Chapter 20 - R l R 2 R 3 R 4 R 5 R 6 R 7 CHAPTER 19 REVIEW...

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Unformatted text preview: R. l. R. 2. R. 3. R. 4. R. 5. R. 6. R. 7. CHAPTER 19 REVIEW QUESTIONS The foreign exchange market is a market that exchanges one currency into another. Unlike stock markets such as the New York Stock Exchange, the foreign exchange market has no centralized location but is rather a network of dealers linked by telephones. Black exchange rate markets are markets that develop outside the control of governments. Black markets for foreign exchange arise when governments set exchange rates well outside what would occur under a free market. Because prices on black markets are driven by supply and demand, the black market price is usually significantly different from the official exchange rate set by the government. A foreign currency value can be translated into any other currency by multiplying the foreign currency value by the exchange rate between the foreign and domestic currencies. The law of one price is an economic principal that states that identical goods must have identical values. The law of one price requires that identical assets traded in different currencies will be equal to each other if they are converted into a common currency using foreign exchange rates. Under the law of one price, it would be impossible to earn a profit by purchasing a basket of commodities in one country and selling them in another. The law of one price described in question 4 above will work in perfect or near perfect markets. How closely prices behave to the law of one price depends upon the type of good and the trading costs. For widely traded similar assets we would expect the law of one price to hold approximately. The examples include precious metals and oil. However, for less often traded goods, dissimilar goods, or goods that are not easily transported, we would expect price differences such that the law of one price fails to hold. Examples include tropical fruit, manual labor, and medical care. Purchasing power parity is a theory stating that the purchasing power of a currency in one country will have the same power when converted to another currency and spent in another country. Purchasing power parity implies that, for example, the US. dollar will have the same overall purchasing power in the United States as it does when converted into another currency and spent in that country. A forward contract is a contract allowing the exchange of future units of one currency for future units in another currency at an agreed upon price today. So, forward contracts can be used to lock in a rate of foreign exchange providing protection from fluctuations in foreign exchange rates in the future. 150 R. 8. Although forward or futures contracts can be used to eliminate foreign exchange risk, there may be two problems with their use. The first problem is commitment. These contracts commit participants to exchange at a predetermined rate even if the need to exchange currency vanishes. The second problem is regret. While the contract is used to eliminate the risk of currency fluctuations, it could turn out that the participant could have profited by the move in foreign exchange prices if the futures or forward contracts were not used. R. 9. Options on foreign exchange contracts allow users to avoid or lessen the two problems discussed in problem 8 above. Like other option contacts, an option contract on foreign exchange allows its holder the option to exchange a given amount of one currency for another without the obligation to do so. Thus, if the need to exchange currency vanishes or if market prices move in favor of the participant, the participant need not act (let the option expire). R. 10.Interest rate parity is a theory stating that risk free bonds of various currencies must offer the same return when translated into a common currency using forward contracts. Interest rate parity implies that investors cannot earn a profit by converting one currency to another, purchasing foreign bonds, and converting the foreign currency to domestic currency using forward contracts. R. 11.Systematic risk is the risk that remains in a diversified portfolio. Given the ability to form portfolios with securities of different countries, in an international context, systematic risk relates to the correlation between an asset’s return and the return of the world economy or in other words the world portfolio. R. 12.Political risk is the risk that actions by a foreign government will have a negative impact on a firm’s wealth. An example of political risk would be the decision by a government to nationalize a certain industry. R. 13.Question 12 above used nationalization as an example of political risk. Recall that nationalization is the process whereby private property is seized by the government for the good of the people with little or no compensation to the original owner. R. 14.1nnovative financing arrangements designed to remove political risk are arrangements that ensure that as large as possible a percentage of any losses due to the seizure of private property by foreign governments will be borne by the host country itself. An example is to require the host country to provide a portion of the project’s financing. R. 15.Letters of credit are financial instruments often used to facilitate international trade. The letter of credit represents a guarantee of payment by the importer to the exporter, backed by the issuer of the letter such as a bank. 151 CHAPTER 19 PROBLEMS 1. Domestic Currency Value = Foreign Currency Value * Exchange Rate a. The domestic model at $140,000 Euro = 120,000.00 * $1.30 Euro = $156,000.00 b. The Euro model at 120,000 Euro 2 120,000.00 * $1.10 Euro = $132,000.00 c. $1.17 $140,000.00 = 120,000.00 * Exchange Rate Exch. Rate = 1.1667 d. 0.857 Euros per U. S. Dollar 2. The Foreign currency values are converted into U. S. Dollar values by multiplying them by the figures from the column labeled "U. S. $ equiv.” Foreign Currency * U. S. $ equiv. = $US a. 140,000 * $08598 = $120,372 b. 340,000 * $13139 = $446,726 0. 804,000 * $0.008379 = $6,737 d. 145,000 * $0.8101 = $117,465 3. The Domestic currency values are converted into Foreign Currency values by multiplying them by the figures from the column labeled "Currency per U. S. $“ Domestic Currency * Currency / $ = Foreign Currency a. $123,000 * 1.1631 = 143,061 b. $150,000 * 0.7611 = 114,165 c. $8,000 * 119.3500 = 954,800 d. $456,000 * 1.2344 = 562,886 4. The Foreign currency price of gold in a perfect market is found by multiplying the U. S. price of $1,000 times the value from the column labeled "Currency per U. S. $" Domestic Currency * Currency / $ = Foreign Currency a. $1,000 * 1.2706 = 1,270.60 b. $1,000 * 0.5128 = 512.80 c. $1,000 * 0.7611 = 761.10 d. $ 1,000 * 24.2700 = 24,270.00 e. $1,000 * 7.1429 = 7,142.90 152 5. Domestic Currency Value = Foreign Currency Value * Exchange Rate Domestic = 1,300.00 * $0.75 Domestic = $975.00 Thus, the gold can be bought for the equivalent of $975 (U. S. Dollars) by converting the U. S. dollars (975) to Australian dollars (1,300) and buying an ounce in Australia The gold can then be sold in the U. S. for $1,000, producing a $25 per ounce profit. Since there is virtually no time or risk involved, this is an arbitrage profit and could not be expected to persist. 6. a. $15,000 per quarter. First, compute the cost of the equipment in dollars: Domestic Currency Value = Foreign Currency Value * Exchange Rate Domestic = 100,000.00 * $1.10 Domestic = $110,000.00 Next, compute the profit by subtracting the cost from the revenue: Profit = Revenue — Cost Profit=$125,000—$110,000 Profit=$15,000 per quarter. b. See Table. Error in book, should be $1.50 in quarter 8. Quarter Exch Rate Revenue Cost in $ Profit/Loss Cum. P/L $1.40 $125,000 $140,000 ($15,000) ($15,000) $1.45 $125,000 $145,000 ($20,000) ($35,000) $1.50 $125,000 $150,000 ($25,000) ($60,000) 1 $1.15 $125,000 $115,000 $10,000 $10,000 2 $1.20 $125,000 $120,000 $5,000 $15,000 3 $1.25 $125,000 $125,000 $0 $15,000 4 $1.30 $125,000 $130,000 ($5,000) $10,000 5 $1.35 $125,000 $135,000 ($10,000) $0 6 7 8 7. a. See Table. Quarter Exch Rate Revenue Cost in$ Profit/Loss Cum. P/L $1.15 $125,000 $115,000 $10,000 $10,000 $1.15 $125,000 $115,000 $10,000 $20,000 $1.15 $125,000 $115,000 $10,000 $30,000 $1.35 $125,000 $135,000 ($10,000) $20,000 $1.35 $125,000 $135,000 ($10,000) $10,000 $1.35 $125,000 $135,000 ($10,000) $0 $1.50 $125,000 $150,000 ($25,000) ($25,000) $1.50 $125,000 $150,000 ($25,000) ($50,000) OO\]O\LA4>UJl\Jl—A 153 b. See Table. Quarter Exch Rate Revenue Cost in$ Profit/Loss Cum. P/L $1.40 $125,000 $140,000 ($15,000) $45,000 $1.40 $125,000 $140,000 ($15,000) $30,000 1 $1.05 $125,000 $105,000 $20,000 $20,000 2 $1.05 $125,000 $105,000 $20,000 $40,000 3 $1.05 $125,000 $105,000 $20,000 $60,000 4 $1.25 $125,000 $125,000 $0 $60,000 5 $1.25 $125,000 $125,000 $0 $60,000 6 $1.25 $125,000 $125,000 $0 $60,000 7 8 8. a. a loss of $50,000 as shown in the solution to Problem 7a. b. $120,000 as shown in Table: Quarter Exch Rate Revenue Cost in $ Profit/Loss Cum. P/L $1.10 $125,000 $110,000 $15,000 $15,000 $1.10 $125,000 $110,000 $15,000 $30,000 $1.10 $125,000 $110,000 $15,000 $45,000 $1.10 $125,000 $110,000 $15,000 $60,000 $1.10 $125,000 $110,000 $15,000 $75,000 $1.10 $125,000 $110,000 $15,000 $90,000 $1.10 $125,000 $110,000 $15,000 $105,000 $1.10 $125,000 $110,000 $15,000 $120,000 OO\]O\UIJ>UJNl—t C. Using the futures contracts, the cumulative loss would have been $50,000. But, if Mat’s did not use futures and the exchange rate fell as given in Problem 8b., then Mat’s would have had a cumulative profit of $120,000. Thus, using hindsight, the use of futures contracts cost the firm $170,000. This loss may be checked as follows: Quarter Exch Rate Futures Loss/Qtr Cum. P/L 1 $1.10 $1.15 ($5,000) ($5,000) 2 $1.10 $1.15 ($5,000) ($10,000) 3 $1.10 $1.15 ($5,000) ($15,000) 4 $1.10 $1.35 ($25,000) ($40,000) 5 $1.10 $1.35 ($25,000) ($65,000) 6 $1.10 $1.35 ($25,000) ($90,000) 7 $1.10 $1.50 ($40,000) ($130,000) 8 $1.10 $1.50 ($40,000) ($170,000) 9. a. 100.00 Krone Domestic Currency Value = Foreign Currency Value * Exchange Rate $25.00 = Price in Krone * $0.25 Price in Krone = 100.00 154 b. $33,000,000. First, compute the cost of one barrel of the oil in dollars: Domestic Currency Value = Foreign Currency Value * Exchange Rate Domestic Curr. Value = 110.00 * $0.30 Domestic Curr. Value = $33.00 per barrel of oil $33,000,000 for 1,000,000 barrels of oil. c. $28,600,000. First, compute the cost of one barrel of the oil in dollars: Domestic Currency Value = Foreign Currency Value * Exchange Rate Domestic Curr. Value = 110.00 * $0.26 Domestic Curr. Value = $28.60 per barrel of oil $28,600,000 for 1,000,000 barrels of oil. 10a. A loss of $6,600,000. First compute the cost at an exchange rate of $0.20: Domestic Currency Value = Foreign Currency Value * Exchange Rate Domestic Curr. Value = 110.00 * $0.20 Domestic Curr. Value = $22.00 per barrel of oil $22,000,000 for 1,000,000 barrels of oil. Next, compute the profit or loss by subtracting this cost from the cost at $0.26: Profit/Loss = Cost without futures — Cost with futures Profit/Loss = $22,000,000 — $28,600,000 Profit/Loss = ($6,600,000) b. Profit = $9,900,000. Compute the costs at each exchange rate: Domestic Currency Value = Foreign Currency Value * Exchange Rate Domestic Curr. Value = 110.00 * $0.16 Domestic Curr. Value = $17.60 per barrel of oil $17,600,000 for 1,000,000 barrels of oil. Domestic Currency Value = Foreign Currency Value * Exchange Rate Domestic Curr. Value = 110.00 * $0.25 Domestic Curr. Value = $27.50 per barrel of oil $27,500,000 for 1,000,000 barrels of oil. Next, compute the profit or loss by subtracting these costs: Profit/Loss = Cost without futures — Cost with futures Profit/Loss = $27,500,000 —— $17,600,000 Profit/Loss = $9,900,000 155 11 12. 13. .Rather than entering into futures contracts that obligate a firm to engage in an exchange of currency, Mat’s could have purchased a foreign exchange option that would give Mat’s the right to exchange currencies without any obligation in the event that foreign exhange rates moved such that Mat’s could get a better deal by not using the option. Mat’s would simply purchase options to exchange U. S. Dollars into Euros in amounts and times that correspond to Mat’s needs for Euros: Since Mat’s needs 100,000 Euros in each of the eight quarters, then Mat’s should purchase eight options. Each option should permit the exchange of American dollars into 100,000 Euros. The difference between the eight options is that there should be one option expiring in each of the eight quarters. a. $02250 found by dividing the $24,750,000 by the 110,000,000 Krone b. $19,600,000 found by using the market exchange rate of $0.16 (since it is cheaper than the option strike rate) on the 110,000 Krone and then adding in the cost of the option ($2,000,000). $26,750,000 found by using the option’s strike rate of $0.225 (since it is cheaper than the market exchange rate) on the 110,000 Krone and then adding in the cost of the option ($2,000,000). . $26,750,000 found by using the option’s strike rate of $0.225 (since it is cheaper than the market exchange rate) on the 110,000 Krone and then adding in the cost of the option ($2,000,000). $2,950,000 Cost without option = 110,000,000 * $0.27 = Cost with option (as determined above) = Savings due to use of option = $29,700,000 $26,750,000 $2,950,000 0.9815 Canadian Dollars per American Dollar From the text Formula 19.2: (1 + Dom)/(1 + For) = Spot Exchange Rate / Forward Exchange Rate 1.08/ 1.06 = 1.00 / Forward Exchange Rate 1 Forward Exchange Rate = 1.06/ 1.08 = 0.9815 Canadian Dollars per US Dollar Note that the value of the Canadian Dollar is higher in the forward market to offset the lower interest rate being offered in Canadian Dollars. 156 14. 15 16. 17. 1.0189 Canadian Dollars per American Dollar From the text Formula 19.2: (1 + Dom)/(1 + For) = Spot Exchange Rate / Forward Exchange Rate 1.06/ 1.08 = 1.00 / Forward Exchange Rate Forward Exchange Rate = 1.08/ 1.06 = 1.0189 Canadian Dollars per US Dollar Note that the value of the Canadian Dollar is lower in the forward market to offset the higher interest rate being offered in Canadian Dollars. .An important problem is that the text Formula 19.2 expresses exhange rates in the foreign currency, while the problem gives exchange rates in the domestic currency. Thus, the first step is to invert each exchange rate so that it reflects the foreign currency. Then, Formula 19.2 can be used. (1 + Dom)/(1 + For) = Spot Exchange Rate / Forward Exchange Rate Expressed in US Dollars Expressed in Foreign Currency Domestic Foreign Spot Exch. For’d Rate Spot Exch. Forward Rate a. 10.00% 15.00% $05000 $04783 2.0000 2.0909 b. 18.00% 12.00% $02373 $02500 4.2143 4.0000 c. 15.00% 9.52% $02000 $02100 5.0000 4.7619 (1. 0.00% 10.00% $04400 $04000 2.2727 2.5000 Note: Use the last two columns on the right, the foreign currency exchange rates, or change formula 19.2 as shown below and use the US Dollar rates: (1 + Dom)/(1 + For) = Forward Exchange Rate / Spot Exchange Rate a. b. The world, the International CAPM assumes the world economy is the "market". 13.00% Found by plugging the known values into the CAPM: E(R) = risk free rate + (beta*(Exp. mkt. return — risk free rate)) E(R) = 8% + 0.5 (18% — 8%) = 8% + 5% = 13% 20.80% Found by plugging the known values into the CAPM: E(R) = risk free rate + (beta*(Exp. mkt. return — risk free rate)) E(R) = 8% + 0.8 (24% — 8%) = 8% + 12.8% = 20.8% a. The world, the International CAPM assumes the world economy is the "market". 5.00% Found by plugging the known values into the CAPM: E(R) = risk free rate + (beta*(Exp. mkt. return — risk free rate)) E(R) = 0% + 0.5 (10% —- 0%) = 0% _+ 5% = 5% 10.50% Found by plugging the known values into the CAPM: E(R) = risk free rate + (beta*(Exp. mkt. return — risk free rate)) E(R) = 0% + 1.5 (7% — 0%) = 0% + 10.5% = 10.5% 157 18a. 1.0800 American Dollars per British Pound From the text Formula 19.2, using exchange rates in the foreign currency: (1 + Dom)/(1 + For) = Spot Exchange Rate / Forward Exchange Rate 1.08/ 1.00 = 1.00 / Forward Exchange Rate Forward Exchange Rate = 1.00/ 1.08 = To convert the exchange rate into Dollars/Pounds, simply invert: 0.9259 British Pounds per US Dollar 1.0800 Note that the value of the American Dollar is lower in the forward market to offset the higher interest rate being offered in US Dollars. b. 8% Found by dividing the price change ($0.08) by the original price ($1.00) 193. 5.00% The answer to 16(b), (13%), minus the answer to 18(b), (8%), is 5%. The intuition of this is that the value of the American Dollar (ignoring risk) is expected to decline by 10% as shown in Problem 18. By subtracting this 10% decline from the US Dollar returns in Problem 16, we are able to provide an estimate of the return that a Britich investor would receive investing in the American project Trunk and using the International CAPM. . The answers are the same. What this teaches is as follows: is we use the Int’l CAPM and adjust interest rates using forward exchange rates, we find that any two projects with identical International betas will have the same expected return if the returns are converted into a common currency. This is an important result since it premits an equilibrium relationship free of arbitrage opportunities. 12.80% The answer to 16(c), (20.8%), minus the answer to 18(c), (8%), is 12.8%. The intuition of this is that the value of the American Dollar (ignoring risk) is expected to decline by 10% as shown in Problem 18. By subtracting this 10% decline from the US Dollar returns in Problem 16, we are able to provide an estimate of the return that a Britich investor would receive investing in the American project Trunk but allowing returns to be generated by domestic CAPMs rather than the International CAPM. . The answers are different. The British investor can receive a return (converted to British Pounds) of 12.8% in the U. S. but only 10.5% in England. However, it is entirely possible that these two projects are identical. This difference could permit arbitrage opportunities and therefore there appears to be a problem 158 20. The International CAPM produces identical required rates of return on identical projects (in different nations) when the rates of return from each of the projects are converted into a common currency and the Interest Rate Parity Theorem holds. But domestic CAPM’s will generally give different answers whenever the projects being analyzed and the domestic economies contain unsytematic risk. These different answers are wrong. When a domestic CAPM is used, it allows the possibility that a diversifiable risk will be treated like a systematic risk and therefore the asset will be mispriced. For example, suppose that the American economy suffers (slightly) whenever the price of British ale rises because America imports alot of British ale. However, note that the British economy will thrive whenever they are able to raise the price of British ale (without drying up demand) since we assume that England is able to export a great deal of its ale. Thus, the price of British ale has an influence on both of the domestic economies of England and the U. S. However, it may very well be true that the combined economies of the two nations (and also the world economy) is relatively unaffected by the price of British ale since the losses to the Americans are offset by the gains to the British. Oil prices provide more realistic examples. England and the U. S. have domestic economies that contain risks that are diversifiable from an international perspective. However, if domestic CAPM’s are used, the risks of the domestic economies will be viewed as entirely systematic and project betas will therefore incorporate some of these diversifiable risks as if they are systematic. The resulting required rates of return will be in error. The international CAPM solves this problem by viewing a risk as systematic only if it is correlated with the entire world economy. Since the entire world economy is able to diversify away all risk possible, it does not introduce similar error. 159 CHAPTER 19 DISCUSSION QUESTIONS 1. No. The major principles of modern corporate finance hold for decision making irrespective of whether the decisions are made in one country, another country or internationally. Note that some disciplines such as history, language and art differ tremedously between nations. Others, like math and physics do not. Modern corporate finance studies behavior in competitive and non~competitive markets involving time and risk. Financial markets throughout the world reflect the idea that people are utility maximizing, that they prefer more wealth to less wealth and that they are risk averse. Important international aspects to modern corporate finance include currency differentials, taxes and regulations. 2. Yes. The idea that a particular currency such as the American dollar can purchase a higher (Eastern Europe?) or lower (Japan?) standard of living in some countries than others is indicative of a violation of the purchasing power parity theorem. 3. An internationally diversified investor should be indifferent between the firms in a competitive market since the diversification will eliminate any diversifiable risks. An investor without good diversification may have a preference. 4. As a manager, one would prefer to work for Hops under the reasonable assumption that the firm has a lower probability of encountering major financial problems and that the labor market is sufficiently imperfect that the financial problems of Firm Barley could cause a job loss and that the job loss would result in a loss of utility. 5. Yes. When futures contracts are properly used to hedge risks the profit or loss from the futures contracts will offset the profits or losses being hedged. Futures contracts are frequently used to hedge interest rate risk and foreign exchange rate risk. At the end of each accounting period, we would expect the futures contracts to exhibit a net loss approximately half of the time. This does not indicate mismanagement if indeed the futures contracts were being used to hedge risk rather than increase risk. Thus, to offset the futures contracts losses, the firm should have a large profit in its operations. The fact that Scoundrel Savings and Loan had a small profit could indicate either that the firm had losses in other aspects of its operations (such as loan losses), accounting conventions or that I. M. Leavin did not hedge correctly. 6. As with all international operations, the firm should recognize the risk exposure of having contracts in multiple currencies. Especially in an emerging market, the fluctuations in foreign currency exchange rates can be high. However, another major concern would be political risk. A country that has recently undergone the type of political instability that would change the economy from being planned to being a free market, might also be expected to have a high probability of continued political instability and a relatively high probability of returning to a planned economy. Thus, the firm runs the risk that its efforts will be in vain or even worse, that its assets will be confiscated. 160 7. One of the major advantages from a corporate finance perspective was the elimination of foreign exchange risk between the member nations. The move was also to add convenience and simplification. From a corporate finance perspective there were few or no disadvantages. However, from a political and macroeconomic perspective, the concept raises serious difficulties regarding the control of the money supply. 161 ...
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This note was uploaded on 11/30/2011 for the course FINOPMGT 301 taught by Professor Lacey during the Spring '10 term at UMass (Amherst).

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Chapter 20 - R l R 2 R 3 R 4 R 5 R 6 R 7 CHAPTER 19 REVIEW...

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