INTERNATIONAL FINANCE END-OF SEMESTER CASE STUDY 1 QUESTIONS (40...

INTERNATIONAL FINANCE END-OF SEMESTER CASE STUDY 1 QUESTIONS (40 Marks)

INSTRUCTIONS: READ THE QUESTIONS CAREFULLY. ANSWER THE QUESTIONS ON THE SEPARATE ANSWER SHEET THAT CAN BE DOWNLOADED

HighTech is a multinational U.S.A. company that performs diverse activities. It manufactures electronic tools like hand-held digital electronic veniers, digital multimeters, voltage testers etc. 

To conduct this manufacturing they import certain electronic components from countries like Japan and South Korea. 

The market for the manufactured tools are the U.S.A, Australia, Canada and United Kingdom (U.K). However, the majority of sales is in the U.K. Therefore, the company has already put up a subsidiary in the U.K. It resells and distribute the products to different businesses. The quarterly net profit after tax generated by the subsidiary is £500,000. The exports to Canada and Australia are to other independent distributing companies that buys the tools at wholesale prices from HighTech.

HighTech is also considering the construction of an electronic component manufacturing plant in the U.S.A. to eliminate the risks and costs associated with the current importing of electronic components from countries like Japan and South Korea. 

HighTech already has sufficient manufacturing space available and only has to import manufacturing equipment of 63,000,000 Yen from Japan. The installation of the machinery will be conducted by local U.S.A. companies and will cost $1000,000.

The Chief Executive Officer (CEO) of HighTech, requests the following information to assist him with determining the extent of exchange rate risk and the availability of funds to conduct the multinational transactions:

1. The CEO requires a forecast of the one year and two year exchange rates for the $/£ calculated based on purchasing power parity (PPP) and with the International Fisher Effect (IFE) with the following existing available information: 

Current $/£ spot exchange rate $1.3036/£

Expected annual U.S. inflation 0.37%

Expected annual British inflation 0.20%

 Expected U.S. one-year interest rate 0.140%

Expected British one-year interest rate 0.077%

2. The CEO is afraid interest rates will increase by 0.5% in the U.K. The U.K. subsidiary has a current short term loan of £1,000,000 that expires 90 days from now, but will have to borrow the same amount again after expiry for operational expenses that will be incurred. Calculate the expected outcome of a 90 day forward rate agreement entered into in the United Kingdom to hedge against the increase in interest rates on £1,000,000. The current risk free United Kingdom rate is to be used as the agreed rate for the calculation. Also assume the settlement rate is the current risk free rate plus 0.5%. Advise the CEO whether HighTech should take a long or short position to hedge the risk of the increasing interest rates. Information from the following table can be used for your calculations:

Annual risk free interest rates:

USA 0.140%

Japan 0.025%

South Korea 0.664%

Canada 0.166%

UK 0.077%

Australia 0.112%

South Africa 4.545%

3. The profit generated by the subsidiary in the U.K. is considered as a good source of money to be used to pay for the import of manufacturing equipment from Japan for the electronic component plant in the U.S.A. The CEO has already entered into negotiations with the Japan supplier of the equipment. The supplier is willing to provide HighTech 3 years to pay for the equipment that will be shipped to HighTech, but the payments must be conducted with quarterly instalments of 5,250,000 Yen by the U.K. subsidiary. This is why the CEO wants you to construct a currency swap arrangement where the profits of the U.K. subsidiary can be used to pay for the equipment. You have to apply the swap bank quotes to conduct this three year swap and also depict the swap graphically for the CEO to see how the swap will work. Relevant information, that you will require are provided below:

Exchange rates: Spot

Bid Ask

$/JPY 0.0094 0.0095

$/Won 0.0006 0.0008

$/CAD 0.7614 0.7616

$/GPD 1.3034 1.3038

$/AU$ 0.7225 0.7226

$/ZAR 0.0606 0.0607

Current borrowing interest rates on loans: Fixed Libor 

USA 0.640% 0.130%

Japan 0.525% 0.015%

South Korea 1.164% 0.654%

Canada 0.666% 0.156%

UK 0.577% 0.067%

Australia 0.612% 0.102%

South Africa 5.045% 4.535%

BANK CURRENCY SWAP INTEREST RATE QUOTES AGAINST U.S. LIBOR RATE

$ Yen Won CAD$ GPD AU$ ZAR

Years Bid% Ask% Bid% Ask% Bid% Ask% Bid% Ask% Bid% Ask% Bid% Ask% Bid% Ask%

1 0.630 0.650 0.515 0.535 1.154 1.174 0.656 0.676 0.567 0.587 0.602 0.622 5.035 5.055

2 0.640 0.660 0.525 0.545 1.164 1.184 0.666 0.686 0.577 0.597 0.612 0.632 5.045 5.065

3 0.650 0.670 0.535 0.555 1.174 1.194 0.676 0.696 0.587 0.607 0.622 0.642 5.055 5.075

4 0.660 0.680 0.545 0.565 1.184 1.204 0.686 0.706 0.597 0.617 0.632 0.652 5.065 5.085

5 0.670 0.690 0.555 0.575 1.194 1.214 0.696 0.716 0.607 0.627 0.642 0.662 5.075 5.095

6 0.680 0.700 0.565 0.585 1.204 1.224 0.706 0.726 0.617 0.637 0.652 0.672 5.085 5.105

7 0.690 0.710 0.575 0.595 1.214 1.234 0.716 0.736 0.627 0.647 0.662 0.682 5.095 5.115

8 0.700 0.720 0.585 0.605 1.224 1.244 0.726 0.746 0.637 0.657 0.672 0.692 5.105 5.125

9 0.710 0.730 0.595 0.615 1.234 1.254 0.736 0.756 0.647 0.667 0.682 0.702 5.115 5.135

10 0.720 0.740 0.605 0.625 1.244 1.264 0.746 0.766 0.657 0.677 0.692 0.712 5.125 5.145

Other summarised information:

United Kingdom subsidiary profits generated quarterly: £500,000

Import cost of equipment/machinery for the manufacturing of electronic components in the U.S.A:  ¥63,000,000

Period of time that the components can be paid (in years) 3

Number of payments per year 4

Amount of each payment: ¥5,250,000

4. The banks of Australian and Canadian companies that purchase electronic tools from HighTech provides letters of credit and are required to conduct payment within 180 days after the goods have been shipped to them. Therefore, the banks issue bankers acceptances to HighTech's bank. There are currently two bankers acceptances that HighTech can request his bank to discount: Bankers acceptance one is from Canada. It's maturity value is $1,500,000 and it will mature in 45 days. The bankers acceptance commission is 1.35% and the market rate is 1.50%. The other bankers acceptance is from Australia. It's maturity value is $3000,000 and it will mature in 120 days. The bankers acceptance commission is 0.95% and the market rate is 1.25%. The CEO mentions that HighTech pays an average of 1.1% on existing loans. He requires information of whether it is viable to discount any of the bankers acceptances or not. Calculate the bond equivalent rate that HighTech will receive for each of the bonds when they are discounted and compare it to the average cost of HighTech's debt to determine whether any of the bankers acceptances should be discounted.

In the process to answer all the letter of credit questions of the CEO, you have collected and summarised the following data:

Bankers acceptances that HighTech holds: Time till maturity (Days) Maturity value Acceptance commission Market rate 

B/A for export to Canadian company 45 $1,500,000 1.35% 1.5%

B/A for export to Australian company 120 $3,000,000 0.95% 1.25%

Existing average interest cost of debt for HighTech = 1.1%

Instructions:

Complete the separate Case Study answer sheet to respond to the questions of the CEO in this scenario.

Question 1: (10 Marks)

The CEO requires a forecast of the one year and two year exchange rates for the $/£ calculated based on purchasing power parity (PPP) and with the International Fisher Effect (IFE).

Calculate the one year forward $/£ exchange rate based on PPP in the space provided below: (2 marks) 

Calculate the two year forward $/£ exchange rate based on PPP in the space provided below: (2 marks)

Calculate the one year forward $/£ exchange rate based on IFE in the space provided below: (2 marks)

Calculate the two year forward $/£ exchange rate based on IFE in the space provided below: (2 marks)

Explain the conditions under which the forward exchange rates calculated by you will be unbiased predictors of the future spot exchange rate. Use the space provided below. (2 marks)

Question 2: (10 Marks)

The CEO is afraid interest rates will increase by 0.5% in the United Kingdom. The U.K. subsidiary has a current short term loan of £1,000,000 that expires 90 days from now, but it will have to borrow the same amount again after expiry for operational expenses that will be incurred. Calculate the expected outcome of a 90 day forward rate agreement entered into in the United Kingdom to hedge against the increase in interest rates on £1,000,000. The current risk free United Kingdom rate is to be used as the agreed rate for the calculation. Also assume the settlement rate is the current risk free rate plus 0.5%. Advise the CEO whether HighTech should take a long or short position to hedge the risk of the increasing interest rates.  

Show your calculation by applying the correct formula in the space provided below: 6 marks

Question Your answer

Do you recommend that HighTech should be the seller or buyer of the forward rate agreement? (1 mark)

Briefly explain how the forward rate agreement will assist Hightech in terms of the interest rate that it will have to pay if it borrows £1,000,000 again for 90 days after expiry of the current loan. (3 marks)

Question 3: (16 marks)

a. The profit generated by the subsidiary in the U.K. is considered as a good source of money to be used to pay for the import of manufacturing equipment from Japan for the electronic component plant in the U.S.A. The CEO has already entered into negotiations with the Japan supplier of the equipment. The supplier is willing to provide HighTech 3 years to pay for the equipment that will be shipped to HighTech, but the payments must be conducted with quarterly instalments of 5,250,000 Yen by the U.K. subsidiary. This is why the CEO wants you to construct a currency swap arrangement where the profits of the U.K. subsidiary can be used to pay for the equipment. You have to apply the swap bank quotes to conduct this three year swap and also depict the swap graphically for the CEO to see how the swap will work.

Workings:

Calculation of the notional principal of the hedge in Japanese yen:

Provide your answers in the cells below Marks

Payments to be conducted by HighTech subsidiary in the U.K. 0.5 mark

How often? Monthly = 12/ Quarterly = 4/Semi-annual = 2 0.5 mark

Swap bank Yen bid rate 0.5 mark

Therefore, notional Yen principal calculated with information above 0.5 mark

Calculation of the notional principal of the hedge in British pounds:

Provide your answers in the cells below Marks

Spot exchange rate $/Yen ask rate 0.5 mark

Spot exchange rate $/GBP bid rate 0.5 mark

Therefore, British pound notional principal calculated with information above. 0.5 mark

Swap bank 3 year GBP ask rate 0.5 mark

U.K. subsidiary pays quarterly: 0.5 mark

GBP/Yen Exchange rate locked in for three years: 0.5 mark

Question 3 continued:

Complete the diagram below to show the swap transaction graphically by inserting the correct interest rate or currency values below: (6 marks)

b. Explain to the CEO what forfaiting is, why it is possible that forfaiting of the transaction can occur and the implication that it will have on the swap transaction. (4 marks)

Provide your answers in space provided below: 

Question Your answer

What is forfaiting? (Give an explanation). (3 marks)

Why can forfaiting occur? (1 mark)

Implication on the swap transaction (State whether it impacts the swap or not and the reason for it). (1 mark)

Question 4: (14 marks)

The banks of Australian and Canadian companies that purchase electronic tools from HighTech provides letters of credit and are required to conduct payment within 180 days after the goods have been shipped to them. Therefore, the banks issue bankers acceptances to HighTech's bank. There are currently two bankers acceptances that HighTech can request his bank to discount: Bankers acceptance one is from Canada. It's maturity value is $1,500,000 and it will mature in 45 days. The bankers acceptance commission is 1.35% and the market rate is 1.50%. The other bankers acceptance is from Australia. It's maturity value is $3000,000 and it will mature in 120 days. The bankers acceptance commission is 0.95% and the market rate is 1.25%. The CEO mentions that HighTech's pays an average of 1.1% on existing loans. He requires information of whether it is viable to discount any of the bankers acceptances or not. Calculate the bond equivalent rate that HighTech will receive for each of the bonds when they are discounted and compare it to the average cost of HighTech's debt to determine whether any of the bankers acceptances should be discounted.

Calculate the value of the Canadian bankers acceptance at maturity by applying the correct formula in the space below: (2 marks)

Calculate the discounted value of the Canadian bankers acceptance at maturity by applying the correct formula in the space below: (2 marks)

Calculate the bond equivalent rate of the Canadian bankers acceptance by applying the correct formula in the space below: (2 marks)

Should the Canadian bankers acceptance be discounted if you compare it to the average cost of existing loans to HighTech? Provide one reason for your answer in the space below: (1 mark)

Calculate the value of the Australian bankers acceptance at maturity by applying the correct formula in the space below: (2 marks)

Calculate the discounted value of the Australian bankers acceptance at maturity by applying the correct formula in the space below: (2 marks)

Calculate the bond equivalent rate of the Australian bankers acceptance by applying the correct formula in the space below: (2 marks)

Should the Australian bankers acceptance be discounted if you compare it to the average cost of existing loans to HighTech? Provide one reason for your answer. (1 mark)