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Unformatted text preview: UNIVERSITY OF SOUTHERN CALIFORNIA
Marshall School of Business
INTERNATIONAL FINANCIAL MANAGEMENT
ANSWERS TO PROBLEM SET # 5: Multiple Choice Questions:
M5.1 (7.12a) The above table shows the annualized yield for pure discount bonds and the
associated prices. Which line includes an incorrect entry? A
7.30% Line A is incorrect.
Line B is incorrect.
Line C is incorrect.
Lines A and C are incorrect.
All three lines are correct. Prices & Maturity (days)
0.9648 FBE 436
Answers to Problem Set #5 Problem #5.1:
Discuss the similarities and differences between a Currency Board and Dollarization, in terms of
their different economic impacts, market credibility and feasibility.
Answer: Currency Board and dollarization, assuming the currency is pegged to the $ by the
Currency Board, have similar macroeconomic properties. In both cases the local FX rate
appreciates and depreciates along with the $, and independent monetary policy is not feasible or
There are three main differences.
It is less costly to eliminate a currency board than to eliminate dollarization. Therefore, country
risk premia should be smaller under dollarization. There is no currency to “attack”; interest rates
will depend almost exclusively on the business risk characteristics of the borrowing entity, more
so than under a currency board.
With dollarization, the government may not be bale to discharge its lender-of-last-resort role,
and guarantee the solvency of the payments system under all eventualities. That would give rise
to a “risk premium” that would not be necessary under a currency board.
With dollarization, it is not possible to guarantee that the government itself will not go bankrupt.
Thus taxation and deficit policies will play a bigger role in the formation of expectations and on
risk premia. Problem #5.2:
Describe the “fatal flaw” of fixed FX regimes. Why do countries often peg their FX rates
Fixed exchange rate regimes have had short lives. The main reason is that governments have
been unwilling to adhere for long to the restrictions implied by the existence of a fixed FX
“Defending” the fixed rate when there is excess demand for the home currency (i.e., the currency
would tend to appreciate if unchecked) is relatively easy, because it involves purchasing foreign
assets (foreign reserves) with its home currency. However, even this operation eventually
creates inflationary pressures, because the Central bank finds it increasingly difficult to
“sterilize” the liquidity it creates when it purchases foreign assets.
“Defending” the currency in the face of excess supply for its currency (i.e., the currency would
tend to depreciate if unchecked) is harder, because the central ban must sell its foreign reserves
to purchase its home currency. Foreign reserves (unlike home money) are generally limited, and
Central banks inevitably “run out” of foreign reserves with which to support their currency’s
Furthermore, speculators will sell short the home currency as soon as they think the Central bank
might not be able to continue to support the currency. This is a one-way bet, in the sense that if
they are wrong they lose little (the currency doesn’t depreciate) but if they are correct they gain
much. 2 FBE 436
Answers to Problem Set #5 Countries do it anyway because of the perceived short run benefits; stabilization of inflation,
stability in the FX market, etc. Problem #5.3:
• What is an interest rate swap? • What is a currency swap? • What is the difference between a currency swap and parallel loans? • What is the difference between a currency swap and an appropriate series of forward
contracts? See your notes on swaps. Problem #5.4:
Barthez Ltd. can borrow Euros at 6.25% and $s at 7.45%; it is a European company that needs to
have $ debt in its Balance sheet.
Beasley Inc. can borrow $s at 7.00% and Euros at 6.75%; it is a US company that would like to
incur some Euro debt. Could these firms profitably enter into a swap arrangement –the current
FX is 1.15 $/€?
Hint: Compute the cost of borrowing $100 worth of each of the currencies for each company
and compare the total costs of borrowing on their own versus swapping. Clearly, borrowing in their home currency is their comparative advantage. Consider the interest
cost to each of borrowing €100 worth of each of the currencies. This means they have to
€100/1.15 = €86.96. Euros
$s Borrowing Costs
€86.96 *6.25% = €5.43
€86.96 *6.75% = €5.87
$100 *7.45% = $7.45
$100 *7.00% = $7.00 Joint cost of borrowing directly in the currency they need (in $s) –this is called “autarky”:
i.e., Barthez borrows in $s and Beasley in Euros.
$7.45 + €5.87*$/€1.15 = $14.20.
Joint cost of borrowing in their own currency and swapping (in $s):
€5.43*$/€1.15 + $7.00 = $13.25. 3 FBE 436
Answers to Problem Set #5 Clearly there are gains from trade (i.e., swapping). They are better off swapping and sharing the
savings. They would benefit jointly from a swap.
Also notice that the FX rate is not relevant. Thus, the shorter calculation is:
$7.45 + $6.75 = $14.20.
$6.25 + $7.00 = $13.25. Problem #5.5:
You purchased a WEBS one year ago, for 500,000 fc. It current value is 600,000 fc.
When you purchased the WEBS, the local 1-year interest rate was 15.0%, the FX rate was
0.6522 $/fc, and the local CPI was 120.0.
Now, the FX rate is 0.5336, and the CPI is 134.4. What was your return in local currency, your
real return in the local currency, and your return in $s?
The money return is 600,000/500,000 – 1 = 20%.
The approximate real return is the 20% minus the 12% inflation you can calculate from the CPIs.
The get the “exact” real return you must deflate each quantity by the appropriate CPI and then
calculate the growth rate. (600,000/134.4)/(500,000/120) – 1 = 7.14%
The approximate $ return is the 20% minus the appreciation of the $; 20% - 22%. To gte the
precise return: (600,000*0.5346)/(500,000*0.6522) – 1 = -1.64% Problem #5.6:
You estimate an APT regression on the total returns of Owen Inc. The table below shows the
estimates with their significance levels, as well as estimates of the factor risk premia: What is
the expected return for Owen Inc.? The current short and long term T Bill and Bond rates are
3.8% and 4.6%, respectively.
RM - Rf
0.550 Risk Premium
4.10% If you take every beta (coefficient) and multiply its risk premium, you get:
1.2250*6.50 + 0.7830*1.60 + 0.2256*4.10 = 10.26% expected return. However, that is
incorrect. The reason is that the HML beta is statistically highly insignificant.
The correct expected risk premium for Owen Inc. is = 1.2250*6.50 + 0.7830*1.60 = 9.22%.
The correct expected return is 9.22% + 3.8% = 13.02% 4 FBE 436
Answers to Problem Set #5 Problem #5.7 (optional):
Note: There were no numerical examples for FX operations provided in class because of time
constraints. Try your hand at working this out from the information in class and in the text.
The CB of Erehwon is contemplating a $15 billion FX operation in $s to support its depreciating
currency. Below is the CB’s Balance Sheet.
Trace through the transactions required for an unsterilized and a sterilized
If the CB’s FX reserves were in ¥, how would this sequence change?
1,100 High Powered Money
80 Other Liabilities
Step 1: The CB sells $15 of Foreign securities. This reduces H by $15 (to 1,085).
This would be the end of unsterilized intervention.
To sterilize the intervention:
Step 2: The CB buys $15 of Gov. securities. This increases H back to $1,100, and increases
Gov. Securities to 1,065. See below: 5 FBE 436
Answers to Problem Set #5 Unsterilized:
1,085 High Powered Money
80 Other Liabilities
1,100 High Powered Money
80 Other Liabilities
1,215 (2) The denomination of the foreign assets is not really important. If the CB wants to do the
intervention in the $ market, it can start by selling its ¥-securities and purchase $ securities. 6 ...
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