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1: Chapter Managing Finance in Foreign Subsidiaries: An Overview 3 Answers to End of Chapter Questions 1. Motives of an MNC. Describe constraints that interfere with an MNCs objective. ANSWER: The constraints faced by financial managers attempting to maximize shareholder wealth are: a. Environmental constraintscountries impose environmental regulations such as building codes and pollution controls, which increase costs of production. b. Regulatory constraintshost governments can impose taxes, restrictions on earnings remittances, and restrictions on currency convertibility, which may reduce cash flows to be received by the parent. c. Ethical constraintsU. S.-based MNCs may be at a competitive disadvantage if they follow a worldwide code of ethics, because other firms may use tactics that are allowed in some foreign countries but considered illegal by U. S. standards. 2. International Opportunities. a. How does access to international opportunities affect the size of corporations? ANSWER: Additional opportunities will often cause a firm to grow more than if it did not have access to such opportunities. Thus, a firm that considers international opportunities has greater potential for growth. b. Describe a scenario in which the size of a corporation is not affected by access to international opportunities. ANSWER: Some firms may avoid opportunities because they lack knowledge about foreign markets or expect that the risks are excessive. Thus, the size of these firms is not affected by the opportunities. c. Explain why MNCs such as Coca Cola and PepsiCo, Inc., still have numerous opportunities for international expansion. ANSWER: Coca Cola and PepsiCo still have new international opportunities because countries are at various stages of development. Some countries have just recently opened their borders to MNCs. Many of these countries do not offer sufficient food or drink products to their consumers. 3. Impact of the Euro on U.S. Subsidiaries. McCanna Corp. has a French subsidiary that produces wine and exports to various European countries. Explain how the subsidiarys business may have been affected since the conversion of many European currencies into a single European currency (the euro) in 1999. ANSWER: The subsidiary and its customers based in countries that now use the euro as their currency would no longer be exposed to exchange rate risk. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 4 4. Agency Problems of MNCs. Explain the agency problem of MNCs. International Corporate Finance ANSWER: The agency problem reflects a conflict of interests between decision-making managers and the owners of the MNC. Agency costs occur in an effort to assure that managers act in the best interest of the owners. b. Why might agency costs be larger for an MNC than for a purely domestic firm? ANSWER: The agency costs are normally larger for MNCs than purely domestic firms for the following reasons. First, MNCs incur larger agency costs in monitoring managers of distant foreign subsidiaries. Second, foreign subsidiary managers raised in different cultures may not follow uniform goals. Third, the sheer size of the larger MNCs would also create large agency problems. 5. International Business Methods. Snyder Golf Co., a U.S. firm that sells high-quality golf clubs in the U.S., wants to expand internationally by selling the same golf clubs in Brazil. a. Describe the tradeoffs that are involved for each method (such as exporting, direct foreign investment, etc.) that Snyder could use to achieve its goal. ANSWER: Snyder can export the clubs, but the transportation expenses may be high. If could establish a subsidiary in Brazil to produce and sell the clubs, but this may require a large investment of funds. It could use licensing, in which it specifies to a Brazilian firm how to produce the clubs. In this way, it does not have to establish its own subsidiary there. b. Which method would you recommend for this firm? Justify your recommendation. ANSWER: If the amount of golf clubs to be sold in Brazil is small, it may decide to export. However, if the expected sales level is high, it may benefit from licensing. If it is confident that the expected sales level will remain high, it may be willing to establish a subsidiary. The wages are lower in Brazil, and the large investment needed to establish a subsidiary may be worthwhile. 6. Impact of Eastern European Growth. The managers of Loyola Corp. recently had a meeting to discuss new opportunities in Europe as a result of the recent integration among Eastern European countries. They decided not to penetrate new markets because of their present focus on expanding market share in the United States. Loyolas financial managers have developed forecasts for earnings based on the 12 percent market share (defined here as its percentage of total European sales) that Loyola currently has in Eastern Europe. Is 12 percent an appropriate estimate for next years Eastern European market share? If not, does it likely overestimate or underestimate the actual Eastern European market share next year? ANSWER: It would likely overestimate its market share because the competition should increase as competitors penetrate the European countries. 7. Discussion in the Boardroom. This exercise is provided in Appendix E in the back of the text. It may be used as a project assignment that is to be completed by the end of the semester. Possible answers to the discussion questions are provided at the end of this Instructors Manual (after Chapter 21). If you use this appendix for in-class discussion on a weekly basis, you may benefit This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 1: Managing Finance in Foreign Subsidiaries: An Overview 5 from making a copy of the discussion questions and possible answers provided at the end of the Instructors Manual so that you have easy access to this exercise each week in class. 8. Comparative Advantage. a. Explain how the theory of comparative advantage relates to the need for international business. ANSWER: The theory of comparative advantage implies that countries should specialize in production, thereby relying on other countries for some products. Consequently, there is a need for international business. b. Explain how the product cycle theory relates to the growth of an MNC. ANSWER: The product cycle theory suggests that at some point in time, the firm will attempt to capitalize on its perceived advantages in markets other than where it was initially established. 9. Impact of Political Risk. Explain why political risk may discourage international business. ANSWER: Political risk increases the rate of return required to invest in foreign projects. Some foreign projects would have been feasible if there was no political risk, but will not be feasible because of political risk. 10. Valuation of Wal-Marts International Business. In addition to all of its stores in the U.S., WalMart has 11 stores in Argentina, 24 stores in Brazil, 214 stores in Canada, 29 stores in China, 92 stores in Germany, 15 stores in South Korea, 611 stores in Mexico, and 261 stores in the U.K. Consider the value of Wal-Mart as being composed of two parts, a U.S. part (due to business in the U.S.) and a non-U.S. part (due to business in other countries). Explain how to determine the present value (in dollars) of the non-U.S. part assuming that you had access to all the details of Wal-Mart businesses outside the U.S. ANSWER: The non-U.S. part can be measured as the present value of future dollar cash flows resulting from the non-U.S. businesses. Based on recent earnings data for each store and applying an expected growth rate, you can estimate the remitted earnings that will come from each country in each year in the future. You can convert those cash flows to dollars using a forecasted exchange rate per year. Determine the present value of cash flows of all stores within one country. Then repeat the process for other countries. Then add up all the present values that you estimated to derive a consolidated present value of all non-U.S. subsidiaries. 11. Valuation of an MNC. Birm Co., based in Alabama, considers several international opportunities in Europe that could affect the value of its firm. The valuation of its firm is dependent on four factors: (1) expected cash flows in dollars, (2) expected cash flows in euros that are ultimately converted into dollars, (3) the rate at which it can convert euros to dollars, and (4) Birms weighted average cost of capital. For each opportunity, identify the factors that would be affected. a. Birm plans a licensing deal in which it will sell technology to a firm in Germany for $3,000,000; the payment is invoiced in dollars, and this project has the same risk level as its existing businesses. b. Birm plans to acquire a large firm in Portugal that is riskier than its existing businesses. c. Birm plans to discontinue its relationship with a U.S. supplier so that can import a small amount of supplies (denominated in euros) at a lower cost from a Belgian supplier. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 6 International Corporate Finance d. Birm plans to export a small amount of materials to Ireland that are denominated in euros. ANSWER: Opportunity Dollar CF Euro CF Exchange rate at which Birm Co. converts euros to dollars Birminghams weighted average cost of capital a. joint venture b. acquisition c. imported supplies d. exports to Ireland X X X X X 12. Centralization and Agency Costs. Would the agency problem be more pronounced for Berkley Corp., which has its parent company make most major decisions for its foreign subsidiaries, or Oakland Corp., which uses a decentralized approach? ANSWER: The agency problem would be more pronounced for Oakland because of a higher probability that subsidiary decisions would conflict with the parent. Assuming that the parent attempts to maximize shareholder wealth, decisions by the parent should be compatible with shareholder objectives. If the subsidiaries made their own decisions, the agency costs would be higher since the parent would need to monitor the subsidiaries to assure that their decisions were intended to maximize shareholder wealth. 13. International Opportunities Due to the Internet. a. What factors cause some firms to become more internationalized than others? ANSWER: The operating characteristics of the firm (what it produces or sells) and the risk perception of international business will influence the degree to which a firm becomes internationalized. Several other factors such as access to capital could also be relevant here. Firms that are labor-intensive could more easily capitalize on low-wage countries while firms that rely on technological advances could not. b. Offer your opinion on why the Internet may result in more international business. ANSWER: The Internet allows for easy and low-cost communication between countries, so that firms could now develop contacts with potential customers overseas by having a website. Many firms use their website to identify the products that they sell, along with the prices for each product. This allows them to easily advertise their products to potential importers anywhere in the world without mailing brochures to various countries. In addition, they can add to their product line and change prices by simply revising their website, so importers are kept abreast of the exporters product information by monitoring the exporters website periodically. Firms can also use their websites to accept orders online. Some firms with an international reputation use their brand name to advertise products over the internet. They may use manufacturers in some foreign countries to produce some of their products subject to their specification This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 1: Managing Finance in Foreign Subsidiaries: An Overview 14. Imperfect Markets. 7 a. Explain how the existence of imperfect markets has led to the establishment of subsidiaries in foreign markets. ANSWER: Because of imperfect markets, resources cannot be easily and freely retrieved by the MNC. Consequently, the MNC must sometimes go to the resources rather than retrieve resources (such as land, labor, etc.). b. If perfect markets existed, would wages, prices, and interest rates among countries be more similar or less similar than under conditions of imperfect markets? Why? ANSWER: If perfect markets existed, resources would be more mobile and could therefore be transferred to those countries more willing to pay a high price for them. As this occurred, shortages of resources in any particular country would be alleviated and the costs of such resources would be similar across countries. 15. International Joint Venture. Anheuser-Busch, the producer of Budweiser and other beers, has recently expanded into Japan by engaging in a joint venture with Kirin Brewery, the largest brewery in Japan. The joint venture enables Anheuser-Busch to have its beer distributed through Kirins distribution channels in Japan. In addition, it can utilize Kirins facilities to produce beer that will be sold locally. In return, Anheuser-Busch provides information about the American beer market to Kirin. a. Explain how the joint venture can enable Anheuser-Busch to achieve its objective of maximizing shareholder wealth. ANSWER: The joint venture creates a way for Anheuser-Busch to distribute Budweiser throughout Japan. It enables Anheuser-Busch to penetrate the Japanese market without requiring a substantial investment in Japan. b. Explain how the joint venture can limit the risk of the international business. ANSWER: The joint venture has limited risk because Anheuser-Busch does not need to establish its own distribution network in Japan. Thus, Anheuser-Busch may be able to use a smaller investment for the international business, and there is a higher probability that the international business will be successful. c. Many international joint ventures are intended to circumvent barriers that normally prevent foreign competition. What barrier in Japan is Anheuser-Busch circumventing as a result of the joint venture? What barrier in the United States is Kirin circumventing as a result of the joint venture? ANSWER: Anheuser-Busch is able to benefit from Kirins distribution system in Japan, which would not normally be so accessible. Kirin is able to learn more about how Anheuser-Busch expanded its product across numerous countries, and therefore breaks through an information barrier. d. Explain how Anheuser-Busch could lose some of its market share in countries outside Japan as a result of this particular joint venture. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 8 International Corporate Finance ANSWER: Anheuser-Busch could lose some of its market share to Kirin as a result of explaining its worldwide expansion strategies to Kirin. However, it appears that Anheuser-Busch expects the potential benefits of the joint venture to outweigh any potential adverse effects. 16. Internet Application. Assessing Direct Foreign Investment Trends. The website address of the Bureau of Economic Analysis is http://www.bea.doc.gov. Answers will vary. 17. Macro versus Micro Topics. Review the table of contents and indicate whether each of the chapters from Chapter 2 through Chapter 21 has a macro or micro perspective. ANSWER: Chapters 2 through 8 are macro, while Chapters 9 through 21 are micro. 18. Impact of International Business on Cash Flows and Risk. Nantucket Travel Agency specializes in tours for American tourists. Until recently, all of its business was in the U.S. It just established a subsidiary in Athens, Greece, which provides tour services in the Greek islands for American tourists. It rented a shop near the port of Athens. It also hired residents of Athens, who could speak English and provide tours of the Greek islands. The subsidiarys main costs are rent and salaries for its employees and the lease of a few large boats in Athens that it uses for tours. American tourists pay for the entire tour in dollars at Nantuckets main U.S. office before they depart for Greece. a. Explain why Nantucket may be able to effectively capitalize on international opportunities such as the Greek island tours. ANSWER: It already has established credibility with American tourists, but could penetrate a new market with some of the same customers that it has served on tours in the U.S. b. Nantucket is privately-owned by owners who reside in the U.S. and work in the main office. Explain possible agency problems associated with the creation of a subsidiary in Athens, Greece. How can Nantucket attempt to reduce these agency costs? ANSWER: The employees of the subsidiary in Athens are not owners, and may have no incentive to manage in a manner that maximizes the wealth of the owners. Thus, they may manage the tours inefficiently. Nantucket could attempt to allow the employees a portion of the ownership of the company so that they benefit more directly from good performance. Alternatively, Nantucket may consider having one of its owners transfer to Athens to oversee the subsidiarys operations. c. Greeces cost of labor and rent are relatively low. Explain why this information is relevant to Nantuckets decision to establish a tour business in Greece. ANSWER: The low cost of rent and labor will be beneficial to Nantucket, because it enables Nantucket to create the subsidiary at a low cost. d. Explain how the cash flow situation of the Greek tour business exposes Nantucket to exchange rate risk. Is Nantucket favorably or unfavorably affected when the euro (Greeces currency) appreciates against the dollar? Explain. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 1: Managing Finance in Foreign Subsidiaries: An Overview 9 ANSWER: Nantuckets tour business in Greece results in dollar cash inflows and euro cash outflows. It will be adversely affected by the appreciation of the euro because it will require more dollars to cover the costs in Athens if the euros value rises. e. Nantucket plans to finance its Greek tour business. Its subsidiary could obtain loans in euros from a bank in Greece to cover its rent, and its main office could pay off the loans over time. Alternatively, its main office could borrow dollars and would periodically convert dollars to euros to pay the expenses in Greece. Does either type of loan reduce the exposure of Nantucket to exchange rate risk? Explain. ANSWER: No. The euro loans would be used to cover euro expenses, but Nantucket would need dollars to pay off the loans. Alternatively, the U.S. dollar loans would still require conversion of dollars to euros. With either type of loan, Nantucket is still adversely affected by the appreciation of the euro against the dollar. f. Explain how the Greek island tour business could expose Nantucket to country risk. ANSWER: The subsidiary could be subject to government restrictions or taxes in Greece that would place it at a disadvantage relative to other Greek tour companies based in Athens. 19. Benefits and Risks of International Business. As an overall review of this chapter, identify possible reasons for growth in international business. Then, list the various disadvantages that may discourage international business. ANSWER: Growth in international business can be stimulated by (1) access to foreign resources which can reduce costs, or (2) access to foreign markets which boost revenues. Yet, international business is subject to risks of exchange rate fluctuations, foreign exchange restrictions, a host government takeover, tax regulations, etc. 20. Methods Used to Conduct International Business. Duve, Inc., desires to penetrate a foreign market with either a licensing agreement with a foreign firm or by acquiring a foreign firm. Explain the differences in potential risk and return between a licensing agreement with a foreign firm, and the acquisition of a foreign firm. Register to View Answerlicensing agreement has limited potential for return, because the foreign firm will receive much of the benefits as a result of the licensing agreement. Yet, the MNC has limited risk, because it did not need to invest substantial funds in the foreign country. An acquisition by the MNC requires a substantial investment. If this investment is not a success, the MNC may have trouble selling the firm it acquired for a reasonable price. Thus, there is more risk. However, if this investment is successful, all of the benefits accrue to the MNC. 21. Impact of the Euro. Explain how the adoption of the euro as the single currency by European countries could be beneficial to MNCs based in Europe and to MNCs based in the U.S. ANSWER: There is now no exchange rate risk between the countries participating in the euro. This makes it easier to compare prices across countries and to compete for MNCs based in Europe. The advantages are the same for MNCs based in the U.S. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 10 International Corporate Finance 22. Impact of September 11. Following the terrorist attack on the U.S., the valuations of many MNCs declined by more than 10 percent. Explain why the expected cash flows of MNCs were reduced, even if they were not directly hit by the terrorist attacks. ANSWER: An MNCs cash flows could be reduced in the following ways. First, a decline in travel would affect any MNCs that have business in travel-related industries. The airline, hotel, and tourist-related industries were expected to experience a decline in business. Layoffs were announced immediately by many of these MNCs. Second, these effects on travel-related industries can carry over to other industries, and weaken economies. Third, the cost of international trade increased as a result of tighter restrictions on some products. Fourth, some MNCs incurred expenses as a result of increasing security to protect their employees. 23. Assessing Motives for International Business. Fort Worth Inc. specializes in manufacturing some basic parts for sports utility vehicles that are produced and sold in the U.S. Its main advantage in the U.S. is that its production is efficient, and less costly than that of some other unionized manufacturers. It has a substantial market share in the U.S. Its manufacturing process is labor-intensive. It pays relatively low wages compared to U.S. competitors, but has guaranteed the local workers that their job positions will not be eliminated for the next 30 years. It hired a consultant to determine whether it should set up a subsidiary in Mexico, where the parts would be produced. The consultant suggested that Forth Worth should expand for the following reasons. Offer your opinion on whether the consultants reasons are logical: a. Theory of Competitive Advantage: There are not many SUVs sold in Mexico, so Fort Worth Inc. would not have to face much competition there. b. Imperfect Markets Theory: Fort Worth Inc. can not easily transfer workers to Mexico, but it can establish a subsidiary there in order to penetrate a new market. c. Product Cycle Theory: Fort Worth Inc. has been successful in the U.S. It has limited growth opportunities because it already controls much of the U.S. market for the parts it produces. Thus, the natural next step is to conduct the same business in a foreign country. d. Exchange Rate Risk. The exchange rate of the peso has weakened recently, so this would allow Fort Worth Inc. to build a plant at a very low cost (by exchanging dollars for the cheap pesos to build the plant). e. Political Risk. The political conditions in Mexico have stabilized in the last few months, so Fort Worth should attempt to penetrate the Mexican market now. ANSWER: None of the arguments by the consultant are logical. If SUVs are not sold in the Mexican market, there is no need for these parts in Mexico. Fort Worth Inc. should only attempt to penetrate a new market if there is demand. Just because it has limited growth potential in the U.S., this does not mean that there will be demand for its product in Mexico. Even if the exchange rate is low relative to recent periods, it could decline further, which would adversely affect any the dollar amount of future remitted earnings. Stable political conditions in Mexico are not a sufficient reason to pursue direct foreign investment there. 24. Global Competition. Explain why more standardized product specifications across countries can increase global competition. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 1: Managing Finance in Foreign Subsidiaries: An Overview 11 ANSWER: Standardized product specifications allow firms to more easily expand their business across other countries, which increases global competition. Solution to Continuing Case Problem: Blades, Inc. 1. What are the advantages Blades could gain from importing from and/or exporting to a foreign country such as Thailand? ANSWER: The advantages Blades, Inc. could gain from importing from Thailand include potentially lowering Blades cost of goods sold. If the inputs (rubber and plastic) are cheaper when imported from a foreign country such as Thailand, this would increase Blades net income. Since numerous competitors of Blades are already importing components from Thailand, importing would increase Blades competitiveness in the U.S., especially since its prices are among the highest in the roller blade industry. Furthermore, since Blades is considering longer range plans in Thailand, importing from and exporting to Thailand may present it with an opportunity to establish initial relationships with some Thai suppliers. As far as exporting is concerned, Blades, Inc. could be one of the first firms to sell roller blades in Thailand. Considering that Blades is contemplating to eventually shift its sales to Thailand, this could be a major competitive advantage. 2. What are some of the disadvantages Blades could face as a result of foreign trade in the short run? In the long run? ANSWER: There are several potential disadvantages Blades, Inc. should consider. First of all, Blades would be exposed to currency fluctuations in the Thai baht. For example, the dollar cost of imported inputs may become more expensive over time if the baht appreciates even if Thai suppliers do not adjust their prices. However, Blades sales in Thailand would also increase in dollar terms if the baht appreciates, even if Blades does not increase its prices. Blades, Inc. would also be exposed to the economic conditions in Thailand. For example, if there is a recession, Blades would suffer from decreased sales to Thailand. In the long run, Blades should be aware of any regulatory and environmental constraints the Thai government may impose on it (such as pollution controls). Furthermore, the company should be aware of the political risk involved in operating in Thailand. For example, the likelihood of expropriation by the Thai government should be assessed. Another important issue involved in Blades long-run plans is how the foreign subsidiary would be monitored. Geographical distance may make monitoring very difficult. This is an especially important point since Thai managers may conform to goals other than the maximization of shareholder wealth. 3. Which theories of international business described in this chapter apply to Blades, Inc. in the short run? In the long run? ANSWER: There are at least three theories of international business: the theory of comparative advantage, the imperfect markets theory, and the product cycle theory. In the short run, Blades would like to import from Thailand because inputs such as rubber and plastic are cheaper in Thailand. Also, it would like to export to Thailand to take advantage of the fact that few roller blades are currently sold in Thailand. Both of these factors suggest that the imperfect markets theory applies to Blades in the short run. In the long run, the goal is to possibly establish a subsidiary in Thailand and to be one of the first roller blade manufacturers in Thailand. The This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 2: International Fund Flows 17 Answers to End of Chapter Questions 1. IMF. a. What are some of the major objectives of the IMF? ANSWER: Major IMF objectives are to (1) promote cooperation among countries on international monetary issues, (2) promote stability in exchange rates, (3) provide temporary funds to member countries attempting to correct imbalances of international payments, (4) promote free mobility of capital funds across countries, and (5) promote free trade. b. How is the IMF involved in international trade? ANSWER: The IMF in involved in international trade because it attempts to stabilize international payments, and trade represents a significant portion of the international payments. 2. Internet Application. U.S. Balance of Trade. The website address of the Bureau of Economic Analysis is http://www.bea.doc.gov. Answers will vary. 3. Balance of Payments. a. What is the current account generally composed of? ANSWER: The current account balance is composed of (1) the balance of trade, (2) the net amount of payments of interest to foreign investors and from foreign investment, (3) payments from international tourism, and (4) private gifts and grants. b. What is the capital account generally composed of? ANSWER: The capital account is composed of all capital investments made between countries, including both direct foreign investment and purchases of securities with maturities exceeding one year. 4. Free Trade. There has been considerable momentum to reduce or remove trade barriers in an effort to achieve free trade. Yet, one disgruntled executive of an exporting firm stated, Free trade is not conceivable; we are always at the mercy of the exchange rate. Any country can use this mechanism to impose trade barriers. What does this statement mean? ANSWER: This statement implies that even if there were no explicit barriers, a government could attempt to manipulate exchange rates to a level that would effectively reduce foreign competition. For example, a U.S. firm may be discouraged from attempting to export to Japan if the value of the dollar is very high against the yen. The prices of the U.S. goods from the Japanese perspective are too high because of the strong dollar. The reverse situation could also be possible in which a Japanese exporting firm is priced out of the U.S. market because of a strong yen (weak dollar). [Answer is based on opinion.] 5. Government Restrictions. How can government restrictions affect international payments among countries? ANSWER: Governments can place tariffs or quotas on imports to restrict imports. They can also place taxes on income from foreign securities, thereby discouraging investors from purchasing This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 18 International Corporate Finance foreign securities. If they loosen restrictions, they can encourage international payments among countries. 6. Discussion in the Boardroom. This exercise is provided in Appendix E in the back of the text. It may be used as a project assignment that is to be completed by the end of the semester. Possible answers to the discussion questions are provided at the end of this Instructors Manual (after Chapter 21). If you use this appendix for in-class discussion on a weekly basis, you may benefit from making a copy of the discussion questions and possible answers provided at the end of the Instructors Manual so that you have easy access to this exercise each week in class. 7. Inflation Effect on Trade. a. How would a relatively high home inflation rate affect the home countrys current account, other things being equal? Register to View Answerhigh inflation rate tends to increase imports and decrease exports, thereby increasing the current account deficit, other things equal. b. Is a negative current account harmful to a country? Discuss. ANSWER: This question is intended to encourage opinions and does not have a perfect solution. A negative current account is thought to reflect lost jobs in a country, which is unfavorable. Yet, the foreign importing reflects strong competition from foreign producers, which may keep prices (inflation) low. 8. International Investments. In recent years many U.S.-based MNCs have increased their investments in foreign securities, which are not as susceptible to negative shocks in the U.S. market. Also, when MNCs believe that U.S. securities are overvalued, they can pursue non-U.S. securities that are driven by a different market. Moreover, in periods of low U.S. interest rates, U.S. corporations tend to seek investments in foreign securities. In general, the flow of funds into foreign countries tends to decline when U.S. investors anticipate a strong dollar. a. Explain how expectations of a strong dollar can affect the tendency of U.S. investors to invest abroad. Register to View Answerweak dollar would discourage U.S. investors from investing abroad. It can cause the investors to purchase foreign currency (when investing) at a higher exchange rate than the exchange rate at which they would sell the currency (when the investment is liquidated). b. Explain how low U.S. interest rates can affect the tendency of U.S.-based MNCs to invest abroad. ANSWER: Low U.S. interest rates can encourage U.S.-based MNCs to invest abroad, as investors seek higher returns on their investment than they can earn in the U.S. c. In general terms, what is the attraction of foreign investments to U.S. investors? ANSWER: The main attraction is potentially higher returns. The international stocks can outperform U.S. stocks, and international bonds can outperform U.S. bonds. However, there is no guarantee that the returns on international investments will be so favorable. Some investors may This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 2: International Fund Flows 19 also pursue international investments to diversify their investment portfolio, which can possibly reduce risk. 9. Exchange Rate Effect on Trade Balance. Would the U.S. balance of trade deficit be larger or smaller if the dollar depreciates against all currencies, versus depreciating against some currencies but appreciated against others? Explain. ANSWER: If the dollar weakens against all currencies, the U.S. balance of trade deficit will likely be smaller. Some U.S. importers would have more seriously considered purchasing their goods in the U.S. if most or all currencies simultaneously strengthened against the dollar. Conversely, if some currencies weaken against the dollar, the U.S. importers may have simply shifted their importing from one foreign country to another. 10. Exchange Rate Effects on Trade. a. Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explain why a weaker dollar could affect the U.S. balance of trade deficit. Register to View Answerstronger dollar makes U.S. exports more expensive to importers and may reduce imports. It makes U.S. imports cheap and may increase U.S. imports. A weaker home currency increases the prices of imports purchased by the home country and reduces the prices paid by foreign businesses for the home countrys exports. This should cause a decrease in the home countrys demand for imports and an increase in the foreign demand for the home countrys exports, and therefore increase the current account. However, this relationship can be distorted by other factors. b. It is sometimes suggested that a floating exchange rate will adjust to reduce or eliminate any current account deficit. Explain why this adjustment would occur. Register to View Answercurrent account deficit reflects a net sale of the home currency in exchange for other currencies. This places downward pressure on that home currencys value. If the currency weakens, it will reduce the home demand for foreign goods (since goods will now be more expensive), and will increase the home export volume (since exports will appear cheaper to foreign countries). c. Why does the exchange rate not always adjust to a current account deficit? ANSWER: In some cases, the home currency will remain strong even though a current account deficit exists, since other factors (such as international capital flows) can offset the forces placed on the currency by the current account. 11. Currency Effects. When South Koreas export growth stalled, some South Korean firms suggested that South Koreas primary export problem was the weakness in the Japanese yen. How would you interpret this statement? ANSWER: One of South Koreas primary competitors in exporting is Japan, which produces and exports many of the same types of products to the same countries. When the Japanese yen is weak, some importers switch to Japanese products in place of South Korean products. For this reason, it is often suggested that South Koreas primary export problem is weakness in the Japanese yen. 12. Effects of the Euro. Explain how the existence of the euro may affect U.S. international trade. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 20 International Corporate Finance ANSWER: The euro allowed for a single currency among many European countries. It could encourage firms in those countries to trade among each other since there is no exchange rate risk. This would possibly cause them to trade less with the U.S. The euro can increase trade within Europe because it eliminates the need for several European countries to exchange currencies when trading with each other. 13. Effects of Tariffs. Assume a simple world in which the U.S. exports soft drinks and beer to France and imports wine from France. If the U.S. imposes large tariffs on the French wine, explain the likely impact on the values of the U.S. beverage firms, U.S. wine producers, the French beverage firms, and the French wine producers. ANSWER: The U.S. wine producers benefit from the U.S. tariffs, while the French wine producers are adversely affected. The French government would likely retaliate by imposing tariffs on the U.S. beverage firms, which would adversely affect their value. The French beverage firms would benefit. 14. September 11 Effects on Trade. Why do you think international trade volume could be reduced as a result of the terrorist attacks on the U.S. on September 11, 2001? Are there any products for which international trade may increase? ANSWER. Open-ended. The terrorist attacks caused an increase in security, which could make it more difficult to ship some types of products. There could be an increase in the international trade of some security system products, as the general demand for these products increases. 15. Demand for Exports. A relatively small U.S. balance of trade deficit is commonly attributed to a strong demand for U.S. exports. What do you think is the underlying reason for the strong demand for U.S. exports? ANSWER: The strong demand for U.S. exports is commonly attributed to strong foreign economies or to a weak dollar. Solution to Continuing Case Problem: Blades, Inc. 1. How could a higher level of inflation in Thailand affect Blades (assume U.S. inflation remains constant)? Register to View Answerhigh level of inflation in Thailand relative to the United States could affect Blades favorably. Generally, if a countrys inflation rate increases relative to the countries with which it trades, consumers and corporations within the country will most likely purchase more goods overseas, as local goods become more expensive. Consequently, Blades sales to Thailand may increase. 2. How could competition from firms in Thailand and from U.S. firms conducting business in Thailand affect Blades? ANSWER: Blades would be favorably affected relative to Thai roller blade manufacturers and relative to other U.S. roller blade manufacturers with operations in Thailand. Both groups of firms will likely be forced to raise their prices if they want to maintain the same profit margin should inflation in Thailand increase. This is especially true if both groups of firms source their supplies directly from Thailand, so that the prices of these supplies are subject to the higher inflation in Thailand. Conversely, Blades cost of goods sold incurred in Thailand is relatively small. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 3: International Financial Markets 25 Answers to End of Chapter Questions 1. Euro. Explain the foreign exchange situation for countries that use the euro when they engage in international trade among themselves. ANSWER: There is no foreign exchange. Euros are used as the medium of exchange. 2. Eurocredit Loans. a. With regard to Eurocredit loans, who are the borrowers? b. Why would a bank desire to participate in syndicated Eurocredit loans? c. What is LIBOR and how is it used in the Eurocredit market? Register to View AnswerLarge corporations and some government agencies commonly request Eurocredit loans. b. With a Eurocredit loan, no single bank would be totally exposed to the risk that the borrower may fail to repay the loan. The risk is spread among all lending banks within the syndicate. c. LIBOR (London interbank offer rate) is the rate of interest at which banks in Europe lend to each other. It is used as a base from which loan rates on other loans are determined in the Eurocredit market. 3. Bid/Ask Spread. Compute the bid/ask percentage spread for Mexican peso retail transactions in which the ask rate is $.11 and the bid rate is $.10. ANSWER: [($.11 $.10)/$.11] = .091, or 9.1%. 4. Bid/Ask Spread. Utah Banks bid price for Canadian dollars is $.7938 and its ask price is $.81. What is the bid/ask percentage spread? ANSWER: ($.81 $.7938)/$.81 = .02 or 2% 5. International Financial Markets. Recently, Wal-Mart established two retail outlets in the city of Shanzen, China, which has a population of 3.7 million. These outlets are massive and contain products purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs in Shanzen, it may remit those earnings back to the United States. Wal-Mart is likely to build additional outlets in Shanzen or in other Chinese cities in the future. a. Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange. ANSWER: The Wal-Mart stores in China need other currencies to buy products from other countries, and must convert the Chinese currency (yuan) into the other currencies in the spot market to purchase these products. They also could use the spot market to convert excess earnings denominated in yuan into dollars, which would be remitted to the U.S. parent. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 26 International Corporate Finance b. Explain how Wal-Mart might utilize the international money market when it is establishing other Wal-Mart stores in Asia. ANSWER: Wal-Mart may need to maintain some deposits in the Eurocurrency market that can be used (when needed) to support the growth of Wal-Mart stores in various foreign markets. When some Wal-Mart stores in foreign markets need funds, they borrow from banks in the Eurocurrency market. Thus, the Eurocurrency market serves as a deposit or lending source for Wal-Mart and other MNCs on a short-term basis. c. Explain how Wal-Mart could use the international bond market to finance the establishment of new outlets in foreign markets. ANSWER: Wal-Mart could issue bonds in the Eurobond market to generate funds needed to establish new outlets. The bonds may be denominated in the currency that is needed; then, once the stores are established, some of the cash flows generated by those stores could be used to pay interest on the bonds. 6. International Markets. What is the function of the international money market? Briefly describe the reasons for the development and growth of the European money market. Explain how the international money, credit, and bond markets differ from one another. ANSWER: The function of the international money market is to efficiently facilitate the flow of international funds from firms or governments with excess funds to those in need of funds. Growth of the European money market was largely due to (1) regulations in the U.S. that limited foreign lending by U.S. banks; and (2) regulated ceilings placed on interest rates of dollar deposits in the U.S. that encouraged deposits to be placed in the Eurocurrency market where ceilings were nonexistent. The international money market focuses on short-term deposits and loans, while the international credit market is used to tap medium-term loans, and the international bond market is used to obtain long-term funds (by issuing long-term bonds). 7. International Diversification. Explain how the Asian crisis would have affected the returns to a U.S. firm investing in the Asian stock markets as a means of international diversification. [See the chapter appendix.] ANSWER: The returns to the U.S. firm would have been reduced substantially as a result of the Asian crisis because of both declines in the Asian stock markets and because of currency depreciation. For example, the Indonesian stock market declined by about 27% from June 1997 to June 1998. Furthermore, the Indonesian rupiah declined again the U.S. dollar by 84%. 8. Stock Market Integration. Bullet, Inc., a U.S. firm, is planning to issue new stock in the United States during this month. The only decision still to be made is the specific day on which the stock will be issued. Why do you think Bullet monitors results of the Tokyo stock market every morning? ANSWER: The U.S. stock market prices sometimes follow Japanese market prices. Thus, the firm would possibly be able to issue its stock at a lower price in the U.S. if it can use the Japanese market as an indicator of what will happen in the U.S. market. However, this indicator will not always be accurate. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 3: International Financial Markets 27 9. Foreign Stock Markets. Explain why firms may issue stock in foreign markets. Why might U.S. firms issue more stock in Europe since the conversion to a single currency in 1999? ANSWER: Firms may issue stock in foreign markets when they are concerned that their home market may be unable to absorb the entire issue. In addition, these firms may have foreign currency inflows in the foreign country that can be used to pay dividends on foreign-issued stock. They may also desire to enhance their global image. Since the euro can be used in several countries, firms may need a large amount of euros if they are expanding across Europe. 10. Discussion in the Boardroom. This exercise is provided in Appendix E in the back of the text. It may be used as a project assignment that is to be completed by the end of the semester. Possible answers to the discussion questions are provided at the end of this Instructors Manual (after Chapter 21). If you use this appendix for in-class discussion on a weekly basis, you may benefit from making a copy of the discussion questions and possible answers provided at the end of the Instructors Manual so that you have easy access to this exercise each week in class. 11. Foreign Exchange. You just came back from Canada, where the Canadian dollar was worth $.70. You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 130 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain. ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange desk, the cross-rate is $.60/$10 = 6. Thus, the C$200 would be exchanged for 120 pesos (computed as 200 6). If you exchange Canadian dollars for pesos with the tourist, you will receive 130 pesos. 12. Indirect Exchange Rate. If the direct exchange rate of the euro is worth $1.25, what is the indirect rate of the euro? That is, what is the value of a dollar in euros? ANSWER: 1/1.25 = .8 euros. 13. Cross Exchange Rate. Assume Polands currency (the zloty) is worth $.17 and the Japanese yen is worth $.008. What is the cross rate of the zloty with respect to yen? That is, how many yen equal a zloty? ANSWER: $.17/$.008 = 21.25 1 zloty = 21.25 yen 14. Exchange Rate Effects on Investing. Explain how the appreciation of the Australian dollar against the U.S. dollar would affect the return to a U.S. firm that invested in an Australian money market security. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 28 International Corporate Finance ANSWER: If the Australian dollar appreciates over the investment period, this implies that the U.S. firm purchased the Australian dollars to make its investment at a lower exchange rate than the rate at which it will convert A$ to U.S. dollars when the investment period is over. Thus, it benefits from the appreciation. Its return will be higher as a result of this appreciation. 15. Exchange Rate Effects on Borrowing. Explain how the appreciation of the Japanese yen against the U.S. dollar would affect the return to a U.S. firm that borrowed Japanese yen and used the proceeds for a U.S. project. ANSWER: If the Japanese yen appreciates over the borrowing period, this implies that the U.S. firm converted yen to U.S. dollars at a lower exchange rate than the rate at which it paid for yen at the time it would repay the loan. Thus, it is adversely affected by the appreciation. Its cost of borrowing will be higher as a result of this appreciation. 16. Bank Services. List some of the important characteristics of bank foreign exchange services that MNCs should consider. ANSWER: The important characteristics are (1) competitiveness of the quote, (2) the firms relationship with the bank, (3) speed of execution, (4) advice about current market conditions, and (5) forecasting advice. 17. Syndicated Loans. Explain how syndicated loans are used in international markets. Register to View Answerlarge MNC may want to obtain a large loan that no single bank wants to accommodate by itself. Thus, a bank may create a syndicate whereby several other banks also participate in the loan. 18. Loan Rates. Explain the process used by banks in the Eurocredit market to determine the rate to charge on loans. ANSWER: Banks set the loan rate based on the prevailing LIBOR, and allow the loan rate to float (change every 6 months) in accordance with changes in LIBOR. 19. Evolution of Floating Rates. Briefly describe the historical developments that led to floating exchange rates as of 1973. ANSWER: Country governments had difficulty in maintaining fixed exchange rates. In 1971, the bands were widened. Yet, the difficulty of controlling exchange rates even within these wider bands continued. As of 1973, the bands were eliminated so that rates could respond to market forces without limits (although governments still did intervene periodically). 20. Interest Rates. Why do interest rates vary among countries? Why are interest rates normally similar for those European countries that use the euro as their currency? Offer a reason why the government interest rate of one country could be slightly higher than that of the government interest rate of another country, even though the euro is the currency used in both countries. ANSWER: Interest rates in each country are based on the supply of funds and demand for funds for a given currency. However, the supply and demand conditions for the euro are dictated by all participating countries in aggregate, and do not vary among participating countries. Yet, the government interest rate in one country that uses the euro could be slightly higher than others that use the euro if it is subject to default risk. The higher interest rate would reflect a risk premium. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 3: International Financial Markets 29 21. Forward Contract. The Wolfpack Corporation is a U.S. exporter that invoices its exports to the United Kingdom in British pounds. If it expects that the pound will appreciate against the dollar in the future, should it hedge its exports with a forward contract? Explain. ANSWER: The forward contract can hedge future receivables or payables in foreign currencies to insulate the firm against exchange rate risk. Yet, in this case, the Wolfpack Corporation should not hedge because it would benefit from appreciation of the pound when it converts the pounds to dollars. 22. Motives for Investing in Foreign Money Markets. Explain why an MNC may invest funds in a financial market outside its own country. ANSWER: The MNC may be able to earn a higher interest rate on funds invested in a financial market outside of its own country. In addition, the exchange rate of the currency involved may be expected to appreciate. 23. Motives for Providing Credit in Foreign Markets. Explain why some financial institutions prefer to provide credit in financial markets outside their own country. ANSWER: Financial institutions may believe that they can earn a higher return by providing credit in foreign financial markets if interest rate levels are higher and if the economic conditions are strong so that the risk of default on credit provided is low. The institutions may also want to diversity their credit so that they are not too exposed to the economic conditions in any single country. 24. Effects of September 11. Why do you think the terrorist attack on the U.S. was expected to cause a decline in U.S. interest rates? Given the expectations for a potential decline in U.S. interest rates and stock prices, how were capital flows between the U.S. and other countries likely affected? ANSWER: The attack was expected to cause a weaker economy, which would result in lower U.S. interest rates. Given the lower interest rates, and the weak stock prices, the amount of funds invested by foreign investors in U.S. securities would be reduced. 25. Internet Application. Market Information on the Internet. The Bloomberg website provides quotations of various exchange rates and stock market indexes. Its website address is http://www.bloomberg.com. Solution to Continuing Case Problem: Blades, Inc. 1. One point of concern for you is that there is a tradeoff between the higher interest rates in Thailand and the delayed conversion of baht into dollars. Explain what this means. ANSWER: If the net baht-denominated cash flows are converted into dollars today, Blades is not subject to any future depreciation of the baht that would result in less dollar cash flows. 2. If the net baht received from the Thailand operation are invested in Thailand, how will U.S. operations be affected? (Assume that Blades is currently paying 10 percent on dollars borrowed, and needs more financing for its firm.) This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 4: Determining Exchange Rates 35 Answers to End of Chapter Questions 1. Speculative Effects on Exchange Rates. Explain why a public forecast by a respected economist about future interest rates could affect the value of the dollar today. Why do some forecasts by well-respected economists have no impact on todays value of the dollar? ANSWER: Interest rate movements affect exchange rates. Speculators can use anticipated interest rate movements to forecast exchange rate movements. They may decide to purchase securities in particular countries because of their expectations about currency movements, since their yield will be affected by changes in a currencys value. These purchases of securities require an exchange of currencies, which can immediately affect the equilibrium value of exchange rates. If a forecast of interest rates by a respected economist was already anticipated by market participants or is not different from investors original expectations, an announced forecast does not provide new information. Thus, there would be no reaction by investors to such an announcement, and exchange rates would not be affected. 2. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate than does the Canadian income level. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? ANSWER: Assuming no effect on U.S. interest rates, demand for dollars should increase, supply of dollars for sale may not be affected, and the dollars value should increase. 3. Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high relative to Canadian inflation. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? ANSWER: Demand for Canadian dollars should increase, supply of Canadian dollars for sale should decrease, and the Canadian dollars value should increase. 4. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound? ANSWER: Demand for pounds should increase, supply of pounds for sale should decrease, and the pounds value should increase. 5. Factors Affecting Exchange Rates. What factors affect the future movements in the value of the euro against the dollar? ANSWER: The euros value could change because of the balance of trade, which reflects more U.S. demand for European goods than the European demand for U.S. goods. The capital flows between the U.S. and Europe will also affect the U.S. demand for euros and the supply of euros for sale (to be exchanged for dollars). This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 36 International Corporate Finance 6. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect the (a) U.S. demand for Japanese yen, (b) supply of yen for sale, and (c) equilibrium value of the yen? ANSWER: Demand for yen should not be affected, supply of yen for sale should increase, and the value of yen should decrease. 7. Trade Deficit Effects on Exchange Rates. Every month, the U.S. trade deficit figures are announced. Foreign exchange traders often react to this announcement and even attempt to forecast the figures before they are announced. a. Why do you think the trade deficit announcement sometimes has such an impact on foreign exchange trading? ANSWER: The trade deficit announcement may provide a reasonable forecast of future trade deficits and therefore has implications about supply and demand conditions in the foreign exchange market. For example, if the trade deficit was larger than anticipated, and is expected to continue, this implies that the U.S. demand for foreign currencies may be larger than initially anticipated. Thus, the dollar would be expected to weaken. Some speculators may take a position in foreign currencies immediately and could cause an immediate decline in the dollar. b. In some periods, foreign exchange traders do not respond to a trade deficit announcement, even when the announced deficit is very large. Offer an explanation for such a lack of response. ANSWER: If the market correctly anticipated the trade deficit figure, then any news contained in the announcement has already been accounted for in the market. The market should only respond to an announcement about the trade deficit if the announcement contains new information. 8. Factors Affecting Exchange Rates. In the 1990s, Russia was attempting to import more goods but had little to offer other countries in terms of potential exports. In addition, Russias inflation rate was high. Explain the type of pressure that these factors placed on the Russian currency. ANSWER: The large amount of Russian imports and lack of Russian exports placed downward pressure on the Russian currency. The high inflation rate in Russia also placed downward pressure on the Russian currency. 9. Factors Affecting Exchange Rates. If the Asian countries experience a decline in economic growth (and experience a decline in inflation and interest rates as a result), how will their currency values (relative to the U.S. dollar) be affected? Register to View Answerrelative decline in Asian economic growth will reduce Asian demand for U.S. products, which places upward pressure on Asian currencies. However, given the change in interest rates, Asian corporations with excess cash may now invest in the U.S. or other countries, thereby increasing the demand for U.S. dollars. Thus, a decline in Asian interest rates will place downward pressure on the value of the Asian currencies. The overall impact depends on the magnitude of the forces just described. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 4: Determining Exchange Rates 37 10. Comovements of Exchange Rates. Explain why the value of the British pound against the dollar will not always move in tandem with the value of the euro against the dollar. ANSWER: The euros value changes in response to the flow of funds between the U.S. and the countries using the euro or their currency. The pounds value changes in response to the flow of funds between the U.S. and the U.K. [Answer is based on intuition, is not directly from the text.] 11. Measuring Effects on Exchange Rates. Tarheel Co. plans to determine how changes in U.S. and Mexican real interest rates will affect the value of the U.S. dollar. (See Appendix C.) a. Describe a regression model that could be used to achieve this purpose. Also explain the expected sign of the regression coefficient. ANSWER: Various models are possible. One model would be: % Change = a0 + a1 (rU.S. rM) + u in peso Where rU.S. rM a0 a1 u = = = = real interest rate in the U.S. real interest rate in Mexico intercept regression coefficient measuring the relationship between the real interest rate differential and the percentage change in the pesos value error term = Based on the model above, the regression coefficient is expected to have a negative sign. A relatively high real interest rate differential would likely cause a weaker peso value, other things being equal. An appropriate model would also include other independent variables that may influence the percentage change in the pesos value. b. If Tarheel Co. thinks that the existence of a quota in particular historical periods may have affected exchange rates, how might this be accounted for in the regression model? Register to View Answerdummy variable could be included in the model, assigned a value of one for periods when a quota existed and a value of zero when it did not exist. This answer requires some creative thinking, as it is not drawn directly from the text. 12. Factors Affecting Exchange Rates. Mexico tends to have much higher inflation than the United States and also much higher interest rates than the United States. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 38 International Corporate Finance a. Identify the most obvious economic reason for the persistent depreciation of the peso. ANSWER: The high inflation in Mexico places continual downward pressure on the value of the peso. b. High interest rates are commonly expected to strengthen a countrys currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the pesos value has declined against the dollar over most years even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexicos securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico? ANSWER: The high interest rates in Mexico result from expectations of high inflation. That is, the real interest rate in Mexico may not be any higher than the U.S. real interest rate. Given the high inflationary expectations, U.S. investors recognize the potential weakness of the peso, which could more than offset the high interest rate (when they convert the pesos back to dollars at the end of the investment period). Therefore, the high Mexican interest rates do not encourage U.S. investment in Mexican securities, and do not help to strengthen the value of the peso. c. Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized countries? How does this affect a U.S. firm that does substantial business in Mexico? ANSWER: The bid/ask spread is wider because the banks that provide foreign exchange services are subject to more risk when they maintain currencies such as the peso that could decline abruptly at any time. A wider bid/ask spread adversely affects the U.S. firm that does business in Mexico because it increases the transactions costs associated with conversion of dollars to pesos, or pesos to dollars. 13. Interaction of Exchange Rates. Assume that there are substantial capital flows among Canada, the U.S., and Japan. If interest rates in Canada decline to a level below the U.S. interest rate, and inflationary expectations remain unchanged, how could this affect the value of the Canadian dollar against the U.S. dollar? How might this decline in Canadas interest rates possibly affect the value of the Canadian dollar against the Japanese yen? ANSWER: If interest rates in Canada decline, there may be an increase in capital flows from Canada to the U.S. In addition, U.S. investors may attempt to capitalize on higher U.S. interest rates, while U.S. investors reduce their investments in Canadas securities. This places downward pressure on the Canadian dollars value. Japanese investors that previously invested in Canada may shift to the U.S. Thus, the reduced flow of funds from Japan would place downward pressure on the Canadian dollar against the Japanese yen. 14. Aggregate Effects on Exchange Rates. Assume that the United States invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United States. Approximately $10 billion worth of investment transactions occur between these two countries each year. The total dollar value of trade transactions per year is about $8 million. This information is expected to also hold in the future. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 4: Determining Exchange Rates 39 Because your firm exports goods to Country K, your job as international cash manager requires you to forecast the value of Country Ks currency (the krank) with respect to the dollar. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the kranks movement against the dollar. a. U.S. inflation has suddenly increased substantially, while Country Ks inflation remains low. ANSWER: Increased U.S. demand for the krank. Decreased supply of kranks for sale. Upward pressure in the kranks value. b. U.S. interest rates have increased substantially, while Country Ks interest rates remain low. Investors of both countries are attracted to high interest rates. ANSWER: Decreased U.S. demand for the krank. Increased supply of kranks for sale. Downward pressure on the kranks value. c. The U.S. income level increased substantially, while Country Ks income level has remained unchanged. ANSWER: Increased U.S. demand for the krank. Upward pressure on the kranks value. d. The U.S. is expected to impose a small tariff on goods imported from Country K. ANSWER: The tariff will cause a decrease in the United States desire for Country Ks goods, and will therefore reduce the demand for kranks for sale. Downward pressure on the kranks value. e. Combine all expected impacts to develop an overall forecast. ANSWER: Two of the scenarios described above place upward pressure on the value of the krank. However, these scenarios are related to trade, and trade flows are relatively minor between the U.S. and Country K. The interest rate scenario places downward pressure on the kranks value. Since the interest rates affect capital flows and capital flows dominate trade flows between the U.S. and Country K, the interest rate scenario should overwhelm all other scenarios. Thus, when considering the importance of implications of all scenarios, the krank is expected to depreciate. 15. Internet Application. Exchange Rates Online. The website of the Federal Reserve Bank of St. Louis provides exchange rate trends of various currencies. Its address is http://www.federalreserve.gov/releases/. Answers will vary. 16. National Income Effects. Analysts commonly attribute the appreciation of a currency to expectations that economic conditions will strengthen. Yet, this chapter suggests that when other factors are held constant, increased national income could increase imports and cause the local currency to weaken. In reality, other factors are not constant. What other factor is likely to be affected by increased economic growth and could place upward pressure on the value of the local currency? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 40 International Corporate Finance ANSWER: Interest rates tend to rise in response to a stronger economy, and higher interest rates can place upward pressure on the local currency (as long as there is not offsetting pressure by higher expected inflation). 17. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The expected spot rate one year from now is assumed to be $1.66. What percentage depreciation does this reflect? ANSWER: ($1.66 $1.73)/$1.73 = 4.05% Expected depreciation of 4.05% percent 18. Effects of Real Interest Rates. What is the expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies? ANSWER: The higher the real interest rate of a country relative to another country, the stronger will be its home currency, other things equal. 19. Discussion in the Boardroom. This exercise is provided in Appendix E in the back of the text. It may be used as a project assignment that is to be completed by the end of the semester. Possible answers to the discussion questions are provided at the end of this Instructors Manual (after Chapter 21). If you use this appendix for in-class discussion on a weekly basis, you may benefit from making a copy of the discussion questions and possible answers provided at the end of the Instructors Manual so that you have easy access to this exercise each week in class. 20. Impact of September 11. The terrorist attacks on the U.S. on September 11, 2001 were expected to weaken U.S. economic conditions, and reduce U.S. interest rates. How do you think the weaker U.S. economic conditions would affect trade flows? How would this have affected the value of the dollar (holding other factors constant)? How do you think the lower U.S. interest rates would have affected the value of the U.S. dollar (holding other factors constant)? ANSWER: The weak U.S. economy would result in a reduced demand for foreign products, which results in a decline in the demand for foreign currencies, and therefore places downward pressure on currencies relative to the dollar (upward pressure on the dollars value). The lower U.S. interest rates should reduce the capital flows to the U.S., which place downward pressure on the value of the dollar. 21. Impact of Crises. Why do you think most crises in countries (such as the Asian crisis) cause the local currency to weaken abruptly? Is it because of trade or capital flows? ANSWER: Capital flows have a larger influence. In general, crises tend to cause investors to expect that there will be less investment in the country in the future and also cause concern that any existing investments will generate poor returns (because of defaults on loans or reduced valuations of stocks). Thus, as investors liquidate their investments and convert the local currency into other currencies to invest elsewhere, downward pressure is placed on the local currency. 22. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist: This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 4: Determining Exchange Rates U.S. dollar Mexican peso Lending Rate 8.0% 8.5% Borrowing Rate 8.3% 8.7% 41 Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million peos in the interbank market, depending on which currency it wants to borrow. a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. ANSWER: Blue Demon Bank can capitalize on its expectations about pesos (MXP) as follows: 1. Borrow MXP70 million 2. Convert the MXP70 million to dollars: MXP70,000,000 $.15 = $10,500,000 3. Lend the dollars through the interbank market at 8.0% annualized over a 10-day period. The amount accumulated in 10 days is: $10,500,000 [1 + (8% 10/360)] = $10,500,000 [1.002222] = $10,523,333 4. Repay the peso loan. The repayment amount on the peso loan is: MXP70,000,000 [1 + (8.7% 10/360)] = 70,000,000 [1.002417]=MXP70,169,167 5. Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is: MXP70,169,167 $.14 = $9,823,683 6. After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of: $10,523,333 $9,823,683 = $699,650 b. Assume all the preceding information with this exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. ANSWER: Blue Demon Bank can capitalize on its expectations as follows: 1. Borrow $10 million 2. Convert the $10 million to pesos (MXP): $10,000,000/$.15 = MXP66,666,667 This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 42 International Corporate Finance 3. Lend the pesos through the interbank market at 8.5% annualized over a 30-day period. The amount accumulated in 30 days is: MXP66,666,667 [1 + (8.5% 30/360)] = 66,666,667 [1.007083] = MXP67,138,889 4. Repay the dollar loan. The repayment amount on the dollar loan is: $10,000,000 [1 + (8.3% 30/360)] = $10,000,000 [1.006917] = $10,069,170 5. Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30 days (based on the expected spot rate of $.17) is: MXP67,138,889 $.17 = $11,413,611 6. The profits are determined by estimating the dollars available after repaying the loan: $11,413,611 $10,069,170 = $1,344,441 23. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the dollar from its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist: Lending Rate U.S. dollar Singapore dollar 7.0% 22.0% Borrowing Rate 7.2% 24.0% Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in dollars for 60 days. Estimate the profits (or losses) that could be earned from this strategy. Should Diamond Bank pursue this strategy? ANSWER: Borrow S$10,000,000 and convert to U.S. $: S$10,000,000 $.43 = $4,300,000 Invest funds for 60 days. The rate earned in the U.S. for 60 days is: 7% (60/360) = 1.17% Total amount accumulated in 60 days: $4,300,000 (1 + .0117) = $4,350,310 Convert U.S. $ back to S$ in 60 days: $4,350,310/$.42 = S$10,357,881 The rate to be paid on loan is: .24 (60/360) = .04 Amount owed on S$ loan is: S$10,000,000 (1 + .04) = S$10,400,000 This strategy results in a loss: S$10,357,881 S$10,400,000 = S$42,119 This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 4: Determining Exchange Rates Diamond Bank should not pursue this strategy. 43 Solution to Continuing Case Problem: Blades, Inc. 1. How are percentage changes in a currencys value measured? Illustrate your answer numerically by assuming a change in the Thai bahts value from a value of $0.022 to $0.026. ANSWER: The percentage change in a currencys value is measured as follows: % S St St 1 1 where S denotes the spot rate, and St 1 denotes the spot rate as of the earlier date. A positive percentage change represents appreciation of the foreign currency, while a negative percentage change represents depreciation. In the example provided, the percentage change in the Thai baht would be: % S St St 1 1 $0.026 $0.022 $0.022 . 1818% That is, the baht would be expected to appreciate by 18.18%. 2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors? ANSWER: The basic factors that determine the value of a currency are the supply of the currency for sale and the demand for the currency. A high level of supply of a currency generally decreases the currencys value, while a high level of demand for a currency increases its value. In equilibrium, the supply of the currency equals the demand for the currency. 3. How might the relatively high levels of inflation and interest rates have affected the bahts value? (Assume a constant level of U.S. inflation and interest rates.) ANSWER: The baht would be affected both by inflation levels and interest rates in Thailand relative to levels of these variables in the U.S. A high level of inflation tends to result in currency depreciation, as it would increase the Thai demand for U.S. goods, causing an increase in the Thai demand for dollars. Furthermore, a relatively high level of Thai inflation would reduce the U.S. demand for Thai goods, causing an increase in the supply of baht for sale. Conversely, the high level of interest rates in Thailand may cause appreciation of the baht relative to the dollar. A relatively high level of interest rates in Thailand would have rendered investments there more attractive for U.S. investors, causing an increase in the demand for baht. Furthermore, U.S. securities would have been less attractive to Thai investors, causing an increase in the supply of dollars for sale. However, investors might be unwilling to invest in baht-denominated securities if they are concerned about the potential depreciation of the baht that could result from Thailands inflation. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 50 International Corporate Finance distribution of future exchange rate movements. Speculators who are confident that the exchange rate will appreciate, with very little risk of depreciation, may be more willing to buy futures than call options, because they do not need to insure against depreciation. However, speculators who expect appreciation but want to cover against possible depreciation may be willing to buy call options so that their downside risk is limited to what they pay for the call option. Answers to End of Chapter Questions 1. Discussion in the Boardroom. This exercise is provided in Appendix E in the back of the text. It may be used as a project assignment that is to be completed by the end of the semester. Possible answers to the discussion questions are provided at the end of this Instructor s Manual (after Chapter 21). If you use this appendix for in-class discussion on a weekly basis, you may benefit from making a copy of the discussion questions and possible answers provided at the end of the Instructors Manual so that you have easy access to this exercise each week in class. 2. Risk of Currency Futures. Currency futures markets are commonly used as a means of capitalizing on shifts in currency values, because the value of a futures contract tends to move in line with the change in the corresponding currency value. Recently, many currencies appreciated against the dollar. Most speculators anticipated that these currencies would continue to strengthen and took large buy positions in currency futures. However, the Fed intervened in the foreign exchange market by immediately selling foreign currencies in exchange for dollars, causing an abrupt decline in the values of foreign currencies (as the dollar strengthened). Participants that had purchased currency futures contracts incurred large losses. One floor broker responded to the effects of the Fed's intervention by immediately selling 300 futures contracts on British pounds (with a value of about $30 million). Such actions caused even more panic in the futures market. a. Explain why the central bank s intervention caused such panic among currency futures traders with buy positions. ANSWER: Futures prices on pounds rose in tandem with the value of the pound. However, when central banks intervened to support the dollar, the value of the pound declined, and so did values of futures contracts on pounds. So traders with long (buy) positions in these contracts experienced losses because the contract values declined. b. Explain why the floor broker s willingness to sell 300 pound futures contracts at the going market rate aroused such concern. What might this action signal to other brokers? ANSWER: Normally, this order would have been sold in pieces. This action could signal a desperate situation in which many investors sell futures contracts at any price, which places more downward pressure on currency future prices, and could cause a crisis. c. Explain why speculators with short (sell) positions could benefit as a result of the central bank s intervention. ANSWER: The central bank intervention placed downward pressure on the pound and other European currencies. Thus, the values of futures contracts on these currencies declined. Traders that had short positions in futures would benefit because they could now close out their short positions by purchasing the same contracts that they had sold earlier. Since the prices of futures contracts declined, they would purchase the contracts for a lower price than the price at which they initially sold the contracts. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives 51 d. Some traders with buy positions may have responded immediately to the central bank s intervention by selling futures contracts. Why would some speculators with buy positions leave their positions unchanged or even increase their positions by purchasing more futures contracts in response to the central bank s intervention? ANSWER: Central bank intervention sometimes has only a temporary effect on exchange rates. Thus, the European currencies could strengthen after a temporary effect caused by central bank intervention. Traders have to predict whether natural market forces will ultimately overwhelm any pressure induced as a result of central bank intervention. 3. Using Currency Futures. a. How can currency futures be used by corporations? ANSWER: U.S. corporations that desire to lock in a price at which they can sell a foreign currency would sell currency futures. U.S. corporations that desire to lock in a price at which they can purchase a foreign currency would purchase currency futures. b. How can currency futures be used by speculators? ANSWER: Speculators who expect a currency to appreciate could purchase currency futures contracts for that currency. Speculators who expect a currency to depreciate could sell currency futures contracts for that currency. 4. Currency Bull Spreads and Bear Spreads. A call option on British pounds ( ) exists with a strike price of $1.56 and a premium of $.08 per unit. Another call option on British pounds has a strike price of $1.59 and a premium of $.06 per unit. (See Appendix B in this chapter.) a. Complete the worksheet for a bull spread below. Value of British Pound at Option Expiration $1.50 $1.56 $1.59 Call @ $1.56 Call @ $1.59 Net b. What is the breakeven point for this bull spread? c. What is the maximum profit of this bull spread? What is the maximum loss? d. If the British pound spot rate is $1.58 at option expiration, what is the total profit or loss for the bull spread? e. If the British pound spot rate is $1.55 at option expiration, what is the total profit or loss for a bear spread? $1.65 This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 52 Register to View Answer International Corporate Finance Call @ $1.56 Call @ $1.59 Net Value of British Pound at Option Expiration $1.50 $1.56 $1.59 $.08 $.08 $.05 +$.06 +$.06 +$.06 $.02 $.02 +$.01 $1.65 +$.01 $.00 +$.01 b. The breakeven point of a bull spread occurs at the lower exercise price plus the difference in premiums, at $1.58 = $1.56 + ($.08 $.06). c. The maximum gain for the bull spread is limited to the difference between the strike prices less the difference in the premiums, or $.01 = ($1.59 $1.56) ($.08 $.06). The maximum loss for the bull spreader limited to the difference in the option premiums, or $.02. d. Selling Price of Purchase price of Premium paid for call option + Premium received for call option = Net profit Per Unit $1.58 1.56 .08 +.06 $.00 Per Contract $49,375 ($1.58 31,250 units) 48,750 ($1.56 31,250 units) 2,500 ($.08 31,250 units) +1,875 ($.06 31,250 units) $0 ($.00 31,250 units) e. A bear spread using these options involves writing the call option with the $1.56 exercise price and buying the call option with the $1.59 exercise price. At a spot price of $1.55, neither call option will be exercised, so the bear spreader nets the difference in options premiums. + Premium paid for call option Premium received for call option = Net profit Per Unit +.08 .06 $.02 Per Contract +2,500 ($.08 31,250 units) 1,875 ($.06 31,250 units) $625 ($.02 31,250 units) 5. Currency Options. Differentiate between a currency call option and a currency put option. Register to View Answercurrency call option provides the right to purchase a specified currency at a specified price within a specified period of time. A currency put option provides the right to sell a specified currency for a specified price within a specified period of time. 6. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01 per unit. The strike price was $.76, and the spot rate at the time the option was exercised was $.82. Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Mike s net profit on the call option? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives ANSWER: Premium received per unit Amount per unit received from selling C$ Amount per unit paid when purchasing C$ Net profit per unit Net Profit = 50,000 units ( $.05) = $.01 = $.76 = $.82 = $.05 = $2,500 53 7. Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for $.03 per unit. The strike price was $.75, and the spot rate at the time the option was exercised was $.72. Assume Brian immediately sold off the Canadian dollars received when the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Brian s net profit on the put option? ANSWER: Premium received per unit Amount per unit received from selling C$ Amount per unit paid for C$ Net profit per unit = $.03 = $.72 = $.75 = $0 8. Forward versus Futures Contracts. Compare and contrast forward and futures contracts. ANSWER: Because currency futures contracts are standardized into small amounts, they can be valuable for the speculator or small firm (a commercial bank s forward contracts are more common for larger amounts). However, the standardized format of futures forces limited maturities and amounts. 9. Forward Premium. Compute the forward discount or premium for the Mexican peso whose 90day forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or premium. ANSWER: (F - S) / S =($.098 - $.10) / $.10 (360/90) = .02, or 2%, which reflects a 8% discount 10. Forward versus Currency Option Contracts. What are the advantages and disadvantages to a U.S. corporation that uses currency options on euros rather than a forward contract on euros to hedge its exposure in euros? Explain why an MNC use forward contracts to hedge committed transactions and use currency options to hedge contracts that are anticipated but not committed. Why might forward contracts be advantageous for committed transactions, and currency options be advantageous for anticipated transactions? Register to View Answercurrency option on euros allows more flexibility since it does not commit one to purchase or sell euros (as is the case with a euro futures or forward contract). Yet, it does allow the option holder to purchase or sell euros at a locked-in price. The disadvantage of a euro option is that the option itself is not free. One must pay a premium for the call option, which is above and beyond the exercise price specified in the contract at which the euro could be purchased. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 54 International Corporate Finance An MNC may use forward contracts to hedge committed transactions because it would be cheaper to use a forward contract (a premium would be paid on an option contract that has an exercise price equal to the forward rate). The MNC may use currency options contracts to hedge anticipated transactions because it has more flexibility to let the contract go unexercised if the transaction does not occur. 11. Speculating with Currency Options. Barry Egan is a currency speculator. Barry believes that the Japanese yen will fluctuate widely against the U.S. dollar in the coming month. Currently, onemonth call options on Japanese yen () are available with a strike price of $.0085 and a premium of $.0007 per unit. One-month put options on Japanese yen are available with a strike price of $.0084 and a premium of $.0005 per unit. One option contract on Japanese yen contains 6.25 million yen. (See Appendix B in this chapter.) a. Describe how Barry Egan could utilize these options to speculate on the movement of the Japanese yen. b. Assume Barry decides to construct a long strangle in yen. What are the break-even points of this strangle? c. What is Barry s total profit or loss if the value of the yen in one month is $.0070? d. What is Barry s total profit or loss if the value of the yen in one month is $.0090? Register to View AnswerSince Barry seems uncertain as to the direction of the yen fluctuation, he could construct a long straddle using the call and put option. The long strangle would become profitable if the yen either depreciates or appreciates substantially. b. Lower BE point = $.0084 ($.0007 + $.0005) = $.0072 Upper BE point = $.0085 + ($.0007 + $.0005) = $.0097 c. Selling Price of Purchase price of Premium paid for call option Premium paid for put option = Net profit d. Selling Price of Purchase price of Premium paid for call option Premium paid for put option = Net profit Per Unit $.0090 .0085 .0007 .0005 $.0007 Per Contract $56,250 ($.0090 6.25 million units) 53,125 ($.0085 6.25 million units) 4,375 ($.0007 6.26 million units) 3,125 ($.0005 6.25 million units) $4,375 ($.0007 6.25 million units) Per Unit $.0084 .0070 .0007 .0005 $.0002 Per Contract $52,500 ($.0084 6.25 million units) 43,750 ($.0070 6.25 million units) 4,375 ($.0007 6.26 million units) 3,125 ($.0005 6.25 million units) $1,250 ($.0002 6.25 million units) 12. Internet Application. Currency Futures Online. The website of the Chicago Mercantile Exchange provides information about currency futures and options. Its address is http://www.cme.com. Answers will vary. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives 55 13. Profits from Using Currency Options and Futures. On July 2, the two-month futures rate of the Mexican peso contained a 2 percent discount (unannualized). There was a call option on pesos with an exercise price that was equal to the spot rate. There was also a put option on pesos with an exercise price equal to the spot rate. The premium on each of these options was 3 percent of the spot rate at that time. On September 2, the option expired. Go to the oanda.com website (or any site that has foreign exchange rate quotations) and determine the direct quote of the Mexican peso. You exercised the option on this date if it was feasible to do so. a. What was your net profit per unit if you had purchased the call option? b. What was your net profit per unit if you had purchased the put option? c. What was your net profit per unit if you had purchased a futures contract on July 2 that had a settlement date of September 2? d. What was your net profit per unit if you sold a futures contract on July 2 that had a settlement date of September 2? ANSWER: The answer depends on exchange rates on the specified dates. This question forces students to look up exchange rate information before determining the net profit. 14. Effects of a Forward Contract. How can a forward contract backfire? ANSWER: If the spot rate of the foreign currency at the time of the transaction is worth less than the forward rate that was negotiated, or is worth more than the forward rate that was negotiated, the forward contract has backfired. 15. Bull Spreads and Bear Spreads. Two British pound ( ) put options are available with exercise prices of $1.60 and $1.62. The premiums associated with these options are $.03 and $.04 per unit, respectively. (See Appendix B in this chapter.) a. Describe how a bull spread can be constructed using these put options. What is the difference between using put options versus call options to construct a bull spread? b. Complete the following worksheet. Value of British Pound at Option Expiration $1.55 $1.60 $1.62 Put @ $1.60 Put @ $1.62 Net c. At option expiration, the spot rate of the pound is $1.60. What is the bull spreader s total gain or loss? d. At option expiration, the spot rate of the pound is $1.58. What is the bear spreader s total gain or loss? $1.67 This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 56 ANSWER: International Corporate Finance a. Using put options to construct a bull spread involves exactly the same actions as constructing a bull spread using call options. The bull spreader would buy the $1.60 put option and write the $1.62 put option. The difference between using call and put options to construct a bull spread is that using put options results in a credit spread. b. Value of British Pound at Option Expiration $1.55 $1.60 $1.62 +$.02 $.03 $.03 $.03 +$.02 +$.04 $.01 $.01 +$.01 Put @ $1.60 Put @ $1.62 Net c. $1.67 $.03 +$.04 +$.01 Selling price of Purchase price of Premium paid for put option + Premium received for put option = Net profit Per Unit $1.60 1.62 .03 +.04 $.01 Per Contract $50,000 ($1.60 31,250 units) 50,625 ($1.62 31,250 units) 937.50 ($.03 31,250 units) +1,250 ($.04 31,250 units) $312.50 ($.01 31,250 units) d. A bear spread using these put options would be constructed by writing the $1.60 put option and buying the $1.62 put option. Selling price of Purchase price of + Premium received for put option + Selling price of Purchase price of Premium paid for put option = Net profit Per Unit $1.58 1.60 +.03 $1.62 1.58 .04 +$.01 Per Contract $49,375 ($1.58 31,250 units) 50,000 ($1.60 31,250 units) +937.50 ($.03 31,250 units) +50,625 ($1.62 31,250 units) 49,375 ($1.58 31,250 units) 1,250 ($.04 31,250 units) $312.50 ($.01 31,250 units) 16. Hedging With Currency Options. When would a U.S. firm consider purchasing a call option on euros for hedging? When would a U.S. firm consider purchasing a put option on euros for hedging? Register to View Answercall option can hedge a firm s future payables denominated in euros. It effectively locks in the maximum price to be paid for euros. A put option on euros can hedge a U.S. firm s future receivables denominated in euros. It effectively locks in the minimum price at which it can exchange euros received. 17. Speculating With Currency Options. When should a speculator purchase a call option on Australian dollars? When should a speculator purchase a put option on Australian dollars? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives 57 ANSWER: Speculators should purchase a call option on Australian dollars if they expect the Australian dollar value to appreciate substantially over the period specified by the option contract. Speculators should purchase a put option on Australian dollars if they expect the Australian dollar value to depreciate substantially over the period specified by the option contract. 18. Currency Call Option Premiums. List the factors that affect currency call option premiums and briefly explain the relationship that exists for each. Do you think an at-the-money call option in euros has a higher or lower premium than an at-the-money call option in British pounds (assuming the expiration date and the total dollar value represented by each option are the same for both options)? ANSWER: These factors are listed below: The higher the existing spot rate relative to the strike price, the greater is the call option value, other things equal. The longer the period prior to the expiration date, the greater is the call option value, other things equal. The greater the variability of the currency, the greater is the call option value, other things equal. The at-the-money call option in euros should have a lower premium because the euro should have less volatility than the pound. 19. Currency Put Option Premiums. List the factors that affect currency put options and briefly explain the relationship that exists for each. ANSWER: These factors are listed below: The lower the existing spot rate relative to the strike price, the greater is the put option value, other things equal. The longer the period prior to the expiration date, the greater is the put option value, other things equal. The greater the variability of the currency, the greater is the put option value, other things equal. 20. Speculating with Currency Call Options. Randy Rudecki purchased a call option on British pounds for $.02 per unit. The strike price was $1.45 and the spot rate at the time the option was exercised was $1.46. Assume there are 31,250 units in a British pound option. What was Randy s net profit on this option? ANSWER: Profit per unit on exercising the option Premium paid per unit Net profit per unit Net profit per option = 31,250 units ( $.01) = $.01 = $.02 = $.01 = $312.50 21. Speculating with Put Currency Options. Alice Duever purchased a put option on British pounds for $.04 per unit. The strike price was $1.80 and the spot rate at the time the pound option was This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 58 International Corporate Finance exercised was $1.59. Assume there are 31,250 units in a British pound option. What was Alice s net profit on the option? ANSWER: Profit per unit on exercising the option Premium paid per unit Net profit per unit Net profit for one option = 31,250 units $.17 = $.21 = $.04 = $.17 = $5,312.50 22. Speculating with Currency Futures. Assume that the euro s spot rate has moved in cycles over time. How might you try to use futures contracts on euros to capitalize on this tendency? How could you determine whether such a strategy would have been profitable in previous periods? ANSWER: Use recent movements in the euro to forecast future movements. If the euro has been strengthening, purchase futures on euros. If the euro has been weakening, sell futures on euros. A strategy s profitability can be determined by comparing the amount paid for each contract to the amount for which each contract was sold. 23. Hedging with Currency Derivatives. Assume that the transactions listed in the first column of the following table are anticipated by U.S. firms that have no other foreign transactions. Place an X in the table wherever you see possible ways to hedge each of the transactions. a. b. c. d. e. Georgetown Co. plans to purchase Japanese goods denominated in yen. Harvard, Inc., sold goods to Japan, denominated in yen. Yale Corp. has a subsidiary in Australia that will be remitting funds to the U.S. parent. Brown, Inc., needs to pay off existing loans that are denominated in Canadian dollars. Princeton Co. may purchase a company in Japan in the near future (but the deal may not go through). ANSWER: Forward Contract Forward Forward Purchase Sale X X X X Futures Contract Buy Sell Futures Futures X X X X Options Contract Purchase Purchase Calls Puts X X X X X a. b. c. d. e. 24. Price Movements of Currency Futures. Assume that on November 1, the spot rate of the British pound was $1.58 and the price on a December futures contract was $1.59. Assume that the pound depreciated during November so that by November 30 it was worth $1.51. a. What do you think happened to the futures price over the month of November? Why? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives 59 ANSWER: The December futures price would have decreased, because it reflects expectations of the future spot rate as of the settlement date. If the existing spot rate is $1.51, the spot rate expected on the December futures settlement date is likely to be near $1.51 as well. b. If you had known that this would occur, would you have purchased or sold a December futures contract in pounds on November 1? Explain. ANSWER: You would have sold futures at the existing futures price of $1.59. Then as the spot rate of the pound declined, the futures price would decline and you could close out your futures position by purchasing a futures contract at a lower price. Alternatively, you could wait until the settlement date, purchase the pounds in the spot market, and fulfill the futures obligation by delivering pounds at the price of $1.59 per pound. 25. Speculating with Currency Futures. Assume that a March futures contract on Mexican pesos was available in January for $.09 per unit. Also assume that forward contracts were available for the same settlement date at a price of $.092 per peso. How could speculators capitalize on this situation, assuming zero transaction costs? How would such speculative activity affect the difference between the forward contract price and the futures price? ANSWER: Speculators could purchase peso futures for $.09 per unit, and simultaneously sell pesos forward at $.092 per unit. When the pesos are received (as a result of the futures position) on the settlement date, the speculators would sell the pesos to fulfill their forward contract obligation. This strategy results in a $.002 per unit profit. As many speculators capitalize on the strategy described above, they would place upward pressure on futures prices and downward pressure on forward prices. Thus, the difference between the forward contract price and futures price would be reduced or eliminated. 26. Speculating with Currency Call Options. LSU Corp. purchased Canadian dollar call options for speculative purposes. If these options are exercised, LSU will immediately sell the Canadian dollars in the spot market. Each option was purchased for a premium of $.03 per unit, with an exercise price of $.75. LSU plans to wait until the expiration date before deciding whether to exercise the options. Of course, LSU will exercise the options at that time only if it is feasible to do so. In the following table, fill in the net profit (or loss) per unit to LSU Corp. based on the listed possible spot rates of the Canadian dollar on the expiration date. ANSWER: Possible Spot Rate of Canadian Dollar on Expiration Date $.76 .78 .80 .82 .85 .87 Net Profit (Loss) per Unit to LSU Corporation if Spot Rate Occurs $.02 .00 .02 .04 .07 .09 27. Speculating with Currency Put Options. Auburn Co. has purchased Canadian dollar put options for speculative purposes. Each option was purchased for a premium of $.02 per unit, with an exercise price of $.86 per unit. Auburn Co. will purchase the Canadian dollars just before it This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 60 International Corporate Finance exercises the options (if it is feasible to exercise the options). It plans to wait until the expiration date before deciding whether to exercise the options. In the following table, fill in the net profit (or loss) per unit to Auburn Co. based on the listed possible spot rates of the Canadian dollar on the expiration date. ANSWER: Possible Spot Rate of Canadian Dollar on Expiration Date $.76 .79 .84 .87 .89 .91 Net Profit (Loss) per Unit to Auburn Corporation if Spot Rate Occurs $.08 .05 .00 .02 .02 .02 28. Speculating with Currency Call Options. Bama Corp. has sold British pound call options for speculative purposes. The option premium was $.06 per unit, and the exercise price was $1.58. Bama will purchase the pounds on the day the options are exercised (if the options are exercised) in order to fulfill its obligation. In the following table, fill in the net profit (or loss) to Bama Corp. if the listed spot rate exists at the time the purchaser of the call options considers exercising them. ANSWER: Possible Spot Rate at the Time Purchaser of Call Option Considers Exercising Them $1.53 1.55 1.57 1.60 1.62 1.64 1.68 Net Profit (Loss) per Unit to Bama Corporation if Spot Rate Occurs $.06 .06 .06 .04 .02 .00 .04 29. Speculating with Currency Put Options. Bulldog, Inc., has sold Australian dollar put options at a premium of $.01 per unit, and an exercise price of $.76 per unit. It has forecasted the Australian dollar s lowest level over the period of concern as shown in the following table. Determine the net profit (or loss) per unit to Bulldog, Inc., if each level occurs and the put options are exercised at that time. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives ANSWER: Possible Value of Australian Dollar $.72 .73 .74 .75 .76 Net Profit (Loss) to Bulldog, Inc. if Value Occurs $.03 .02 .01 .00 .01 61 30. Hedging with Currency Derivatives. A U.S. professional football team plans to play an exhibition game in the United Kingdom next year. Assume that all expenses will be paid by the British government, and that the team will receive a check for 1 million pounds. The team anticipates that the pound will depreciate substantially by the scheduled date of the game. In addition, the National Football League must approve the deal, and approval (or disapproval) will not occur for three months. How can the team hedge its position? What is there to lose by waiting three months to see if the exhibition game is approved before hedging? ANSWER: The team could purchase put options on pounds in order to lock in the amount at which it could convert the 1 million pounds to dollars. The expiration date of the put option should correspond to the date in which the team would receive the 1 million pounds. If the deal is not approved, the team could let the put options expire. If the team waits three months, option prices will have changed by then. If the pound has depreciated over this three-month period, put options with the same exercise price would command higher premiums. Therefore, the team may wish to purchase put options immediately. The team could also consider selling futures contracts on pounds, but it would be obligated to exchange pounds for dollars in the future, even if the deal is not approved. 31. Currency Strangles. (See Appendix B in this chapter.) Assume the following options are currently available for British pounds ( ): Call option premium on British pounds = $.04 per unit Put option premium on British pounds = $.03 per unit Call option strike price = $1.56 Put option strike price = $1.53 One option contract represents 31,250. a. Construct a worksheet for a long strangle using these options. b. Determine the break-even point(s) for a strangle. c. If the spot price of the pound at option expiration is $1.55, what is the total profit or loss to the strangle buyer? d. If the spot price of the pound at option expiration is $1.50, what is the total profit or loss to the strangle writer? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 62 ANSWER: International Corporate Finance a. Many different worksheets are possible, but one worksheet is shown below. Value of Pound at Option Expiration $1.53 $1.56 $.04 $.04 $.03 $.03 $.07 $.07 Call Put Net $1.40 $.04 +$.10 +$.06 $1.65 +$.05 $.03 +$.02 b. The break-even points for a strangle are located below the lower exercise price and above the higher exercise price. The lower break-even point is located at $1.46 = $1.53 ($.04 + $.03). The higher break-even point is located at $1.63 = $1.56 + ($.04 + $.03). c. Since $1.55 is between the two exercise prices, neither option will be exercised, and the strangle buyer will incur the maximum loss of $.07. d. If the spot price is $1.50, the put option will be exercised, but the call option will expire. On the put option, the strangle writer will lose $.03 = $1.53 $1.50. The writer will also collect the premiums from both options of $.07. Therefore, the strangle writer will net $.04 = $.07 $.03 at a spot price of the pound equal to $1.50 at option expiration. 32. Currency Straddles. Refer to the previous question, but assume that the call and put option premiums are $.035 per unit and $.025 per unit, respectively. (See Appendix B in this chapter.) a. Construct a contingency graph for a long pound straddle. b. Construct a contingency graph for a short pound straddle. Register to View AnswerThe plotted points should create a U shape that cuts through the horizontal (break-even) axis at $1.47 and $1.62. The bottom of the U shape occurs from $1.53 to $1.56 and reflects a net profit of $.06. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives Net profit per unit 63 - b. The plotted points should create an upside down U shape that cuts through the horizontal (break-even) axis at $1.47 and $1.62. The peak of the upside down U shape occurs at from $1.53 to $1.56 and reflects a net profit of $.06. Net profit per unit - This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 64 International Corporate Finance 33. Currency Straddles. Reska, Inc., has constructed a long euro straddle. A call option on euros with an exercise price of $1.10 has a premium of $.025 per unit. A euro put option has a premium of $.017 per unit. Some possible euro values at option expiration are shown in the following table. (See Appendix B in this chapter.) Value of Euro at Option Expiration $1.05 $1.50 $.90 Call Put Net $2.00 a. Complete the worksheet and determine the net profit per unit to Reska Inc. for each possible future spot rate. b. Determine the break-even point(s) of the long straddle. What are the break-even points of a short straddle using these options? Register to View AnswerValue of Euro at Option Expiration $1.05 $1.50 $.025 +$.375 +$.033 $.017 +$.008 +$.358 Call Put Net $.90 $.025 +$.183 +$.158 $2.00 +$.875 $.017 +$.858 b. The break-even points for a long straddle can be found by subtracting and adding both premiums to the exercise price. Thus, the break-even points are located at future euro spot values of $1.10 ($.025 + $.017) = $1.058 and $1.10 + ($.025 + $.017) = $1.142. The breakeven points for a short straddle are also $1.058 and $1.142. 34. Currency Straddles. Refer to the previous question, but assume that the call and put option premiums are $.02 per unit and $.015 per unit, respectively. (See Appendix B in this chapter.) a. Construct a contingency graph for a long euro straddle. b. Construct a contingency graph for a short euro straddle. Register to View AnswerThe plotted points should create a V shape that cuts through the horizontal (break-even) axis at $1.065 and $1.135. The bottom point of the V shape occurs at $1.10, and reflects a net profit of $.035. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives Net profit per unit 65 - b. The plotted points should create an upside down V shape that cuts through the horizontal (break-even) axis at $1.065 and $1.135. The peak of the upside down V shape occurs at $1.10 and reflects a net profit of $.035. Net profit per unit - This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 66 International Corporate Finance 35. Currency Strangles. For the following options available on Australian dollars (A$), construct a worksheet and contingency graph for a long strangle. Locate the break-even points for this strangle. (See Appendix B in this chapter.) Put option strike price = $.67 Call option strike price = $.65 Put option premium = $.01 per unit Call option premium = $.02 per unit ANSWER: Note that the put strike price exceeds the call strike price in this case. Value of Australian dollar at Option Expiration $.60 $.65 $.67 $.02 $.02 $.00 +$.06 +$.01 $.01 +$.04 $.01 $.01 $.70 +$.03 $.01 +$.02 Own a Call Own a Put Net The plotted points should create a U shape that cuts through the horizontal (break-even) axis at $.64 and $.68. The bottom of the U shape occurs from $.65 to $.67 and reflects a net profit of $.01. Net profit per unit - The break-even points for a strangle where the put option exercise price exceeds the call option exercise price can be obtained by subtracting the difference in premiums from the call option strike price and by adding the difference in premiums to the put option strike price: Lower BE = $.65 ($.02 $.01) = $.64 Upper BE = $.67 + ($.02 $.01) = $.68 This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives 67 36. Currency Strangles. The following information is currently available for Canadian dollar (C$) options (see Appendix B in this chapter): Put option exercise price = $.75 Put option premium = $.014 per unit Call option exercise price = $.76 Call option premium = $.01 per unit One option contract represents C$50,000 a. What is the maximum possible gain the purchaser of a strangle can achieve using these options? b. What is the maximum possible loss the writer of a strangle can incur? c. Locate the break-even point(s) of the strangle. Register to View AnswerThe maximum gain of a long strangle is unlimited for currency appreciation. For currency depreciation, the maximum gain is limited to the lower strike price ($.75) less both premiums ($.024), or $.726. b. The maximum loss of a short strangle is unlimited for currency appreciation. For currency depreciation, it is limited to the lower strike price ($.75) less both premiums ($.024), or $.726. c. The lower break-even point is obtained by subtracting both premiums from the put option exercise price, at $.726 = $.75 ($.014 + $.01). The upper break-even points is obtained by adding both premiums to the call option exercise price, at $.784 = $.76 + ($.014 + $.01). 37. Currency Option Contingency Graphs. (See Appendix B in this chapter.) The current spot rate of the Singapore dollar (S$) is $.50. The following option information is available: Call option premium on Singapore dollar (S$) = $.015 Put option premium on Singapore dollar (S$) = $.009 Call and put option strike price = $.55 One option contract represents S$70,000 Construct a contingency graph for a short straddle using these options. ANSWER: The plotted points should create an upside down V shape that cuts through the horizontal (break-even) axis at $.526 and $.574. The peak of the upside down V shape occurs at $.55 and reflects a net profit of $.024. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 68 Net profit per unit International Corporate Finance - 38. Speculating with Currency Straddles. Maggie Hawthorne is a currency speculator. She has noticed recently that the euro has appreciated substantially against the U.S. dollar. The current exchange rate of the euro is $1.15. After reading a variety of articles on the subject, she believes that the euro will continue to fluctuate substantially in the months to come. Although most forecasters believe that the euro will depreciate against the dollar in the near future, Maggie thinks that there is also a good possibility of further appreciation. Currently, a call option on euros is available with an exercise price of $1.17 and a premium of $.04. A euro put option with an exercise price of $1.17 and a premium of $.03 is also available. (See Appendix B in this chapter.) a. Describe how Maggie could use straddles to speculate on the euro s value. b. At option expiration, the value of the euro is $1.30. What is Maggie s total profit or loss from a long straddle position? c. What is Maggie s total profit or loss from a long straddle position if the value of the euro is $1.05 at option expiration? d. What is Maggie s total profit or loss from a long straddle position if the value of the euro at option expiration is still $1.15? e. Given your answers to the questions above, when is it advantageous for a speculator to engage in a long straddle? When is it advantageous to engage in a short straddle? Register to View AnswerSince Maggie believes the euro will either appreciate or depreciate substantially, she may consider purchasing a straddle on euros. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 5: Exchange Rate Derivatives b. Selling Price of Purchase price of Premium paid for call option Premium paid for put option = Net profit c. Selling Price of Purchase price of Premium paid for call option Premium paid for put option = Net profit d. Selling Price of Purchase price of Premium paid for call option Premium paid for put option = Net profit Per Unit $1.17 1.15 .04 .03 $.05 Per Contract $73,125 ($1.17 62,500 units) 71,875 ($1.15 62,500 units) 2,500 ($.04 62,500 units) 1,875 ($.03 62,500 units) $3,125 ($.05 62,500 units) Per Unit $1.17 1.05 .04 .03 $.05 Per Contract $73,125 ($1.17 62,500 units) 65,625 ($1.05 62,500 units) 2,500 ($.04 62,500 units) 1,875 ($.03 62,500 units) $3,125 ($.05 62,500 units) Per Unit $1.30 1.17 .04 .03 $.06 Per Contract $81,250 ($1.30 62,500 units) 73,125 ($1.17 62,500 units) 2,500 ($.04 62,500 units) 1,875 ($.03 62,500 units) $3,750 ($.06 62,500 units) 69 e. It is advantageous for a speculator to engage in a long straddle if the underlying currency is expected to fluctuate drastically, in either direction, prior to option expiration. This is because the advantage of benefiting from either an appreciation or depreciation is offset by the cost of two option premiums. It is advantageous for a speculator to engage in a short straddle if the underlying currency is not expected to deviate far from the strike price prior to option expiration. In that case, the speculator would collect both premiums, and the loss associated with either the call or the put option is minimal. Solution to Continuing Case Problem: Blades, Inc. 1. If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of $0.00756 or the call option with the exercise price of $0.00792? Describe the tradeoff. ANSWER: The table shows how the option choices have changed for Blades. If it wants to ensure paying no more than 5 percent above the spot rate, the option with the exercise price of $0.00756 should be considered, although the premium on that option now has increased to be worth 2 percent of the exercise price (more expensive). The option premium is higher than what the firm normally prefers to pay. The firm could pay a lower premium by purchasing the alternative option with an exercise price of $0.00792, but that exercise price is 10 percent above the existing spot rate. This alternative option does not achieve the firm s desire to ensure paying no more than 5 percent above the existing spot rate. So if the firm is to continue to use options, it must accept either paying a higher premium than it would prefer, or a higher exercise price that limits the This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 78 International Corporate Finance Answers to End of Chapter Questions 1. Discussion in the Boardroom. This exercise is provided in Appendix E in the back of the text. It may be used as a project assignment that is to be completed by the end of the semester. Possible answers to the discussion questions are provided at the end of this Instructors Manual (after Chapter 21). If you use this appendix for in-class discussion on a weekly basis, you may benefit from making a copy of the discussion questions and possible answers provided at the end of the Instructors Manual so that you have easy access to this exercise each week in class. 2. Effects of September 11. Within a few days after the September 11, 2001 terrorist attack on the U.S., the Federal Reserve reduced short-term interest rates in the U.S. to stimulate the U.S. economy. How might this action have affected the foreign flow of funds into the U.S. and affected the value of the dollar? How could such an effect on the dollar increase the probability that the U.S. economy would strengthen? ANSWER: The lower interest rates are expected to stimulate the U.S. economy, by encouraging more borrowing and spending. Lower U.S. interest rates may reduce the amount of foreign flows to the U.S., which could have reduced the value of the dollar. If the dollar weakened U.S. exports would be cheaper, which could have increased the demand for products produced by U.S. exporters. 3. Internet Application. Bank of Japan. The website for Japans central bank, the Bank of Japan, provides information about its mission and its policy actions. Its address is http://www.boj.or. jp/en/index.htm. Answers will vary. 4. Exchange Rate Systems. Compare and contrast the fixed, freely floating, and managed float exchange rate systems. What are some advantages and disadvantages of a freely floating exchange rate system versus a fixed exchange rate system? ANSWER: Under a fixed exchange rate system, the governments attempted to maintain exchange rates within 1% of the initially set value (slightly widening the bands in 1971). Under a freely floating system, government intervention would be non-existent. Under a managed float system, governments will allow exchange rates move according to market forces; however, they will intervene when they believe it is necessary. A freely floating system may help correct balance-of-trade deficits since the currency will adjust according to market forces. Also, countries are more insulated from problems of foreign countries under a freely floating exchange rate system. However, a disadvantage of freely floating exchange rates is that firms have to manage their exposure to exchange rate risk. Also, floating rates still can often have a significant adverse impact on a countrys unemployment or inflation. 5. Pegged Currencies. Why do you think a country suddenly decides to peg its currency to the dollar or some other currency? When a currency is unable to maintain the peg, what do you think are the typical forces that break the peg? Register to View Answercountry will usually attempt a peg to reduce speculative flows that occur because of exchange rate volatility. It tries to comfort investors by making them believe that the currency will be stable. In some cases, the peg is broken when there are adverse conditions in the country that make investors believe that the peg will be broken. For example, foreign investors become concerned that if the peg breaks, the currency may decline by 20 percent or more against their This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 6: Governments and Exchange Rates 79 home currency. This would adversely affect the return on their investment, so they attempt to liquidate their investment and move their fund out of that currency before the peg breaks. If many investors have this concern simultaneously, they are all selling that currency at the same time. They place downward pressure on the currency because there is a larger supply of the currency for sale than the demand for the currency. The central bank may attempt to offset these forces by buying the currency in the foreign exchange market. However, it has a limited amount of that currency as a reserve, and may be overwhelmed by market forces. 6. Currency Effects on Economy. What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal? Register to View Answerweak home currency tends to increase a countrys exports and decrease its imports, thereby lowering its unemployment. However, it also can cause higher inflation since there is a reduction in foreign competition (because a weak home currency is not worth much in foreign countries). Thus, local producers can more easily increase prices without concern about pricing themselves out of the market. A strong home currency can keep inflation in the home country low, since it encourages consumers to buy abroad. Local producers must maintain low prices to remain competitive. Also, foreign supplies can be obtained cheaply. This also helps to maintain low inflation. However, a strong home currency can increase unemployment in the home country. This is due to the increase in imports and decrease in exports often associated with a strong home currency (imports become cheaper to that country but the countrys exports become more expensive to foreign customers). 7. Effects on Currencies Tied to the Dollar. The Hong Kong dollars value is tied to the U.S. dollar. Explain how the following trade patterns would be affected by the appreciation of the Japanese yen against the dollar: (a) Hong Kong exports to Japan and (b) Hong Kong exports to the United States. Register to View AnswerHong Kong exports to Japan should increase because the yen will have appreciated against the Hong Kong dollar. Therefore, Hong Kong goods will be less expensive to Japanese importers. b. Hong Kong exports to the U.S. should increase because Japanese goods become more expensive to U.S. importers as a result of yen appreciation. Therefore, some U.S. importers may find that even though the exchange rate between the U.S. dollar and Hong Kong dollar is unchanged, the Hong Kong prices are now lower than Japanese prices (from a U.S. perspective). This answer assumes that Japanese exporters did not reduce their prices to compensate U.S. importers for the weaker dollar. If Japanese exporters do reduce their prices to fully offset the effect of the stronger yen, there would be less of a shift to Hong Kong goods. 8. Freely Floating Exchange Rates. Should the governments of Asian countries allow their currencies to float freely? What would be the advantages of letting their currencies float freely? What would be the disadvantages? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 80 International Corporate Finance Register to View Answerfreely floating currency may allow the exchange rate to adjust to market conditions, which can stabilize flows of funds between countries. If there is a larger amount of funds going out versus coming in, the exchange rate will weaken due to the forces and the flows may change because the currency has become cheaper; this discourages further outflows. Yet, a disadvantage is that speculators may take positions that force a freely floating currency to deviate far from what is perceived to be a desirable exchange rate. 9. Direct Intervention. How can a central bank use direct intervention to change the value of a currency? Explain why a central bank may desire to smooth exchange rate movements of its currency. ANSWER: Central banks can use their currency reserves to buy up a specific currency in the foreign exchange market in order to place upward pressure on that currency. Central banks can also attempt to force currency depreciation by flooding the market with that specific currency (selling that currency in the foreign exchange market in exchange for other currencies). Abrupt movements in a currencys value may cause more volatile business cycles, and may cause more concern in financial markets (and therefore more volatility in these markets). Central bank intervention used to smooth exchange rate movements may stabilize the economy and financial markets. 10. Indirect Intervention. How can a central bank use indirect intervention to change the value of a currency? ANSWER: To increase the value of its home currency, a central bank could attempt to increase interest rates, thereby attracting a foreign demand for the home currency to buy high-yield securities. To decrease the value of its home currency, a central bank could attempt to lower interest rates in order to reduce demand for the home currency by foreign investors. 11. Intervention Effects. Assume there is concern that the United States may experience a recession. How should the Federal Reserve influence the dollar to prevent a recession? How might U.S. exporters react to this policy (favorably or unfavorably)? What about U.S. importing firms? ANSWER: The Federal Reserve would normally consider a loose money policy to stimulate the economy. However, to the extent that the policy puts upward pressure on economic growth and inflation, it could weaken the dollar. A weak dollar is expected to favorably affect U.S. exporting firms and adversely affect U.S. importing firms. If the U.S. interest rates rise in response to the possible increase in economic growth and inflation in the U.S., this could offset the downward pressure on the U.S. dollar. In this case, U.S. exporting and importing firms would not be affected as much. 12. Intervention with Euros. Assume that Belgium, one of the European countries that uses the euro as its currency, would prefer that its currency depreciate against the dollar. Can it apply central bank intervention to achieve this objective? Explain. ANSWER: It can not apply intervention on its own because the European Central Bank (ECB) controls the money supply of euros. Belgium is subject to the intervention decisions of the ECB. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 6: Governments and Exchange Rates 81 13. Sterilized Intervention. Explain the difference between sterilized and nonsterilized intervention. ANSWER: Sterilized intervention is conducted to ensure no change in the money supply while nonsterilized intervention is conducted without concern about maintaining the same money supply. 14. Impact of Intervention on Currency Option Premiums. Assume that the central bank of the country Zakow periodically intervenes in the foreign exchange market to prevent large upward or downward fluctuations in its currency (called the zak) against the U.S. dollar. Today, the central bank announced that it will no longer intervene in the foreign exchange market. The spot rate of the zak against the dollar was not affected by this news. Will the news affect the premium on currency call options that are traded on the zak? Will the news affect the premium on currency put options that are traded on the zak? Explain. ANSWER: It should cause the call option premium and put option premium to increase, because there is more uncertainty surrounding the zak. The seller of a call or put option will require a higher premium on the option, because the seller recognizes that the exchange rate may be more volatile than in the past. 15. Intervention Effects on Corporate Performance. Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the dollar as a result. Explain whether these actions would increase, reduce, or have no effect on: a. The volume of your subsidiarys sales in Australia (measured in A$), b. The cost to your subsidiary of purchasing materials (measured in A$) c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$). Briefly explain each answer. Register to View AnswerThe volume of the sales should decline as the cost to consumers who finance their purchases would rise due to the higher interest rates. b. The cost of purchasing materials should decline because the A$ appreciates against the HK$ as it appreciates against the U.S. dollar. c. The interest expenses should decline because it will take fewer A$ to make the monthly payment of $100,000. 16. Feedback Effects. Explain the potential feedback effects of a currencys changing value on inflation. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 82 International Corporate Finance Register to View Answerweak home currency can cause inflation since it tends to reduce foreign competition within any given industry. Higher inflation can weaken the currency further since it encourages consumers to purchase goods abroad (where prices are not inflated). A strong home currency can reduce inflation since it reduces the prices of foreign goods and forces home producers to offer competitive prices. Low inflation, in turn, places upward pressure on the home currency. 17. Effects of Indirect Intervention. Suppose that the government of Chile reduces one of its key interest rates. The values of several other Latin American currencies are expected to change substantially against the Chilean peso in response to the news. a. Explain why other Latin American currencies could be affected by a cut in Chiles interest rates. ANSWER: Exchange rates are partially driven by relative interest rates of the countries of concern. When Chile's interest rates decline, there is a smaller flow of funds to be exchanged into Chilean pesos because the Chile interest rate is not as attractive to investors. There may be a shift of investment into the other Latin American countries where interest rates have not declined. However, if these Latin American countries are expected to reduce their rates as well, they will not attract more capital and may even attract less capital flows in the future, which could reduce their values. b. How would the central banks of other Latin American countries likely adjust their interest rates? How would the currencies of these countries respond to the central bank interventions? ANSWER: The central banks would likely attempt to lower interest rates, which causes the currency to weaken. A weaker currency and lower interest rates can stimulate the economy. c. How would a U.S. firm that exports products to Latin American countries be affected by the central bank interventions? (Assume the exports are denominated in the corresponding Latin American currency for each country.) ANSWER: The exporter is adversely affected if the Chilean peso and other currencies depreciate. It is favorably affected by the appreciation of any Latin American currencies. 18. Indirect Intervention. Why would the Feds indirect intervention have a stronger impact on some currencies than others? Why would a central banks indirect intervention have a stronger impact than its direct intervention? ANSWER: Intervention may have a more pronounced impact when the market for a given currency is less active, such that the intervention can jolt the supply and demand conditions more. A central banks indirect intervention can affect the factors that influence exchange rates and therefore affect the natural equilibrium exchange rate. Conversely, direct intervention is a superficial method of affecting the demand and supply conditions for a currency, and could be overwhelmed by market forces. 19. Direct Intervention in Europe. If most countries in Europe experience a recession, how might the European Central Bank use direct intervention to stimulate economic growth? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 6: Governments and Exchange Rates 83 ANSWER: The ECB could sell euros in the foreign exchange market, which may cause the euro to depreciate against other currencies, and therefore cause an increase in the demand for European imports. 20. Indirect Intervention. During the Asian crisis, some Asian central banks raised their interest rates to prevent their currencies from weakening. Yet, the currencies weakened anyway. Offer your opinion as to why the central banks efforts at indirect intervention did not work. ANSWER: The higher interest rates did not attract sufficient funds to offset the outflow of funds, as investors had no confidence that the currencies would stabilize and were unwilling to invest in Asia. 21. Intervention Effects on Bond Prices. U.S. bond prices are normally inversely related to U.S. inflation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be affected? ANSWER: Expectations of a weak dollar can cause expectations of higher inflation, because a weak dollar places upward pressure on U.S. prices for reasons mentioned in the chapter. Higher inflation tends to place upward pressure on interest rates. Because there is an inverse relationship between interest rates and bond prices, bond prices would be expected to decline. Such an expectation causes bond portfolio managers to liquidate some of their bond holdings, thereby causing bond prices to decline immediately. 22. Monitoring of the Feds Intervention. Why do foreign market participants attempt to monitor the Feds direct intervention efforts? How does the Fed attempt to hide its intervention actions? The media frequently reports that the dollars value strengthened against many currencies in response to the Federal Reserves plan to increase interest rates. Explain why the dollars value may change even before the Federal Reserve affects interest rates. ANSWER: Foreign market participants make investment and borrowing decisions that can be influenced by anticipated exchange rate movements and therefore by the Feds direct intervention efforts. Thus, they may attempt to obtain information from commercial banks about the Feds intervention actions. The Fed may attempt to disguise its actions by requesting bid and ask quotes on exchange rates, and even mixing some buy orders with sell orders, or vice versa. Foreign exchange market participants may anticipate that once the Fed increases interest rates, there will be an increased demand for dollars, which will result in a stronger dollar. Consequently, they may take positions in dollars immediately, which could place upward pressure on the dollar even before interest rates are affected. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 92 International Corporate Finance Answers to End of Chapter Questions 1. Effects of September 11. The terrorist attack on the U.S. on September 11, 2001 caused expectations of a weaker U.S. economy. Explain how such expectations could have affected U.S. interest rates, and therefore have affected the forward rate premium (or discount) on various foreign currencies. ANSWER: The expectations of a weaker U.S. economy resulted in a decline of short-term interest rates (in fact, the Fed expedited the movement by increasing liquidity in the banking system). The U.S. interest rate was reduced while foreign interest rates were not. Therefore, the forward premium on foreign currencies increased. 2. Interest Rate Parity. Explain the concept of interest rate parity. Provide the rationale for its possible existence. ANSWER: Interest rate parity states that the forward rate premium (or discount) of a currency should reflect the differential in interest rates between the two countries. If interest rate parity didn't exist, covered interest arbitrage could occur (in the absence of transactions costs, and foreign risk), which should cause market forces to move back toward conditions which reflect interest rate parity. The exact formula is provided in the chapter. 3. Interest Rate Parity. Why would U.S. investors consider covered interest arbitrage in France when the interest rate on euros in France is lower than the U.S. interest rate? ANSWER: If the forward premium on euros more than offsets the lower interest rate, investors could use covered interest arbitrage by investing in euros and achieve higher returns than in the U.S. 4. Interest Rate Parity. If the relationship that is specified by interest rate parity does not exist at any period but does exist on average, then covered interest arbitrage should not be considered by U.S. firms. Do you agree or disagree with this statement? Explain. ANSWER: Disagree. If at any point in time, interest rate parity does not exist, covered interest arbitrage could earn excess returns (unless transactions costs, tax differences, etc., offset the excess returns). 5. Interest Rate Parity. Consider investors who invest in either U.S. or British one-year Treasury bills. Assume zero transaction costs and no taxes. a. If interest rate parity exists, then the return for U.S. investors who use covered interest arbitrage will be the same as the return for U.S. investors who invest in U.S. Treasury bills. Is this statement true or false? If false, correct the statement. Register to View Answerb. If interest rate parity exists, then the return for British investors who use covered interest arbitrage will be the same as the return for British investors who invest in British Treasury bills. Is this statement true or false? If false, correct the statement. Chapter 7: Interest Rate Parity and International Arbitrage Register to View Answer 93 6. Testing Interest Rate Parity. Describe a method for testing whether interest rate parity exists. Why are transactions costs, currency restrictions, and differential tax laws important when evaluating whether covered interest arbitrage can be beneficial? ANSWER: At any point in time, identify the interest rates of the U.S. versus some foreign country. Then determine the forward rate premium (or discount) that should exist according to interest rate parity. Then determine whether this computed forward rate premium (or discount) is different from the actual premium (or discount). Even if interest rate parity does not hold, covered interest arbitrage could be of no benefit if transactions costs or tax laws offset any excess gain. In addition, currency restrictions enforced by a foreign government may disrupt the act of covered interest arbitrage. 7. Testing IRP. The one-year interest rate in Singapore is 11 percent. The one-year interest rate in the U.S. is 6 percent. The spot rate of the Singapore dollar (S$) is $.50 and the forward rate of the S$ is $.46. Assume zero transactions costs. a. Does interest rate parity exist? ANSWER: No, because the discount is larger than the interest rate differential. b. Can a U.S. firm benefit from investing funds in Singapore using covered interest arbitrage? ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of investing in Singapore. 8. Inflation Effects on the Forward Rate. Why do you think currencies of countries with high inflation rates tend to have forward discounts? ANSWER: These currencies have high interest rates, which cause forward rates to have discounts as a result of interest rate parity. 9. Deriving the Forward Rate. Assume that annual interest rates in the U.S. are 4 percent, while interest rates in France are 6 percent. a. According to IRP, what should the forward rate premium or discount of the euro be? b. If the euros spot rate is $1.10, what should the one-year forward rate of the euro be? Register to View Answerp b. F (1.04) 1 (1.06) .0189 1.89% $1.10(1 .0189) $1.079 10. Differences among Forward Rates. Assume that the 30-day forward premium of the euro is -1 percent, while the 90-day forward premium of the euro is 2 percent. Explain the likely interest 94 International Corporate Finance rate conditions that would cause these premiums. Does this ensure that covered interest arbitrage is worthwhile? ANSWER: These premiums could occur when the euros 30-day interest rate is above the U.S. 30-day interest rate, but the euros 90-day interest rate is below the U.S. 90-day interest rate. Covered interest arbitrage is not necessarily worthwhile, since interest rate parity may still hold. 11. Deriving the Forward Rate. Before the Asian crisis began, Asian central banks were maintaining a somewhat stable value for their respective currencies. Nevertheless, the forward rate of Southeast Asian currencies exhibited a discount. Explain. ANSWER: The forward rate for the Asian currencies exhibited a discount to reflect that differential between the Asian country's interest rate and the U.S. interest rate, in accordance with interest rate parity (IRP). If the forward rate had not exhibited a discount, a U.S. investor could have conducted covered interest arbitrage by converting dollars to the foreign currency, investing in the foreign country, and simultaneously selling the foreign currency forward. 12. Economic Effects on the Forward Rate. Assume that Mexicos economy has expanded significantly, causing a high demand for loanable funds there by local firms. How might these conditions affect the forward discount of the Mexican peso? ANSWER: Expansion in Mexico creates a demand for loanable funds, which places upward pressure on Mexican interest rates, which increases the forward discount on the Mexican peso (or reduces the premium). 13. Locational Arbitrage. Explain the concept of locational arbitrage and the scenario necessary for it to be plausible. ANSWER: Locational arbitrage can occur when the spot rate of a given currency varies among locations. Specifically, the ask rate at one location must be lower than the bid rate at another location. The disparity in rates can occur since information is not always immediately available to all banks. If a disparity does exist, locational arbitrage is possible; as it occurs, the spot rates among locations should become realigned. 14. Locational Arbitrage. Assume the following information: Beal Bank Yardley Bank $.401 $.398 $.404 $.400 Bid price of New Zealand dollar Ask price of New Zealand dollar Given this information, is locational arbitrage possible? If so, explain the steps involved in locational arbitrage, and compute the profit from this arbitrage if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of locational arbitrage? ANSWER: Yes! One could purchase New Zealand dollars at Yardley Bank for $.40 and sell them to Beal Bank for $.401. With $1 million available, 2.5 million New Zealand dollars could be purchased at Yardley Bank. These New Zealand dollars could then be sold to Beal Bank for $1,002,500, thereby generating a profit of $2,500. Chapter 7: Interest Rate Parity and International Arbitrage 95 The large demand for New Zealand dollars at Yardley Bank will force this bank's ask price on New Zealand dollars to increase. The large sales of New Zealand dollars to Beal Bank will force its bid price down. Once the ask price of Yardley Bank is no longer less than the bid price of Beal Bank, locational arbitrage will no longer be beneficial. 15. Covered Interest Arbitrage. Explain the concept of covered interest arbitrage and the scenario necessary for it to be plausible. ANSWER: Covered interest arbitrage involves the short-term investment in a foreign currency that is covered by a forward contract to sell that currency when the investment matures. Covered interest arbitrage is plausible when the forward premium does not reflect the interest rate differential between two countries specified by the interest rate parity formula. If transactions costs or other considerations are involved, the excess profit from covered interest arbitrage must more than offset these other considerations for covered interest arbitrage to be plausible. 16. Covered Interest Arbitrage. Assume the following information: Spot rate of Mexican peso 180-day forward rate of Mexican peso 180-day Mexican interest rate 180-day U.S. interest rate = $.100 = $.098 = 6% = 5% Given this information, is covered interest arbitrage worthwhile for Mexican investors who have pesos to invest? Explain your answer. ANSWER: To answer this question, begin with an assumed amount of pesos and determine the yield to Mexican investors who attempt covered interest arbitrage. Using MXP1,000,000 as the initial investment: MXP1,000,000 $.100 = $100,000 (1.05) = $105,000/$.098 = MXP1,071,429 Mexican investors would generate a yield of about 7.1% ([MXP1,071,429 MXP1,000,000]/MXP1,000,000), which exceeds their domestic yield. Thus, it is worthwhile for them. 17. Covered Interest Arbitrage. Assume the following information: Quoted Price $.80 $.79 4% 2.5% Spot rate of Canadian dollar 90-day forward rate of Canadian dollar 90-day Canadian interest rate 90-day U.S. interest rate Given this information, what would be the yield (percentage return) to a U.S. investor who used covered interest arbitrage? (Assume the investor invests $1,000,000.) What market forces would occur to eliminate any further possibilities of covered interest arbitrage? 96 ANSWER: $1,000,000/$.80 = C$1,250,000 (1.04) = C$1,300,000 $.79 = $1,027,000 International Corporate Finance Yield = ($1,027,000 $1,000,000)/$1,000,000 = 2.7%, which exceeds the yield in the U.S. over the 90-day period. The Canadian dollar's spot rate should rise, and its forward rate should fall; in addition, the Canadian interest rate may fall and the U.S. interest rate may rise. 18. Covered Interest Arbitrage in Both Directions. Assume that the existing U.S. one-year interest rate is 10 percent and the Canadian one-year interest rate is 11 percent. Also assume that interest rate parity exists. Should the forward rate of the Canadian dollar exhibit a discount or a premium? If U.S. investors attempt covered interest arbitrage, what will be their return? If Canadian investors attempt covered interest arbitrage, what will be their return? ANSWER: The Canadian dollar's forward rate should exhibit a discount because its interest rate exceeds the U.S. interest rate. U.S. investors would earn a return of 10 percent using covered interest arbitrage, the same as what they would earn in the U.S. Canadian investors would earn a return of 11 percent using covered interest arbitrage, the same as they would earn in Canada. 19. Covered Interest Arbitrage in Both Directions. Assume that the annual U.S. interest rate is currently 8 percent and Germanys annual interest rate is currently 9 percent. The euros one-year forward rate currently exhibits a discount of 2 percent. a. Does interest rate parity exist? ANSWER: No, because the discount is larger than the interest rate differential. b. Can a U.S. firm benefit from investing funds in Germany using covered interest arbitrage? ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of investing in Germany. c. Can a German subsidiary of a U.S. firm benefit by investing funds in the United States through covered interest arbitrage? ANSWER: Yes, because even though it would earn 1 percent less interest over the year by investing in U.S. dollars, it would be able to sell dollars for 2 percent more than it paid for them (it would be buying euros forward at a discount of 2 percent). Chapter 7: Interest Rate Parity and International Arbitrage 97 20. Covered Interest Arbitrage. The South African rand has a one-year forward premium of 2 percent. One-year interest rates in the U.S. are 3 percentage points higher than in South Africa. Based on this information, is covered interest arbitrage possible for a U.S. investor if interest rate parity holds? ANSWER: No, covered interest arbitrage is not possible for a U.S. investor. Although the investor can lock in the higher exchange rate in one year, interest rates are 3 percent lower in South Africa. 21. Covered Interest Arbitrage in Both Directions. The one-year interest rate in New Zealand is 6 percent. The one-year U.S. interest rate is 10 percent. The spot rate of the New Zealand dollar (NZ$) is $.50. The forward rate of the New Zealand dollar is $.54. Is covered interest arbitrage feasible for U.S. investors? Is it feasible for New Zealand investors? In each case, explain why covered interest arbitrage is or is not feasible. ANSWER: To determine the yield from covered interest arbitrage by U.S. investors, start with an assumed initial investment, such as $1,000,000. $1,000,000/$.50 = NZ$2,000,000 (1.06) = NZ$2,120,000 $.54 = $1,144,800 Yield = ($1,144,800 $1,000,000)/$1,000,000 = 14.48% Thus, U.S. investors can benefit from covered interest arbitrage because this yield exceeds the U.S. interest rate of 10 percent. To determine the yield from covered interest arbitrage by New Zealand investors, start with an assumed initial investment, such as NZ$1,000,000: NZ$1,000,000 $.50 = $500,000 (1.10) = $550,000/$.54 = NZ$1,018,519 Yield = (NZ$1,018,519 NZ$1,000,000)/NZ$1,000,000 = 1.85% Thus, New Zealand investors would not benefit from covered interest arbitrage since the yield of 1.85% is less than the 6% that they could receive from investing their funds in New Zealand. 22. Limitations of Covered Interest Arbitrage. Assume that the one-year U.S. interest rate is 11 percent, while the one-year interest rate in Malaysia is 40 percent. Assume that a U.S. bank is willing to purchase the currency of that country from you one year from now at a discount of 13 percent. Would covered interest arbitrage be worth considering? Is there any reason why you should not attempt covered interest arbitrage in this situation? (Ignore tax effects.) ANSWER: Covered interest arbitrage would be worth considering since the return would be 21.8 percent, which is much higher than the U.S. interest rate. Assuming a $1,000,000 initial investment, $1,000,000 (1.40) .87 = $1,218,000 Yield = ($1,218,000 $1,000,000)/$1,000,000 = 21.8% However, the funds would be invested in Malaysia, which could cause some concern about default risk or government restrictions on convertibility of the currency back to dollars. 98 International Corporate Finance 23. Covered Interest Arbitrage in Both Directions. The following information is available: You have $500,000 to invest The current spot rate of the Moroccan dirham is $.110. The 60-day forward rate of the Moroccan dirham is $.108. The 60-day interest rate in the U.S. is 1 percent. The 60-day interest rate in Morocco is 2 percent. a. What is the yield to a U.S. investor who conducts covered interest arbitrage? Did covered interest arbitrage work for the investor in this case? b. Would covered interest arbitrage be possible for a Moroccan investor in this case? Register to View AnswerCovered interest arbitrage would involve the following steps: 1. Convert dollars to Moroccan dirham: $500,000/$.11 = MD4,545,454.55 2. Deposit the dirham in a Moroccan bank for 60 days. You will have MD4,545,454.55 (1.02) = MD4,636,363.64 in 60 days. 3. In 60 days, convert the dirham back to dollars at the forward rate and receive MD4,636,363.64 $.108 = $500,727.27 The yield to the U.S. investor is $500,727.27/$500,000 1 = .15%. Covered interest arbitrage did not work for the investor in this case. The lower Moroccan forward rate more than offsets the higher interest rate in Morocco. b. Yes, covered interest arbitrage would be possible for a Moroccan investor. The investor would convert dirham to dollars, invest the dollars at a 1 percent interest rate in the U.S., and sell the dollars forward 60 days. Even though the Moroccan investor would earn an interest rate that is 1 percent lower in the U.S., the forward rate discount of the dirham more than offsets that differential. 24. Triangular Arbitrage. Explain the concept of triangular arbitrage and the scenario necessary for it to be plausible. ANSWER: Triangular arbitrage is possible when the actual cross exchange rate between two currencies differs from what it should be. The appropriate cross rate can be determined given the values of the two currencies with respect to some other currency. 25. Triangular Arbitrage. Assume the following information: Quoted Price $.90 $.30 NZ$3.02 Value of Canadian dollar in U.S. dollars Value of New Zealand dollar in U.S. dollars Value of Canadian dollar in New Zealand dollars Chapter 7: Interest Rate Parity and International Arbitrage 99 Given this information, is triangular arbitrage possible? If so, explain the steps that would reflect triangular arbitrage, and compute the profit from this strategy if you had $1,000,000 to use. What market forces would occur to eliminate any further possibilities of triangular arbitrage? ANSWER: Yes. The appropriate cross exchange rate should be 1 Canadian dollar = 3 New Zealand dollars. Thus, the actual value of the Canadian dollars in terms of New Zealand dollars is more than what it should be. One could obtain Canadian dollars with U.S. dollars, sell the Canadian dollars for New Zealand dollars and then exchange New Zealand dollars for U.S. dollars. With $1,000,000, this strategy would generate $1,006,667 thereby representing a profit of $6,667. [$1,000,000/$.90 = C$1,111,111 3.02 = NZ$3,355,556 $.30 = $1,006,667] The value of the Canadian dollar with respect to the U.S. dollar would rise. The value of the Canadian dollar with respect to the New Zealand dollar would decline. The value of the New Zealand dollar with respect to the U.S. dollar would fall. 26. Discussion in the Boardroom. This exercise is provided in Appendix E in the back of the text. It may be used as a project assignment that is to be completed by the end of the semester. Possible answers to the discussion questions are provided at the end of this Instructors Manual (after Chapter 21). If you use this appendix for in-class discussion on a weekly basis, you may benefit from making a copy of the discussion questions and possible answers provided at the end of the Instructors Manual so that you have easy access to this exercise each week in class. 27. Interpreting a Large Forward Discount. The interest rate in Indonesia is commonly higher than the interest rate in the U.S., which reflects a higher expected rate of inflation there. Why should Nike consider hedging its future remittances from Indonesia to the U.S. parent even when the forward discount on the currency (rupiah) is so large? ANSWER: Nike may still consider hedging under these conditions because the alternative is to be exposed to the risk that the rupiah may depreciate over the six-month period by an amount that exceeds the degree of the discount. A large forward discount implies that the nominal interest rate in Indonesia is much higher than in the U.S., which may suggest a higher rate of expected inflation. Thus, there may be severe downward pressure on the rupiahs spot rate over time. 28. Changes in Forward Premiums. Assume that the forward rate premium of the euro was higher last month than it is today. What does this imply about interest rate differentials between the United States and Europe today compared to those last month? ANSWER: The interest rate differential is smaller now than it was last month. 29. Changes in Forward Premiums. Assume that the Japanese yens forward rate currently exhibits a premium of 6 percent and that interest rate parity exists. If U.S. interest rates decrease, how must this premium change to maintain interest rate parity? Why might we expect the premium to change? ANSWER: The premium will decrease in order to maintain IRP, because the difference between the interest rates is reduced. We would expect the premium to change because as U.S. interest rates decrease, U.S. investors could benefit from covered interest arbitrage if the forward premium stays the same. The return earned by U.S. investors who use covered interest arbitrage would not 100 International Corporate Finance be any higher than before, but the return would now exceed the interest rate earned in the U.S. Thus, there is downward pressure on the forward premium. 30. Change in the Forward Premium. At the end of this month, you (owner of a U.S. firm) are meeting with a Japanese firm to which you will try to sell supplies. If you receive an order from that firm, you will obtain a forward contract to hedge the future receivables in yen. As of this morning, the forward rate of the yen and spot rate are the same. You believe that interest rate parity holds. This afternoon, news occurs that makes you believe that the U.S. interest rates will increase substantially by the end of this month, and that the Japanese interest rate will not change. However, your expectations of the spot rate of the Japanese yen are not affected at all in the future. How will your expected dollar amount of receivables from the Japanese transaction be affected (if at all) by the news that occurred this afternoon? Explain. ANSWER: If U.S. interest rates increase, then the forward rate of the yen will exhibit a premium. Therefore, if you hedge your receivables at the end of this month, the dollar amount to be received would be higher. 31. Interpreting Changes in the Forward Premium. Assume that interest rate parity holds. At the beginning of the month, the spot rate of the Canadian dollar is $.70, while the one-year forward rate is $.68. Assume that U.S. interest rates increase steadily over the month. At the end of the month, the one-year forward rate is higher than it was at the beginning of the month. Yet, the oneyear forward discount is larger (the one-year premium is more negative) at the end of the month than it was at the beginning of the month. Explain how the relationship between the U.S. interest rate and the Canadian interest rate changed from the beginning of the month until the end of the month. ANSWER: The forward discount at the beginning of the month implies that the U.S. interest rate is lower than the Canadian interest rate. During the month, the Canadian interest rate must have increased by a greater degree than the U.S. interest rate. At the end of the month, the gap between the Canadian dollar and the U.S. dollar is greater than it was at the beginning of the month. This results in a more pronounced forward discount. 32. Internet Application. Cross Rates Online. The Bloomberg website provides quotations in foreign exchange markets. Its address is http://www.bloomberg.com. Answers will vary. Solution to Continuing Case Problem: Blades, Inc. 1. The first arbitrage opportunity relates to locational arbitrage. Holt has obtained spot rate quotations from two banks in Thailand, Minzu Bank and Sobat Bank, both located in Bangkok. The bid and ask prices of Thai baht for each bank are displayed in the table below: Minzu Bank $0.0224 $0.0227 Sobat Bank $0.0228 $0.0229 Bid Ask Chapter 8: Relationships Among Exchange Rates, Inflation, and Interest Rates 107 not necessarily hold the stock for the long term. Thus, investors may prefer that firms manage in a manner that reduces the volatility in their performance in short-run and long-run periods. WHO IS CORRECT? Use InfoTrac or some other search engine to learn more about this issue. Which argument do you support? Offer your own opinion on this issue. ANSWER: It is possible that inflation and exchange rate effects will offset over the long run. However, many investors will not be satisfied because they may invest in the firm for just a few years or even a shorter term. Thus, they will prefer that MNCs assess their exposure to exchange rate risk and attempt to limit the risk. Answers to End of Chapter Questions 1. IFE. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in the United States is 8 percent for one-year securities that are free from default risk. What does the IFE suggest about the differential in expected inflation in these two countries? Using this information and the PPP theory, describe the expected nominal return to U.S. investors who invest in Mexico. ANSWER: If investors from the U.S. and Mexico required the same real (inflation-adjusted) return, then any difference in nominal interest rates is due to differences in expected inflation. Thus, the inflation rate in Mexico is expected to be about 40 percent above the U.S. inflation rate. According to PPP, the Mexican peso should depreciate by the amount of the differential between U.S. and Mexican inflation rates. Using a 40 percent differential, the Mexican peso should depreciate by about 40 percent. Given a 48 percent nominal interest rate in Mexico and expected depreciation of the peso of 40 percent, U.S. investors will earn about 8 percent. (This answer used the inexact formula, since the concept is stressed here more than precision.) 2. IFE. Shouldnt the IFE discourage investors from attempting to capitalize on higher foreign interest rates? Why do some investors continue to invest overseas, even when they have no other transactions overseas? ANSWER: According to the IFE, higher foreign interest rates should not attract investors because these rates imply high expected inflation rates, which in turn imply potential depreciation of these currencies. Yet, some investors still invest in foreign countries where nominal interest rates are high. This may suggest that some investors believe that (1) the anticipated inflation rate embedded in a high nominal interest rate is overestimated, or (2) the potentially high inflation will not cause substantial depreciation of the foreign currency (which could occur if adequate substitute products were not available elsewhere), or (3) there are other factors that can offset the possible impact of inflation on the foreign currencys value. 3. IFE. Beth Miller does not believe that the international Fisher effect (IFE) holds. Current one-year interest rates in Europe are 5 percent, while one-year interest rates in the U.S. are 3 percent. Beth converts $100,000 to euros and invests them in Germany. One year later, she converts the euros back to dollars. The current spot rate of the euro is $1.10. a. According to the IFE, what should the spot rate of the euro in one year be? b. If the spot rate of the euro in one year is $1.00, what is Beths percentage return from her strategy? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 108 International Corporate Finance c. If the spot rate of the euro in one year is $1.08, what is Beths percentage return from her strategy? d. What must the spot rate of the euro be in one year for Beths strategy to be successful? Register to View Answer ef (1 i h ) (1 i f ) (1 . 03 ) (1 .05 ) 1 1 1 . 90 % If the IFE holds, the euro should depreciate by 1.90 percent in one year. This translates to a spot rate of $1.10 (1 1.90%) = $1.079. b. 1. Convert dollars to euros: $100,000/$1.10 = 90,909.09 2. Invest euros for one year and receive 90,909.09 1.05 = 95,454.55 3. Convert euros back to dollars and receive 95,454.55 $1.00 = $95,454.55 The percentage return is $95,454.55/$100,000 1 = 4.55%. c. 1. Convert dollars to euros: $100,000/$1.10 = 90,909.09 2. Invest euros for one year and receive 90,909.09 1.05 = 95,454.55 3. Convert euros back to dollars and receive 95,454.55 $1.08 = $103,090.91 The percentage return is $103,090.91/$100,000 1 = 3.09%. d. Beths strategy would be successful if the spot rate of the euro in one year is greater than $1.079. 4. Implications of IFE. Assume U.S. interest rates are generally above foreign interest rates. What does this suggest about the future strength or weakness of the dollar based on the IFE? Should U.S. investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in U.S. securities if they believe in the IFE? ANSWER: The IFE would suggest that the U.S. dollar will depreciate over time if U.S. interest rates are currently higher than foreign interest rates. Consequently, foreign investors who purchased U.S. securities would on average receive a similar yield as what they receive in their own country, and U.S. investors that purchased foreign securities would on average receive a yield similar to U.S. rates. 5. Implications of IFE. Explain the international Fisher effect (IFE). What is the rationale for the existence of the IFE? What are the implications of the IFE for firms with excess cash that consistently invest in foreign Treasury bills? Explain why the IFE may not hold. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 8: Relationships Among Exchange Rates, Inflation, and Interest Rates 109 ANSWER: The IFE suggests that a currencys value will adjust in accordance with the differential in interest rates between two countries. The rationale is that if a particular currency exhibits a high nominal interest rate, this may reflect a high anticipated inflation. Thus, the inflation will place downward pressure on the currencys value if it occurs. The implications are that a firm that consistently purchases foreign Treasury bills will on average earn a similar return as on domestic Treasury bills. The IFE may not hold because exchange rate movements react to other factors in addition to interest rate differentials. Therefore, an exchange rate will not necessarily adjust in accordance with the nominal interest rate differentials, so that IFE may not hold. 6. Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate of the Singapore dollar is $.70. The one-year interest rate is 11 percent in the United States and 7 percent in Singapore. What will the spot rate be in one year according to the IFE? (You may use the approximate formula to answer this question.) ANSWER: $.70 (1 + .04) = $.728 7. IFE Applied to the Euro. Given the recent conversion of several European currencies to the euro, explain what would cause the euros value to change against the dollar according to the IFE. ANSWER: If interest rates change in these European countries whose home currency is the euro, the expected inflation rate in those countries change, so that the inflation differential between those countries and the U.S. changes. Thus, there may be an impact on the value of the euro, because a change in the inflation differential affects trade flows and therefore affects the exchange rate. 8. IFE Application to Asian Crisis. Before the Asian crisis, many investors attempted to capitalize on the high interest rates prevailing in the Southeast Asian countries although the level of interest rates primarily reflected expectations of inflation. Explain why investors behaved in this manner. Why does the IFE suggest that the Southeast Asian countries would not have attracted foreign investment before the Asian crisis despite the high interest rates prevailing in those countries? ANSWER: The investors' behavior suggests that they did not expect the international Fisher effect (IFE) to hold. Since central banks of some Asian countries were maintaining their currencies within narrow bands, they were effectively preventing the exchange rate from depreciating in a manner that would offset the interest rate differential. Consequently, superior profits from investing in the foreign countries were possible. If investors believed in the IFE, the Asian countries would not attract a high level of foreign investment because of exchange rate expectations. Specifically, the high nominal interest rate should reflect a high level of expected inflation. According to purchasing power parity (PPP), the higher interest rate should result in a weaker currency because of the implied market expectations of high inflation. 9. Testing the IFE. Describe a statistical test for the IFE. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 110 International Corporate Finance Register to View Answerregression model could be applied to historical data to test IFE. The model is specified as: e f = a 0 + a1 1 + I U.S. 1 + If 1 +u where ef is the percentage change in the foreign currencys exchange rate, IU.S. and If are U.S. and foreign interest rates, a0 is a constant, a1 is the slope coefficient, and u is an error term. If IFE holds, a0 should equal zero and a1 should equal 1. A t-test on a0 and a1 is shown below: t - test for a 0 : t = a0 0 s.e. of a 0 a1 1 s.e. of a 1 t - test for a 1 : t = The t-statistic can be compared to the critical level (from a t-table) to determine whether the values of a0 and a1 differ significantly from their hypothesized values. 10. Comparing Parity Theories. Compare and contrast interest rate parity (discussed in the previous chapter), purchasing power parity (PPP), and the international Fisher effect (IFE). ANSWER: Interest rate parity can be evaluated using data at any one point in time to determine the relationship between the interest rate differential of two countries and the forward premium (or discount). PPP suggests a relationship between the inflation differential of two countries and the percentage change in the spot exchange rate over time. IFE suggests a relationship between the interest rate differential of two countries and the percentage change in the spot exchange rate over time. IFE is based on nominal interest rate differentials, which are influenced by expected inflation. Thus, the IFE is closely related to PPP. 11. Integrating IRP and IFE. Assume the following information is available for the U.S. and Europe: Nominal interest rate Expected inflation Spot rate One-year forward rate a. b. c. d. U.S. 4% 2% --------Europe 6% 5% $1.13 $1.10 Does IRP hold? According to PPP, what is the expected spot rate of the euro in one year? According to the IFE, what is the expected spot rate of the euro in one year? Reconcile your answers to parts (a). and (c). This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 8: Relationships Among Exchange Rates, Inflation, and Interest Rates Register to View Answer 111 p (1 ih ) 1 (1 i f ) (1.04) 1 (1.06) 1.89% Therefore, the forward rate of the euro should be $1.13 (1 1.89%) = $1.109. IRP does not hold in this case. b. ef (1 I h ) 1 (1 I f ) (1.02) 1 (1.05) 2.86% According to PPP, the expected spot rate of the euro in one year is $1.13 (1 2.86%) = $1.098. c. ef (1 ih ) 1 (1 i f ) (1.04) 1 (1.06) 1.89% According to the IFE, the expected spot rate of the euro in one year is $1.13 (1 2.86%) = $1.098. Parts a and c combined say that the forward rate premium or discount is exactly equal to the expected percentage appreciation or depreciation of the euro. 12. IRP. The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. a. What is the forward rate premium? b. What is the one-year forward rate of the peso? c. Based on the international Fisher effect, what is the expected change in the spot rate over the next year? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 112 International Corporate Finance d. If the spot rate changes as expected according to the IFE, what will be the spot rate in one year? e. Compare your answers to (b) and (d) and explain the relationship. Register to View AnswerAccording to interest rate parity, the forward premium is (1 .02) 1 (1 .10) .07273 b. The forward rate is $.14 (1 .07273) = $.1298. c. According to the IFE, the expected change in the peso is: (1 .02) 1 (1 .10) .07273 or 7.273% d. $.14 (1 .07273) = $.1298 e. The answers are the same. When IRP holds, the forward rate premium and the expected percentage change in the spot rate are derived in the same manner. Thus, the forward premium serves as the forecasted percentage change in the spot rate according to IFE. 13. Applying IRP and IFE. Assume that Mexico has a one-year interest rate that is higher than the U.S. one-year interest rate. Assume that you believe in the international Fisher effect (IFE), and interest rate parity. Assume zero transactions costs. Ed is based in the U.S. and he attempts to speculate by purchasing Mexican pesos today, investing the pesos in a risk-free asset for a year, and then converting the pesos to dollars at the end of one year. Ed did not cover his position in the forward market. Maria is based in Mexico and she attempts covered interest arbitrage by purchasing dollars today and simultaneously selling dollars one year forward, investing the dollars in a risk-free asset for a year, and then converting the dollars back to pesos at the end of one year. Do you think the rate of return on Eds investment will be higher than, lower than, or the same as the rate of return on Marias investment? Explain. ANSWER: Marias rate of return will be higher. Since interest rate parity exists, she will earn whatever the local risk-free interest rate is in Mexico. Eds expected rate of return is whatever the risk-free rate is in the U.S. (based on the IFE). This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 8: Relationships Among Exchange Rates, Inflation, and Interest Rates 113 14. IRP versus IFE. You believe that interest rate parity and the international Fisher effect hold. Assume the U.S. interest rate is presently much higher than the New Zealand interest rate. You have receivables of 1 million New Zealand dollars that you will receive in one year. You could hedge the receivables with the one-year forward contract. Or you could decide to not hedge. Is your expected U.S. dollar amount of the receivables in one year from hedging higher, lower, or the same as your expected U.S. dollar amount of the receivables without hedging? Explain. ANSWER: The expected amount is the same, because the forward rate reflects the interest rate differential, and the expected spot rate (if you do not hedge) according to IFE reflects the interest rate differential. 15. PPP. Explain the theory of purchasing power parity (PPP). Based on this theory, what is a general forecast of the values of currencies in countries with high inflation? ANSWER: PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. If inflation in a foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power. Currencies in countries with high inflation will be weak according to PPP, causing the purchasing power of goods in the home country versus these countries to be similar. 16. Testing PPP. Explain how you could determine whether PPP exists. Describe a limitation in testing whether PPP holds. ANSWER: One method is to choose two countries and compare the inflation differential to the exchange rate change for several different periods. Then, determine whether the exchange rate changes were similar to what would have been expected under PPP theory. A second method is to choose a variety of countries and compare the inflation differential of each foreign country relative to the home country for a given period. Then, determine whether the exchange rate changes of each foreign currency were what would have been expected based on the inflation differentials under PPP theory. A limitation in testing PPP is that the results will vary with the base period chosen. The base period should reflect an equilibrium position, but it is difficult to determine when such a period exists. 17. Rationale of PPP. Explain the rationale of the PPP theory. ANSWER: When inflation is high in a particular country, foreign demand for goods in that country will decrease. In addition, that countrys demand for foreign goods should increase. Thus, the home currency of that country will weaken; this tendency should continue until the currency has weakened to the extent that a foreign countrys goods are no more attractive than the home countrys goods. Inflation differentials are offset by exchange rate changes. 18. Limitations of PPP. Explain why PPP does not hold. ANSWER: PPP does not consistently hold because there are other factors besides inflation that influences exchange rates. Thus, exchange rates will not move in perfect tandem with inflation This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 114 International Corporate Finance differentials. In addition, there may not be substitutes for traded goods. Therefore, even when a countrys inflation increases, the foreign demand for its products will not necessarily decrease (in the manner suggested by PPP) if substitutes are not available. 19. Testing PPP. Inflation differentials between the U.S. and other industrialized countries have typically been a few percentage points in any given year. Yet, in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more. What does this information suggest about PPP? ANSWER: The information suggests that there are other factors besides inflation differentials that influence exchange rate movements. Thus, the exchange rate movements will not necessarily conform to inflation differentials, and therefore PPP will not necessarily hold. 20. PPP Applied to the Euro. Assume that several European countries that use the euro as their currency experience higher inflation than the United States, while two other European countries that use the euro as their currency experience lower inflation than the United States. According to PPP, how will the euros value against the dollar be affected? ANSWER: The high European inflation overall would reduce the U.S. demand for European products, increase the European demand for U.S. products, and cause the euro to depreciate against the dollar. According to the PPP theory, the euro's value would adjust in response to the weighted inflation rates of the European countries that are represented by the euro relative to the inflation in the U.S. If the European inflation rises, while the U.S. inflation remains low, there would be downward pressure on the euro. 21. PPP. Japan has typically had lower inflation than the United States. How would one expect this to affect the Japanese yens value? Why does this expected relationship not always occur? ANSWER: Japans low inflation should place upward pressure on the yens value. Yet, other factors can sometimes offset this pressure. For example, Japan heavily invests in U.S. securities, which places downward pressure on the yens value. 22. Estimating Depreciation Due to PPP. Assume that the spot exchange rate of the British pound is $1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent? ANSWER: According to PPP, the exchange rate of the pound will depreciate by 4.7 percent. Therefore, the spot rate would adjust to $1.73 [1 + (.047)] = $1.65. 23. Testing the PPP. How could you use regression analysis to determine whether the relationship specified by PPP exists on average? Specify the model, and describe how you would assess the regression results to determine if there is a significant difference from the relationship suggested by PPP. Register to View Answerregression model could be applied to historical data to test PPP. The model is specified as: This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 8: Relationships Among Exchange Rates, Inflation, and Interest Rates ef a0 a1 1+ I U.S. 115 1 + If 1 u where ef is the percentage change in the foreign currencys exchange rate, IU.S. and If are U.S. and foreign inflation rates, a0 is a constant, a1 is the slope coefficient, and u is an error term. If PPP holds, a0 should equal zero, and a1 should equal 1. A t-test on a0 and a1 is shown below. t - test for a 0: t = a0 0 s.e. of a 0 a1 1 s.e. of a1 t - test for a1: t = The t-statistic can be compared to the critical level (from a t-table) to determine whether the values of a0 and a1 differ significantly from their hypothesized values. 24. Interactive Effects of PPP. Assume that the inflation rates of the countries that use the euro are very low, while other European countries that have their own currencies experience high inflation. Explain how and why the euros value could be expected to change against these currencies according to the PPP theory. ANSWER: According to the PPP theory, the euros value would increase against the value of the other European currencies, because the trade patterns would shift in response to the inflation differential. There would be an increase in demand for the euro by these other European countries that experienced higher inflation because they will increase their importing of products from those European countries whose home currency is the euro. 25. Arbitrage and PPP. Assume that locational arbitrage ensures that spot exchange rates are properly aligned. Also assume that you believe in purchasing power parity. The spot rate of the British pound is $1.80. The spot rate of the Swiss franc is .3 pounds. You expect that the one-year inflation rate is 7 percent in the U.K., 5 percent in Switzerland, and 1 percent in the U.S. The oneyear interest rate is 6% in the U.K., 2% in Switzerland, and 4% in the U.S. What is your expected spot rate of the Swiss franc in one year with respect to the U.S. dollar? Show your work. ANSWER: SF spot rate in $ = 1.80 .3 = $.54. Expected % change in SF in one year = (1.01)/(1.05) 1 = 3.8% Expected spot rate of SF in one year = $.54 (1 .038) = $51.94 26. Comparing PPP and IFE. How is it possible for PPP to hold if the IFE does not? ANSWER: For the IFE to hold, the following conditions are necessary: (1) investors across countries require the same real returns, (2) the expected inflation rate embedded in the nominal interest rate occurs, (3) the exchange rate adjusts to the inflation rate differential according to PPP. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 116 International Corporate Finance If conditions (1) or (2) do not hold, PPP may still hold, but investors may achieve consistently higher returns when investing in a foreign countrys securities. Thus, IFE would be refuted. 27. Impact of Barriers on PPP and IFE. Would PPP be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungarys currency were allowed to float without any government intervention? Would the IFE be more likely to hold between the United States and Hungary if trade barriers were completely removed and if Hungarys currency were allowed to float without any government intervention? Explain. ANSWER: Changes in international trade result from inflation differences and affects the exchange rate (by affecting the demand for the currency and the supply of the currency for sale). The effect on the exchange rate is more likely to occur if (a) free trade is allowed and (b) the currencys exchange rate is allowed to fluctuate without any government intervention. The underlying force of IFE is the differential in expected inflation between two countries, which can affect trade and capital flows. The effects on the exchange rate are more likely to occur if (a) free trade is allowed, and (b) the currencys exchange rate is allowed to fluctuate without government intervention. 28. IRP, PPP, and Speculating in Currency Derivatives. The U.S. three-month interest rate (unannualized) is 1%. The Canadian three-month interest rate (unannualized) is 4%. Interest rate parity exists. The expected inflation over this period is 5% in the U.S. and 2% in Canada. A call option with a three-month expiration date on Canadian dollars is available for a premium of $.02 and a strike price of $.64. The spot rate of the Canadian dollar is $.65. Assume that you believe in purchasing power parity. a. Determine the dollar amount of your profit or loss from buying a call option contract specifying C$100,000. ANSWER: The expected change in the Canadian dollars spot rate is: (1.05)/(1.02) 1 = 2.94%. Therefore, the expected spot rate in 3 months is $.65 (1.0294) = $.66911. The net profit per unit on a call option is $.66911 $.64 $.02 = $.00911. For the contract, the net profit is $.00911 100,000 = $911. b. Determine the dollar amount of your profit or loss from buying a futures contract specifying C$100,000. ANSWER: According to IRP, the futures rate premium should be (1.01)/(1.04) 1 = 2.88% Therefore, the futures rate should be $.65 (1 .0288) = $.6313. Recall that the expected spot rate in 3 months is $.65 (1.0294) = $.66911. The expected net profit per unit from buying a futures contract is $.66911 $.6313 = $.03781. For the contract, the net profit is $.03781 100,000 = $4,341. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 8: Relationships Among Exchange Rates, Inflation, and Interest Rates 117 29. Discussion in the Boardroom. This exercise is provided in Appendix E in the back of the text. It may be used as a project assignment that is to be completed by the end of the semester. Possible answers to the discussion questions are provided at the end of this Instructors Manual (after Chapter 21). If you use this appendix for in-class discussion on a weekly basis, you may benefit from making a copy of the discussion questions and possible answers provided at the end of the Instructors Manual so that you have easy access to this exercise each week in class. 30. Real Interest Rate. One assumption made in developing the IFE is that all investors in all countries have the same real interest rate. What does this mean? ANSWER: The real return is the nominal return minus the inflation rate. If all investors require the same real return, then the differentials in nominal interest rates should be solely due to differentials in anticipated inflation among countries. 31. Inflation and Interest Rate Effects. The opening of Russia's market has resulted in a highly volatile Russian currency (the ruble). Russia's inflation has commonly exceeded 20 percent per month. Russian interest rates commonly exceed 150 percent, but this is sometimes less than the annual inflation rate in Russia. a. Explain why the high Russian inflation has put severe pressure on the value of the Russian ruble. ANSWER: As Russian prices were increasing, the purchasing power of Russian consumers was declining. This would encourage them to purchase goods in the U.S. and elsewhere, which results in a large supply of rubles for sale. Given the high Russian inflation, foreign demand for rubles to purchase Russian goods would be low. Thus, the rubles value should depreciate against the dollar, and against other currencies. b. Does the effect of Russian inflation on the decline in the rubles value support the PPP theory? How might the relationship be distorted by political conditions in Russia? ANSWER: The general relationship suggested by PPP is supported, but the rubles value will not normally move exactly as specified by PPP. The political conditions that could restrict trade or currency convertibility can prevent Russian consumers from shifting to foreign goods. Thus, the ruble may not decline by the full degree to offset the inflation differential between Russia and the U.S. Furthermore, the government may not allow the ruble to float freely to its proper equilibrium level. c. Does it appear that the prices of Russian goods will be equal to the prices of U.S. goods from the perspective of Russian consumers (after considering exchange rates)? Explain. ANSWER: Russian prices might be higher than U.S. prices, even after considering exchange rates, because the ruble might not depreciate enough to fully offset the Russian inflation. The exchange rate cannot fully adjust if there are barriers on trade or currency convertibility. d. Will the effects of the high Russian inflation and the decline in the ruble offset each other for U.S. importers? That is, how will U.S. importers of Russian goods be affected by the conditions? This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. 118 International Corporate Finance ANSWER: U.S. importers will likely experience higher prices, because the Russian inflation may not be completely offset by the decline in the rubles value. This may cause a reduction in the U.S. demand for Russian goods. 32. Changes in Inflation. Assume that the inflation rate in Brazil is expected to increase substantially. How will this affect Brazils nominal interest rates and the value of its currency (called the real)? If the IFE holds, how will the nominal return to U.S. investors who invest in Brazil be affected by the higher inflation in Brazil? Explain. ANSWER: Brazils nominal interest rate would likely increase to maintain the real return required by Brazilian investors. The Brazilian real would be expected to depreciate according to the IFE. If the IFE holds, the return to U.S. investors who invest in Brazil would not be affected. Even though they now earn a higher nominal interest rate, the expected decline in the Brazilian real offsets the additional interest to be earned. 33. Internet Application. Currency Interest Rates. The Market section of the Bloomberg website provides interest rate quotations for numerous currencies. Its address is http://www.bloomberg.com. Answers will vary. 34. Interpreting Inflationary Expectations. If investors in the United States and Canada require the same real interest rate, and the nominal rate of interest is 2 percent higher in Canada, what does this imply about expectations of U.S. inflation and Canadian inflation? What do these inflationary expectations suggest about future exchange rates? ANSWER: Expected inflation in Canada is 2 percent above expected inflation in the U.S. If these inflationary expectations come true, PPP would suggest that the value of the Canadian dollar should depreciate by 2 percent against the U.S. dollar. 35. Source of Weak Currencies. Currencies of some Latin American countries, such as Brazil and Venezuela, frequently weaken against most other currencies. What concept in this chapter explains this occurrence? Why dont all U.S.-based MNCs use forward contracts to hedge their future remittances of funds from Latin American countries to the U.S. even if they expect depreciation of the currencies against the dollar? ANSWER: Latin American countries typically have very high inflation, as much as 200 percent or more. PPP theory would suggest that currencies of these countries will depreciate against the U.S. dollar (and other major currencies) in order to retain purchasing power across countries. The high inflation discourages demand for Latin American imports and places downward pressure in their Latin American currencies. Depreciation of the currencies offsets the increased prices on Latin American goods from the perspective of importers in other countries. Interest rate parity forces the forward rates to contain a large discount due to the high interest rates in Latin America, which reflects a disadvantage of hedging these currencies. The decision to hedge makes more sense if the expected degree of depreciation exceeds the degree of the forward discount. Also, keep in mind that some remittances cannot be perfectly hedged anyway because the amount of future remittances is uncertain. 36. Deriving Forecasts of the Future Spot Rate. As of today, assume the following information is available: This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. Chapter 8: Relationships Among Exchange Rates, Inflation, and Interest Rates U.S. Real rate of interest required by investors Nominal interest rate Spot rate One-year forward rate 2% 11% Mexico 2% 15% $.20 $.19 119 a. Use the forward rate to forecast the percentage change in the Mexican peso over the next year. ANSWER: ($.19 $.20)/$.20 = .05, or 5% b. Use the differential in expected inflation to forecast the percentage change in the Mexican peso over the next year. ANSWER: 11% 15% = 4%; the negative sign represents depreciation of the peso. c. Use the spot rate to forecast the percentage change in the Mexican peso over the next year. ANSWER: zero percent change Solution to Continuing Case Problem: Blades, Inc. 1. What is the relationship between the exchange rates and relative inflation levels of the two countries? How will this relationship affect Blades Thai revenue and costs given that the baht is freely floating? What is the net effect of this relationship on Blades? ANSWER: The relationship between exchange rates and relative inflation rates is summarized by the purchasing power parity (PPP) theory. When one countrys inflation rate rises relative to that of another, the demand for the former countrys currency declines as its exports decline (due to its higher prices). Furthermore, consumers and firms in the country with higher inflation tend to increase their importing. Thus, the absolute form of PPP states that prices of similar products of two different countries should be equal when measured in a common currency. The relative form of PPP states that prices of similar products of different countries will not necessarily be the same when measured in a common currency because of market imperfections. However, it states that the rate of change in the prices of products should be similar. Both forms of the theory suggest that the currency of the country with the higher level of inflation should depreciate to offset the inflation differential. Since the baht has become a freely floating currency, the currency should be expected to depreciate due to the high inflation levels prevailing in Thailand. Blades revenue generated in Thailand will be negatively affected by PPP. Because of Blades export arrangement, it is unable to increase its prices in line with Thai levels of inflation. However, since Blades exports are denominated in baht, a depreciation of the baht will result in a conversion of baht into fewer dollars. Blades cost of goods sold generated in Thailand will increase as Thai exporters adjust their prices according to Thai inflation rates. However, the high prices resulting from high levels of inflation in Thailand may be somewhat offset by a depreciation of the baht. Since Blades generates net cash inflows from its Thai operations, it will be negatively affected by PPP. This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher. ... View Full Document

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