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Case II.2 �


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Case II.2 EUCLIDES ENGINEERING LTD (Rosa and Wilson) Q1. In the view of the relative values of the U.S. dollar and the Deutsche mark. How can you explain the discrepancy between the U.S. and the Swiss-West German bids? According to the given information, the total payment will be paid in three future determinate date. That means there will be three different future cash flow denominated in two currencies. However, the Mexican government just converted the different bidding prices at the current exchange rate between DM and dollar. This is obviously wrong, and causes the huge discrepancy of the two biding prices. The right way is discount each cash flow on the expected future spot rate. We can use the WEFA Exchange Rate Forecast data to recalculate the dollar biding price to DM. Since the estimated exchange rate is base on the end of each month, the effective date for July 1 is the June rate. The DM biding price is $54million×DM3.14/$=$169.56million DM million $ million 1986 Jun 56.52 DM2.71/$ 20.8560 1986 Dec 56.52 DM2.57/$ 21.9922 1987 Jun 56.52 DM2.47/$ 22.8826 total 169.56 $65.7308 Here, we just ignore the effect of time value of money. The undiscounted value of the competitor’s biding price in dollar is very close to Euclides’ bidding of $67 million. This is not the end of the story, since we just use an estimated forward exchange rate to convert each future payment. There is also possibility that the actual future spot rate will different from our expectation. Then we can use some theories to explain the remaining component of discrepancy of the two currency biding price after adjust for the forward exchange price.
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The principle of law of one price states that: in a perfect competitive market, identical exchange rate. It means one unit of currency should have the same purchasing power in every country. However, in the real world, things are different. Just like the case, two companies contested for the same project, the exchange adjusted bid price for the Germany Company is $54 million, which is quite different from the exchange rate adjusted price offered by Euclides Engineering, $ 67 million. The major reasons for the discrepancy of the biding price are summarized as follow: i) Non-tradable goods. Because of the two companies are located in different country (German and U.S.); their business operated under local conditions. Many costs incurred in local are un-tradable, such as real estate, labor cost, administrative and transportation expenditures. It also referred as the Balassa-Samuelson effect. It argues that the consumption may be cheaper in some countries than others, because non-tradable (especially land and labor) are cheaper in less developed countries. Here, in our case, the total operational cost is higher in the US by comparing to the German. ii) Market inefficient. The law of one price is available under the assumption of a perfect or called efficient market, with no cost for any information transmit and no transaction cost, have a high financial liquidity. All of them are ideal conceptions easy for explaining the theory or analyzing the situation.
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