change in cash flows, which is due to the pound depreciation, from the benchmark case presented in Exhibit 12.4. (c) What actions, if any, can Albion take to mitigate the projected operating losses due to the pound depreciation?

Suggested Solution to Economic Exposure of Albion Computers PLC a) The projected annual cash flow can be computed as follows: ______________________________________________________ Sales (40,000 units at £1,080/unit)

£43,200,000

Variable costs (40,000 units at £697/unit)£27,880,000 Fixed overhead costs

4,000,000

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Depreciation allowances

1,000,000

Net profit before tax

£15,315,000

Income tax (50%)

7,657,500

Profit after tax

7,657,500

Add back depreciation

1,000,000

Operating cash flow in pounds

£8,657,500

Operating cash flow in dollars

$12,986,250

______________________________________________________

b) ______________________________________________________

Variables

Benchmark

Current

Case

Case

______________________________________________________ Exchange rate ($/£)

1.60

1.50

Unit variable cost (£)

650

697

Unit sales price (£)

1,000

1,080

Sales volume (units)

50,000

40,000

Annual cash flow (£)

7,250,000

8,657,500

Annual cash flow ($)

11,600,000

12,986,250

Four-year present value ($) 33,118,000

37,076,946

Operating gains/losses ($)

3,958,946

______________________________________________________ c) In this case, Albion actually can expect to realize exchange gains, rather than losses. This is mainly due to the fact that while the selling price appreciates by 8% in the U.K. market, the variable cost of imported input increased by about 6.25%. Albion may choose not to do anything about the exposure.

CHAPTER 10 MANAGEMENT OF TRANSLATION EXPOSURE SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Explain the difference in the translation process between the monetary/nonmonetary method and the temporal method.

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Answer: Under the monetary/nonmonetary method, all monetary balance sheet accounts of a foreign subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at the historical rate exchange rate in effect when the account was first recorded.

Under the temporal method, monetary accounts are translated at the current exchange rate.

Other balance sheet accounts are also translated at the current rate, if they are carried on the books at current value. If they are carried at historical value, they are translated at the rate in effect on the date the item was put on the books. Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary/nonmonetary method will typically provide the same translation.

2.

How are translation gains and losses handled differently according to the current rate

method in comparison to the other three methods, that is, the current/noncurrent method, the monetary/nonmonetary method, and the temporal method?

Answer: Under the current rate method, translation gains and losses are handled only as an adjustment to net worth through an equity account named the ―cumulative translation adjustment‖ account.

Nothing passes through the income statement.

The other three

translation methods pass foreign exchange gains or losses through the income statement before they enter on to the balance sheet through the accumulated retained earnings account.

3. Identify some instances under FASB 52 when a foreign entity‘s functional currency would be the same as the parent firm‘s currency.

Answer: Three examples under FASB 52, where the foreign entity‘s functional currency will be the same as the parent firm‘s currency, are: i) the foreign entity‘s cash flows directly affect the parent‘s cash flows and are readily available for remittance to the parent firm; ii) the sales prices for the foreign entity‘s products are responsive on a short-term basis to exchange rate changes, where sales prices are determined through worldwide competition; and, iii) the sales market is primarily located in the parent‘s country or sales contracts are denominated in the parent‘s currency.

4. Describe the remeasurement and translation process under FASB 52 of a wholly owned affiliate that keeps its books in the local currency of the country in which it operates, which is

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different than its functional currency.

Answer: For a foreign entity that keeps its books in its local currency, which is different from its functional currency, the translation process according to FASB 52 is to: first, remeasure the financial reports from the local currency into the functional currency using the temporal method of translation, and second, translate from the functional currency into the reporting currency using the current rate method of translation.

5. It is, generally, not possible to completely eliminate both translation exposure and transaction exposure. In some cases, the elimination of one exposure will also eliminate the other. But in other cases, the elimination of one exposure actually creates the other.

Discuss which

exposure might be viewed as the most important to effectively manage, if a conflict between controlling both arises.

Also, discuss and critique the common methods for controlling

translation exposure.

Answer:

Since it is, generally, not possible to completely eliminate both transaction and

translation exposure, we recommend that transaction exposure be given first priority since it involves real cash flows. The translation process, on-the-other hand, has no direct effect on reporting currency cash flows, and will only have a realizable effect on net investment upon the sale or liquidation of the assets.

There are two common methods for controlling translation exposure: a balance sheet hedge and a derivatives hedge. The balance sheet hedge involves equating the amount of exposed assets in an exposure currency with the exposed liabilities in that currency, so the net exposure is zero.

Thus when an exposure currency exchange rate changes versus the

reporting currency, the change in assets will offset the change in liabilities. To create a balance sheet hedge, once transaction exposure has been controlled, often means creating new transaction exposure. This is not wise since real cash flow losses can result. A derivatives hedge is not really a hedge, but rather a speculative position, since the size of the ―hedge‖ is based on the future expected spot rate of exchange for the exposure currency with the reporting currency. If the actual spot rate differs from the expected rate, the ―hedge‖ may result in the loss of real cash flows.

PROBLEMS

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1. Assume that FASB 8 is still in effect instead of FASB 52. Construct a translation exposure report for Centralia Corporation and its affiliates that is the counterpart to Exhibit 10.6 in the text.

Centralia and its affiliates carry inventory and fixed assets on the books at historical values.

Solution: The following table provides a translation exposure report for Centralia Corporation and its affiliates under FASB 8, which is essentially the temporal method of translation. The difference between the new report and Exhibit 10.6 is that nonmonetary accounts such as inventory and fixed assets are translated at the historical exchange rate if they are carried at historical costs. Thus, these accounts will not change values when exchange rates change and they do not create translation exposure.

Examination of the table indicates that under FASB 8 there is negative net exposure for the Mexican peso and the euro, whereas under FASB 52 the net exposure for these currencies is positive. There is no change in net exposure for the Canadian dollar and the Swiss franc.

Consequently, if the euro depreciates against the dollar from €1.1000/$1.00 to €1.1786/$1.00, as the text example assumed, exposed assets will now fall in value by a smaller amount than exposed liabilities, instead of vice versa. The associated reporting currency imbalance will be $239,415, calculated as follows:

Reporting Currency Imbalance= - €3,949,0000 €1.1786 / $1.00

-

- €3,949,0000

= $239,415.

€1.1000 / $1.00

Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates, December 31, 2019 (in 000 Currency Units) Canadian

Mexican

Dollar

Peso

Swiss Euro

Franc

Assets Cash Accounts receivable

CD200

Ps 6,000

€ 825

0

9,000

1,045

SF

0 0

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Inventory

0

0

0

0

Net fixed assets

0

0

0

0

CD200

Ps15,000

€ 1,870

SF

0

CD 0

Ps 7,000

€ 1,364

SF

0

Notes payable

0

17,000

935

1,400

Long-term debt

0

27,000

3,520

0

Exposed liabilities

CD 0

Ps51,000

€ 5,819

SF1,400

Net exposure

CD200

(Ps36,000)

(€3,949)

(SF1,400)

Exposed assets

Liabilities Accounts payable

2. Assume that FASB 8 is still in effect instead of FASB 52. Construct a consolidated balance sheet for Centralia Corporation and its affiliates after a depreciation of the euro from €1.1000/$1.00 to €1.1786/$1.00 that is the counterpart to Exhibit 10.7 in the text. Centralia and its affiliates carry inventory and fixed assets on the books at historical values.

Solution: This problem is the sequel to Problem 1. The solution to Problem 1 showed that if the euro depreciated there would be a reporting currency imbalance of $239,415. Under FASB 8 this is carried through the income statement as a foreign exchange gain to the retained earnings on the balance sheet. The following table shows that consolidated retained earnings increased to $4,190,000 from $3,950,000 in Exhibit 10.7. This is an increase of $240,000, which is the same as the reporting currency imbalance after accounting for rounding error.

Note to instructor: Since Centralia and its affiliates carry inventory and fixed assets on the books at historical values, the monetary/monetary method (essentially IAS 21) will produce the same translation.

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Consolidated Balance Sheet under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates, December 31, 2019: Post-Exchange Rate Change (in 000 Dollars) Centralia Corp.

Mexican

Spanish

Consolidated

(parent)

Affiliate

Affiliate

Balance Sheet

Assets Cash

$ 950a

$ 600

$ 700

$ 2,250

Accounts receivable

1,450b

900

887

3,237

Inventory

3,000

1,500

1,500

6,000

Investment in Mexican affiliate

-c

-

-

-

Investment in Spanish affiliate

-d

-

-

-

9,000

4,600

4,000

17,600

Net fixed assets Total assets

$29,087

Liabilities and Net Worth Accounts payable

$1,800

$ 700b

$1,157

$ 3,657

Notes payable

2,200

1,700

1,043e

4,943

Long-term debt

7,110

2,700

2,987

12,797

Common stock

3,500

-c

-d

3,500

Retained earnings

4,190

-c

-d

4,190

Total liabilities and net worth

$29,087

a

This includes CD200,000 the parent firm has in a Canadian bank, carried as $150,000.

CD200,000/(CD1.3333/$1.00) = $150,000. b $1,750,000 - $300,000 (= Ps3,000,000/(Ps10.00/$1.00)) intracompany loan = $1,450,000. c,d Investment in affiliates cancels with the net worth of the affiliates in the consolidation. e The Spanish affiliate owes a Swiss bank SF375,000 (’ SF1.2727/€1.00 = €294,649). This is carried on the books, after the exchange rate change, as part of €1,229,649 = €294,649 + €935,000. €1,229,649/(€1.1786/$1.00) = $1,043,313.

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3. In Example 10.2, a forward contract was used to establish a derivatives ―hedge‖ to protect Centralia from a translation loss if the euro depreciated from €1.1000/$1.00 to €1.1786/$1.00.

Assume that an over-the-counter put option on the euro with a strike price of €1.1393/$1.00 (or $0.8777/€1.00) can be purchased for $0.0088 per euro. Show how the potential translation loss can be ―hedged‖ with an option contract.

Solution: As in example 10.2, if the potential translation loss is $110,704, the equivalent amount in functional currency that needs to be hedged is €3,782,468. If in fact the euro does depreciate to €1.1786/$1.00 ($0.8485/€1.00), €3,782,468 can be purchased in the spot market for $3,209,289.

At a striking price of €1.1393/$1.00, the €3,782,468 can be sold through the put

for $3,319,993, yielding a gross profit of $110,704. The put option cost $33,286 (= €3,782,468 x $0.0088). Thus, at an exchange rate of €1.1786/$1.00, the put option will effectively hedge $110,704 - $33,286 = $77,418 of the potential translation loss. At terminal exchange rates of €1.1393/$1.00 to €1.1786/$1.00, the put option hedge will be less effective. An option contract does not have to be exercised if doing so is disadvantageous to the option owner. Therefore, the put will not be exercised at exchange rates less than €1.1393/$1.00 (more than $0.8777/€1.00), in which case the ―hedge‖ will lose the $33,286 cost of the option.

MINI CASE: SUNDANCE SPORTING GOODS, INC.

Sundance Sporting Goods, Inc., is a U.S. manufacturer of high-quality sporting goods-principally golf, tennis and other racquet equipment, and also lawn sports, such as croquet and badminton-- with administrative offices and manufacturing facilities in Chicago, Illinois.

Sundance has two wholly owned manufacturing affiliates, one in Mexico and the other in Canada. The Mexican affiliate is located in Mexico City and services all of Latin America. The Canadian affiliate is in Toronto and serves only Canada. Each affiliate keeps its books in its local currency, which is also the functional currency for the affiliate. The current exchange rates are: $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800. The nonconsolidated balance sheets for Sundance and its two affiliates appear in the accompanying table.

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Nonconsolidated Balance Sheet for Sundance Sporting Goods, Inc. and Its Mexican and Canadian Affiliates, December 31, 2019 (in 000 Currency Units) Sundance, Inc. (parent)

Mexican Affiliate

Canadian Affiliate

Cash

$ 1,500

Ps 1,420

CD 1,200

Accounts receivable

2,500a

2,800e

1,500f

Inventory

5,000

6,200

2,500

Investment in Mexican affiliate

2,400b

-

-

Investment in Canadian affiliate

3,600c

-

-

Net fixed assets

12,000

11,200

5,600

Total assets

$27,000

Ps21,620

CD10,800

Accounts payable

$ 3,000

Ps 2,500a

CD 1,700

Notes payable

4,000d

4,200

2,300

Long-term debt

9,000

7,000

2,300

Common stock

5,000

4,500b

2,900c

Retained earnings

6,000

3,420b

1,600c

$27,000

Ps21,620

CD10,800

Assets

Liabilities and Net Worth

Total liabilities and net worth a

The parent firm is owed Ps1,320,000 by the Mexican affiliate. This sum is included in the parent‘s accounts receivable as $400,000, translated at Ps3.30/$1.00. The remainder of the parent‘s (Mexican affiliate‘s) accounts receivable (payable) is denominated in dollars (pesos). b

The Mexican affiliate is wholly owned by the parent firm. It is carried on the parent firm‘s books at $2,400,000. This represents the sum of the common stock (Ps4,500,000) and retained earnings (Ps3,420,000) on the Mexican affiliate‘s books, translated at Ps3.30/$1.00. c

The Canadian affiliate is wholly owned by the parent firm. It is carried on the parent firm‘s books at $3,600,000. This represents the sum of the common stock (CD2,900,000) and the retained earnings (CD1,600,000) on the Canadian affiliate‘s books, translated at CD1.25/$1.00.

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d

The parent firm has outstanding notes payable of ¥126,000,000 due a Japanese bank. This sum is carried on the parent firm‘s books as $1,200,000, translated at ¥105/$1.00. Other notes payable are denominated in U.S. dollars. e

The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This sum is carried on the Mexican affiliate‘s books as Ps396,000, translated at A1.00/Ps3.30. Other accounts receivable are denominated in Mexican pesos. f

The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This sum is carried on the Canadian affiliate‘s books as CD300,000, translated at W800/CD1.25. Other accounts receivable are denominated in Canadian dollars.

You joined the International Treasury division of Sundance six months ago after spending the last two years receiving your MBA degree. The corporate treasurer has asked you to prepare a report analyzing all aspects of the translation exposure faced by Sundance as a MNC. She has also asked you to address in your analysis the relationship between the firm‘s translation exposure and its transaction exposure. After performing a forecast of future spot rates of exchange, you decide that you must do the following before any sensible report can be written. a. Using the current exchange rates and the nonconsolidated balance sheets for Sundance and its affiliates, prepare a consolidated balance sheet for the MNC according to FASB 52. b. i. Prepare a translation exposure report for Sundance Sporting Goods, Inc., and its two affiliates. ii. Using the translation exposure report you have prepared, determine if any reporting currency imbalance will result from a change in exchange rates to which the firm has currency exposure. Your forecast is that exchange rates will change from $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800 to $1.00 = CD1.30 = Ps3.30 = A1.03 = ¥105 = W800. c. Prepare a second consolidated balance sheet for the MNC using the exchange rates you expect in the future.

Determine how any reporting currency imbalance will affect the new

consolidated balance sheet for the MNC. d. i. Prepare a transaction exposure report for Sundance and its affiliates. Determine if any transaction exposures are also translation exposures. ii. Investigate what Sundance and its affiliates can do to control its transaction and translation exposures. Determine if any of the translation exposure should be hedged.

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Suggested Solution to Sundance Sporting Goods, Inc.

Note to Instructor: It is not necessary to assign the entire case problem. Parts a. and b.i. can be used as self-contained problems, respectively, on basic balance sheet consolidation and the preparation of a translation exposure report.

a. Below is the consolidated balance sheet for the MNC prepared according to the current rate method prescribed by FASB 52. Note that the balance sheet balances. That is, Total Assets and Total Liabilities and Net Worth equal one another. Thus, the assumption is that the current exchange rates are the same as when the affiliates were established. This assumption is relaxed in part c.

Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates, December 31, 2019: Pre-Exchange Rate Change (in 000 Dollars) Sundance, Inc. (parent)

Mexican Affiliate

Canadian Affiliate

Consolidated Balance Sheet

Cash

$ 1,500

$ 430

$ 960

$ 2,890

Accounts receivable

2,100a

849e

1,200f

4,149

Inventory

5,000

1,879

2,000

8,879

Investment in Mexican affiliate

-b

-

-

-

Investment in Canadian affiliate

-c

-

-

-

12,000

3,394

4,480

19,874

Assets

Net fixed assets Total assets

$35,792

Liabilities and Net Worth Accounts payable

$ 3,000

$ 358a

$1,360

$ 4,718

Notes payable

4,000d

1,273

1,840

7,113

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Long-term debt

9,000

2,121

1,840

12,961

Common stock

5,000

-b

-c

5,000

Retained earnings

6,000

-b

-c

6,000

Total liabilities and net worth

$35,792

a

$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.

b,c

The investment in the affiliates cancels with the net worth of the affiliates in the consolidation.

d

The parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)). e

The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate‘s books as Ps396,000 (= A120,000 x Ps3.30/A1.00). f

The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer.

This is carried on the Canadian affiliate‘s books as CD300,000 (= W192,000,000/(W800/CD1.25)). b. i. Below is presented the translation exposure report for the Sundance MNC. Note, from the report that there is net positive exposure in the Mexican peso, Canadian dollar, Argentine austral and Korean won. If any of these exposure currencies appreciates (depreciates) against the U.S. dollar, exposed assets denominated in these currencies will increase (fall) in translated value by a greater amount than the exposed liabilities denominated in these currencies. There is negative net exposure in the Japanese yen. If the yen appreciates (depreciates) against the U.S. dollar, exposed assets denominated in the yen will increase (fall) in translated value by smaller amount than the exposed liabilities denominated in the yen.

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Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates, December 31, 2019 (in 000 Currency Units) Japanese Yen

Mexican Peso

Canadian Dollar

Argentin e Austral

Korean Won

0

Ps 1,420

CD 1,200

A 0

W

Accounts receivable

0

2,404

1,200

120

192,000

Inventory

0

6,200

2,500

0

0

Fixed assets

0

11,200

5,600

0

0

¥

0

Ps21,224

CD10,500

A120

W192,000

Accounts payable

¥

0

Ps 1,180

CD 1,700

A 0

W

Notes payable

126,000

4,200

2,300

0

0

Long-term debt

¥

0

7,000

2,300

0

0

Exposed liabilities

¥126,000

Ps12,380

CD 6,300

A 0

W

Net exposure

(¥126,000)

Ps 8,844

CD 4,200

A120

W192,000

Assets Cash

¥

Exposed assets

0

Liabilities

b. ii.

0

0

The problem assumes that Canadian dollar depreciates from CD1.25/$1.00 to

CD1.30/$1.00 and that the Argentine austral depreciates from A1.00/$1.00 to A1.03/$1.00. To determine the reporting currency imbalance in translated value caused by these exchange rate changes, we can use the following formula:

Net Exposure Currency i Net Exposure Currency i S new (i / reporting) S old (i / reporting)

= Reporting Currency Imbalance.

From the translation exposure report we can determine that the depreciation in the Canadian dollar will cause a

CD4,200,000 CD4,200,000 = - $129,231 CD1.30 / $1.00 CD1.25 / $1.00

reporting currency imbalance.

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Similarly, the depreciation in the Argentine austral will cause a

A120,000 A120,000 = - $3,495 A1.03 / $1.00 A1.00 / $1.00

reporting currency imbalance.

In total, the depreciation of the Canadian dollar and the Argentine austral will cause a reporting currency imbalance in translated value equal to -$129,231 -$3,495= -$132,726.

c.

The new consolidated balance sheet for Sundance MNC after the depreciation of the

Canadian dollar and the Argentine austral is presented below. Note that in order for the new consolidated balance sheet to balance after the exchange rate change, it is necessary to have a cumulative translation adjustment account balance of -$133 thousand, which is the amount of the reporting currency imbalance determined in part b. ii (rounded to the nearest thousand).

Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates, December 31, 2019: Post-Exchange Rate Change (in 000 Dollars) Sundance, Inc. (parent)

Mexican Affiliate

Canadian Affiliate

Consolidate d Balance Sheet

Cash

$ 1,500

$ 430

$ 923

$ 2,853

Accounts receivable

2,100a

845e

1,163f

4,108

Inventory

5,000

1,879

1,923

8,802

Investment in Mexican affiliate

-b

-

-

-

Investment in Canadian affiliate

-c

-

-

-

12,000

3,394

4,308

19,702

Assets

Net fixed assets Total assets

$35,465

Liabilities and Net Worth

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Accounts payable

$3,000

$ 358a

$1,308

$ 4,666

Notes payable

4,000d

1,273

1,769

7,042

Long-term debt

9,000

2,121

1,769

12,890

Common stock

5,000

-b

-c

5,000

Retained earnings

6,000

-b

-c

6,000

-

-

-

(133)

CTA Total liabilities and net worth

$35,465

a

$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.

b,c

The investment in the affiliates cancels with the net worth of the affiliates in the consolidation.

d

The parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)). e

The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate‘s books as Ps384,466 (= A120,000 x Ps3.30/A1.03). f

The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer.

This is carried on the Canadian affiliate‘s books as CD312,000 (=W192,000,000/(W800/CD1.30)). d. i. The transaction exposure report for Sundance, Inc. and its two affiliates is presented below. The report indicates that the Ps1,320,000 accounts receivable due from the Mexican affiliate is not also a translation exposure because this is netted out in the consolidation.

However, the ¥126,000,000 notes payable of the parent is also a translation exposure.

Additionally, the A120,000 accounts receivable of the Mexican affiliate and the W192,000,000 accounts receivable of the Canadian affiliate are both translation exposures.

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Transaction Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates, December 31, 2019

Translation Affiliate

Parent

Amount

Ps1,320,000

Account

Exposure

Accounts

No

Receivable

Parent

Mexican

¥126,000,000

A120,000

Notes Payable

Yes

Accounts

Yes

Receivable

Canadian

W192,000,000

Accounts

Yes

Receivable

d. ii. Since transaction exposure may potentially result in real cash flow losses while translation exposure does not have an immediate direct effect on operating cash flows, we will first address the transaction exposure that confronts Sundance and its affiliates. The analysis assumes the depreciation in the Canadian dollar and the Argentine austral have already taken place.

The parent firm can pay off the ¥126,000,000 loan from the Japanese bank using funds from the cash account and money from accounts receivable that it will collect. Additionally, the parent firm can collect the accounts receivable of Ps1,320,000 from its Mexican affiliate that is carried on the books as $400,000.

In turn, the Mexican affiliate can collect the A120,000

accounts receivable from the Argentine importer, valued at Ps384,466 after the depreciation in the austral, to guard against further depreciation and to use to partially pay off the peso liability to the parent. The Canadian affiliate can eliminate its transaction exposure by collecting the W192,000,000 accounts receivable as soon as possible, which is currently valued at CD312,000.

The elimination of these transaction exposures will affect the translation exposure of Sundance MNC. A revised translation exposure report follows.

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Revised Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates, December 31, 2019 (in 000 Currency Units)

Japanese

Mexican

Canadian

Argentine

Korean

Yen

Peso

Dollar

Austral

Won

¥0

Ps 484

CD 1,512

A0

W0

Accounts receivable

0

2,404

1,200

0

0

Inventory

0

6,200

2,500

0

0

Fixed assets

0

11,200

5,600

0

0

¥0

Ps20,288

CD10,812

A0

W0

¥0

Ps 1,180

CD1,700

A0

W0

Notes payable

0

4,200

2,300

0

0

Long-term debt

0

7,000

2,300

0

0

¥0

Ps12,380

CD6,300

A0

W0

¥0

Ps 7,908

CD4,512

A0

W0

Assets Cash

Exposed assets Liabilities Accounts payable

Exposed liabilities Net exposure

Note from the revised translation exposure report that the elimination of the transaction exposure will also eliminate the translation exposure in the Japanese yen, Argentine austral and the Korean won.

Moreover, the net translation exposure in the Mexican peso has been

reduced. But the net translation exposure in the Canadian dollar has increased as a result of the Canadian affiliate‘s collection of the won receivable.

The remaining translation exposure can be hedged using a balance sheet hedge or a derivatives hedge. Use of a balance sheet hedge is likely to create new transaction exposure, however. Use of a derivatives hedge is actually speculative, and not a real hedge, since the size of the ―hedge‖ is based on one‘s expectation as to the future spot exchange rate. An incorrect estimate will result in the ―hedge‖ losing money for the MNC.

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CHAPTER 11 INTERNATIONAL BANKING AND MONEY MARKET ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Briefly discuss some of the services that international banks provide their customers and the market place.

Answer: International banks can be characterized by the types of services they provide that distinguish them from domestic banks. Foremost, international banks facilitate the imports and exports of their clients by arranging trade financing. Additionally, they serve their clients by arranging for foreign exchange necessary to conduct cross-border transactions and make foreign investments and by assisting in hedging exchange rate risk in foreign currency receivables and payables through forward and options contracts. Since international banks have established trading facilities, they generally trade foreign exchange products for their own account.

Two major features that distinguish international banks from domestic banks are the types of deposits they accept and the loans and investments they make. Large international banks both borrow and lend in the Eurocurrency market. Moreover, depending upon the regulations of the country in which it operates and its organizational type, an international bank may participate in the underwriting of Eurobonds and foreign bonds.

International banks frequently provide consulting services and advice to their clients in the areas of foreign exchange hedging strategies, interest rate and currency swap financing, and international cash management services.

Not all international banks provide all services.

Banks that do provide a majority of these services are known as full service banks.

2. Briefly discuss the various types of international banking offices.

Answer: The services and operations which an international bank undertakes is a function of the regulatory environment in which the bank operates and the type of banking facility established.

A correspondent bank relationship is established when two banks maintain a correspondent bank account with one another. The correspondent banking system provides a means for a bank‘s MNC clients to conduct business worldwide through his local bank or its

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contacts.

A representative office is a small service facility staffed by parent bank personnel that is designed to assist MNC clients of the parent bank in its dealings with the bank‘s correspondents. It is a way for the parent bank to provide its MNC clients with a level of service greater than that provided through merely a correspondent relationship.

A foreign branch bank operates like a local bank, but legally it is a part of the parent bank.

As such, a branch bank is subject to the banking regulations of its home country and the country in which it operates. The primary reason a parent bank would establish a foreign branch is that it can provide a much fuller range of services for its MNC customers through a branch office than it can through a representative office.

A subsidiary bank is a locally incorporated bank that is either wholly owned or owned in major part by a foreign subsidiary. An affiliate bank is one that is only partially owned, but not controlled by its foreign parent. Both subsidiary and affiliate banks operate under the banking laws of the country in which they are incorporated. U.S. parent banks find subsidiary and affiliate banking structures desirable because they are allowed to engage in security underwriting.

Edge Act banks are federally chartered subsidiaries of U.S. banks which are physically located in the United States that are allowed to engage in a full range of international banking activities. A 1919 amendment to Section 25 of the Federal Reserve Act created Edge Act banks. The purpose of the amendment was to allow U.S. banks to be competitive with the services foreign banks could supply their customers. Federal Reserve Regulation K allows Edge Act banks to accept foreign deposits, extend trade credit, finance foreign projects abroad, trade foreign currencies, and engage in investment banking activities with U.S. citizens involving foreign securities. As such, Edge Act banks do not compete directly with the services provided

by U.S. commercial banks. Edge Act banks are not prohibited from owning equity in business corporations as are domestic commercial banks. Thus, it is through the Edge Act that U.S. parent banks have historically owned foreign banking subsidiaries and held ownership positions in foreign banking affiliates. Since 1966, however, U.S. banks can invest directly in foreign banks, and since 1970, U.S. bank holding companies have been permitted to invest in foreign companies.

An offshore banking center is a country whose banking system is organized to permit external accounts beyond the normal economic activity of the country. Offshore banks operate as branches or subsidiaries of the parent bank. The primary activities of offshore banks are to seek deposits and grant loans in currencies other than the currency of the host government.

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In 1981, the Federal Reserve authorized the establishment of International Banking Facilities (IBF). An IBF is a separate set of asset and liability accounts that are segregated on the parent bank‘s books; it is not a unique physical or legal entity. IBFs operate as foreign banks in the U.S. IBFs were established largely as a result of the success of offshore banking.

The Federal Reserve desired to return a large share of the deposit and loan business of U.S. branches and subsidiaries to the U.S.

3. How does the deposit-loan rate spread in the Eurodollar market compare with the depositloan rate spread in the domestic U.S. banking system? Why?

Answer: Competition has driven the deposit-loan spread in the domestic U.S. banking system to about the same level as in the Eurodollar market. That is, in the Eurodollar market the deposit rate is about the same as the deposit rate for dollars in the U.S. banking system.

Similarly the lending rates are about the same. In theory, the Eurodollar market can operate at a lower cost than the U.S. banking system because it is not subject to mandatory reserve requirements on deposits or deposit insurance on foreign currency deposits.

4. What is the difference between the Euronote market and the Eurocommercial paper market?

Answer: Euronotes are short-term notes underwritten by a group of international investment or commercial banks called a ―facility.‖ A client-borrower makes an agreement with a facility to issue Euronotes in its own name for a period of time, generally three to 10 years. Euronotes are sold at a discount from face value, and pay back the full face value at maturity. Euronotes typically have maturities of from three to six months. Eurocommercial paper is an unsecured short-term promissory note issued by a corporation or a bank and placed directly with the investment public through a dealer. Like Euronotes, Eurocommercial paper is sold at a discount from face value. Maturities typically range from one to six months.

5. Briefly discuss the cause and the solution(s) to the international bank crisis involving lessdeveloped countries.

Answer: The international debt crisis began on August 20, 1982 when Mexico asked more than 100 U.S. and foreign banks to forgive its $68 billion in loans. Soon Brazil, Argentina and more than 20 other developing countries announced similar problems in making the debt service on

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their bank loans. At the height of the crisis, Third World countries owed $1.2 trillion!

The international debt crisis had oil as its source. In the early 1970s, the Organization of Petroleum Exporting Countries (OPEC) became the dominant supplier of oil worldwide.

Throughout this time period, OPEC raised oil prices dramatically and amassed a tremendous supply of U.S. dollars, which was the currency generally demanded as payment from the oil importing countries.

OPEC deposited billions in Eurodollar deposits; by 1976 the deposits amounted to nearly $100 billion. Eurobanks were faced with a huge problem of lending these funds in order to generate interest income to pay the interest on the deposits. Third World countries were only too eager to assist the equally eager Eurobankers in accepting Eurodollar loans that could be used for economic development and for payment of oil imports.

The high oil prices were

accompanied by high interest rates, high inflation, and high unemployment during the 19791981 period. Soon, thereafter, oil prices collapsed and the crisis was on.

U.S. Treasury Secretary Nicholas F. Brady of the first Bush Administration is largely credited with designing a strategy in the spring of 1989 to resolve the problem. Three important factors were necessary to move from the debt management stage, employed over the years 1982-1988 to keep the crisis in check, to debt resolution. First, banks had to realize that the face value of the debt would never be repaid on schedule. Second, it was necessary to extend the debt maturities and to use market instruments to collateralize the debt. Third, the LDCs needed to open their markets to private investment if economic development was to occur.

Debt-for-equity swaps helped pave the way for an increase in private investment in the LDCs. However, monetary and fiscal reforms in the developing countries and the recent privatization trend of state owned industry were also important factors.

Treasury Secretary Brady‘s solution was to offer creditor banks one of three alternatives: (1) convert their loans to marketable bonds with a face value equal to 65 percent of the original loan amount; (2) convert the loans into collateralized bonds with a reduced interest rate of 6.5 percent; or, (3) lend additional funds to allow the debtor nations to get on their feet. The second alternative called for an extension the debt maturities by 25 to 30 years and the purchase by the debtor nation of zero-coupon U.S. Treasury bonds with a corresponding maturity to guarantee the bonds and make them marketable. These bonds have come to be called Brady bonds.

6. What were the weaknesses Basel II that became apparent during the global financial crisis that began in mid-2007?

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Answer: The crisis illustrated how quickly and severely liquidity risks can crystallize and certain sources of funding can evaporate, compounding concern related the valuation of assets and capital adequacy. Prior to the onset of the financial crisis, banks built up significant exposures to off-balance sheet market risks that were not adequately reflected in the capital requirements of Basel II. A number of banking organizations have experienced large losses, most of which were sustained in the banks‘ trading accounts.

These losses have not arisen from actual

defaults, but rather from credit agency downgrades, widening credit spreads, and the loss of liquidity.

7. Discuss the regulatory and macroeconomic factors that contributed to the credit crunch of 2007-2008.

Answer: The origin of the credit crunch can be traced back to three key contributing factors: liberalization of banking and securities regulation, a global savings glut, and the low interest rate environment created by the Federal Reserve Bank in the early part of this decade.

The U.S. Glass-Steagall Act of 1933 mandated a separation of commercial banking from other financial services firms—such as securities, insurance, and real estate. The repeal of Glass-Steagall caused a blurring of the functioning of commercial banks, investment banks, insurance companies, and real estate mortgage banking firms.

Since the repeal of Glass-

Steagall, commercial banks began engaging in risky financial service activities that they previously would not have and which contributed to the credit crunch.

The Commodity Futures Trading Commission (CFTC) was created in 1974 to oversee futures trading to guard against price manipulation, prevent fraud among market participants, and to ensure the soundness of the exchanges. Credit default swaps (CDSs), a type of OTC credit derivative security, were not regulated by the CFTC. The CDS market grew from virtually nothing a half dozen years ago to a $58 trillion market that went largely unregulated and unknown. CDSs have played a prominent role in the credit crunch.

In the years leading up to the crisis, the world was awash in liquidity in recent years, much of it denominated in U.S. dollars, awaiting investment. As a result, the United States was able to maintain domestic investment at a rate that otherwise would have required higher domestic savings (or reduced consumption) and also found a ready market with central banks for U.S. Treasury and government agency securities, helping keep U.S. interest rates low.

The Fed Funds target rate fell from 6.5 percent set on May 16, 2000 to 1.0 percent on June 25, 2003, and stayed below 3.0 percent until May 3, 2005. The decrease in the Fed

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Funds rate was the Fed‘s response to the financial turmoil created by the fall in stock market prices in 2000 as the high-tech, dot-com, boom came to an end. Low interest rates created the means for first-time homeowners to afford mortgage financing and also created the means for existing homeowners to trade up to more expensive homes.

Low interest rate mortgages

created an excess demand for homes, driving prices up substantially in most parts of the country, in particular in popular residential areas such as California and Florida.

8. How did the credit crunch become a global financial Crisis?

Answer: As the credit crunch escalated, many CDOs found themselves stuck with various tranches of MBS debt, especially the highest risk tranches, which they had not yet placed or were unable to place as subprime foreclosure rates around the country escalated. Commercial and investment banks were forced to write down billions of subprime debt.

As the U.S.

economy slipped into recession, banks also started to set aside billions for credit-card debt and other consumer loans they feared would go bad. The credit rating firms—Moody‘s, S&P, and Fitch—lowered their ratings on many CDOs after recognizing that the models they had used to evaluate the risk of the various tranches were mis-specified. Additionally, the credit rating firms downgraded many MBS, especially those containing subprime mortgages, as foreclosures around the country increased. An unsustainable problem arose for bond insurers who sold credit default swap (CDS) contracts and the banks that purchased this credit insurance. As the bond insurers got hit with claims from bank-sponsored SIVs as the MBS debt in their portfolios defaulted, the credit rating agencies required the insurers to put up more collateral with the counterparties who held the other side of the CDSs, which put stress on their capital base and prompted credit-rating downgrades, which in turn triggered more margin calls.

If big bond

insurers, such as American International Group (AIG) failed, the banks that relied on the insurance protection would be forced to write down even more mortgage-backed debt which would further erode their Tier I Core capital bases. By September 2008, a worldwide flight to quality investments—primarily short term U.S. Treasury Securities—ensued. The demand for safety was so great, at one point in November 2008, the one-month U.S. Treasury bill was yielding only one basis point. The modern day equivalent of a ‗bank run‘ was operating in full force and many financial institutions could not survive.

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9. What is a mortgage backed security?

Answer: A mortgage-backed security is a derivative security because its value is derived from the value of the underlying mortgages that secure it. Conceptually, mortgage-backed securities seem to make sense. Each MBS represents a portfolio of mortgages, thus diversifying the credit risk that the investor holds.

10. What is a structured investment vehicle and what effect did they have on the credit crunch?

Answer:

A structured investment vehicle (SIV) is a virtual bank, frequently operated by a

commercial bank or an investment bank, but which operates off balance sheet. Typically, an SIV raises short term funds in the commercial paper market to finance longer-term investment in mortgage-backed securities (MBSs). SIVs are frequently highly levered, with ratios of 10 to 15 times the amount equity raised. Structured investment vehicles have been one large investor in MBS. Since yield curves are typically upward sloping, the SIV might normally earn .25 percent by doing this. SIVs are subject to the interest rate risk of the yield curve inverting, that is, shortterm rates rising above long-term rates, thus necessitating the SIV to refinance the MBS investment at short-term rates in excess of the rate being earned on the MBS. Default risk is another risk with which SIVs must contend. If the underlying mortgage borrowers default on their home loans, the SIV will lose investment value. Nevertheless, SIVs predominately invest only in high-grade Aaa/AAA MBS. By investing in a variety of MBS, an SIV further diversifies the credit risk of MBS investment. The SIV‘s value obviously derives from the value of the portfolio of MBS it represents.

To cool the growth of the economy, the Fed steadily increased the Fed Funds target rate at meetings of the Federal Open Market Committee, from a low of 1.0 percent on June 25, 2003 to 5.25 percent on June 29, 2006. In turn, mortgage rates increased and home prices stopped increasing, thus stalling new housing starts and precluding mortgage refinancing to draw out paper capital gains. Many subprime borrowers found it difficult, if not impossible, to make mortgage payments in this economic environment, especially when their adjustable-rate mortgages were reset at higher rates. As matters unfolded, it was discovered that the amount of subprime MBS debt in structured investment vehicles was essentially unknown. While it was thought SIVs would spread MBS risk worldwide to investors best able to bear it, it turned out that many banks that did not hold mortgage debt directly, held it indirectly through MBS in SIVs they sponsored. To make matters worse, the diversification that investors in MBS and SIVs

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thought they had was only illusory.

Diversification of credit risk only works when a portfolio is

diversified over a broad set of asset classes. MBS and SIVs were diversified over a single asset class—poor quality residential mortgages! When subprime debtors began defaulting on their mortgages, commercial paper investors were unwilling to finance SIVs and trading in the interbank Eurocurrency market essentially ceased as traders became fearful of the counterparty risk of placing funds with even the strongest international banks. Liquidity worldwide essentially dried up, creating the credit crunch.

11. What is a collateralized debt obligation and what effect did they have on the credit crunch?

Answer:

A collateralized debt obligation (CDO) is a corporate entity constructed to hold a

portfolio of fixed-income assets as collateral. The portfolio of fixed-income assets is divided into different tranches, each representing a different risk class: AAA, AA-BB, or unrated. CDOs serve as an important funding source for fixed-income securities. An investor in a CDO is taking a position in the cash flows of a particular tranche, not in the fixed-income securities directly.

The investment is dependent on the metrics used to define the risk and reward of the tranche.

To cool the growth of the economy, the Fed steadily increased the Fed Funds target rate at meetings of the Federal Open Market Committee, from a low of 1.0 percent on June 25, 2003 to 5.25 percent on June 29, 2006. In turn, mortgage rates increased and home prices stopped increasing, thus stalling new housing starts and precluding mortgage refinancing to draw out paper capital gains. Many subprime borrowers found it difficult, if not impossible, to make mortgage payments in this economic environment, especially when their adjustable-rate mortgages were reset at higher rates. As matters unfolded, it was discovered that the amount of subprime MBS debt in CDOs and SIVs, and who exactly owned it, were essentially unknown, or at least unappreciated. The diversification that investors in CDOs and SIVs thought they had was only illusory.

Diversification of credit risk only works when a portfolio is diversified over a

broad set of asset classes. MBS, SIVs and CDOs, however, were diversified over a single asset class—poor quality residential mortgages! When subprime debtors began defaulting on their mortgages, commercial paper investors were unwilling to finance SIVs and trading in the interbank Eurocurrency market essentially ceased as traders became fearful of the counterparty risk of placing funds with even the strongest international banks. Liquidity worldwide essentially dried up, creating the credit crunch.

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PROBLEMS

1. Grecian Tile Manufacturing of Athens, Georgia, borrows $1,500,000 at LIBOR plus a lending margin of 1.25 percent per annum on a six-month rollover basis from a London bank. If sixmonth LIBOR is 4.50 percent over the first six-month interval and 5.375 percent over the second six-month interval, how much will Grecian Tile pay in interest over the first year of its Eurodollar loan?

Solution: $1,500,000 x (.045 + .0125)/2 + $1,500,000 x (.05375 + .0125)/2 = $43,125 + $49,687.50 = $92,812.50.

2. A bank sells a ―three against six‖ $3,000,000 FRA for a three-month period beginning three months from today and ending six months from today. The purpose of the FRA is to cover the interest rate risk caused by the maturity mismatch from having made a three-month Eurodollar loan and having accepted a six-month Eurodollar deposit. The agreement rate with the buyer is 5.50 percent. There are actually 92 days in the three-month FRA period. Assume that three months from today the settlement rate is 4.875 percent. Determine how much the FRA is worth and who pays who--the buyer pays the seller or the seller pays the buyer.

Solution: Since the settlement rate is less than the agreement rate, the buyer pays the seller the absolute value of the FRA. The absolute value of the FRA is:

$3,000,000 x [(.04875-.055) x 92/360]/[1 + (.04875 x 92/360)] = $3,000,000 x [-.001597/(1.012458)] = $4,732.05.

3. Assume the settlement rate in problem 2 is 6.125 percent. What is the solution now?

Solution: Since the settlement rate is greater than the agreement rate, the seller pays the buyer the absolute value of the FRA. The absolute value of the FRA is:

$3,000,000 x [(.06125-.055) x 92/360]/[1 + (.06125 x 92/360)] = $3,000,000 x [.001597/(1.015653)] = $4,717.16.

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4. A ―three-against-nine‖ FRA has an agreement rate of 4.75 percent. You believe six-month LIBOR in three months will be 5.125 percent. You decide to take a speculative position in a FRA with a $1,000,000 notional value. There are 183 days in the FRA period. Determine whether you should buy or sell the FRA and what your expected profit will be if your forecast is correct about the six-month LIBOR rate.

Solution: Since the agreement rate is less than your forecast, you should buy a FRA. If your forecast is correct your expected profit will be:

$1,000,000 x [(.05125-.0475) x 183/360]/[1 + (.05125 x 183/360)] = $1,000,000 x [.001906/(1.026052)] = $1,857.61.

5. Recall the FRA problem presented as Example 11.2. Show how the bank can alternatively use a position in Eurodollar futures contracts (Chapter 7) to hedge the interest rate risk created by the maturity mismatch it has with the $3,000,000 six-month Eurodollar deposit and rollover Eurocredit position indexed to three-month LIBOR. Assume that the bank can take a position in Eurodollar futures contracts that mature in three months and have a futures price of 94.00.

Solution: To hedge the interest rate risk created by the maturity mismatch, the bank would need to buy (go long) three Eurodollar futures contracts. If on the last day of trading, three-month LIBOR is 5.125 percent, the bank will earn a profit of $6,562.50 from its futures position. This is calculated as: [94.875 - 94.00] x 100 bp x 2 x $12.50 x 3 contracts = $6,562.50.

Note that this sum differs slightly from the $6,550.59 profit that the bank will earn from the FRA for two reasons. First, the Eurodollar futures contract assumes an arbitrary 90 days in a threemonth period, whereas the FRA recognizes that the actual number of days in the specific threemonth period is 91 days. Second, the Eurodollar futures contract pays off in future value terms, or as of the end of the three-month period, whereas the FRA pays off in present value terms, or as of the beginning of the three-month period.

6. The Fisher effect (Chapter 6) suggests that nominal interest rates differ between countries because of differences in the respective rates of inflation. According to the Fisher effect and

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your examination of the one-year Eurocurrency interest rates presented in Exhibit 11.3, order the currencies from the eight countries from highest to lowest in terms of the size of the inflation premium embedded in the nominal ask interest rates for April 3, 2019.

Solution: According to the Fisher effect, the one-year Eurocurrency interest rates suggest that the inflation premiums for the countries representing the eight currencies ordered from highest to lowest are: U.S. dollar, Canadian dollar, Singapore dollar, British pound, Japanese yen, euro, Swiss franc, and Danish krone.

7. George Johnson is considering a possible six-month $100 million LIBOR-based, floating-rate bank loan to fund a project at terms shown in the table below. Johnson fears a possible rise in the LIBOR rate by December and wants to use the December Eurodollar futures contract to hedge this risk. The contract expires December 20, 2009, has a US$ 1 million contract size, and a discount yield of 7.3 percent.

Johnson will ignore the cash flow implications of marking to market, initial margin requirements, and any timing mismatch between exchange-traded futures contract cash flows and the interest payments due in March.

Loan Terms

September 20, 2009  Borrow $100 million at September 20 LIBOR + 200 basis points (bps)  September 20 LIBOR = 7%

December 20, 2009

March 20, 2010

 Pay interest for first three

 Pay back principal

months

plus interest

 Roll loan over at December 20 LIBOR + 200 bps

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Loan

First loan payment (9%)

Second payment

initiated

and futures contract expires

and principal













9/20/09

12/20/09

3/20/10

a. Formulate Johnson‘s September 20 floating-to-fixed-rate strategy using the Eurodollar future contracts discussed in the text above. Show that this strategy would result in a fixed-rate loan, assuming an increase in the LIBOR rate to 7.8 percent by December 20, which remains at 7.8 percent through March 20. Show all calculations.

Johnson is considering a 12-month loan as an alternative. This approach will result in two additional uncertain cash flows, as follows:

Loan

First

Second

Third

Fourth

initiated

payment (9%)

payment

payment

payment and principal





















9/20/09

12/20/09

3/20/10

6/20/10

9/20/10

b. Describe the strip hedge that Johnson could use and explain how it hedges the 12-month loan (specify number of contracts). No calculations are needed.

CFA Guideline Answer

a. The basis point value (BPV) of a Eurodollar futures contract can be found by substituting the contract specifications into the following money market relationship: BPV FUT = Change in Value = (face value) x (days to maturity / 360) x (change in yield)

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= ($1 million) x (90 / 360) x (.0001) = $25 The number of contract, N, can be found by: N = (BPV spot) / (BPV futures) = ($2,500) / ($25) = 100 OR N = (value of spot position) / (face value of each futures contract) = ($100 million) / ($1 million) = 100 OR N = (value of spot position) / (value of futures position) = ($100,000,000) / ($981,750) where value of futures position = $1,000,000 x [1 – (0.073 / 4)]  102 contracts

Therefore on September 20, Johnson would sell 100 (or 102) December Eurodollar futures contracts at the 7.3 percent yield. The implied LIBOR rate in December is 7.3 percent as indicated by the December Eurofutures discount yield of 7.3 percent. Thus a borrowing rate of 9.3 percent (7.3 percent + 200 basis points) can be locked in if the hedge is correctly implemented.

A rise in the rate to 7.8 percent represents a 50 basis point (bp) increase over the implied LIBOR rate. For a 50 basis point increase in LIBOR, the cash flow on the short futures position is: = ($25 per basis point per contract) x 50 bp x 100 contracts = $125,000.

However, the cash flow on the floating rate liability is: = -0.098 x ($100,000,000 / 4) = - $2,450,000.

Combining the cash flow from the hedge with the cash flow from the loan results in a net outflow of $2,325,000, which translates into an annual rate of 9.3 percent:

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= ($2,325,000 x 4) / $100,000,000 = 0.093 This is precisely the implied borrowing rate that Johnson locked in on September 20.

Regardless of the LIBOR rate on December 20, the net cash outflow will be $2,325,000, which translates into an annualized rate of 9.3 percent. Consequently, the floating rate liability has been converted to a fixed rate liability in the sense that the interest rate uncertainty associated with the March 20 payment (using the December 20 contract) has been removed as of September 20.

b. In a strip hedge, Johnson would sell 100 December futures (for the March payment), 100 March futures (for the June payment), and 100 June futures (for the September payment). The objective is to hedge each interest rate payment separately using the appropriate number of contracts. The problem is the same as in Part A except here three cash flows are subject to rising rates and a strip of futures is used to hedge this interest rate risk. This problem is simplified somewhat because the cash flow mismatch between the futures and the loan payment is ignored. Therefore, in order to hedge each cash flow, Johnson simply sells 100 contracts for each payment. The strip hedge transforms the floating rate loan into a strip of fixed rate payments. As was done in Part A, the fixed rates are found by adding 200 basis points to the implied forward LIBOR rate indicated by the discount yield of the three different Eurodollar futures contracts. The fixed payments will be equal when the LIBOR term structure is flat for the first year.

8. Jacob Bower has a liability that:  has a principal balance of $100 million on June 30, 2008,  accrues interest quarterly starting on June 30, 2008,  pays interest quarterly,  has a one-year term to maturity, and  calculates interest due based on 90-day LIBOR (the London Interbank Offered Rate).

Bower wishes to hedge his remaining interest payments against changes in interest rates.

Bower has correctly calculated that he needs to sell (short) 300 Eurodollar futures contracts to accomplish the hedge. He is considering the alternative hedging strategies outlined in the following table.

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Initial Position (6/30/08) in 90-Day LIBOR Eurodollar Contracts

Strategy A

Strategy B

Contract Month

(contracts)

(contracts)

September 2008

300

100

December 2008

0

100

March 2009

0

100

a. Explain why strategy B is a more effective hedge than strategy A when the yield curve undergoes an instantaneous nonparallel shift. b. Discuss an interest rate scenario in which strategy A would be superior to strategy B.

CFA Guideline Answer a. Strategy B‘s Superiority Strategy B is a strip hedge that is constructed by selling (shorting) 100 futures contracts maturing in each of the next three quarters. With the strip hedge in place, each quarter of the coming year is hedged against shifts in interest rates for that quarter. The reason Strategy B will be a more effective hedge than Strategy A for Jacob Bower is that Strategy B is likely to work well whether a parallel shift or a nonparallel shift occurs over the one-year term of Bower‘s liability. That is, regardless of what happens to the term structure, Strategy B structures the futures hedge so that the rates reflected by the Eurodollar futures cash price match the applicable rates for the underlying liability-the 90day LIBOR-based rate on Bower‘s liability. The same is not true for Strategy A. Because Jacob Bower‘s liability carries a floating interest rate that resets quarterly, he needs a strategy that provides a series of three-month hedges.

Strategy A will need to be restructured when the three-month September contract expires. In particular, if the yield curve twists upward (futures yields rise more for distant expirations than for near expirations), Strategy A will produce inferior hedge results.

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b. Scenario in Which Strategy A is Superior Strategy A is a stack hedge strategy that initially involves selling (shorting) 300 September contracts. Strategy A is rarely better than Strategy B as a hedging or risk-reduction strategy.

Only from the perspective of favorable cash flows is Strategy A better than Strategy B. Such cash flows occur only in certain interest rate scenarios. For example Strategy A will work as well as Strategy B for Bower‘s liability if interest rates (instantaneously) change in parallel fashion. Another interest rate scenario where Strategy A outperforms Strategy B is one in which the yield curve rises but with a twist so that futures yields rise more for near expirations than for distant expirations. Upon expiration of the September contract, Bower will have to roll out his hedge by selling 200 December contracts to hedge the remaining interest payments. This action will have the effect that the cash flow from Strategy A will be larger than the cash flow from Strategy B because the appreciation on the 300 short September futures contracts will be larger than the cumulative appreciation in the 300 contracts shorted in Strategy B (i.e., 100 September, 100 December, and 100 March). Consequently, the cash flow from Strategy A will more than offset the increase in the interest payment on the liability, whereas the cash flow from Strategy B will exactly offset the increase in the interest payment on the liability.

MINI CASE: DETROIT MOTORS‘ LATIN AMERICAN EXPANSION

It is September 1990 and Detroit Motors of Detroit, Michigan, is considering establishing an assembly plant in Latin America for a new utility vehicle it has just designed. The cost of the capital expenditures has been estimated at $65,000,000. There is not much of a sales market in Latin America, and virtually all output would be exported to the United States for sale.

Nevertheless, an assembly plant in Latin America is attractive for at least two reasons. First, labor costs are expected to be half what Detroit Motors would have to pay in the United States to union workers. Since the assembly plant will be a new facility for a newly designed vehicle, Detroit Motors expects minimal resistance from its U.S. union in establishing the plant in Latin America. Secondly, the chief financial officer (CFO) of Detroit Motors believes that a debt-forequity swap can be arranged with at least one of the Latin American countries that has not been able to meet its debt service on its sovereign debt with some of the major U.S. banks.

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The September 10, 1990, issue of Barron’s indicated the following prices (cents on the dollar) on Latin American bank debt: Brazil

21.75

Mexico

43.12

Argentina

14.25

Venezuela

46.25

Chile

70.25

The CFO is not comfortable with the level of political risk in Brazil and Argentina, and has decided to eliminate them from consideration. After some preliminary discussions with the central banks of Mexico, Venezuela, and Chile, the CFO has learned that all three countries would be interested in hearing a detailed presentation about the type of facility Detroit Motors would construct, how long it would take, the number of locals that would be employed, and the number of units that would be manufactured per year. Since it is time-consuming to prepare and make these presentations, the CFO would like to approach the most attractive candidate first. He has learned that the central bank of Mexico will redeem its debt at 80 percent of face value in a debt-for-equity swap, Venezuela at 75 percent, and Chile 100 percent. As a first step, the CFO decides an analysis based purely on financial considerations is necessary to determine which country looks like the most viable candidate. You are asked to assist in the analysis.

What do you advise?

Suggested Solution for Detroit Motors‘ Latin American Expansion

Regardless in which LDC Detroit Motors establishes the new facility, it will need $65,000,000 in the local currency of the country to build the plant. The analysis involves a comparison of the dollar cost of enough LDC debt from a creditor bank to provide $65,000,000 in local currency upon redemption with the LDC central bank.

If Detroit Motors builds in Mexico, it will need to purchase $81,250,000 (= $65,000,000/.80) in Mexican sovereign debt in order to have $65,000,000 in pesos after redemption with the Mexican central bank. The cost in dollars will be $35,035,000 (= $81,250,000 x .4312).

If Detroit Motors builds in Venezuela, it will need to purchase $86,666,667 (= $65,000,000/.75) in Venezuelan sovereign debt in order to have $65,000,000 in bolivars after redemption with the Venezuelan central bank.

The cost in dollars will be $40,083,333 (=

$86,666,667 x .4625).

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If Detroit Motors builds in Chile, it will need to purchase $65,000,000 (= $65,000,000/1.00) in Chilean sovereign debt in order to have $65,000,000 in pesos after redemption with the Chilean central bank. The cost in dollars will be $45,662,500 (= $65,000,000 x .7025).

Based on the above analysis, Detroit Motors should consider approaching Mexico about the possibility of a debt-for-equity swap to build an assembly facility. Of course, there are many other factors, such as tax rates, shipping costs, and labor costs that also should be considered.

Assuming all else is equal, however, Mexico seems to be the most attractive candidate.

APPENDIX 11A QUESTION

1. Explain how Eurocurrency is created.

Answer: The core of the international money market is the Eurocurrency market. A Eurocurrency is a time deposit of money in an international bank located in a country different from the country that issues the currency. For example, Eurodollars are deposits of U.S. dollars in banks located outside of the United States. As an illustration, assume a U.S. Importer purchases $100 of merchandise from a German Exporter and pays for the purchase by drawing a $100 check on his U.S. checking account (demand deposit). If the funds are not needed for the operation of the business, the German Exporter can deposit the $100 in a time deposit in a bank outside the U.S. and receive a greater rate of interest than if the funds were put in a U.S. time deposit. Assume the German Exporter deposits the funds in a London Eurobank. The London Eurobank credits the German Exporter with a $100 time deposit and deposits the $100 into its correspondent bank account (demand deposit) with the U.S. Bank (banking system) to hold as reserves. Two points are noteworthy. First, the entire $100 remains on deposit in the U.S. Bank. Second, the $100 time deposit of the German Exporter in the London Eurobank represents the creation of Eurodollars. This deposit exists in addition to the dollars deposited in the U.S. Hence, no dollars have flowed out of the U.S. banking system in the creation of Eurodollars.

CHAPTER 12 INTERNATIONAL BOND MARKETS ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

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1.

Describe the differences between foreign bonds and Eurobonds.

Also discuss why

Eurobonds make up the lion‘s share of the international bond market.

Answer: The two segments of the international bond market are: foreign bonds and Eurobonds.

A foreign bond issue is one offered by a foreign borrower to investors in a national capital market and denominated in that nation‘s currency. A Eurobond issue is one denominated in a particular currency, but sold to investors in national capital markets other than the country which issues the denominating currency.

Eurobonds make up over 80 percent of the international bond market.

The two major

reasons for this stem from the fact that the U.S. dollar is the currency most frequently sought in international bond financing. First, Eurodollar bonds can be brought to market more quickly than Yankee bonds because they are not offered to U.S. investors and thus do not have to meet the strict SEC registration requirements. Second, Eurobonds are typically bearer bonds that provide anonymity to the owner and thus allow a means for evading taxes on the interest received.

Because of this feature, investors are generally willing to accept a lower yield on Eurodollar bonds in comparison to registered Yankee bonds of comparable terms, where ownership is recorded.

For borrowers the lower yield means a lower cost of debt service.

2. Briefly define each of the major types of international bond market instruments, noting their distinguishing characteristics.

Answer:

The major types of international bond instruments and their distinguishing

characteristics are as follows: Straight fixed-rate bond issues have a designated maturity date at which the principal of the bond issue is promised to be repaid. During the life of the bond, fixed coupon payments that are some percentage rate of the face value are paid as interest to the bondholders. This is the major international bond type. Straight fixed-rate Eurobonds are typically bearer bonds and pay coupon interest annually.

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Floating-rate notes (FRNs) are typically medium-term bonds with their coupon payments indexed to some reference rate. Common reference rates are either three-month or six-month U.S. dollar LIBOR. Coupon payments on FRNs are usually quarterly or semi-annual, and in accord with the reference rate.

A convertible bond issue allows the investor to exchange the bond for a pre-determined number of equity shares of the issuer. The floor value of a convertible bond is its straight fixedrate bond value. Convertibles usually sell at a premium above the larger of their straight debt value and their conversion value. Additionally, investors are usually willing to accept a lower coupon rate of interest than the comparable straight fixed coupon bond rate because they find the call feature attractive. Bonds with equity warrants can be viewed as a straight fixed-rate bond with the addition of a call option (or warrant) feature. The warrant entitles the bondholder to purchase a certain number of equity shares in the issuer at a pre-stated price over a predetermined period of time.

Zero coupon bonds are sold at a discount from face value and do not pay any coupon interest over their life. At maturity the investor receives the full face value. Another form of zero coupon bonds are stripped bonds. A stripped bond is a zero coupon bond that results from stripping the coupons and principal from a coupon bond. The result is a series of zero coupon bonds represented by the individual coupon and principal payments.

A dual-currency bond is a straight fixed-rate bond which is issued in one currency and pays coupon interest in that same currency. At maturity, the principal is repaid in a second currency.

Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for some appreciation in the exchange rate of the stronger currency. From the investor‘s perspective, a dual currency bond includes a long-term forward contract.

Composite currency bonds are denominated in a currency basket, such as SDRs or ECUs, instead of a single currency. They are frequently called currency cocktail bonds. They are typically straight fixed-rate bonds. The currency composite is a portfolio of currencies: when some currencies are depreciating others may be appreciating, thus yielding lower variability overall.

3. Why do most international bonds have high Moody‘s or Standard & Poor‘s credit ratings?

Answer:

Moody‘s Investors Service and Standard & Poor‘s provide credit ratings on most

international bond issues. It has been noted that a disproportionate share of international bonds

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have high credit ratings.

The evidence suggests that a logical reason for this is that the

Eurobond market is only accessible to firms that have good credit ratings to begin with.

4. What factors does S&P Global Ratings analyze in determining the credit rating it assigns to a sovereign government?

Answer: In rating a sovereign government, S&P‘s analysis centers around an assessment of institutional, economic, external, fiscal, and monetary factors.

The rating assigned to a

sovereign is particularly important because it usually represents the ceiling for ratings S&P will assign to an obligation of an entity domiciled within that country.

5. Discuss the process of bringing a new international bond issue to market.

Answer: A borrower desiring to raise funds by issuing Eurobonds to the investing public will contact an investment banker and ask it to serve as lead manager of an underwriting syndicate that will bring the bonds to market. The lead manager will usually invite other banks to form a managing group to help negotiate terms with the borrower, ascertain market conditions, and manage the issuance. The managing group, along with other banks, will serve as underwriters for the issue, i.e., they will commit their own capital to buy the issue from the borrower at a discount from the issue price. Most of the underwriters, along with other banks, will be part of a selling group that sells the bonds to the investing public.

The various members of the

underwriting syndicate receive a portion of the spread (usually in the range of 2 to 2.5 percent of the issue size), depending upon the number and type of functions they perform. The lead manager receives the full spread, and a bank serving as only a member of the selling group receives a smaller portion.

6. You are an investment banker advising a Eurobank about a new international bond offering it is considering. The proceeds are to be used to fund Eurodollar loans to bank clients. What type of bond instrument would you recommend that the bank consider issuing? Why?

Answer: Since the Eurobank desires to use the bond proceeds to finance Eurodollar loans, which are floating-rate loans, the investment banker should recommend that the bank issue FRNs, which are a variable rate instrument. Thus there will a correspondence between the interest rate the bank pays for funds and the interest rate it receives from its loans.

For

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example, if the bank frequently makes term loans indexed to 3-month LIBOR, it might want to issue FRNs, also, indexed to 3-month LIBOR.

7. What should a borrower consider before issuing dual-currency bonds? What should an investor consider before investing in dual-currency bonds?

Answer: A dual currency bond is a straight fixed-rate bond which is issued in one currency and pays coupon interest in that same currency. At maturity, the principal is repaid in a second currency. Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for some appreciation in the exchange rate of the stronger currency. From the investor‘s perspective, a dual currency bond includes a long-term forward contract. If the second currency appreciates over the life of the bond, the principal repayment will be worth more than a return of principal in the issuing currency.

However, if the payoff currency

depreciates, the investor will suffer an exchange rate loss. Dual currency bonds are attractive to MNCs seeking financing in order to establish or expand operations in the country issuing the payoff currency. During the early years, the coupon payments can be made by the parent firm in the issuing currency. At maturity, the MNC anticipates the principal to be repaid from profits earned by the subsidiary. The MNC may suffer an exchange rate loss if the subsidiary is unable to repay the principal and the payoff currency has appreciated relative to the issuing currency.

Consequently, both the borrower and the investor are exposed to exchange rate uncertainty from a dual currency bond.

PROBLEMS:

1. Your firm has just issued five-year floating-rate notes indexed to six-month U.S. dollar LIBOR plus 1/4%. What is the amount of the first coupon payment your firm will pay per U.S. $1,000 of face value, if six-month LIBOR is currently 7.2%?

Solution: 0.5 x (.072 + .0025) x $1,000 = $37.25.

2.

Consider 8.5 percent Swiss franc/U.S. dollar dual-currency bonds that pay $666.67 at

maturity per SF1,000 of par value. It sells at par. What is the implicit SF/$ exchange rate at maturity? Will the investor be better or worse off at maturity if the actual SF/$ exchange rate is SF1.35/$1.00?

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Solution: Implicitly, the dual currency bonds call for the exchange of SF1,000 of face value for $666.67.

Therefore, the implicit exchange rate built into the dual currency bond issue is

SF1,000/$666.67, or SF1.50/$1.00. If the exchange rate at maturity is SF1.35/$1.00, SF1,000 would buy $740.74 = SF1,000/SF1.35. Thus, the dual currency bond investor is worse off with $666.67 because the dollar is at a depreciated level in comparison to the implicit exchange rate of SF1.50/$1.00. .

3. A five-year, 4 percent Euroyen bond sells at par. A comparable risk five year, 5.5 percent yen/dollar dual currency bond pays $833.33 at maturity. It sells for ¥110,000. What is the implied ¥/$ exchange rate at maturity? Hint: The dual-currency bond pays 5.5 percent interest on a notional value of ¥100,000, whereas the par value of the bond is not necessarily equivalent to ¥100,000.

Solution: Since the dual currency bond is of comparable risk, it will yield 4 percent like the straight Euroyen bond selling at par. Thus,

¥110,000 = ¥5,500 x PVIFA(n = 5, i = 4%) + S5(¥/$) x $833.33 x PVIF(n = 5, i = 4%) = ¥5,500 x 4.4518 + S5(¥/$) x $833.33 x .8219 = ¥24,484.90 + S5(¥/$) x $684.91 This implies that the expected S5(¥/$) is 124.856.

MINI CASE: SARA LEE CORPORATION‘S EUROBONDS

Sara Lee Corp. is serving up a brand name and a shorter maturity than other recent corporate borrowers to entice buyers to its first-ever dollar Eurobonds. The U.S. maker of consumer products, from Sara Lee cheesecake to Hanes pantyhose and Hillshire Farm meats, is selling $100 million in bonds with a 6 percent coupon. These are three-year bonds; other corporate bond sellers including Coca-Cola Co., Unilever NV, and Wal-Mart Stores, Inc., have concentrated on their five-year maturities. ―It is a well-known name and it is bringing paper to a part of the maturity curve where there is not much there,‖ said Noel Dunn of Goldman Sachs International. Goldman Sachs expects to find most buyers in the Swiss retail market, where ―high-quality American corporate paper is their favorite buy,‖ Dunn said.

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These are the first bonds out of a $500 million Eurobond program that Sara Lee announced in August 1995, and the proceeds will be used for general corporate purposes, said Jeffery Smith, a spokesman for the company.

The bond is fairly priced, according to Bloomberg Fair Value analysis, which compared a bond with similar issues available in the market. The bond offers investors a yield of 5.881 percent annually or 5.797 percent semiannually. That is 22 basis points more than they can get on the benchmark five-year U.S. Treasury note.

BFV analysis calculates that the bond is worth $100,145 on a $100,000 bond, compared with the re-offer price of $100,320. Anything within a $500 range on a $100,000 bond more or less than its BFV price is deemed fairly priced. Sara Lee is rated ―AA-‖ by Standard & Poor‘s Corp. and ―A1,‖ one notch lower, by Moody‘s Investors Service.

In July 1994, Sara Lee‘s Netherlands division sold 200 million Dutch guilders ($127 million) of three-year bonds at 35 basis points over comparable Netherlands government bonds. In January, its Australian division sold 51 million British pounds ($78 million) of bonds maturing in 2004, to yield 9.43 percent.

What thoughts do you have about Sara Lee‘s debt-financing strategy?

Suggested Solution to Sara Lee Corp.‘s Eurobonds

Sara Lee is the ideal candidate to issue Eurobonds. The company has worldwide name recognition, and it has an excellent credit rating that allows it to place new bond issues easily.

By issuing dollar denominated Eurobonds to Swiss investors, Sara Lee can bring new issues to market much more quickly than if it sold domestic dollar denominated bonds. Moreover, the Eurodollar bonds likely sell at a lower yield than comparable domestic bonds.

Additionally, it appears as if Sara Lee is raising funds in a variety of foreign currencies.

Sara Lee most likely has large cash inflows in these same currencies that can be used to meet the debt service obligations on these bond issues. Thus Sara Lee is finding a use for some of its foreign currency receipts and does not have to be concerned with the exchange rate uncertainty of these part of its foreign cash inflows.

CHAPTER 13 INTERNATIONAL EQUITY MARKETS ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

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1. Exhibit 13.8 presents a listing of major national stock market indexes as displayed daily in the print edition of the Financial Times. At www.ft.com you can find an online tracking of these national stock market indexes that shows performance over the past day, month, and year. Go to this website and compare the performance for several stock market indexes from various regions of the world. How does the performance compare? What do you think accounts for differences?

Answer: This question is designed to provide an intuitive understanding of the benefits from international diversification of equity portfolios. Over different time periods, different market forces will affect each national market in unique ways. Some markets will have yielded a positive return and others a negative return. Consequently, since all markets will not have moved in unison, i.e., are not perfectly correlated, international diversification provides volatility reduction to the portfolio investor.

2. As an investor, what factors would you consider before investing in the emerging stock market of a developing country?

Answer: An investor in emerging market stocks needs to be concerned with the depth of the market and the market‘s liquidity. Depth of the market refers to the opportunities to invest in the country. One measure of the depth of the market is the concentration ratio of a country‘s stock market. The concentration ratio frequently is calculated to show the market value of the ten largest stocks traded as a fraction of the total market capitalization of all equities traded. The higher the concentration ratio, the less deep is the market. That is, most value is concentrated in only a few companies. While this does not necessarily imply that the largest stocks in the emerging market are not good investments, it does, however, suggest that there are few opportunities for investment in that country and that proper diversification within the country may be difficult. In terms of liquidity, an investor would be wise to examine the market turnover ratio of the country‘s stock market. High market turnover suggests that the market is liquid, or that there are opportunities for purchasing or selling the stock quickly at close to the current market price. This is important because liquidity means you can get in or out of a stock position quickly without spending more than you intended on purchase or receiving less than you expected on sale.

3. Compare and contrast the various types of secondary market trading structures.

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Answer: There are two basic types of secondary market trading structures: dealer and agency.

In a dealer market, the dealer serves as market maker for the security, holding an inventory of the security. The dealer buys at his bid price and sells at his asked price from this inventory. All public trades go through the dealer. In an agency market, public trades go through the agent who matches it with another public trade. Both dealer and agency markets can be continuous trade markets, but non-continuous markets tend to be only agency markets. Over-the-counter trading, specialist markets, and automated markets are types of continuous market trading systems. Call markets and crowd trading are each types of non-continuous trading market systems. Continuous trading systems are desirable for actively traded issues, whereas call markets and crowd trading offer advantages for smaller markets with many thinly traded issues because they mitigate the possibility of sparse order flow over short time periods.

4. Discuss any benefits you can think of for a company to (a) cross-list its equity shares on more than one national exchange, and (b) to source new equity capital from foreign investors as well as domestic investors.

Answer: A MNC that has a product market presence or manufacturing facilities in several countries may cross-list its shares on the exchanges of these same countries because there is typically investor demand for the shares of companies that are known within a country.

Additionally, a company may cross-list its shares on foreign exchanges to broaden its investor base and therefore to increase the demand for its stock. An increase in demand will generally increase the stock price and improve its market liquidity. A broader investor base may also mitigate the possibility of a hostile takeover.

Additional, cross-listing a company‘s shares

establishes name recognition and thus facilitates sourcing new equity capital in these foreign capital markets.

5. Why might it be easier for an investor desiring to diversify his portfolio internationally to buy depository receipts rather than the actual shares of the company?

Answer:

A depository receipt can be purchased on the investor‘s domestic exchange.

It

represents a package of the underlying foreign security that is priced in the investor‘s local currency and in a trading range that is typical for the investor‘s marketplace. The investor can purchase a depository receipt directly from his domestic broker, rather than having to deal with

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an overseas broker and the necessity of obtaining foreign funds to make the foreign stock purchase. Additionally, dividends are received in the local currency rather than in foreign funds that would need to be converted into the local currency.

6.

Why do you think the empirical studies about factors affecting equity returns basically

showed that domestic factors were more important than international factors, and, secondly, that industrial membership of a firm was of little importance in forecasting the international correlation structure of a set of international stocks?

Answer: While national security markets have become more integrated in recent years, there is still a tremendous amount of segmentation that brings about the benefit to be derived from international diversification of financial assets.

Monetary and fiscal policies differ among

countries because of different economic circumstances. The economic policies of a country directly affect the securities traded in the country, and they will behave differently than securities traded in another country with other economic policies being implemented. Hence, it is not surprising that domestic factors are found to be more important than international factors in affecting security returns. Similarly, industrial activity within a country is also affected by the economic policies of the country; thus firms in the same industry group, but from different countries, will not necessarily behave the same in all countries, nor should we expect the securities issued by these firms to behave alike.

PROBLEMS

1. On the Tokyo Stock Exchange, Honda Motor Company stock closed at ¥2,907 per share on Monday, June 6, 2016. Honda trades as and ADR on the NYSE. One underlying Honda share equals one ADR. On June 6, 2016, the ¥/$ spot exchange rate was ¥107.57/$1.00. a. At this exchange rate, what is the no-arbitrage U.S. dollar price of one ADR? b.

By comparison, Honda ADRs traded at $27.18.

Do you think an arbitrage opportunity

exists?

Solution: a. The no-arbitrage ADR U.S. dollar price is: ¥2,907 ÷ 107.57 = $27.02.

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b. It is unlikely that an arbitrage opportunity exists after transaction costs. Additionally the slight difference in prices is likely accounted for by a difference in information contained in prices since the Tokyo Stock Exchange closes several hours before the NYSE.

2. If Honda ADRs were trading at $31 when the underlying shares were trading in Tokyo at ¥2,907, what could you do to earn a trading profit? Use the information in problem 1, above, to help you and assume that transaction costs are negligible.

Solution: As the solution to problem 1 shows, the no-arbitrage ADR U.S. dollar price is $27.02.

If Honda ADRs were trading at $31, a wise investor might sell short the relatively overvalued ADRs. Since the ADRs are a derivative security, one would expect the ADRs to decrease in price from $31 to $27.02. Assuming this happens, the position could be liquidated for a profit of $31 - $27.02 = $3.98 per ADR. MINI CASE: SAN PICO‘S NEW STOCK EXCHANGE

San Pico is a rapidly growing Latin American developing country. The country is blessed with miles of scenic beaches that have attracted tourists by the thousands in recent years to new resort hotels financed by joint ventures of San Pico businessmen and moneymen from the Middle East, Japan, and the United States. Additionally, San Pico has good natural harbors that are conducive for receiving imported merchandise from abroad and exporting merchandise produced in San Pico and other surrounding countries that lack access to the sea. Because of these advantages, many new businesses are being started in San Pico.

Presently, stock is traded in a cramped building in La Cobijio, the nation‘s capital.

Admittedly, the San Pico Stock Exchange system is rather archaic. Twice a day an official of the exchange will call out the name of each of the 43 companies whose stock trades on the exchange. Brokers wanting to buy or sell shares for their clients then attempt to make a trade with one another. This crowd trading system has worked well for over one hundred years, but the government desires to replace it with a new modern system that will allow greater and more frequent opportunities for trading in each company, and will allow for trading the shares of the many new start-up companies that are expected to trade in the secondary market. Additionally, the government administration is rapidly privatizing many state-owned businesses in an attempt to foster their efficiency, obtain foreign exchange from the sale, and convert the country to a more capitalist economy. The government believes that it could conduct this privatization faster

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and perhaps at more attractive prices if it had a modern stock exchange facility where the shares of the newly privatized companies will eventually trade.

You are an expert in the operation of secondary stock markets and have been retained as a consultant to the San Pico Stock Exchange to offer your expertise in modernizing the stock market. What would you advise?

Suggested Solution to San Pico‘s New Stock Exchange

Most new and renovated stock exchanges are being established these days as either a partially or fully automated trading system. A fully automated system is especially beneficial for a small to medium size country in which there is only moderate trading in most issues. Such a system that deserves special note is the continuous National Integrated Market system of New Zealand.

This system is fully computerized and does not require a physical structure.

Essentially, all buyers and sellers of a stock enter through their broker into the computer system the number of shares they desire to buy or sell and their required transaction price. The system is updated constantly as new purchase or sale orders are entered into the system.

The

computer constantly searches for a match between buyer and seller, and when one is found a transaction takes place. This type of system would likely serve San Pico‘s needs very well.

There is existing technology to implement, the bugs have been worked out in other countries, and it would satisfy all the demands of the San Pico government and easily accommodate growth in market activity.

CHAPTER 14 INTEREST RATE AND CURRENCY SWAPS ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Describe the difference between a swap broker and a swap dealer.

Answer: A swap broker arranges a swap between two counterparties for a fee without taking a risk position in the swap. A swap dealer is a market maker of swaps and assumes a risk position in matching opposite sides of a swap and in assuring that each counterparty fulfills its contractual obligation to the other.

2. What is the necessary condition for a fixed-for-floating interest rate swap to be possible?

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Answer: For a fixed-for-floating interest rate swap to be possible it is necessary for a quality spread differential to exist. In general, the default-risk premium of the fixed-rate debt will be larger than the default-risk premium of the floating-rate debt.

3. Discuss the basic motivations for a counterparty to enter into a currency swap.

Answer: One basic reason for a counterparty to enter into a currency swap is to exploit the comparative advantage of the other in obtaining debt financing at a lower interest rate than could be obtained on its own. A second basic reason is to lock in long-term exchange rates in the repayment of debt service obligations denominated in a foreign currency.

4. How does the theory of comparative advantage relate to the currency swap market?

Answer: Name recognition is extremely important in the international bond market. Without it, even a creditworthy corporation will find itself paying a higher interest rate for foreign denominated funds than a local borrower of equivalent creditworthiness. Consequently, two firms of equivalent creditworthiness can each exploit their, respective, name recognition by borrowing in their local capital market at a favorable rate and then re-lending at the same rate to the other.

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5. Discuss the risks confronting an interest rate and currency swap dealer.

Answer: An interest rate and currency swap dealer confronts many different types of risk.

Interest rate risk refers to the risk of interest rates changing unfavorably before the swap dealer can lay off on an opposing counterparty the unplaced side of a swap with another counterparty.

Basis risk refers to the floating rates of two counterparties being pegged to two different indices.

In this situation, since the indexes are not perfectly positively correlated, the swap bank may not always receive enough floating rate funds from one counterparty to pass through to satisfy the other side, while still covering its desired spread, or avoiding a loss. Exchange-rate risk refers to the risk the swap bank faces from fluctuating exchange rates during the time it takes the bank to lay off a swap it undertakes on an opposing counterparty before exchange rates change.

Additionally, the dealer confronts credit risk from one counterparty defaulting and its having to fulfill the defaulting party‘s obligation to the other counterparty. Mismatch risk refers to the difficulty of the dealer finding an exact opposite match for a swap it has agreed to take.

Sovereign risk refers to a country imposing exchange restrictions on a currency involved in a swap making it costly, or impossible, for a counterparty to honor its swap obligations to the dealer. In this event, provisions exist for the early termination of a swap, which means a loss of revenue to the swap bank.

6. Briefly discuss some variants of the basic interest rate and currency swaps diagramed in the chapter.

Answer: Instead of the basic fixed-for-floating interest rate swap, there are also zero-couponfor-floating rate swaps where the fixed rate payer makes only one zero-coupon payment at maturity on the notional value. There are also floating-for-floating rate swaps where each side is tied to a different floating rate index or a different frequency of the same index. Currency swaps need not be fixed-for-fixed; fixed-for-floating and floating-for-floating rate currency swaps are frequently arranged. Moreover, both currency and interest rate swaps can be amortizing as well as non-amortizing.

7. If the cost advantage of interest rate swaps would likely be arbitraged away in competitive markets, what other explanations exist to explain the rapid development of the interest rate swap market?

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Answer: All types of debt instruments are not always available to all borrowers. Interest rate swaps can assist in market completeness. That is, a borrower may use a swap to get out of one type of financing and to obtain a more desirable type of credit that is more suitable for its asset maturity structure.

8. Suppose Morgan Guaranty, Ltd. is quoting swap rates as follows: 7.75 - 8.10 percent annually against six-month dollar LIBOR for dollars and 11.25 - 11.65 percent annually against six-month dollar LIBOR for British pound sterling. At what rates will Morgan Guaranty enter into a $/£ currency swap?

Answer: Morgan Guaranty will pay annual fixed-rate dollar payments of 7.75 percent against receiving six-month dollar LIBOR flat, or it will receive fixed-rate annual dollar payments at 8.10 percent against paying six-month dollar LIBOR flat. Morgan Guaranty will make annual fixedrate £ payments at 11.25 percent against receiving six-month dollar LIBOR flat, or it will receive annual fixed-rate £ payments at 11.65 percent against paying six-month dollar LIBOR flat.

Thus, Morgan Guaranty will enter into a currency swap in which it would pay annual fixed-rate dollar payments of 7.75 percent in return for receiving semi-annual fixed-rate £ payments at 11.65 percent, or it will receive annual fixed-rate dollar payments at 8.10 percent against paying annual fixed-rate £ payments at 11.25 percent.

9. A U.S. company needs to raise €50,000,000. It plans to raise this money by issuing dollardenominated bonds and using a currency swap to convert the dollars to euros. The company expects interest rates in both the United States and the euro zone to fall.

a. Should the swap be structured with interest paid at a fixed or a floating rate? b. Should the swap be structured with interest received at a fixed or a floating rate?

CFA Guideline Answer:

a. The U.S. company would pay the interest rate in euros. Because it expects that the interest rate in the euro zone will fall in the future, it should choose a swap with a floating rate on the interest paid in euros to let the interest rate on its debt float down.

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b. The U.S. company would receive the interest rate in dollars. Because it expects that the interest rate in the United States will fall in the future, it should choose a swap with a fixed rate on the interest received in dollars to prevent the interest rate it receives from going down.

*10. Assume a currency swap in which two counterparties of comparable credit risk each borrow at the best rate available, yet the nominal rate of one counterparty is higher than the other. After the initial principal exchange, is the counterparty that is required to make interest payments at the higher nominal rate at a financial disadvantage to the other in the swap agreement? Explain your thinking.

Answer: Superficially, it may appear that the counterparty paying the higher nominal rate is at a disadvantage since it has borrowed at a lower rate. However, if the forward rate is an unbiased predictor of the expected spot rate and if IRP holds, then the currency with the higher nominal rate is expected to depreciate versus the other. In this case, the counterparty making the interest payments at the higher nominal rate is in effect making interest payments at the lower interest rate because the payment currency is depreciating in value versus the borrowing currency.

PROBLEMS

1. Alpha and Beta Companies can borrow for a five-year term at the following rates: Alpha

Beta

Moody‘s credit rating

Aa

Baa

Fixed-rate borrowing cost

10.5%

12.0%

Floating-rate borrowing cost

LIBOR

LIBOR + 1%

a. Calculate the quality spread differential (QSD). b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt.

No swap bank is involved in this transaction.

Solution: a. The QSD = (12.0% - 10.5%) minus (LIBOR + 1% - LIBOR) = .5%. b. Alpha needs to issue fixed-rate debt at 10.5% and Beta needs to issue floating rate-debt at

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LIBOR + 1%. Alpha needs to pay LIBOR to Beta. Beta needs to pay 10.75% to Alpha. If this is done, Alpha‘s floating-rate all-in-cost is: 10.5% + LIBOR - 10.75% = LIBOR - .25%, a .25% savings over issuing floating-rate debt on its own. Beta‘s fixed-rate all-in-cost is: LIBOR+ 1% + 10.75% - LIBOR = 11.75%, a .25% savings over issuing fixed-rate debt.

2. Do problem 1 over again, this time assuming more realistically that a swap bank is involved as an intermediary. Assume the swap bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat.

Solution:

Alpha will issue fixed-rate debt at 10.5% and Beta will issue floating rate-debt at

LIBOR + 1%. Alpha will receive 10.7% from the swap bank and pay it LIBOR. Beta will pay 10.8% to the swap bank and receive from it LIBOR. If this is done, Alpha‘s floating-rate all-incost is: 10.5% + LIBOR - 10.7% = LIBOR - .20%, a .20% savings over issuing floating-rate debt on its own. Beta‘s fixed-rate all-in-cost is: LIBOR+ 1% + 10.8% - LIBOR = 11.8%, a .20% savings over issuing fixed-rate debt.

3. Company A is a AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue FRNs at six-month LIBOR + .125 percent or at three-month LIBOR + .125 percent. Given its asset structure, three-month LIBOR is the preferred index. Company B is an A-rated firm that also desires to issue five-year FRNs. It finds it can issue at six-month LIBOR + 1.0 percent or at three-month LIBOR + .625 percent. Given its asset structure, six-month LIBOR is the preferred index. Assume a notional principal of $15,000,000. Determine the QSD and set up a floatingfor-floating rate swap where the swap bank receives .125 percent and the two counterparties share the remaining savings equally.

Solution: The quality spread differential is [(Six-month LIBOR + 1.0 percent) minus (Six-month LIBOR + .125 percent) =] .875 percent minus [(Three-month LIBOR + .625 percent) minus (Three-month LIBOR + .125 percent) =] .50 percent, which equals .375 percent. If the swap bank receives .125 percent, each counterparty is to save .125 percent. To affect the swap, Company A would issue FRNs indexed to six-month LIBOR and Company B would issue FRNs indexed three-month LIBOR.

Company B might make semi-annual payments of six-month

LIBOR + .125 percent to the swap bank, which would pass all of it through to Company A. Company A, in turn, might make quarterly payments of three-month LIBOR to the swap bank, which would pass through three-month LIBOR - .125 percent to Company B. On an annualized

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basis, Company B will remit to the swap bank six-month LIBOR + .125 percent and pay threemonth LIBOR + .625 percent on its FRNs. It will receive three-month LIBOR - .125 percent from the swap bank. This arrangement results in an all-in cost of six-month LIBOR + .825 percent, which is a rate .125 percent below the FRNs indexed to six-month LIBOR + 1.0 percent Company B could issue on its own. Company A will remit three-month LIBOR to the swap bank and pay six-month LIBOR + .125 percent on its FRNs. It will receive six-month LIBOR + .125 percent from the swap bank. This arrangement results in an all-in cost of three-month LIBOR for Company A, which is .125 percent less than the FRNs indexed to three-month LIBOR + .125 percent it could issue on its own. The arrangements with the two counterparties net the swap bank .125 percent per annum, received quarterly.

*4. A corporation enters into a five-year interest rate swap with a swap bank in which it agrees to pay the swap bank a fixed rate of 9.75 percent annually on a notional amount of €15,000,000 and receive LIBOR. As of the second reset date, determine the price of the swap from the corporation‘s viewpoint assuming that the fixed-rate side of the swap has increased to 10.25 percent.

Solution: On the reset date, the present value of the future floating-rate payments the corporation will receive from the swap bank based on the notional value will be €15,000,000.

The present value of a hypothetical bond issue of €15,000,000 with three remaining 9.75 percent coupon payments at the new fixed-rate of 10.25 percent is €14,814,304. This sum represents the present value of the remaining payments the swap bank will receive from the corporation. Thus, the swap bank should be willing to buy and the corporation should be willing to sell the swap for €15,000,000 - €14,814,304 = €185,696.

5. DVR, Inc. can borrow dollars for five years at a coupon rate of 2.75 percent. Alternatively, it can borrow yen for five years at a rate of .85 percent. The five-year yen swap rates are .64--.70 percent and the dollar swap rates are 2.41--2.44 percent. The current ¥/$ exchange rate is 87.575. Determine the dollar AIC and the dollar cash flow that DVR would have to pay under a currency swap where it borrows ¥1,750,000,000 and swaps the debt service into dollars. This problem can be solved using the excel spreadsheet CURSWAP.xls.

Solution: Since the dollar AIC is 2.66% and the DVR‘s dollar borrowing rate is 2.75%, it should borrow yen and swap into dollars. The swap locks-in the dollar cashflows DVR needs to cover

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the yen debt service. The output from using the excel spreadsheet CURSWAP.xls is:

Cross-Currency Swap Analyzer

Year 0 1 2 3 4 5

FC Bond Cashflow

FC Received

1,750,000,000 -14,875,000 -14,875,000 -14,875,000 -14,875,000 1,764,875,000 0.85%

AIC Face Value:

$ Paid

Actual $ Cashflow

-1,768,027,402 14,875,000 14,875,000 14,875,000 14,875,000

20,188,723 -492,605 -492,605 -492,605 -492,605

1,764,875,000

-20,681,328

19,982,872 -492,605 -492,605 -492,605 -492,605 20,681,328

0.64%

2.44%

2.66%

1,750,000,000

Bid

Ask

Coupon Rate:

0.850%

Spot FX Rate:

87.57500 87.57500

OP as % of Par:

100.000%

FC Swap Rate:

0.64%

0.70%

Underwriting Fee:

0.000%

$ Swap Rate:

2.41%

2.44%

6. Karla Ferris, a fixed income manager at Mangus Capital Management, expects the current positively sloped U.S. Treasury yield curve to shift parallel upward.

Ferris owns two $1,000,000 corporate bonds maturing on June 15, 2020, one with a variable rate based on 6-month U.S. dollar LIBOR and one with a fixed rate. Both yield 50 basis points over comparable U.S. Treasury market rates, have very similar credit quality, and pay interest semi-annually.

Ferris wished to execute a swap to take advantage of her expectation of a yield curve shift and believes that any difference in credit spread between LIBOR and U.S. Treasury market rates will remain constant. a.

Describe a six-month U.S. dollar LIBOR-based swap that would allow Ferris to take

advantage of her expectation. Discuss, assuming Ferris‘ expectation is correct, the change in the swap‘s value and how that change would affect the value of her portfolio. [No calculations required to answer part a.]

Instead of the swap described in part a, Ferris would use the following alternative derivative strategy to achieve the same result.

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b. Explain, assuming Ferris‘ expectation is correct, how the following strategy achieves the same result in response to the yield curve shift. [No calculations required to answer part b.]

Settlement Date 12-15-18 03-15-19 06-15-19 09-15-19 12-15-19 03-15-20

Nominal Eurodollar Futures Contract Value $1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000

c. Discuss one reason these two derivative strategies provide the same result.

CFA Guideline Answer a. The Swap Value and its Effect on Ferris‘ Portfolio Because Karla Ferris believes interest rates will rise, she will want to swap her $1,000,000 fixed-rate corporate bond interest to receive six-month U.S. dollar LIBOR. She will continue to hold her variable-rate six-month U.S. dollar LIBOR rate bond because its payments will increase as interest rates rise. Because the credit risk between the U.S. dollar LIBOR and the U.S. Treasury market is expected to remain constant, Ferris can use the U.S. dollar LIBOR market to take advantage of her interest rate expectation without affecting her credit risk exposure.

To execute this swap, she would enter into a two-year term, semi-annual settle, $1,000,000 nominal principal, pay fixed-receive floating U.S. dollar LIBOR swap. If rates rise, the swap‘s mark-to-market value will increase because the U.S. dollar LIBOR Ferris receives will be higher than the LIBOR rates from which the swap was priced. If Ferris were to enter into the same swap after interest rates rise, she would pay a higher fixed rate to receive LIBOR rates. This higher fixed rate would be calculated as the present value of now higher forward LIBOR rates.

Because Ferris would be paying a stated fixed rate that is lower than this new higher-presentvalue fixed rate, she could sell her swap at a premium. This premium is called the ―replacement cost‖ value of the swap.

b. Eurodollar Futures Strategy

The appropriate futures hedge is to short a combination of Eurodollar futures contracts with different settlement dates to match the coupon payments and principal. This futures hedge accomplishes the same objective as the pay fixed-receive floating swap described in Part a. By

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discussing how the yield-curve shift affects the value of the futures hedge, the candidate can show an understanding of how Eurodollar futures contracts can be used instead of a pay fixedreceive floating swap.

If rates rise, the mark-to-market values of the Eurodollar contracts decrease; their yields must increase to equal the new higher forward and spot LIBOR rates. Because Ferris must short or sell the Eurodollar contracts to duplicate the pay fixed-receive variable swap in Part a, she gains as the Eurodollar futures contracts decline in value and the futures hedge increases in value. As the contracts expire, or if Ferris sells the remaining contracts prior to maturity, she will recognize a gain that increases her return. With higher interest rates, the value of the fixedrate bond will decrease. If the hedge ratios are appropriate, the value of the portfolio, however, will remain unchanged because of the increased value of the hedge, which offsets the fixed-rate bond‘s decrease.

Why the Derivative Strategies Achieve the Same Result

Arbitrage market forces make these two strategies provide the same result to Ferris. The two strategies are different mechanisms for different market participants to hedge against increasing rates. Some money managers prefer swaps; others, Eurodollar futures contracts.

Each institutional market participant has different preferences and choices in hedging interest rate risk. The key is that market makers moving into and out of these two markets ensure that the markets are similarly priced and provide similar returns.

As an example of such an

arbitrage, consider what would happen if forward market LIBOR rates were lower than swap market LIBOR rates. An arbitrageur would, under such circumstances, sell the futures/forwards contracts and enter into a received fixed-pay variable swap. This arbitrageur could now receive the higher fixed rate of the swap market and pay the lower fixed rate of the futures market. He or she would pocket the differences between the two rates (without risk and without having to make any [net] investment.) This arbitrage could not last.

As more and more market makers sold Eurodollar futures contracts, the selling pressure would cause their prices to fall and yields to rise, which would cause the present value cost of selling the Eurodollar contracts also to increase. Similarly, as more and more market makers offer to receive fixed rates in the swap market, market makers would have to lower their fixed rates to attract customers so they could lock in the lower hedge cost in the Eurodollar futures market. Thus, Eurodollar forward contract yields would rise and/or swap market receive-fixed

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rates would fall until the two rates converge. At this point, the arbitrage opportunity would no longer exist and the swap and forwards/futures markets would be in equilibrium.

7.

Rone Company asks Paula Scott, a treasury analyst, to recommend a flexible way to

manage the company‘s financial risks.

Two years ago, Rone issued a $25 million (U.S.$), five-year floating rate note (FRN). The FRN pays an annual coupon equal to one-year LIBOR plus 75 basis points. The FRN is noncallable and will be repaid at par at maturity.

Scott expects interest rates to increase and she recognizes that Rone could protect itself against the increase by using a pay-fixed swap. However, Rone‘s Board of Directors prohibits both short sales of securities and swap transactions. Scott decides to replicate a pay-fixed swap using a combination of capital market instruments.

a. Identify the instruments needed by Scott to replicate a pay-fixed swap and describe the required transactions. b. Explain how the transactions in Part a are equivalent to using a pay-fixed swap.

CFA Guideline Answer

a. The instruments needed by Scott are a fixed-coupon bond and a floating rate note (FRN).

The transactions required are to: ∙ issue a fixed-coupon bond with a maturity of three years and a notional amount of $25 million, and ∙ buy a $25 million FRN of the same maturity that pays one-year LIBOR plus 75 bps.

b. At the outset, Rone will issue the bond and buy the FRN, resulting in a zero net cash flow at initiation. At the end of the third year, Rone will repay the fixed-coupon bond and will be repaid the FRN, resulting in a zero net cash flow at maturity. The net cash flow associated with each of the three annual coupon payments will be the difference between the inflow (to Rone) on the FRN and the outflow (to Rone) on the bond. Movements in interest rates during the three-year period will determine whether the net cash flow associated with the coupons is positive or negative to Rone. Thus, the bond transactions are financially equivalent to a plain vanilla payfixed interest rate swap.

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8.

A company based in the United Kingdom has an Italian subsidiary.

The subsidiary

generates €25,000,000 a year, received in equivalent semiannual installments of €12,500,000.

The British company wishes to convert the euro cash flows to pounds twice a year. It plans to engage in a currency swap in order to lock in the exchange rate at which it can convert the euros to pounds.

The current exchange rate is €1.5/£.

The fixed rate on a plain vanilla

currency swap in pounds is 7.5 percent per year, and the fixed rate on a plain vanilla currency swap in euros is 6.5 percent per year. a. Determine the notional principals in euros and pounds for a swap with semiannual payments that will help achieve the objective. b. Determine the semiannual cash flows from this swap.

CFA Guideline Answer a. The semiannual cash flow must be converted into pounds is €25,000,000/2 = €12,500,000.

In order to create a swap to convert €12,500,000, the equivalent notional principals are ∙ Euro notional principal = €12,500,000/(0.065/2) = €384,615,385 ∙ Pound notional principal = €384,615,385/€1.5/£ = £256,410,257 b. The cash flows from the swap will now be ∙ Company makes swap payment = €384,615,385(0.065/2) = €12,500,000 ∙ Company receives swap payment = £256,410,257(0.075/2) = £9,615,385 The company has effectively converted euro cash receipts to pounds.

9. Ashton Bishop is the debt manager for World Telephone, which needs €3.33 billion Euro financing for its operations.

Bishop is considering the choice between issuance of debt

denominated in:  Euros (€), or  U.S. dollars, accompanied by a combined interest rate and currency swap. a. Explain one risk World would assume by entering into the combined interest rate and currency swap.

Bishop believes that issuing the U.S.-dollar debt and entering into the swap can lower World‘s cost of debt by 45 basis points. Immediately after selling the debt issue, World would swap the U.S. dollar payments for Euro payments throughout the maturity of the debt. She assumes a constant currency exchange rate throughout the tenor of the swap.

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Exhibit 1 gives details for the two alternative debt issues.

Exhibit 2 provides current

information about spot currency exchange rates and the three-year tenor euro/U.S. dollar currency and interest rate swap.

Exhibit 1 World Telephone Debt Details Characteristic Par value Term to maturity Fixed interest rate Interest payment

Euro Currency Debt €3.33 billion 3 years 6.25% Annual

U.S. Dollar Currency Debt $3 billion 3 years 7.75% Annual

Exhibit 2 Currency Exchange Rate and Swap Information $0.90 per euro ($0.90/€1.00)

Spot currency exchange rate 3-year tenor euro/U.S. dollar fixed interest rates

5.80% euro/7.30% U.S. Dollar

b. Show the notional principal and interest payment cash flows of the combined interest rate and currency swap.

Note: Your response should show both the correct currency ($ or €) and amount for each cash flow.

Answer problem b in the template provided below: Cash Flows of the Swap World pays

Year 0

Year 1

Year 2

Year 3

Notional principal Interest payment World receives Notional principal Interest payment

c. State whether or not World would reduce its borrowing cost by issuing the debt denominated in U.S. dollars, accompanied by the combined interest rate and currency swap. Justify your response with one reason.

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CFA Guideline Answer

a. World would assume both counterparty risk and currency risk. Counterparty risk is the risk that Bishop‘s counterparty will default on payment of principal or interest cash flows in the swap.

Currency risk is the currency exposure risk associated with all cash flows.

If the US$

appreciates (Euro depreciates), there would be a loss on funding of the coupon payments; however, if the US$ depreciates, then the dollars will be worth less at the swap‘s maturity. b.

Year 0 World pays Notional Principal Interest payment World receives Notional Principal Interest payment 1 2

Year 1

Year 2

Year 3 €3.33 billion

$3 billion €193.14 million1

€193.14 million

€193.14 million €3 billion

$3.33 billion $219 million2

$219 million

$219 million

€ 193.14 million = € 3.33 billion x 5.8% $219 million = $ 3 billion x 7.3%

c. World would not reduce its borrowing cost, because what Bishop saves in the Euro market, she loses in the dollar market. The interest rate on the Euro pay side of her swap is 5.80 percent, lower than the 6.25 percent she would pay on her Euro debt issue, an interest savings of 45 bps. But Bishop is only receiving 7.30 percent in U.S. dollars to pay on her 7.75 percent U.S. debt interest payment, an interest shortfall of

45 bps.

Given a constant currency

exchange rate, this 45 bps shortfall exactly offsets the savings from paying 5.80 percent versus the 6.25 percent. Thus there is no interest cost savings by selling the U.S. dollar debt issue and entering into the swap arrangement.

MINI CASE: THE CENTRALIA CORPORATION‘S CURRENCY SWAP

The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale in the European Union. The plant is expected to cost €5,500,000, and to take about one year to complete. The plant is to be financed over its economic life of eight years. The borrowing capacity created by this capital expenditure is

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$2,900,000; the remainder of the plant will be equity financed. Centralia is not well known in the Spanish or international bond market; consequently, it would have to pay 7 percent per annum to borrow euros, whereas the normal borrowing rate in the euro zone for well-known firms of equivalent risk is 6 percent. Alternatively, Centralia can borrow dollars in the U.S. at a rate of 8 percent.

Study Questions

1.

Suppose a Spanish MNC has a mirror-image situation and needs $2,900,000 to finance a

capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed rate in the United States for dollars, whereas it can borrow euros at 6 percent. The exchange rate has been forecast to be $1.33/€1.00 in one year. Set up a currency swap that will benefit each counterparty.

*2. Suppose that one year after the inception of the currency swap between Centralia and the Spanish MNC, the U.S. dollar fixed-rate has fallen from 8 to 6 percent and the euro zone fixedrate for euros has fallen from 6 to 5.50 percent. In both dollars and euros, determine the market value of the swap if the exchange rate is $1.3343/€1.00.

Suggested Solution to The Centralia Corporation‘s Currency Swap

1.

The Spanish MNC should issue €2,180,500 of 6 percent fixed-rate debt and Centralia

should issue $2,900,000 of fixed-rate 8 percent debt, since each counterparty has a relative comparative advantage in their home market. They will exchange principal sums in one year.

The contractual exchange rate for the initial exchange is $2,900,000/€2,180,500, or $1.33/€1.00. Annually the counterparties will swap debt service: the Spanish MNC will pay Centralia $232,000 (= $2,900,000 x .08) and Centralia will pay the Spanish MNC €130,830 (= €2,180,500 x .06).

The contractual exchange rate of the first seven annual debt service

exchanges is $232,000/€130,830, or $1.7733/€1.00. At maturity, Centralia and the Spanish MNC will re-exchange the principal sums and the final debt service payments. The contractual exchange rate of the final currency exchange is $3,132,000/€2,311,330 = ($2,900,000 + $232,000)/(€2,180,500 + €130,830), or $1.3551/€1.00.

*2. The market value of the dollar debt is the present value of a seven-year annuity of

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$232,000 and a lump sum of $2,900,000 discounted at 6 percent.

This present value is

$3,223,778. Similarly, the market value of the euro debt is the present value of a seven-year annuity of €130,830 and a lump sum of €2,180,500 discounted at 5.50 percent. This present value is €2,242,459. The dollar value of the swap is $3,223,778 - €2,242,459 x 1.3343 = $231,665. The euro value of the swap is €2,242,459 - $3,223,778/1.3343 = -€173,623.

CHAPTER 15 INTERNATIONAL PORTFOLIO INVESTMENT ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. What factors are responsible for the recent surge in international portfolio investment (IPI)?

Answer: The recent surge in international portfolio investments reflects the globalization of financial markets. Specifically, many countries have liberalized and deregulated their capital and foreign exchange markets in recent years. In addition, commercial and investment banks have facilitated international investments by introducing such products as American Depository Receipts (ADRs) and country funds. Also, recent advancements in computer and telecommunication technologies led to a major reduction in transaction and information costs associated with international investments. In addition, investors might have become more aware of the potential gains from international investments.

2. Security returns are found to be less correlated across countries than within a country. Why can this be?

Answer: Security returns are less correlated probably because countries are different from each other in terms of industry structure, resource endowments, macroeconomic policies, and have non-synchronous business cycles. Securities from a same country are subject to the same business cycle and macroeconomic policies, thus causing high correlations among their returns.

3. Explain the concept of the world beta of a security.

Answer: The world beta measures the sensitivity of returns to a security to returns to the world market portfolio. It is a measure of the systematic risk of the security in a global setting.

Statistically, the world beta can be defined as:

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Cov(Ri, RM)/Var(RM), where Ri and RM are returns to the i-th security and the world market portfolio, respectively.

4. Explain the concept of the Sharpe performance measure.

Answer: The Sharpe performance measure (SHP) is a risk-adjusted performance measure. It is defined as the mean excess return to a portfolio above the risk-free rate divided by the portfolio‘s standard deviation.

5. Explain how exchange rate fluctuations affect the return from a foreign market measured in dollar terms. Discuss the empirical evidence on the effect of exchange rate uncertainty on the risk of foreign investment.

Answer: It is useful to refer to Equations 15.4 and 15.5 of the text. Exchange rate fluctuations mostly contribute to the risk of foreign investment through its own volatility as well as its covariance with the local market returns. The covariance may be positive or negative, implying that exchange rate changes may add to exchange risk or offset it. Exchange risk is found to be much more significant in bond investments than in stock investments.

6. Would exchange rate changes always increase the risk of foreign investment? Discuss the condition under which exchange rate changes may actually reduce the risk of foreign investment.

Answer: Exchange rate changes need not always increase the risk of foreign investment. When the covariance between exchange rate changes and the local market returns is sufficiently negative to offset the positive variance of exchange rate changes, exchange rate volatility can actually reduce the risk of foreign investment.

7.

Evaluate a home country‘s multinational corporations as a tool for international

diversification.

Answer: Despite the fact that MNCs have operations worldwide, their stock prices behave very much like purely domestic firms. This is puzzling yet undeniable. As a result, MNCs are a poor substitute for direct foreign portfolio investments.

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8. Discuss the advantages and disadvantages of closed-end country funds (CECFs) relative to the American Depository Receipts (ADRs) as a means of international diversification.

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Answer: CECFs can be used to diversify into exotic markets that are otherwise difficult to access such as India and Turkey. Being a portfolio, CECFs also provide instant diversification.

ADRs do not provide instant diversification; investors should form portfolios themselves. In addition, there are relatively few ADRs from emerging markets. The main disadvantage of CECFs is that their share prices behave somewhat like the host country‘s share prices, reducing the potential diversification benefits.

9. Why do you think closed-end country funds often trade at a premium or discount?

Answer: CECFs trade at a premium or discount because capital markets of the home and host countries are segmented, preventing cross-border arbitrage. If cross-border arbitrage is possible, CECFs should be trading near their net asset values.

10. Why do investors invest the lion‘s share of their funds in domestic securities?

Answer: Investors invest heavily in their domestic securities mainly because there are barriers to investing overseas. The barriers may include excessive transaction costs, information costs for foreign securities, legal and institutional restrictions, extra taxes, exchange risk and political risk associated with overseas investments, etc. Investors may also disproportionately invest in domestic securities due to the behavioral bias toward familiarity.

11. What are the advantages of investing via international mutual funds?

Answer:

The advantages of investing via international mutual funds include: (1) save

transaction/information costs, (2) circumvent legal/institutional barriers, and (3) benefit from the expertise of professional fund managers.

12. Discuss how the advent of the euro would affect international diversification strategies.

Answer: As the euro-zone has the same monetary and exchange-rate policies, the correlations among euro-zone markets are likely to go up. This will reduce diversification benefits. However, to the extent that the adoption of euro strengthens the European economy, investors may benefit from enhanced returns.

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PROBLEMS

1. Suppose you are a euro-based investor who just sold Microsoft shares that you had bought six months ago. You had invested 10,000 euros to buy Microsoft shares for $120 per share; the exchange rate was $1.15 per euro. You sold the stock for $135 per share and converted the dollar proceeds into euro at the exchange rate of $1.06 per euro. First, determine the profit from this investment in euro terms. Second, compute the rate of return on your investment in euro terms. How much of the return is due to the exchange rate movement?

Solution: It is useful first to compute the rate of return in euro terms: r€  r$  e 1   1     135  120   1.06 1.15    1   120     1 .

15    0.125  0.085  0.210

This indicates that this euro-based investor benefited from an appreciation of dollar against the euro, as well as from an appreciation of the dollar value of Microsoft shares. The profit in euro terms is about €2,100, and the rate of return is about 21.0% in euro terms, of which 8.5% is due to the exchange rate movement.

2. Mr. James K. Silber, an avid international investor, just sold a share of Nestlé, a Swiss firm, for SF5,080. The share was bought for SF4,600 a year ago. The exchange rate is SF1.60 per U.S. dollar now and was SF1.78 per dollar a year ago. Mr. Silber received SF120 as a cash dividend immediately before the share was sold. Compute the rate of return on this investment in terms of U.S. dollars.

Solution: Mr. Silber must have paid $2,584.27 (=4,600/1.78) for a share of Néstle a year ago.

When the share was liquidated, he must have received $3,250 [=(5,080 + 120)/1.60]. Therefore, the rate of return in dollar terms is: R($) = [(3,250-2,584.27)/2584.27] x 100 = 25.76%.

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3.

In the above problem, suppose that Mr. Silber sold SF4,600, his principal investment

amount, forward at the forward exchange rate of SF1.62 per dollar. How would this affect the dollar rate of return on this Swiss stock investment? In hindsight, should Mr. Silber have sold the Swiss franc amount forward or not? Why or why not?

Solution: The dollar profit from selling SF4,600 forward is equal to: Profit ($) = 4,600 (1/1.62 – 1/1.60) = 4,600 (0.6173 – 0.625) = -$35.42.

Thus, the total return of investment is: R($) = [(3,250-2,584.27-35.42)/2584.27] x 100 = 24.39%.

By ‗hindsight‘, Mr. Silber should not have sold the SF amount forward as it reduced the return in dollar terms. But this is only by hindsight. Obviously, hedging decision must be made ex ante.

4. Japan Life Insurance Company invested $10,000,000 in pure-discount U.S. bonds in May 1995 when the exchange rate was 80 yen per dollar. The company liquidated the investment one year later for $10,650,000. The exchange rate turned out to be 110 yen per dollar at the time of liquidation. What rate of return did Japan Life realize on this investment in yen terms?

Solution: Japan Life Insurance Company spent ¥800,000,000 to buy $10,000,000 that was invested in U.S. bonds. The liquidation value of this investment is ¥1,171,500,000, which is obtained from multiplying $10,650,000 by ¥110/$. The rate of return in terms of yen is: [(¥1,171,500,000 - ¥800,000,000)/ ¥800,000,000]x100 = 46.44%.

5. At the start of 1996, the annual interest rate was 6 percent in the United States and 2.8 percent in Japan. The exchange rate was 95 yen per dollar at the time. Mr. Jorus, who is the manager of a Bermuda-based hedge fund, thought that the substantial interest advantage associated with investing in the United States relative to investing in Japan was not likely to be offset by the decline of the dollar against the yen. He thus concluded that it might be a good idea to borrow in Japan and invest in the United States. At the start of 1996, in fact, he borrowed ¥1,000 million for one year and invested in the United States. At the end of 1996, the exchange rate became 105 yen per dollar. How much profit did Mr. Jorus make in dollar terms?

Solution: Let us first compute the maturity value of U.S. investment:

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(¥1,000,000,000/95)(1.06) = $11,157,895.

The dollar amount necessary to pay off yen loan is: (¥1,000,000,000)(1.028)/105 = $9,790,476.

The dollar profit = $11,157,895 - $9,790,476 = $1,367,419.

Mr. Jorus was able to realize a large dollar profit because the interest rate was higher in the U.S. than in Japan and the dollar actually appreciated against yen. This is an example of uncovered interest arbitrage.

6. Suppose we obtain the following data in dollar terms:

Stock market

Return (mean)

Risk (SD)

United States

1.26% per month

4.43%

United Kingdom

1.23% per month

5.55%

The correlation coefficient between the two markets is 0.58. Suppose that you invest equally, i.e., 50% each, in the two markets. Determine the expected return and standard deviation risk of the resulting international portfolio.

Solution: The expected return of the equally weighted portfolio is: E(Rp) = (.5)(1.26%) + (.5)(1.23%) = 1.25% The variance of the portfolio is: Var(Rp) = (.5)2(4.43)2 + (.5)2(5.55)2 +2(.5)2(4.43)(5.55)(.58) = 4.91 +7.70 + 7.13 = 19.74 The standard deviation of the portfolio is thus 4.44%.

7. Suppose you are interested in investing in the stock markets of 7 countries--i.e., Australia, Canada, Germany, Japan, Switzerland, the United Kingdom, and the United States--the same 7 countries that appear in Exhibit 15.9. Specifically, you would like to solve for the optimal (tangency) portfolio comprising the above seven stock markets. In solving the optimal portfolio, use the input data (i.e. correlation coefficients, means, and standard deviations) provided in Exhibit 15.4. The risk-free interest rate is assumed to be 0.2% per month and you can take a

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short position in any stock market. What are the optimal weights for each of the seven stock markets? What is the risk and return of the optimal portfolio? This problem can be solved using MPTSolver.xls spreadsheet.

Solution: Sample Period: 1980.1 -2012.12 (in U.S. dollar terms) Correlation Coefficients Stock Market AU CN GM JP SW UK US Mean (%) SD (%) Optimal Weight Australia (AU) 1 0.550 7.18 -0.0557 Canada (CN) 0.69 1 0.549 6.11 -0.2081 Germany (GM) 0.55 0.60 1 0.565 6.87 -0.3597 Japan (JP) 0.39 0.40 0.41 1 0.437 6.59 -0.0344 Switzerland (SW) 0.55 0.58 0.76 0.47 1 0.709 5.42 0.7968 United Kingdom (UK) 0.68 0.69 0.67 0.48 0.69 1 0.550 5.59 -0.1285 United States (US) 0.63 0.77 0.65 0.38 0.65 0.72 1 0.647 4.59 0.9896 The monthly mean return and standard deviation of the optimal portfolio are 0.772% and 4.790%, respectively. Hence, the Sharpe ratio of the optimal portfolio is equal to 0.119 = (0.7720.20)/4.790.

8. The HFS Trustees have solicited input from three consultants concerning the risks and rewards of an allocation to international equities. Two of them strongly favor such action, while the third consultant commented as follows:

―The risk reduction benefits of international

investing have been significantly overstated. Recent studies relating to the cross-country correlation structure of equity returns during different market phases cast serious doubt on the ability of international investing to reduce risk, especially in situations when risk reduction is needed the most.‖ a. Describe the behavior of cross-country equity return correlations to which the consultants is referring. Explain how that behavior may diminish the ability of international investing to reduce risk in the short run. Assume that the consultant‘s assertion is correct. b. Explain why it might still be more efficient on a risk/reward basis to invest internationally rather than only domestically in the long run.

The HFS Trustees have decided to invest in non-U.S. equity markets and have hired Jacob Hind, a specialist manager, to implement this decision. He has recommended that an unhedged equities position be taken in Japan, providing the following comments and the table data to support his view: ―Appreciation of a foreign currency increases the returns to a U.S. dollar investor. Since appreciation of the Yen from ¥100/$U.S. to ¥98/$U.S. is expected, the Japanese stock position should not be hedged.‖

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Market Rates and Hind‘s Expectations U.S. n/a n/a 6.00 3.00

Spot rate (yen per $U.S.) Hind‘s 12-month currency forecast (yen per $U.S.) 1-year Eurocurrency rate (% per annum) Hind‘s 1-year inflation forecast (% per annum)

Japan 100 98 0.80 0.50

Assume that the investment horizon is one year and that there are no costs associated with currency hedging. c. State and justify whether Hind‘s recommendation (not to hedge) should be followed. Show any calculations.

Solution: a. Cross-country correlations tend to increase during the turbulent market phase, reducing the benefits from international diversification in the short run.

b. Unless the investor has to liquidate investments during the turbulent phase, he/she can ride out the turbulence and realize the benefits from international investments in the long run.

c. The interest rate parity implies that the forward exchange rate would be ¥95.09/$: F = [1.06/1.008](1/100) = $0.010516/¥ = ¥95.09/$, which is compared with Hind‘s expected future spot rate of ¥98/$. Clearly, the HFS Trustees can receive more dollar amount from selling yen forward than from the unhedged position.

Relative to the forward rate, Hind underestimates the yen‘s future strength.

9. Rebecca Taylor, an international equity portfolio manager, recognizes that optimal country allocation strategy combined with an optimal currency strategy should produce optimal portfolio performance. To develop her strategy, Taylor produced the table below, which provides expected return data for the three countries and three currencies in which she may invest. The table contains the information she needs to make market strategy (country allocation) decisions and currency strategy (currency allocation) decisions.

Expected Returns for a U.S.-Based Investor Country

Local Currency Equity Returns

Exchange Rate Returns

Local Currency Eurodeposit

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Returns Japan United Kingdom United States

7.0% 10.5 8.4

1.0% -3.0 0.0

5.0% 11.0 7.5

a. Prepare a ranking of the three countries in terms of expected equity-market return premiums.

Show your calculations. b. Prepare a ranking of the three countries in terms of expected currency return premiums from the perspective of a U.S. investor. Show your calculations. c. Explain one advantage a portfolio manager obtains, in formulating a global investment strategy, by calculating both expected market premiums and expected currency premiums.

Solution: a. United Kingdom = first; United States = second; Japan = third.

b. Japan = first; United States = second; United Kingdom = third. c. Computing expected currency premium helps the portfolio manager to decide whether to hedge currency risk.

10. The Glover Scholastic Aid Foundation has received a €20 million global government bond portfolio from a Greek donor. This bond portfolio will be held in euros and managed separately from Glover‘s existing U.S. dollar-denominated assets. Although the bond portfolio is currently unhedged, the portfolio manager, Raine Sofia, is investigating various alternatives to hedge the currency risk of the portfolio. The bond portfolio‘s current allocation and the relevant country performance data are given in Exhibits 1 and 2. Historical correlations for the currencies being considered by Sofia are given in Exhibit 3. Sofia expects that future returns and correlations will be approximately equal to those given in Exhibits 2 and 3.

Exhibit 1. Glover Scholastic Aid Foundation Current Allocation Global Government Bond Portfolio Country

Allocation (%)

Maturity (years)

Greece

25

5

A

40

5

B

10

10

C

10

5

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D

15

10

Exhibit 2. Country Performance Data (in local currency)

Cash Return (%)

5-year Excess Bond Return (%)

10-year Excess Bond Return (%)

Unhedged Currency Return (%)

Liquidity of 90-day Currency Forward Contracts

Greece

2.0

1.5

2.0

---

Good

A

1.0

2.0

3.0

– 4.0

Good

B

4.0

0.5

1.0

2.0

Fair

C

3.0

1.0

2.0

– 2.0

Fair

D

2.6

1.4

2.4

– 3.0

Good

Country

Exhibit 3. Historical Currency Correlation Table (1998-2003, weekly observations) € (Greece)

A

B

C

D

1.00

–0.77

0.45

–0.57

0.77

A

---

1.00

–0.61

0.56

–0.70

B

---

---

1.00

–0.79

0.88

C

---

---

---

1.00

–0.59

D

---

---

---

---

1.00

Currency € (Greece)

a. Calculate the expected total annual return (euro-based) of the current bond portfolio if Sofia decides to leave the currency risk unhedged. Show your calculations. b. Explain, with respect to currency exposure and forward rates, the circumstance in which Sofia should use a currency forward contract to hedge the current bond portfolio‘s exposure to a given currency. c. Determine which one of the currencies being considered by Sofia would be the best proxy hedge for Country B bonds. Justify your response with two reasons.

Sofia has been disappointed with the low returns on the current bond portfolio relative to the benchmark—a diversified global bond index—and is exploring general strategies to generate excess returns on the portfolio. She has already researched two such strategies: duration management and investing in markets outside the benchmark index.

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d. Identify three general strategies (other than duration management and investing in markets outside the benchmark index) that Sofia could use to generate excess returns on the current bond portfolio. Give, for each of the three strategies, a potential benefit specific to the current bond portfolio.

Solution: a. The unhedged expected annual portfolio return in euros is calculated as follows: WG × (rG + eH,G) + WA × (rA + eH,A) + W B × (rB + eH,B) + W C × (rC + eH,C) + WD × (rD + eH,D) = 0.25 × (2% + 1.5%) + 0.4 × (1% + 2% – 4%) + 0.1 × (4% + 1% + 2%) + 0.1 × (3% + 1% – 2%) + 0.15 × (2.6% + 2.4% – 3%) = 0.875% – 0.4% + 0.7% + 0.2% + 0.3% = 1.675% = 1.68%

b. If Sofia expects the unhedged percentage return from exposure to a currency to be less than the forward discount or premium, she should use a forward contract to hedge exposure to that currency. The circumstance can also be expressed as: eH,i < cH – ci where: unhedged expected currency return for country i = eH,i forward premium or discount = cH – ci c. Country D currency would provide the best proxy hedge for Country B bonds for any of the following reasons: •

The liquidity of 90-day currency forward contracts for country D is good.

•

The relevant currencies − Country B and Country D (hedge) − are historically more highly correlated (0.88) and therefore Country D provides a more accurate proxy hedge.

•

Sofia could capitalize on a negative view of Country D currency relative to Country B currency by establishing a short position in Country D currency.

d.

1. Bond Market Selection:

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Because there are bonds from only five countries in the current portfolio, better risk-adjusted returns could be realized by diversifying into government bonds from other countries in the index that have low correlations with existing bonds.

2. Sector/Credit/Security Selection: The current portfolio is invested exclusively in government bonds. Other sectors such as corporate bonds, asset-backed securities, and mortgage-backed securities could provide further diversification and potentially enhance portfolio risk-adjusted return.

3. Currency Selection: Active currency management can be used to produce superior risk-adjusted returns. One could either hedge the entire portfolio from currency risk or implement expectations about specific currencies by fully hedging, partially hedging, or not hedging.

MINI CASE: SOLVING FOR THE OPTIMAL INTERNATIONAL PORTFOLIO Suppose you are a financial advisor and your client, who is currently investing only in the U.S. stock market, is considering diversifying into the U.K. stock market. At the moment, there are neither particular barriers nor restrictions on investing in the U.K. stock market. Your client would like to know what kind of benefits can be expected from doing so. Using the data provided in the above problem (i.e., problem 12), solve the following problems: (a) Graphically illustrate various combinations of portfolio risk and return that can be generated by investing in the U.S. and U.K. stock markets with different proportions. Two extreme proportions are (I) investing 100% in the U.S. with no position in the U.K. market, and (ii) investing 100% in the U.K. market with no position in the U.S. market. (b) Solve for the ‗optimal‘ international portfolio comprised of the U.S. and U.K. markets.

Assume that the monthly risk-free interest rate is 0.5% and that investors can take a short (negative) position in either market. (c) What is the extra return that U.S. investors can expect to capture at the ‗U.S.-equivalent‘ risk level? Also trace out the efficient set. [The Appendix 11.B provides an example.]

Suggested Solution to the Optimal International Portfolio:

Let U.S. be market 1 and U.K. be market 2. The parameter values are: R̄1 = 1.26%, R̄2 = 1.23%, 1 = 4.43%, 2 = 5.55%, Rf = 0.5%.

Accordingly, 12 = 12 ρ12 = (4.43)(5.55)(0.58) = 14.26, 12 = 19.62, 22 = 30.80. (a)

E(Rp) = 1.26w1 + 1.23w2

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The variance of the portfolio is: Var(Rp) = 19.62w12 + 30.80w22 + 2(14.26)w1w2 Some possible portfolios are: w1

w2

E(Rp) Var(Rp)

1.00

0.00

1.26

19.62

0.75

0.25

1.25

18.31

0.50

0.50

1.245 19.74

0.25

0.75

1.238 23.90

0.00

1.00

1.23

30.80

(b) The optimal weights are w1 = 0.79 and w2 = 0.21. (c) R̄I = Rf + US Here,  = Slope of efficient set = (R̄OIP - Rf )/ OIP R̄OIP = (0.79)(1.26) + (0.21)(1.23) = 1.26% OIP2 = (0.79)2(19.62) + (0.21)2(30.8) + 2(0.79)(0.21)(14.26) = 18.55 OIP = 4.28% Therefore, R̄I = 0.5 + [(1.26 - 0.5)/4.28](4.43) = 1.29% Extra return = 1.29 - 1.26 = 0.03% CHAPTER 16 FOREIGN DIRECT INVESTMENT AND CROSS-BORDER ACQUISITIONS ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Recently, many foreign firms from both developed and developing countries acquired hightech U.S. firms. What might have motivated these firms to acquire U.S. firms?

Answer: Many foreign firms might have been motivated to gain access to technical know-how residing in U.S. firms and at the same time monopolize its use. Refer to the reverseinternalization hypothesis discussed in the text.

2. Japanese MNCs, such as Toyota, Toshiba, Matsushita, etc., made extensive investments in the Southeast Asian countries like Thailand, Malaysia and Indonesia. In your opinion, what forces are driving Japanese investments in the region?

Answer: Most likely, these Japanese MNCs have invested heavily in Southeast Asia in order to

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take advantage of underpriced labor services and cheaper land and other factors of production.

Refer to the life-cycle theory of FDI.

3. Since the NAFTA was established, many Asian firms especially those from Japan and South Korea made extensive investments in Mexico. Why do you think these Asian firms decided to build production facilities in Mexico?

Answer: Asian firms might have been motivated to gain access to NAFTA of which Mexico is a member and circumvent the external trade barriers maintained by NAFTA.

4. How would you explain the fact that China emerged as one of the most important recipient of FDI in recent years?

Answer: China attracted a great deal of FDI recently because foreign firms want to (i) take advantage of relatively inexpensive labor and other resources, and also (ii) gain access to the Chinese market that is often not accessible otherwise.

5. Explain the internalization theory of FDI. What are the strength and weakness of the theory?

Answer: According to the internalization theory, firms that have intangible assets with a public good property tend to undertake FDI to take advantage of the assets on a large scale and, at the same time, prevent misappropriation of returns from the assets that may occur during arm‘s length transactions in foreign countries. The theory can be effective in explaining greenfield investments, but not in explaining cross-border mergers and acquisitions.

6. Explain Vernon‘s product life-cycle theory of FDI. What are the strength and weakness of the theory?

Answer: According to the product life-cycle theory, firms undertake FDI at a particular stage in the life-cycle of the products that they initially introduced. When a new product is introduced, the firm chooses to keep production at home, close to customers. But when the product become mature and foreign demands develop, the firm may be induced to start production in foreign countries, especially in low-cost countries, to serve the local markets as well as to export the product back to the home country. As can be inferred from the boxed reading on Singer in the text, the product life-

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cycle theory can explain historical development of FDI quite well. In recent years, however, the international system of production has become too complicated to be explained neatly by the lifecycle theory. For example, new products are often introduced simultaneously in many countries and production facilities may be located in many countries at the same time.

7. Why do you think the host country tends to resist cross-border acquisitions, rather than green field investments?

Answer: The host country tends to view green field investments as creating new production facilities and new job opportunities. In contrast, cross-border acquisitions can be viewed as foreign takeover of existing domestic firms, without creating new job opportunities.

8.

How would you incorporate political risk into the capital budgeting process of foreign

investment projects?

Answer:

One approach is to adjust the cost of capital upward to reflect political risk and

discount the expected future cash flows at a higher rate. Alternatively, one can subtract insurance premium for political risk from the expected future cash flows and use the usual cost of capital which is applied to domestic capital budgeting.

9. Explain and compare forward vs. backward internalization.

Answer: Forward internalization occurs when MNCs with intangible assets make FDI in order to utilize the assets on a larger scale and at the same time internalize any possible externalities generated by the assets. Backward internalization, on the other hand, occurs when MNCs acquire foreign firms in order to gain access to the intangible assets residing in the foreign firms and at the same time internalize any externalities generated by the assets.

10. What can be the reason for the negative synergistic gains for British acquisitions of U.S. firms?

Answer:

Negative synergies for British acquisitions of U.S. firms may reflect that British

managers might have been motivated to invest in U.S. firms in order to pursue their own interests, such as building corporate empire, rather than shareholders‘ interests. Negative

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synergies can be viewed as agency costs.

11. Define country risk. How is it different from political risk?

Answer:

Country risk is a broader measure of risk than political risk, as the former

encompasses political risk, credit risk, and other economic performances.

12. What are the advantages and disadvantages of FDI as opposed to a licensing agreement with a foreign partner?

Answer: The main advantage of FDI over licensing agreement with a foreign partner is that it provides protection against possible interlopers. The main disadvantage of FDI is that it is costly and time consuming to establish foreign presence in this manner and FDI is probably more vulnerable to political risk.

13. What operational and financial measures can a MNC take in order to minimize the political risk associated with a foreign investment project?

Answer: First, MNCs should explicitly incorporate political risk in the capital budgeting process and adjust the project‘s NPV accordingly. Second, MNCs can form joint-ventures with local partners or form a consortium with other MNCs to reduce risk. Third, MNCs can purchase insurance against political risk from OPIC, Lloyd‘s, etc.

14. Study the experience of Enron in India, and discuss what we can learn from it for the management of political risk.

Answer: This question can be used as a mini-case or mini-project. Students can utilize various business/financial publications, such as Wall Street Journal, Financial Times, and Business week, to study the issue.

15. Discuss the different ways political events in a host country may affect local operations of an MNC.

Answer: The answer can be organized based on the three types of political risk: Namely,

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transfer risk, operational risk, and control risk. Transfer risk arises from the uncertainty about cross-border flows of capital, payments, know-how, etc. Operational risk arises from the uncertainty about the host country‘s policies affecting the local operations of MNCs. Control risk arises from the uncertainty about the host country‘s policy regarding ownership and control of local operations of MNCs.

16. What factors would you consider in evaluating the political risk associated with making FDI in a foreign country.

Answer: Factors to be considered include: (1) the host country‘s political and government system; (2) track record of political parties and their relative strength; (3) the degree of integration into the world system; (4) the host country‘s ethnic and religious stability; (5) regional security; and (6) key economic indicators.

17. Daimler, a German carmaker, acquired Chrysler, the third largest U.S. automaker, for $40.5 billion in 1998. But after years of declining profit and labor problem, Daimler sold off Chrysler to the U.S. private equity firm Cerberus for $7.4 billion in 2007. Study the DaimlerChrysler saga and identify the main factors for the failure of this cross-border merger.

Suggested answer: Daimler-Chrysler merger failed to produce synergy effect due to the failure to integrate the two companies with different corporate cultures, inability to cut down labor costs due to a strong labor union at Chrysler, and the competitive pressure from Japanese carmakers.

18. Lured by extremely low labor costs in Bangladesh, many MNCs in the so-called fast-fashion business, including H&M, Inditex, parent of the popular Zara brand, Marks&Spencer, and Gap, are heavily outsourcing to Bangladesh. As a result, garment industry has become a major source of employment and income to Bangladesh. However, the industry has recently suffered a spate of disasters. In September 2012, about 110 workers died in a blaze at the Tazreen Fashions factory outside Dhaka, the capital city. What‘s worse, in April 2013, more than 1,100 workers perished in the collapse of the Rena Plaza Building in Dhaka. In your opinion, (i) what are the root causes of the disasters? (ii) what should be done to prevent future disasters?

Suggested answers: (i) The disasters may be primarily attributable to the weak legal protection of workers‘ rights and the lack of proper government supervision of the health and safety conditions

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workers face in factories. (ii) Future disasters may be prevented by stronger legal and administrative protection of workers‘ rights, better payments to the factory owners and workers to reduce the incentives to skirt the safety rules, better monitoring of workplaces by the outsourcing MNCs, and stronger organization among workers to better protect their own rights.

MINICASE: ENRON VS. BOMBAY POLITICIANS

1) Discuss the chief mistakes that Enron made in India.

Suggested answer: Enron was insensitive to the negative political sentiment against foreign investment in India and ignored the possibility that BJP may win the election and repudiate the contract with Enron. In addition, the deal was closed in a hurry and secretly, giving the impression that it might have involved corruption.

2) Discuss what Enron might have done differently to avoid its predicament in India

Suggested answer: Enron could have done a more accurate analysis of political risk and considered the possibility of election victory of the nationalist party. In addition, Enron could have purchased an insurance policy against this political risk from Overseas Private Investment Corporation or other insurers. Further, involving a local partner could have dampened the nationalistic sentiment in India.

CHAPTER 17 INTERNATIONAL CAPITAL STRUCTURE AND THE COST OF CAPITAL ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Suppose that your firm is operating in a segmented capital market. What actions would you recommend to mitigate the negative effects?

Answer: The best solution for this problem is to cross-list your firm‘s stock in overseas markets like London and New York that are not segmented. But you should be aware of the associated costs such as the cost of adjusting financial statements, fees charged by the listing exchanges, etc.

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2. Explain why and how a firm‘s cost of capital may decrease when the firm‘s stock is crosslisted on foreign stock exchanges.

Answer: If a stock becomes internationally tradable upon overseas listing, the required return on the stock is likely to go down because the shareholder base tends to be expanded across countries and the stock will be priced according to the international systematic risk rather than the local systematic risk. It is well known that for a typical stock, the international systematic risk is lower than the local systematic risk.

3. Explain the pricing spill-over effect.

Answer: Suppose a firm operating in a relatively segmented capital market (like China, for example) decides to cross-list its stock in New York or London. Upon cross-border listing, the firm‘s stock will be priced internationally. In addition, the pricing of remaining purely domestic stocks (other Chinese stocks) will be affected in such a way that these stocks will be priced partially internationally and partially domestically. The degree of international pricing depends on the correlations between these purely domestic stocks and internationally traded stocks.

4. In what sense do firms with nontradable assets get a free-ride from firms whose securities are internationally tradable?

Answer: Due to the spillover effect, firms with nontradable securities can benefit in terms of higher security prices and lower cost of capital, without incurring any costs associated with making the securities internationally tradable. This is an example of free-ride.

5. Define and discuss indirect world systematic risk.

Answer:

The indirect world systematic risk can be defined as the covariance between a

nontradable asset and the world market portfolio that is induced by tradable assets. In the presence of internationally tradable assets, nontradable assets will be priced partly by the indirect world systematic risk and partly by the pure domestic systematic risk.

6. Discuss how the cost of capital is determined in segmented vs. integrated capital markets.

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Answer: In segmented capital markets, the cost of capital will be determined essentially by the securities‘ domestic systematic risks. In integrated capital markets, on the other hand, the cost of capital will be determined by the securities‘ world systematic risk, regardless of nationality.

7. Suppose there exists a nontradable asset with a perfect positive correlation with a portfolio T of tradable assets. How will the nontradable asset be priced?

Answer: The nontradable asset with a perfect positive correlation with portfolio T (for tradable) will be priced as if it were tradable by itself. In a word, it will be priced solely according to its world systematic risk.

8. Discuss what factors motivated Novo Industries to seek U.S. listing of its stock. What lessons can be derived from Novo‘s experiences?

Answer: Novo, a rapidly growing company, was domiciled in a small and segmented Danish market. This restricted the firm‘s ability to raise capital at a competitive rate. As discussed in the text, Novo solved this problem by listing its stock in London and New York stock exchanges.

This move enabled Novo to gain access to large capital sources and lower its cost of capital.

9. Discuss foreign equity ownership restrictions. Why do you think countries impose these restrictions?

Answer: Many countries restrict the maximum fractional ownership of local firms by foreigners.

Mostly, these restrictions are imposed to ensure domestic control of local firms.

10. Explain the pricing-to-market phenomenon.

Answer: The pricing-to-market (PTM) refers to the phenomenon that the same securities are priced differently for different investors. A well-known example of PTM is provided by Nestle. Up until 1988 November, foreigners were only allowed to hold Nestle bearer shares; only Swiss residents were allowed to hold registered shares. As indicated in Exhibit 17.11 in the text, bearer shares were trading for about twice the price of registered shares.

11. Explain how the premium and discount are determined when assets are priced-to-market.

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When would the law of one price prevail in international capital markets even if foreign equity ownership restrictions are imposed?

Answer: The premium and discount are determined by (i) the severity of restrictions imposed on foreigners and (ii) foreigners‘ ability to mitigate the effect of these restrictions using their own domestic securities. In a special case where foreigners can exactly replicate the securities under restriction, then PTM will cease to apply.

12. Under what conditions will the foreign subsidiary‘s financial structure become relevant?

Answer: The subsidiary‘s own financial structure will become relevant when the parent firm is not responsible for the financial obligations of the subsidiary.

13. Under what conditions would you recommend that the foreign subsidiary conform to the local norm of financial structure?

Answer: It may make sense for the subsidiary to confirm to the local norm if the parent is not responsible for the subsidiary‘s debt and the subsidiary has to depend on local financial markets for raising capital.

PROBLEMS

Answer problems 1-3 based on the stock market data given by the following table.

Correlation Coefficients

Telmex Mexico World

Telmex

Mexico

World

SD(%)

R (%)

1.00

.90

0.60

18

?

1.00

0.75

15

14

1.00

10

12

The above table provides the correlations among Telmex, a telephone/communication company located in Mexico, the Mexico stock market index, and the world market index, together with the standard deviations (SD) of returns and the expected returns ( R ). The risk-free rate is 5%.

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1. Compute the domestic country beta of Telmex as well as its world beta. What do these betas measure?

2. Suppose the Mexican stock market is segmented from the rest of the world. Using the CAPM paradigm, estimate the equity cost of capital of Telmex.

3. Suppose now that Telmex has made its shares tradable internationally via cross-listing on NYSE. Again using the CAPM paradigm, estimate Telmex‘s equity cost of capital. Discuss the possible effects of international pricing of Telmex shares on the share prices and the firm‘s investment decisions.

Solutions.

1. The domestic beta,  TM , and the world beta,  TW , of Telmex can be computed as follows:

 TM 

 T M  T M  T M (18)(15)(0.9) 243     1.08 225  M2  M2 (15)2

 TW 

 T W  T W  T W (18)(10)(0.6) 108     1.08 2 2 100 W W (10)2

Both the domestic and world beta turn out to be the same. As the market moves by 1%, Telmex stock return will move by 1.08% .

2.

RT  R f  ( RM  R f ) TM  5  (14  5)(1.08)  14.72%

3.

RT  R f  ( RW  R f )  TW  5  (12  5)(1.08)  12.56%

As the equity cost of capital decreases from 14.72% to 12.56%, Telmex will experience an increase in its share price. In addition, with a reduced cost of capital, Telmex will be able to undertake more investment projects profitably.

CHAPTER 18 INTERNATIONAL CAPITAL BUDGETING ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Why is capital budgeting analysis so important to the firm?

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Answer: The fundamental goal of the financial manager is to maximize shareholder wealth.

Capital investments with positive NPV or APV contribute to shareholder wealth. Additionally, capital investments generally represent large expenditures relative to the value of the entire firm. These investments determine how efficiently and expensively the firm will produce its product. Consequently, capital expenditures determine the long-run competitive position of the firm in the product marketplace.

2. What is the intuition behind the NPV capital budgeting framework?

Answer: The NPV framework is a discounted cash flow technique. The methodology compares the present value of all cash inflows associated with the proposed project versus the present value of all project outflows. If inflows are enough to cover all operating costs and financing costs, the project adds wealth to shareholders.

3. Discuss what is meant by the incremental cash flows of a capital project.

Answer: Incremental cash flows are denoted by the change in total firm cash inflows and cash outflows that can be traced directly to the project under analysis.

4. Discuss the nature of the equation sequence, Equation 18.2a to 18.2f.

Answer: The equation sequence is a presentation of incremental annual cash flows associated with a capital expenditure. Equation 18.2a presents the most detailed expression for calculating these cash flows; it is composed of three terms. Equation 18.2b shows that these three terms are: i) incremental net profit associated with the project; ii) incremental depreciation allowance; and, iii) incremental after-tax interest expense associated with the borrowing capacity created by the project. Note, the incremental ―net profit‖ is not accounting profit but rather net cash actually available for shareholders. Equation 18.2c cancels out the after-tax interest term in 18.2a, yielding a simpler formula. Equation 18.2d shows that the first term in 18.2c is generally called after-tax net operating income.

Equation 18.2e yields yet a computationally simpler

formula by combining the depreciation terms of 18.2c. Equation 18.2f shows that the first term in 18.2e is generally referred to as after-tax operating cash flow.

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5.

What makes the APV capital budgeting framework useful for analyzing foreign capital

expenditures?

Answer: The APV framework is a value-additivity technique. Because international projects frequently have cash flows not encountered in domestic projects, the APV technique easily allows the analyst to add terms to the model that represent the special cash flows.

6. Relate the concept of lost sales to the definition of incremental cash flow.

Answer: When a new capital project is undertaken it may compete with an existing project(s), causing the old project(s) to experience a loss in sales revenue. From an incremental cash flow standpoint, the new project‘s incremental revenue is the total sales revenue associated with the new project minus the lost sales revenue from the old project(s).

7. What problems can enter into the capital budgeting analysis if project debt is evaluated instead of the borrowing capacity created by the project?

Answer: If project debt is greater (less) than the borrowing capacity created by the capital project, and tax shields on the actual new debt are used in the analysis, the APV will be overstated (understated) making the project unjustly appear more (less) attractive than it actually is.

8. What is the nature of a concessionary loan and how is it handled in the APV model?

Answer: A concessionary loan is a loan offered by a governmental body at below the normal market rate of interest as an enticement for a firm to make a capital investment that will economically benefit the lender. The benefit to the MNC is the difference between the face value of the concessionary loan converted into the home currency and the present value of the similarly converted concessionary loan payments discounted at the MNC‘s normal domestic borrowing rate. The loan payments will yield a present value less than the face amount of the concessionary loan when they are discounted at the higher normal rate.

This difference

represents a subsidy the host country is willing to extend to the MNC if the investment is made.

The benefit to the MNC of the concessionary loan is handled in the APV model via a separate term.

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9. What is the intuition of discounting the various cash flows in the APV model at specific discount rates?

Answer: The APV model is a value-additivity technique where total value is determined by the sum of the present values of the individual cash inflows and outflows. Each cash flow will not necessarily have the same amount of risk associated with it. To account for risk differences in the analysis, each cash flow is discounted at a rate commensurate with the inherent riskiness of the cash flow.

10. In the Modigliani-Miller equation, why is the market value of the levered firm greater than the market value of an equivalent unlevered firm?

Answer: The levered firm has a greater market value because less money is taken from the firm by the government in taxes due to tax-deductible interest payments. Thus, there is more cash left for investor groups than when the firm is financed with all-equity funds.

11. Discuss the difference between performing the capital budgeting analysis from the parent firm‘s perspective as opposed to the subsidiary‘s perspective.

Answer: The goal of the financial manager of the parent firm is to maximize its shareholders‘ wealth. A capital project of a subsidiary of the parent may have a positive NPV (or APV) from the subsidiary‘s perspective yet have a negative NPV (or APV) from the parent‘s perspective if certain cash flows cannot be repatriated to the parent because of remittance restrictions by the host country, or if the home currency is expected to appreciate substantially over the life of the project, yielding unattractive cash flows when converted into the home currency of the parent.

Any of these reasons could result in the project being unattractive to the parent and the parent‘s stockholders.

12. Define the concept of a real option. Discuss some of the various real options a firm can be confronted with when investing in real projects.

Answer: A positive APV project is accepted under the assumption that all future operating decisions will be optimal. The firm‘s management does not know at the inception date of a project what future decisions it will be confronted with because all information concerning the

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project has not yet been learned. Consequently, the firm‘s management has alternative paths, or options, that it can take as new information is discovered. The application of options pricing theory to the evaluation of investment options in real projects is known as real options.

The firm is confronted with many possible real options over the life of a capital asset.

For example, the firm may have a timing option as when to make the investment; it may have a growth option to increase the scale of the investment; it may have a suspension option to temporarily cease production; and, it may have an abandonment option to quit the investment early.

13. Discuss the circumstances under which the capital expenditure of a foreign subsidiary might have a positive NPV in local currency terms but be unprofitable from the parent firm‘s perspective.

Answer:

The project NPV might be negative from the parent firm‘s perspective when it is

positive in local currency terms if all foreign cash flows cannot be legally repatriated to the parent firm. Additionally, if the PPP assumption does not hold, such that the actual future real exchange rate has depreciated in foreign currency terms, the after-tax cash flows will yield less units of home currency from the parent firm‘s perspective than expected, possibly resulting in a negative NPV.

PROBLEMS

1. The Alpha Company plans to establish a subsidiary in Hungary to manufacture and sell fashion wristwatches. Alpha has total assets of $70 million, of which $45 million is equity financed. The remainder is financed with debt. Alpha considered its current capital structure optimal.

The construction cost of the Hungarian facility in forints is estimated at

HUF2,400,000,000, of which HUF1,800,000,and 000 is to be financed at a below-market borrowing rate arranged by the Hungarian government. Alpha wonders what amount of debt it should use in calculating the tax shields on interest payments in its capital budgeting analysis.

Can you offer assistance?

Solution: The Alpha Company has an optimal debt ratio of .357 (= $25 million debt/$70 million assets) or 35.7%. The project debt ratio is .75 (= HUF1,800/HUF2,400) or 75%. Alpha will overstate the tax shield on interest payments if it uses the 75% figure because the proposed

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project will only increase borrowing capacity by HUF856,800,000 (=HUF2,400,000,000 x .357).

2. The current spot exchange rate is HUF250/$1.00. Long-run inflation in Hungary is estimated at 10 percent annually and 3 percent in the United States. If PPP is expected to hold between the two countries, what spot exchange should one forecast five years into the future?

Solution: HUF250(1 + .10)5/(1 + .03)5 = HUF347.31/$1.00.

3. The Beta Corporation has an optimal debt ratio of 40 percent. Its cost of equity capital is 12 percent and its before-tax borrowing rate is 8 percent. Given a marginal tax rate of 35 percent, calculate (a) the weighted-average cost of capital, and (b) the cost of equity for an equivalent all-equity financed firm.

Solution: (a)

K = (1 - .40).12 + (.40).08(1 - .35) = .0928 or 9.28%

(b)

A weighted-average cost of capital of 9.28% for a levered firm implies:

K =.0928 = Ku (1-(.35)(.40)). Solving for Ku yields .1079 or 10.79%.

4. Zeda, Inc., a U.S. MNC, is considering making a fixed direct investment in Denmark. The Danish government has offered Zeda a concessionary loan of DKK15,000,000 at a rate of 4 percent per annum. The normal borrowing rate is 6 percent in dollars and 5.5 percent in Danish krone. The loan schedule calls for the principal to be repaid in three equal annual installments.

What is the present value of the benefit of the concessionary loan? The current spot rate is DKK5.60/$1.00 and the expected inflation rate is 3% in the U.S. and 2.5% in Denmark.

Solution:

Principal Year

St

Payment

It

StLPt

(t)

(a)

(b)

(c)

(b + c)/(a)

DKK

DKK

StLPt/(1 + id)t

1

5.57

5,000,000

600,000

1,005,386

948,477

2

5.55

5,000,000

400,000

972,973

865,943

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3

5.52

5,000,000

200,000

942,029

15,000,000

790,946 2,605,366

The dollar value of the concessionary loan is $2,678,574 = DKK15,000,000 ÷ 5.60. The dollar present value of the concessionary loan payments is $2,605,366. Therefore, the present value of the benefit of the concessionary loan is $73,208 = $2,678,574 – 2,605,366.

5. Delta Company, a U.S. MNC, is contemplating making a foreign capital expenditure in South Africa. The initial cost of the project is ZAR10,000. The annual cash flows over the five year economic life of the project in ZAR are estimated to be 3,000, 4,000, 5,000, 6000, and 7,000.

The parent firm‘s cost of capital in dollars is 9.5 percent. Long-run inflation is forecasted to be 3 percent per annum in the U.S. and 7 percent in South Africa.

The current spot foreign

exchange rate is ZAR/USD = 3.75. Determine the NPV for the project in USD by:

a. Calculating the NPV in ZAR using the ZAR equivalent cost of capital according to the Fisher Effect and then converting to USD at the current spot rate.

Solution: ZAR equivalent cost of capital according to the Fisher Effect = 1.095 x [(1.07)/(1.03)] – 1 = .1375 or 13.75 percent.

NPVUSD = [3,000/(1.1375)1 + 4,000/(1.1375)2 + 5,000/(1.1375)3 + 6,000/(1.1375)4 + 7,000/(1.1375)5 – 10,000]/3.75 = USD1,700

b. Converting all cash flows from ZAR to USD at Purchasing Power Parity forecasted exchange rates and then calculating the NPV at the dollar cost of capital.

Solution: The PPP forecasted ZAR/USD exchange rates are: ZAR/USD(t) = 3.75 x [(1.07)/(1.03)]t

ZAR/USD(1) = 3.90; ZAR/USD(2) = 4.05; ZAR/USD(3) = 4.20; ZAR/USD(4) = 4.37; and, ZAR/USD(5) = 4.54.

NPVUSD = [(3,000/3.90)/(1.095)1 + 4,000/(4.05)/(1.095)2 + 5,000/(4.20)/(1.095)3

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+ 6,000/(4.37)/(1.095)4 + 7,000/(4.54)/(1.095)5 – 10,000/(3.75)] = USD1,700

Are the two dollar NPVs different or the same? Explain.

The two dollar NPVs are identical as they always will be under the assumption that both PPP and the Fisher Effect hold. Note, that both parity conditions incorporate relative differences in inflation.

c. What is the NPV in dollars if the actual pattern of ZAR/USD exchange rates is: S(0) = 3.75, S(1) = 5.7, S(2) = 6.7, S(3) = 7.2, S(4) = 7.7, and S(5) = 8.2?

Solution: NPVUSD = [(3,000/5.7)/(1.095)1 + 4,000/(6.7)/(1.095)2 + 5,000/(7.2)/(1.095)3 + 6,000/(7.7)/(1.095)4 + 7,000/(8.2)/(1.095)5 – 10,000/(3.75)] = –USD75.

The NPV is negative because actual exchange rates did not evolve as forecasted by PPP. Consequently, actual NPV and forecasted NPV may be different.

6. Suppose that in the illustrated mini case in the chapter the APV for Centralia had been $60,000. How large would the after-tax terminal value of the project need to be before the APV would be positive and Centralia would accept the project?

Solution: Centralia should not go ahead with its plans to build a manufacturing plant in the Spain unless the terminal value is likely to be large enough to yield a positive APV. The terminal value of the project must be $299,010 in order for the APV to equal zero. This is calculated as follows. Set STTVT/(1+Kud)T = $60,000. This implies TVT = ($60,000/ST)(1+Kud)T = ($60,000/.7261)(1.11)8 = €190,431.

7. With regards to the Centralia illustrated mini case in the chapter, how would the APV change if:

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a. The forecast of d and/or f are incorrect?

Answer:

A larger or smaller d will not have any effect because a change will affect the

numerator and denominator of each APV term in an offsetting manner. Note that imbedded in each domestic discount rate is the inflation premium d. A larger (smaller) f, however, will decrease (increase) the project APV because the foreign currency received will buy less (more) parent country currency upon repatriation.

b. Deprecation cash flows are discounted at Kud instead of id?

Answer: The APV would be less favorable because Kud is a larger discount rate than id. c. The host country did not provide the concessionary loan?

Answer: The APV would be less favorable because the project would have to cover a higher finance charge, i.e., there would be no benefit received from below market financing.

MINI CASE: DORCHESTER, LTD.

Dorchester Ltd., is an old-line confectioner specializing in high-quality chocolates. Through its facilities in the United Kingdom, Dorchester manufactures candies that it sells throughout Western Europe and North America (United States and Canada).

With its current

manufacturing facilities, Dorchester has been unable to supply the U.S. market with more than 225,000 pounds of candy per year. This supply has allowed its sales affiliate, located in Boston, to be able to penetrate the U.S. market no farther west than St. Louis and only as far south as Atlanta. Dorchester believes that a separate manufacturing facility located in the United States would allow it to supply the entire U.S. market and Canada (which presently accounts for 65,000 pounds per year). Dorchester currently estimates initial demand in the North American market at 390,000 pounds, with growth at a 5 percent annual rate. A separate manufacturing facility would, obviously, free up the amount currently shipped to the United States and Canada. But Dorchester believes that this is only a short-run problem.

They believe the economic

development taking place in Eastern Europe will allow it to sell there the full amount presently shipped to North America within a period of five years.

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Dorchester presently realizes £3.00 per pound on its North American exports. Once the U.S. manufacturing facility is operating, Dorchester expects that it will be able to initially price its product at $7.70 per pound. This price would represent an operating profit of $4.40 per pound.

Both sales price and operating costs are expected to keep track with the U.S. price level; U.S. inflation is forecast at a rate of 3 percent for the next several years. In the U.K., long-run inflation is expected to be in the 4 to 5 percent range, depending on which economic service one follows. The current spot exchange rate is $1.50/£1.00. Dorchester explicitly believes in PPP as the best means to forecast future exchange rates.

The manufacturing facility is expected to cost $7,000,000. Dorchester plans to finance this amount by a combination of equity capital and debt. borrowing capacity by £2,000,000,

The plant will increase Dorchester‘s

and it plans to borrow only that amount.

The local

community in which Dorchester has decided to build will provide $1,500,000 of debt financing for a period of seven years at 7.75 percent. The principal is to be repaid in equal installments over the life of the loan. At this point, Dorchester is uncertain whether to raise the remaining debt it desires through a domestic bond issue or a Eurodollar bond issue. It believes it can borrow pounds sterling at 10.75 percent per annum and dollars at 9.5 percent. Dorchester estimates its all-equity cost of capital to be 15 percent.

The U.S. Internal Revenue Service will allow Dorchester to depreciate the new facility over a seven-year period. After that time the confectionery equipment, which accounts for the bulk of the investment, is expected to have substantial market value.

Dorchester does not expect to receive any special tax concessions. Further, because the corporate tax rates in the two countries are the same--35 percent in the U.K. and in the United States--transfer pricing strategies are ruled out.

Should Dorchester build the new manufacturing plant in the United States?

Suggested Solution to Dorchester Ltd.

Summary of Key Information

The current exchange rate in European terms is So(£/$) = 1/1.50 = .6667.

The initial cost of the project in British pounds is SoCo = £0.6667($7,000,000) = £4,666,900.

The U.K. inflation rate is estimated at 4.5% per annum, or the mid-point of the 4%-5% range.

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The U.S. inflation rate is forecast at 3% per annum. Under the simplifying assumption that PPP holds S t = .6667(1.045)t/(1.03)t.

The before-tax nominal contribution margin per unit at t=1 is $4.40(1.03)t-1.

It is assumed that Dorchester will be able to sell one-fifth of the 290,000 pounds of candy it presently sells to North America in Eastern Europe the first year the new manufacturing facility is in operation; two-fifths the second year; etc.; and all 290,000 pounds beginning the fifth year.

The contribution margin on lost sales per pound in year t equals £3.00(1.045)t.

Terminal value will initially be assumed to equal zero.

Straight line depreciation over the seven year economic life of the project is assumed: Dt = $1,000,000 = $7,000,000/7 years.

The marginal tax rate, , is the U.K. (or U.S.) rate of 35%.

Dorchester will borrow $1,500,000 at the concessionary loan rate of 7.75% per annum.

Optimally, Dorchester should borrow the remaining funds it needs, £1,000,000, in pounds sterling because according to the Fisher equation, the real rate is less for borrowing pounds sterling than it is for borrowing dollars: 5.98% or .0598 = (1.1075)/(1.045) - 1.0 versus 6.31% or .0631 = (1.095)/(1.03) - 1.0.

Kud = 15%.

Calculation of the Present Value of the After-Tax Operating Cash Flows

St x Year (t)

St

Quantity

Quantity x $4.40 x (1.03)t-1

Quantity

Quantity

Lost

Lost Sales

S t OCF t

S t OCF t ( 1 -  ) ( 1 + K ud )t

Sales x £3.00

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x (1.045)t (a)

(b)

(a + b)

£

£

£

£

1

.6764

390,000

1,160,702

(232,000)

(727,320)

433,382

244,955

2

.6863

409,500

1,273,673

(174,000)

(570,037)

703,636

345,832

3

.6963

429,975

1,397,548

(116,000)

(397,126)

4

.7064

451,474

1,533,373

(58,000)

(207,498)

1,325,875

492,748

5

.7167

474,048

1,682,524

0

0

1,682,524

543,733

6

.7271

497,750

1,846,053

0

0

1,846,053

518,765

7

.7377

522,638

2,025,613

0

0

2,025,613

494,977

1,000,422

427,566

3,068,576

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Calculation of the Present Value of the Depreciation Tax Shields

Year (t)

St

Dt

S t Dt ( 1 + i d )t

$

£

1

.6764

1,000,000

213,761

2

.6863

1,000,000

195,837

3

.6963

1,000,000

179,404

4

.7064

1,000,000

164,340

5

.7167

1,000,000

150,552

6

.7271

1,000,000

137,911

7

.7377

1,000,000

126,340 1,168,146

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Calculation of the Present Value of the Concessionary Loan Payments

Year (t)

St

(a)

Principal Payment

It

(b)

(c)

(a) x (b + c)

$

$

£

S t LPt

S t LPt t (1+ i d ) £

1

.6764

214,286

116,250

223,574

201,873

2

.6863

214,286

99,643

215,449

175,654

3

.6963

214,286

83,036

207,025

152,402

4

.7064

214,286

66,429

198,297

131,808

5

.7167

214,286

49,821

189,286

113,605

6

.7271

214,286

33,214

179,957

97,523

7

.7377

214,286

16,607

170,330

83,346

1,500,000

956,211

Calculation of the Present Value of the Benefit from the Concessionary Loan T

S t LPt =£0.6667 x $1,500,000 - £956,211 = £43,839 t t =1 ( 1 + i d )

S o CLo - 

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Calculation of the Present Value of the Interest Tax Shields from the $1,500,000 Concessionary Loan Year (t)

St

It

St  I t

(a)

(b)

(a x b x )

$

St  I t t (1+ i d )

£

£

1

.6764

116,250

27,521

24,850

2

.6863

99,643

23,935

19,514

3

.6963

83,036

20,236

14,897

4

.7064

66,429

16,424

10,917

5

.7167

49,821

12,497

7,501

6

.7271

33,214

8,452

4,581

7

.7377

16,607

4,288

2,098 84,357

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Calculation of the Present Value of the Interest Tax Shields from the £1,000,000 Bond Issue Year (t)

Outstanding Loan Balance

Principal Payment

Interest Payment

£

£

£

 It ( 1 + i d )t £

1

1,000,000

0

107,500

33,973

2

1,000,000

0

107,500

30,675

3

1,000,000

0

107,500

27,698

4

1,000,000

0

107,500

25,009

5

1,000,000

0

107,500

22,582

6

1,000,000

0

107,500

20,390

7

1,000,000

1,000,000

107,500

18,411 178,738

Without considering the terminal value of the project, the APV of the project is negative:

APV = £3,068,576 + 1,168,146 + 43,839 + 84,357 + 178,738 - 4,666,900 = -£123,244.

Dorchester should not go ahead with its plans to build a manufacturing plant in the U.S. unless the terminal value is likely to be large enough to yield a positive APV. The terminal value of the project must be $444,397 in order for the APV to equal zero. This is calculated as follows. Set STTVT/(1+Kud)T = £123,244.

This implies TVT = (£123,244/ST)(1+Kud)T = (£123,244/.7377)(1.15)7 = $444,397.

Since the terminal value is expected to be substantial, and the initial cost of the project is $7,000,000, it appears likely that the terminal value will be sufficient to yield a positive APV. Thus, Dorchester should go ahead with its plans to build a manufacturing plant in the U.S.

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MINI-CASE: STRIK-IT-RICH GOLD MINING COMPANY The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so it will need to purchase land that its geologists believe is rich in gold. Strik-it-Rich‘s management believes that the expansion will allow it to mine and sell an additional 2,000 troy ounces of gold per year. The expansion, including the cost of the land, will cost $2,500,000. The current price of gold bullion is $1,400 per ounce and one-year gold futures are trading at $1,484 = $1,400(1.06). Extraction costs are $1,050 per ounce. The firm‘s cost of capital is 10%. At the current price of gold, the expansion appears profitable: NPV = ($1,400 – 1,050) x 2,000/.10 $2,500,000 = $4,500,000.

Strik-it-Rich‘s management is, however, concerned

with the

possibility that large sales of gold reserves by Russia and the United Kingdom will drive the price of gold down to $1,100 for the foreseeable future. On the other hand, management believes there is some possibility that the world will soon return to a gold reserve international monetary system. In the latter event, the price of gold would increase to at least $1,600 per ounce. The course of the future price of gold bullion should become clear within a year. Strik-itRich can postpone the expansion for a year by buying a purchase option on the land for $250,000. What should Strik-it-Rich‘s management do?

Suggested Solution to Strik-it-Rich Gold Mining Company

There is considerable risk in expanding operations at the present time, even though the NPV based on the current price of gold is a positive $4,500,000. If the price of gold falls to $1,100 per ounce, the NPV = ($1,100 – 1,050) x 2000/.10 – $2,500,000 = -$1,500,000. On-the-otherhand, if the price of gold increases to $1,600, the NPV is a very attractive NPV = ($1,600 – 1,050) x 2000/.10 – $2,500,000 = $8,500,000. The purchase option for $250,000 on the land is a relatively small amount to have the opportunity to postpone the decision until additional information is learned. Obviously, Strik-it-Rich‘s management will only invest if the NPV is positive. The risk-neutral probability of gold increasing to $1,600 per ounce is: q = (F0 – S0·d)/S0(u – d) = (1,484 – 1,100)/(1,600 – 1,100) = .7680.

Thus, the value of the timing option to postpone the decision one year is: C = .7680($8,500,000)/(1.06) = $6,158,491.

Since this amount is substantially in excess of the $250,000 cost of the purchase option on the land, Strik-it-Rich‘s management should definitely take advantage of the timing option it is

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confronted with to wait and see what the price of gold is in one year before it makes a decision to expand operations.

CHAPTER 19 MULTINATIONAL CASH MANAGEMENT ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Describe the key factors contributing to effective cash management within a firm. Why is the cash management process more difficult in a MNC?

Answer:

An effective cash management system should be based on a cash budget that

projects expected cash inflows and outflows over some planning horizon. It provides for the systematic receipt and disbursement of cash. It also provides for funds mobilization, where cash shortages are covered by borrowing at the most favorable rates and surplus funds are invested at the most advantageous rates.

Within a MNC the complexity of the cash

management process is compounded because the firm does business in a variety of currencies, and hence the cost of foreign exchange transactions is an additional dimension to be managed.

2.

Discuss the pros and cons of a MNC having a centralized cash manager handle all

investment and borrowing for all affiliates of the MNC versus each affiliate having a local manager who performs the cash management activities of the affiliate.

Answer: Under a centralized cash management system, the cash manager will have a global view of the cash requirements of the MNC.

There will be less chance that funds will be

mislocated, i.e., denominated in the wrong currency.

Additionally, under a global view,

transaction exposure for the MNC can be more efficiently managed. Moreover, a centralized system readily allows for investing excess cash at the most advantageous rates and borrowing to cover cash shortages at the most favorable rates.

Under a decentralized system, the local cash manager is given more responsibility for managing the cash needs of the affiliate than under a centralized system. Consequently, the local cash management position serves as good training for higher level positions within the affiliate or MNC.

Also, under a decentralized system, local bank relationships are better

developed since the affiliate conducts more of its cash management functions at the local level.

This may prove important if funds need to be borrowed locally. But overall, the benefits of a

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centralized cash management system tend to outweigh its disadvantages.

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PROBLEMS 1. Assume that interaffiliate cash flows are uncorrelated with one another. Calculate the standard deviation of the portfolio of cash held by the centralized depository for the following affiliate members: Expected Standard Affiliate Transactions Deviation _______________________________________________ U.S. $100,000 $40,000 Canada $150,000 $60,000 Mexico $175,000 $30,000 Chile $200,000 $70,000 Solution: Portfolio standard deviation = Square root of [($40,000)2 + ($60,000)2 + ($30,000)2 + ($70,000)2] = $104,881.

MINI CASE: EFFICIENT FUNDS FLOW AT EASTERN TRADING COMPANY The Eastern Trading Company of Singapore purchases spices in bulk from around the world, packages them into consumer-size quantities, and sells them through sales affiliates in Hong Kong, the United Kingdom, and the United States. For a recent month, the following payments matrix of interaffiliate cash flows, stated in Singapore dollars, was forecasted.

Show how

Eastern Trading can use multilateral netting to minimize the foreign exchange transactions necessary to settle interaffiliate payments. If foreign exchange transactions cost the company .5 percent, what savings result from netting?

Eastern Trading Company Payments Matrix (S$000)

Disbursements

Receipts

Singapore Hong Kong

U.K.

U.S.

Total Receipts

Singapore

--

40

75

55

170

Hong Kong

8

--

--

22

30

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U.K.

15

--

--

17

32

U.S.

11

25

9

--

45

Total

34

65

84

94

277

disbursements

Suggested Solution to Mini Case 1: Efficient Funds Flow at Eastern Trading Company S$8 Singapore

S$40

Hong Kong

S$11 S$15

S$75

S$25

S$22

S$55

S$9 United Kingdom

S$17

United States

Singapore

S$32

Hong Kong

Bilateral Netting

S$60

S$3 S$44

United Kingdom

S$8

United States

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Multilateral Netting

Singapore

S$35

Hong Kong

S$52 S$49

United States

United Kingdom

Without netting, S$277,000 of interaffiliate foreign exchange transactions occur among the four affiliates of Eastern Trading.

With multilateral netting, interaffiliate foreign exchange

transactions are reduced to S$136,000, or by S$141,000. The savings are .005 x S$141,000 = S$705 for the planning period.

MINI CASE: EASTERN TRADING COMPANY‘S NEW M.B.A. The Eastern Trading Company of Singapore presently follows a decentralized system of cash management where it and its affiliates each maintain their own transaction and precautionary cash balances. Eastern Trading believes that it and its affiliates‘ cash needs are normally distributed and independent from one another. It is corporate policy to maintain two and onehalf standard deviations of cash as precautionary holdings. At this level of safety there is a 99.37 percent chance that each affiliate will have enough cash holdings to cover transactions.

A new MBA hired by the company claims that the investment in precautionary cash balances is needlessly large and can be reduced substantially if the firm converts to a centralized cash management system. Use the projected information for the current month, which is presented below, to determine the amount of cash Eastern Trading needs to hold in precautionary balances under its current decentralized system and the level of precautionary cash it would need to hold under a centralized system. Was the new MBA a good hire?

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Affiliate

Expected Transactions

One Standard Deviation

Singapore

S$125,000

S$40,000

Hong Kong

60,000

25,000

United Kingdom

95,000

40,000

United States

70,000

35,000

Suggested Solution to Mini Case 2: Eastern Trading Company‘s New M.B.A.

Affiliate

Expected Transactions (a)

One Standard Deviation (b)

Expected Needs plus Precautionary (a + 2.5b)

Singapore

S$125,000

S$40,000

S$225,000

Hong Kong

60,000

25,000

122,500

United Kingdom

95,000

40,000

195,000

United States

70,000

35,000

157,500

Total

S$350,000

S$700,000

Eastern Trading is holding S$350,000 to cover expected transactions and S$350,000 as precautionary balances among the four affiliates. In total, it is holding S$700,000 under its decentralized cash management system.

If Eastern Trading views its cash needs from a portfolio perspective under a centralized cash management system, one portfolio standard deviation of cash would be:

Portfolio = (S $40,000 ) 2 + (S $25,000 ) 2 + (S $40,000 ) 2 + (S $35,000 ) 2 Std . Dev . = S $71,063 Hence, under a centralized system, Eastern Trading would continue to need S$350,000 to Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

cover expected transactions, but precautionary cash balances could be reduced to $177,658 (= 2.5 x S$71,063). Thus, the investment in precautionary cash can be reduced by S$172,342 (= S$350,000 – 177,658). The new MBA was a good hire.

CHAPTER 20 INTERNATIONAL TRADE FINANCE ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Discuss some of the reasons why international trade is more difficult and risky from the exporter‘s perspective than is domestic trade.

Answer: International trade is more difficult and risky for a firm than is domestic trade. In foreign trade, the exporter may not be familiar with the buyer, and thus not know if the importer is creditworthy. If merchandise is exported abroad and the buyer does not pay, it may prove difficult, if not impossible, for the exporter to have any legal recourse. Additionally, political instability makes it risky to ship merchandise abroad to certain parts of the world.

2. What three basic documents are necessary to conduct a typical foreign commerce trade?

Briefly discuss the purpose of each.

Answer: The three basic documents necessary to conduct a typical foreign commerce trade are: letter of credit, time draft, and a bill of lading. A letter of credit (L/C) is a guarantee from the importer‘s bank that it will act on behalf of the importer and pay the exporter for the merchandise if all relevant documents specified in the L/C are presented according to the terms of L/C. A time draft is a written order instructing the importer or his agent, the importer‘s bank, to pay the amount specified on its face on a certain date.

A bill of lading (B/L) is a document

issued by the common carrier specifying that it has received the goods for shipment; it can serve as title to the goods.

3. How does a time draft become a banker‘s acceptance?

Answer: When the goods are shipped by the exporter via common carrier, the exporter‘s bank presents the shipping documents and the time draft to the importer‘s bank. After taking title to the goods via the bill of lading, the importer‘s bank accepts the time draft, creating at this point

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a banker’s acceptance (B/A). A B/A is a money market instrument for which a secondary market exists.

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4.

Discuss the various ways the exporter can receive payment in a foreign trade transaction

after the importer‘s bank accepts the exporter‘s time draft and it becomes a banker‘s acceptance.

Answer: The exporter can hold the B/A until maturity and present it to the importer‘s bank for payment at face value. Alternatively, the exporter can receive the discounted value at inception from its bank, or sell it at its current discounted value in the money market prior to maturity.

5. What is a forfaiting transaction?

Answer: Forfaiting is a form of medium-term trade financing used to finance the sale of capital goods. A forfaiting transaction involves the sale by the exporter of promissory notes signed by the exporter in favor of the importer. The forfait, usually a bank, buys the notes at a discount from face value. The forfait does not have recourse against the exporter in the event of default by the importer. The promissory notes typically extend out in a series over a period of three to five years, with a note in the series maturing every six months.

6. What is the purpose of the Export-Import Bank?

Answer:

The Export-Import Bank (Eximbank) of the United States was founded as an

independent government agency to facilitate and finance U.S. export trade.

Eximbank‘s

purpose is to provide financing in situations where private financial institutions are unable or unwilling because: i) the loan maturity was too long; ii) the amount of the loan was too large; iii) the loan risk was too great; and, iv) where the importing firm had difficulty obtaining hard currency for payment. To meet its objectives, Eximbank provides service through three types of programs: direct loans to foreign borrowers, loan guarantees, and credit insurance.

7. Do you think that a country‘s government should assist private business in the conduct of international trade through direct loans, loan guarantees, and/or credit insurance?

Answer:

When a country‘s government offers below-market financing directly to foreign

importers, or offers loan guarantees to domestic banks financing the foreign import, or provides low cost credit insurance to U.S. exporters to alleviate the commercial and political risk in the sale, it is using taxpayers‘ money to subsidize foreign trade. Consequently, the foreign trade is

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not paying for itself.

Nevertheless, if most governments of developed countries offer such

assistance to their domestic exporters, it is difficult for one to refuse if the country desires to have its export-oriented industries remain competitive.

8. Briefly discuss the various types of countertrade.

Answer: Countertrade is an umbrella term used to describe six types of international trade: barter, clearing arrangement, switch trading, buy-back, counterpurchase, and offset. The first three do not involve the use of money, whereas the later three do.

Barter is the direct exchange of goods between two parties.

While money does not

exchange hands in a barter transaction, it is common to value the goods each party exchanges in an agreed-upon currency.

A clearing arrangement is a form of barter in which the

counterparties contract to purchase a certain amount of goods and services from one another.

Both parties set up accounts with each other that are debited whenever one country imports from the other.

The clearing arrangement introduces the concept of credit to barter

transactions, and means bilateral trade can take place that does not have to be immediately settled. A switch trade is the purchase by a third party of one country‘s clearing agreement imbalance for hard currency, which is in turn resold. The second buyer uses the account balance to purchase goods and services from the original clearing agreement counterparty that had the account imbalance.

A buy-back transaction involves a technology transfer via the sale of a manufacturing plant. As part of the transaction, the seller agrees to purchase a certain portion of the plant output once it is constructed. First, the plant buyer borrows hard currency in the capital market to pay the seller for the plant. Second, the plant seller agrees to purchase enough of the plant output over a period of time to enable the buyer to pay back the borrowed funds.

A

counterpurchase is similar to a buy-back transaction, but with some notable differences. The major difference between a buy-back and a counterpurchase transaction is that in the latter, the seller agrees to purchase unrelated merchandise that has not been produced on the exported equipment. The seller agrees to purchase goods from a list drawn up by the importer at prices set by the importer. The list frequently includes items the buyer may be experiencing difficulty in selling. An offset transaction can be viewed as a counterpurchase trade agreement involving the aerospace/defense industry.

9. Discuss some of the pros and cons of countertrade from the country‘s perspective and the

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firm‘s perspective.

Answer: Arguments both for and against countertrade transactions can be made. There are both negative and positive incentives for a country to be in favor of countertrade. Negative incentives are those that are forced upon a country or corporations whether or not they desire to engage in countertrade.

Negative reasons include:

the conservation of cash and hard

currency, the improvement of trade imbalances, and the maintenance of export prices. Positive reasons from both the country and corporate perspectives include:

enhanced economic

development, increased employment, technology transfer, market expansion, increased profitability, less costly sourcing of supply, reduction of surplus goods from inventory, and the development of marketing expertise.

Those against countertrade transactions claim that such transactions tamper with the fundamental operation of free markets, and therefore, resources are used inefficiently.

Opponents claim that transaction costs are increased, that multilateral trade is restricted through fostering bilateral trade agreements, and that, in general, transactions that do not make use of money represent a step backwards in economic development.

10. What is the difference between a buy-back transaction and a counterpurchase?

Answer: A buy-back transaction involves a technology transfer via the sale of a manufacturing plant. As part of the transaction, the seller agrees to purchase a certain portion of the plant output once it is constructed to enable the buyer to pay back the borrowed funds.

In a

counterpurchase, the seller agrees to purchase unrelated merchandise that has not been produced on the exported equipment. Generally, the seller agrees to purchase goods from a list drawn up by the importer at prices set by the importer. The list frequently includes items the buyer may be experiencing difficulty in selling.

PROBLEMS 1. Assume the time from acceptance to maturity on a $2,000,000 banker‘s acceptance is 90 days. Further assume that the importing bank‘s acceptance commission is 1.25 percent and that the market rate for 90-day B/As is 7 percent. Determine the amount the exporter will receive if he holds the B/A until maturity and also the amount the exporter will receive if he discounts the B/A with the importer‘s bank.

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Solution: The exporter will receive $1,993,750 = $2,000,000 x [1 - (.0125 x 90/360)] if he holds the B/A to maturity.

The acceptance commission is $6,250.

The exporter will receive

$1,958,750 = $2,000,000 x [1 - ((.0700 + .0125) x 90/360)] if he discounts the B/A with the importer‘s bank.

2. The time from acceptance to maturity on a $1,000,000 banker‘s acceptance is 120 days.

The importer‘s bank‘s acceptance commission is 1.75 percent and the market rate for 120-day B/As is 5.75 percent. What amount will the exporter receive if he holds the B/A until maturity? If he discounts the B/A with the importer‘s bank? Also determine the bond equivalent yield the importer‘s bank will earn from discounting the B/A with the exporter.

If the exporter‘s

opportunity cost of capital is 11 percent, should he discount the B/A or hold it to maturity?

Solution:

If the exporter holds the B/A until maturity, he will receive $994,166.67 =

$1,000,000 x [1 - (.0175 x 120/360)]. Thus, the acceptance commission is $5,833.33.

If the exporter discounts the B/A he will receive $975,000 = $1,000,000 x [1 - ((.0575 + .0175) x 120/360)].

The importer‘s bank receives a discount rate of interest of 7.5 percent (= 5.75 + 1.75 percent) on its investment. At maturity it will receive $1,000,000 from the importer. The bond equivalent yield the importer‘s bank earns on its investment is 7.8 percent, or .078 = ($1,000,000/$975,000 - 1) x 365/120.

The exporter pays the acceptance commission regardless of whether he discounts the B/A or holds it to maturity. The bond equivalent rate the exporter receives from discounting the B/A is 5.98 percent, or .0598 = ($994,166.67/$975,000 - 1) x 365/120.

Since the exporter‘s

opportunity cost of capital is 11 percent, which is greater than 5.98 percent compounded triannually (an effective annual rate of 6.10 percent), he should discount the B/A.

MINI CASE: AMERICAN MACHINE TOOLS, INC.

American Machine Tools is a mid-western manufacturer of tool-and-die-making equipment.

The company has had an inquiry from a representative of the Estonian government about the terms of sale for a $5,000,000 order of machinery. The sales manager spoke with the Estonian representative, but he is doubtful that the Estonian government will be able to obtain enough hard currency to make the purchase. While the U.S. economy has been growing, American

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Machine Tools has not had a very good year. An additional $5,000,000 in sales would definitely help. If something cannot be arranged, the firm will likely be forced to lay off some of its skilled workforce.

Is there a way that you can think of that American Machine Tools might be able to make the machinery sale to Estonia?

Suggested Solution to American Tools, Inc.

American Machine Tools needs a manager in charge of countertrade. This manage would be skilled in negotiating trades for his firm‘s machine tools. Since the U.S. economy is fairly strong, there are two types of countertrades that might work with the Estonian government and help American Machine Tools consummate the sale: a buy-back transaction or a countertrade.

In a buy-back transaction, the Estonian government would issue debt denominated in a hard currency to obtain the funds to purchase the equipment from American Machine Tools. It should be able to obtain hard currency debt financing if it is likely that it can service the debt.

American Machine Tools, in turn, would agree to buy in dollars from the Estonian tool and die manufacturer enough of the output produced on the machinery to enable it to meet the debt service obligations. A countertrade works similarly, except that American Machine Tools would agree to purchase enough other goods produced in Estonia to enable the hard currency debt service obligations to be met. Either of these two types of countertrade would work if American Machine Tools has the sales ability to market the Estonia output in the U.S., or elsewhere.

CHAPTER 21 INTERNATIONAL TAX ENVIRONMENT AND TRANSFER PRICING ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

QUESTIONS

1. Discuss the twin objectives of taxation. Be sure to define the key words.

Answer: There are two basic objectives of taxation that are necessary to discuss to help frame our thinking about the international tax environment: tax neutrality and tax equity.

Tax neutrality has its foundations in the principles of economic efficiency and equality. Tax neutrality is determined by three criteria.

Capital-export neutrality is the criterion that an ideal

tax should be effective in raising revenue for the government and not have any negative effects on the economic decision making process of the taxpayer. That is, a good tax is one that is

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efficient in raising tax revenue for the government and does not prevent economic resources from being allocated to their most appropriate use no matter where in the world the highest rate of return can be earned. A second neutrality criterion is national neutrality. That is, regardless of where in the world taxable income is earned it is taxed in the same manner by the taxpayer‘s national tax authority. In theory, national tax neutrality is a commendable objective, as it is based on the principle of equality. The third neutrality criterion is capital-import neutrality. This criterion implies that the tax burden placed on the foreign subsidiary of a MNC by the host country should be the same regardless in which country the MNC is incorporated and the same as that placed on domestic firms.

Tax equity is the principle that all similarly situated taxpayers should participate in the cost of operating the government according to the same rules. This means that regardless in which country an affiliate of a MNC earns taxable income, the same tax rate and tax due date apply.

2. Compare and contrast the three basic types of taxation that governments levy within their tax jurisdiction.

Answer: There are three basic types of taxation that national governments throughout the world use in generating tax revenue:

income tax, withholding tax, and value-added tax.

Many

countries in the world obtain a significant portion of their tax revenue from imposing an income tax on personal and corporate income. An income tax is a direct tax, that is, one that is paid directly by the taxpayer on whom it is levied. The tax is levied on active income, that is, income that results from production by the firm or individual or from services that have been provided.

A withholding tax is a tax levied on passive income earned by an individual or corporation of one country within the tax jurisdiction of another country. Passive income includes dividends and interest income, and income from royalties, patents or copyrights paid to the taxpayer.

A

withholding tax is an indirect tax, that is, a tax borne by a taxpayer that did not directly generate the income that serves as the source of the passive income.

The tax is withheld from

payments the corporation makes to the taxpayer and turned over to the local tax authority. A value-added tax (VAT) is an indirect national tax charged on the sales price of a service or consumption good as it moves through the various stages of production and/or service. As such, a VAT is a sales tax borne by the final consumer.

3.

Discuss how double taxation on a taxpayer may result if all countries were to tax the

worldwide income of their residents and the income earned within their territorial boundaries.

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Answer: There are two fundamental types of tax jurisdiction: the worldwide and the territorial.

The worldwide method of declaring a national tax jurisdiction is to tax national residents of the country on their worldwide income no matter in which country it is earned.

The territorial

method of declaring a tax jurisdiction is to tax all income earned within the country by any taxpayer, domestic or foreign. Hence, regardless of the nationality of a taxpayer, if the income is earned within the territorial boundary of a country it is taxed by that country.

If a MNC was a resident of a country that taxed worldwide income, the foreign-source income of its foreign affiliates would be taxed in the parent country. If the host country also taxes the income of the affiliate earned within its territorial borders, the foreign affiliate would pay taxes on the same income both in the host country and in the parent country. To avoid this ―evil,‖ some mechanism needs to be established to prevent double taxation.

4. What methods do taxing authorities use to eliminate or mitigate the evil of double taxation?

Answer: The typical approach to avoiding double taxation is for a nation not to tax foreign-source income of its national residents. An alternative method, and the one the U.S. follows on certain types of foreign-source income, is to grant to the parent firm foreign tax credits against U.S. taxes for taxes paid to foreign tax authorities.

5. How might a MNC use transfer pricing strategies? How do import duties affect transfer pricing policies?

Answer: A MNC might use transfer pricing strategies for two basic purposes: income tax liability reduction or funds repositioning. If the tax rate in the country of the selling affiliate is less than the tax rate in the buying affiliate country, a high markup policy on sales will leave little taxable income in the buying affiliate country to be taxed at the higher rate. Even if the tax rate in the buying affiliate country is not more than that in the selling affiliate country, a high markup policy will leave less funds to be removed from the buying affiliate country. In general, import duties work in the opposite direction from income taxes. For example, a high markup policy will decrease the income taxes due in the buying affiliate country, but increase the import duty due in that country. Generally, the income tax is more important in comparison to the import duty in its after-tax effect on consolidated net income.

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6. What are the various means the taxing authority of a country might use to determine if a transfer price is reasonable?

Answer: The U.S. and many other countries require the transfer price to be consistent with arm‘s length pricing, i.e., be a price that an unrelated party would pay for the same good or service. The taxing authority can arbitrarily set the transfer price if it believes that transfer pricing schemes are being used to evade taxes or that taxable income is not being clearly reflected. There are three general methods to establish arm‘s length pricing. One method is to use a comparable uncontrolled price at which the good or service would be priced between unrelated parties. A second method is the resale price approach; that is, reduce the price at which the good is resold by an amount sufficient to cover overhead costs and a reasonable profit for the selling affiliate. The third method is the cost-plus approach, where an appropriate profit is added to the cost of the manufacturing affiliate.

7. Discuss how a MNC might attempt to repatriate blocked funds from a host country.

Answer: There are several methods a parent firm might use to repatriate profits from an affiliate in a host country that is blocking funds. Some of these measures should be enacted early on as a guard against future funds blockage. One is to establish a regular dividend policy that the host country becomes used to and expects. This assumes, however, the host country will let a reasonable amount of funds be repatriated. If this is not the case, the parent firm might attempt to use a high markup policy transfer pricing scheme. Since host countries are aware of transfer pricing strategies, a large change in the transfer price is likely not to go unquestioned by the host country. Thus, the parent firm should establish early on recognition of, and payment for, specific services that are being provided by the affiliate in addition to payment at an arm‘s length price for the physical goods. For example, the parent firm might charge for a share of worldwide advertising, technical training of employees of the affiliate, appropriate overhead charges, or a royalty or licensing fee for use of well-recognized brand names, technology, or patents. The host country might accept these charges as reasonable, whereas a large transfer price that incorporates all charges into a single price might be questioned as unreasonably large.

Additionally, the parent firm can create exports, by having the affiliate charged in the blocked currency for goods and services for which the parent would typically pay, or through direct negotiation appeal to the host country for more reasonable treatment, if it is in an important industry to the host country.

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PROBLEMS

1.

There are three production stages required before a pair of skis produced by Fjord

Fabrication can be sold at retail for NOK2,300. Fill in the following table to show the value added at each stage in the production process and the incremental and total VAT.

The

Norwegian VAT rate is 25 percent. _______________________________________________________________________ Production Selling Value Incremental Stage Price Added VAT _______________________________________________________________________ 1

NOK 450

2

NOK1,900

3

NOK2,300

Total VAT _______________________________________________________________________

Solution:

Production Selling Value Incremental Stage Price Added VAT _______________________________________________________________________ 1

NOK 450

NOK 450

NOK112.50

2

NOK1,900

NOK1,450

NOK362.50

3

NOK2,300

NOK 400

NOK100.00

Total VAT NOK575.00 _______________________________________________________________________

2. The Docket Company of Asheville, NC USA is considering establishing an affiliate operation in the city of Wellington, on the south island of New Zealand.

It is undecided whether to

establish the affiliate as a branch operation or a wholly-owned subsidiary. New Zealand taxes income of both resident corporations and branch operations at a flat rate of 28 percent. New Zealand withholds taxes at 5 percent on dividends for an investor who holds at least 10

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percent of the shares in the subsidiary company that pays the dividend; 0 percent if the investor holds 80 percent or more of the shares in the subsidiary company and meets other criteria; 15 percent in all other cases.

New Zealand does not withhold taxes on the

repatriation of branch profits. The United States has an income tax rate of 21 percent, but for certain types of income a foreign tax credit is allowed for taxes paid to another country. Based on this information, is a branch or subsidiary the recommended form for the affiliate?

Solution: If Docket establishes a branch operation in New Zealand, it will pay a total of 28 percent on its New Zealand source income. It will pay 28 percent in New Zealand and 0 percent in the United Sates after a receiving a tax credit for the New Zealand taxes. If Docket sets up its New Zealand affiliate as a subsidiary, the subsidiary will pay taxes at 28 percent on New Zealand taxable income, but since the parent firm has 100 percent ownership, there will not be any taxes withhold on dividends paid to the parent. Total taxes credits will be [.28 + 0 – (.28 x 0)] = .28 or 28 percent in the United States. (See Example 21.2 for an explanation of this formula.) No additional taxes will need to be paid in the United Sates after receiving a tax credit for the New Zealand taxes. Consequently, in this case it does not matter whether the Docket Company establishes a branch operation or a wholly owned subsidiary under current tax law in New Zealand.

3. Affiliate X sells 10,000 units to Affiliate Y per year. The marginal tax rates for X and Y are 20 percent and 30 percent, respectively. The transfer price per unit is currently set at $1,000, but it can be set as high as $1,250. Calculate the increase in annual after-tax profits if the higher transfer price of $1,250 per unit is used.

Solution: Total tax savings = 10,000 x ($1,000 - $1,250) x (0.20 - 0.30) = $250,000.

4. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A is 25 percent and the marginal income tax rate for Affiliate B is 40 percent. The transfer price per unit is currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive a formula to determine how much annual after-tax profits can be increased by selecting the optimal transfer price.

Note To Instructor: The solution to this problem is consistent with the example presented in the text as Exhibit 21.6.

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Solution: Let A and B be the marginal income tax rate for Affiliate A and B. Further let Q denote quantity, and let P be the current transfer price per unit and P* be the optimal transfer price per unit. The increase in annual after-tax profit (or the tax savings) can be stated as Q(P P*)(A - B). For each unit there is a tax savings of (A - B) on (P - P*). Using the above numbers, there is a tax savings of (.25 - .40) = .15 for each additional dollar of cost transferred from the low tax affiliate to the high tax affiliate. Thus, at the maximum there can be a $60 = ($2,000 - 2,400)(.25 - .40) tax savings per unit from raising the transfer price from $2,000 to $2,400. In total, the tax savings is 5,000 units x $60 = $300,000.

5. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A is 25 percent and the marginal income tax rate for Affiliate B is 40 percent. Additionally, Affiliate B pays a tax-deductible tariff of 5 percent on imported merchandise. The transfer price per unit is currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive (a) a formula to determine the effective marginal tax rate for Affiliate B and, (b) a formula to determine how much annual after-tax profits can be increased by selecting the optimal transfer price.

Solution: The solution to this problem is consistent with the example presented in the text as Exhibit 21.7.This problem extends the work in problem 4, above. When the ad-valorem import tariff is tax deductible, the effective marginal tax rate paid by Affiliate B is: (1 + Tariff)B - Tariff = (1 + .05)(.40) - .05 = .37. Hence, for each additional dollar of cost transferred from the low tax affiliate to the high tax affiliate there is an after-tax savings of: (P P*)[A + Tariff - (1 + Tariff) B]. In total, the tax savings is: Q(P - P*)[A + Tariff - (1 + Tariff) B] = 5,000 x ($2,000 - 2,400)(.25 - .37) = 5,000 x $48 = $240,000.

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MINI CASE: SIGMA CORP.‘S LOCATION DECISION

Sigma Corporation of Boston is contemplating establishing a wholly owned subsidiary operation in the Mediterranean. Two countries under consideration are Spain and Cyprus.

Sigma intends to repatriate all after-tax foreign-source income to the United States. In the U.S., corporate income is taxed at 21 percent. In Cyprus, the marginal corporate tax rate is 12.5 percent. In Spain, corporate income is taxed at 25 percent. Cyprus does not withhold tax on dividend income paid to the United States. However, the withholding tax treaty rate Spain has with the U.S. on dividend income paid is 10 percent.

The financial manager of Sigma has asked you to help him determine where to locate the new subsidiary. The location decision of Cyprus or Spain will be based on which country has the smallest total tax liability.

Suggested Solution for Sigma Corp.‘s Location Decision

The total (income and withholding) tax liability in Cyprus will be: [.125 + 0 - (.10 x 0)] = .125 or 12.5 percent. Additional taxes in the U.S. would be due, bringing the total tax liability up to the U.S. income tax rate of 21 percent. The total (income and withholding) tax liability in Spain will be: [.25 + .10 - (.25 x .10)] = .325, or 32.5 percent. Since this is greater than the U.S. income tax rate of 21 percent, no additional taxes would be due in the U.S. If there are excess foreign tax credits (equal to 11.5 percent of foreign-source taxable income) that can all be used by carrying them back one year and forward ten years, then the total tax liability will equal the U.S. income tax rate of 21 percent. If excess foreign tax credits cannot all be used, as is more typically the case, the total tax liability can be as high as 32.5 percent. Consequently, Sigma Corporation should establish its wholly-owned subsidiary in Cyprus.

MINI CASE: EASTERN TRADING COMPANY‘S OPTIMAL TRANSFER PRICING STRATEGY

The Eastern Trading Company of Singapore ships prepackaged spices to Hong Kong, the United Kingdom, and the United States, where they are resold by sales affiliates. Eastern Trading is concerned with what might happen in Hong Kong now that control has been turned over to China. Eastern Trading has decided that it should reexamine its transfer pricing policy with its Hong Kong affiliate as a means of repositioning funds from Hong Kong to Singapore.

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The following table shows the present transfer pricing scheme, based on a carton of assorted, prepackaged spices, which is the typical shipment to the Hong Kong sales affiliate. What do you recommend that Eastern Trading should do?

Eastern Trading Company Current Transfer Pricing Policy with Hong Kong Sales Affiliate Singapore Parent

Hong Kong Affiliate

S$300

S$500

S$500

Cost of goods sold

200

300

200

Gross profit

100

200

300

Operating expenses

50

50

100

Taxable income

50

150

200

Income taxes (20%/17.5%)

10

26

36

Net income

40

124

164

Sales revenue

Suggested Solution to Mini Case 2:

Consolidated Company

Eastern Trading Company‘s Optimal Transfer Pricing

Strategy

Eastern Trading is currently in a good situation. Because the income tax rate in Hong Kong is less than in Singapore, Eastern Trading‘s present low markup transfer price strategy results in larger pre-tax income in Hong Kong, which is taxed at only a 17.5% rate versus the 20% rate on taxable income in Singapore. If Eastern Trading is free to repatriate profits from Hong Kong, it defers paying the additional tax due (20% - 17.5% = 2.5%) in Singapore until the profits are actually repatriated. Nevertheless, the marginal tax rate on Hong Kong taxable income will eventually be 20% upon repatriation. Therefore, since Eastern Trading is concerned about repatriation under Chinese control of Hong Kong, it might attempt to increase its transfer price.

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If Eastern Trading is successful in increasing the transfer price, more of the taxable income per unit will be taxed at the current time in Singapore at 20%. A 25% increase in the transfer price would raise it from S$300 to S$375 per unit. At S$375, the split would be as follows:

Eastern Trading Company Current Transfer Pricing Policy with Hong Kong Sales Affiliate Singapore Parent

Hong Kong Affiliate

Consolidated Company

S$375

S$500

S$500

Cost of goods sold

200

375

200

Gross profit

175

125

300

Operating expenses

50

50

100

Taxable income

125

75

200

Income taxes (20%/17.5%)

25

13

38

Net income

100

62

162

Sales revenue

The higher transfer price would result in only S$64 left to be repatriated from Hong Kong instead of S$124.

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