国际财务管理(英文版) 第11版 马杜拉 答案 Chapter 14

Chapter 8Relationships Among Inflation,Interest Rates, and Exchange Rates Lecture OutlinePurchasing Power Parity (PPP)Interpretations of PPPRationale Behind PPP TheoryDerivation of PPPUsing PPP to Estimate Exchange Rate EffectsGraphic Analysis of PPPTesting the PPP TheoryWhy PPP Does Not OccurPPP in the Long RunInternational Fisher Effect (IFE)Implications of the IFE for Foreign InvestorsDerivation of the IFEGraphic Analysis of the IFETests of the IFEWhy the IFE Does Not OccurComparison of IRP, PPP, and IFE TheoriesChapter ThemeThis chapter discusses the relationship between inflation and exchange rates according to the purchasing power parity (PPP) theory. Since this is one of the most popular subjects in inter-national finance, it is covered thoroughly. While PPP is a relevant theory, it should be emphasized that PPP will not always hold in reality. It does however, provide a foundation in understanding how inflation can affect exchange rates. The international Fisher effect (IFE) is also discussed in this chapter. This theory is also very important. Yet, it should again be emphasized that this theory does not always hold. If the PPP and IFE theories held consistently, decision making by MNCs would be much easier. Because these theories do not hold consistently, an MNC’s decision making is very challenging.Topics to Stimulate Class Discussion1. Provide reasoning for why highly inflated countries such as Brazil tend to have weak homecurrencies.2. Identify the inflation rate of your home country and some well-known foreign country. Thenidentify the percentage change of your home currency with respect to that foreign country.Did the currency change in the direction and by the magnitude that you would have expected according to PPP? If not, offer possible reasons for this discrepancy.3. Identify the quoted one-year interest rates in your home country and in a well-known foreigncountry as of one year ago. Also determine how your home currency changed relative to this foreign currency over the last year. Did the currency change according to the IFE theory? If not, does this information disprove IFE? Elaborate.4. Provide a simple explanation of the difference between interest rate parity (from the previouschapter), PPP (from this chapter), and IFE (from this chapter).Critical debateDoes PPP Eliminate Concerns about Long-Term Exchange Rate Risk?Proposition Yes. Studies have shown that exchange rate movements are related to inflation differentials in the long run. Based on PPP, the currency of a high-inflation country will depreciate against the home currency. A subsidiary in that country should generate inflated revenue from the inflation, which will help offset the adverse exchange effects when its earnings are remitted to the parent. If a firm is focused on long-term performance, the deviations from PPP will offset over time. In some years, the exchange rate effects may exceed the inflation effects, and in other years the inflation effects will exceed the exchange rate effects.Opposing view No. Even if the relationship between inflation and exchange rate effects is consistent, this does not guarantee that the effects on the firm will be offsetting. A subsidiary in a high-inflation country will not necessarily be able to adjust its price level to keep up with the increased costs of doing business there. The effects vary with each MNC’s situation. Even if the subsidiary can raise its prices to match the rising costs, there are short-term deviations from PPP. The investors who invest in an MNC’s stock may be concerned about short-term deviations fromPPP, because they will 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.With whom do you agree? State your reasons Examine the exchange rate policies of the major multinationals by referring to their annual reports. The Forbes listing of major multinationals on the web is a good starting point. In particular, consult the reports of Renault (France) and Phillips (Holland).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 Questions1. PPP. Explain the theory of purchasing power parity (PPP). Based on this theory, what is ageneral 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.2. 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 country’s 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 country’s goods are no more attractive than the home country’s goods. Inflation differentials are offset by exchange rate changes. 3. Testing PPP. Explain how you could determine whether PPP exists. Describe a limitation intesting 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 ofeach 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 baseperiod should reflect an equilibrium position, but it is difficult to determine when such a period exists.4. Testing PPP. Inflation differentials between the U.S. and other industrialized countries havetypically 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.5. 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 differentials. In addition, there may not be substitutes for traded goods. Therefore, even when a country’s inflation increases, the foreign demand for its products will not necessarily decrease (in the manner suggested by PPP) if substitutes are not available.6. Implications of IFE. Explain the international Fisher effect (IFE). What is the rationale forthe 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.ANSWER: The IFE suggests that a currency’s 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 currency’s 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.7. Implications of IFE. Assume UK interest rates are generally above foreign interest rates.What does this suggest about the future strength or weakness of the pound based on the IFE?Should UK investors invest in foreign securities if they believe in the IFE? Should foreign investors invest in UK securities if they believe in the IFE?ANSWER: The IFE would suggest that the pound will depreciate over time if UK interest rates are currently higher than foreign interest rates. Consequently, foreign investors who purchased UK securities would on average receive a similar yield as what they receive in their own country, and UK investors who purchased foreign securities would on average receive a yield similar to UK rates.8. Comparing Parity Theories. Compare and contrast interest rate parity (discussed in theprevious 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 suggestsa relationship between the interest rate differential of two countries and the percentagechange 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.9. Real Interest Rate. One assumption made in developing the IFE is that all investors in allcountries 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.10. Interpreting Inflationary Expectations. If investors in the UK and Canada require the samereal interest rate, and the nominal rate of interest is 2 percent higher in Canada, what does this imply about expectations of UK 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 UK. If these inflationary expectations come true, PPP would suggest that the value of the Canadian dollar should depreciate by 2 percent against the pound.11. PPP Applied to the Euro. Assume that several European countries that use the euro as theircurrency 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 euro’s 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.12. Source of Weak Currencies. Currencies of some Latin American countries, such as Braziland Venezuela, frequently weaken against most other currencies. What concept in this chapter explains this occurrence? Why don’t 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 depreciateagainst 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.13. PPP. Japan has typically had lower inflation than the United States. How would one expectthis to affect the Japanese yen’s value? Why does this expected relationship not always occur?ANSWER: Japan’s low inflation should place upward pressure on the yen’s value. Yet, other factors can sometimes offset this pressure. For example, Japan heavily invests in U.S.securities, which places downward pressure on the yen’s value.14. IFE. Assume that the nominal interest rate in Mexico is 48 percent and the interest rate in theUnited 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.)15. IFE. Shouldn’t the IFE discourage investors from attempting to capitalize on higher foreigninterest 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) thereare other factors that can offset the possible impact of inflation on the foreign currency’s value.16. Changes in Inflation. Assume that the inflation rate in Brazil is expected to increasesubstantially. How will this affect Brazil’s nominal interest rates and the value of its currency (called the real)? If the IFE holds, how will the nominal return to UK investors who invest in Brazil be affected by the higher inflation in Brazil? Explain.ANSWER: Brazil’s 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 UK 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.17. 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.If conditions (1) or (2) do not hold, PPP may still hold, but investors may achieve consistently higher returns when investing in a foreign country’s securities. Thus, IFE would be refuted.18. Estimating Depreciation Due to PPP. Assume that the spot exchange rate of the Britishpound 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)] = $1.65.19. Forecasting the Future Spot Rate Based on IFE. Assume that the spot exchange rate of theSingapore dollar is £0.35. The one-year interest rate is 11 percent in the United Kingdom and7 percent in Singapore. What will the spot rate be in one year according to the IFE? (Youmay use the approximate formula to answer this question.)ANSWER: £0.35 × (1 + .04) = £0.36420. Deriving Forecasts of the Future Spot Rate. As of today, assume the following informationis available:UK MexicoReal rate of interest requiredinvestors 2% 2%byNominal interest rate 11% 15%Spot rate — £0.05One-year forward rate — £0.049a. Use the forward rate to forecast the percentage change in the Mexican peso over the nextyear.ANSWER: (£0.049– £0.05)/£0.05 = –.02, or –2%b. Use the differential in expected inflation to forecast the percentage change in theMexican 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 change21. Inflation and Interest Rate Effects. The opening of Russia's market has resulted in a highlyvolatile Russian currency (the rouble). 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 theRussian rouble.ANSWER: As Russian prices were increasing, the purchasing power of Russian consumers was declining. This would encourage them to purchase goods in the UK and elsewhere, which results in a large supply of roubles for sale. Given the high Russian inflation, foreign demand for roubles to purchase Russian goods would be low. Thus, the rouble’s value should depreciate against the dollar, and against other currencies.b. Does the effect of Russian inflation on the decline in the rouble’s value support the PPPtheory? How might the relationship be distorted by political conditions in Russia?ANSWER: The general relationship suggested by PPP is supported, but the rouble’s 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 rouble may not decline by the full degree to offset the inflation differential between Russia and the UK Furthermore, the government may not allow the rouble 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 UK goodsfrom the perspective of Russian consumers (after considering exchange rates)? Explain.ANSWER: Russian prices might be higher than UK prices, even after considering exchange rates, because the rouble 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 rouble offset eachother for UK importers? That is, how will UK importers of Russian goods be affected by the conditions?ANSWER: UK importers will likely experience higher prices, because the Russian inflation may not be completely offset by the decline in the rouble’s value. This may cause a reduction in the UK demand for Russian goods.22. IFE Application to Asian Crisis. Before the Asian crisis, many investors attempted tocapitalize 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.23. IFE Applied to the Euro. Given the recent conversion of several European currencies to theeuro, explain what would cause the euro’s 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.Advanced Questions24. IFE. Beth Miller does not believe that the international Fisher effect (IFE) holds. Currentone-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 Beth’s percentage return from herstrategy?c. If the spot rate of the euro in one year is $1.08, what is Beth’s percentage return from herstrategy?d. What must the spot rate of the euro be in one year for Beth’s strategy to be successful?ANSWER:a.%90.11)05.1()03.1(1)1()1(−=−=−++=f h f i i eIf 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 = €90,909.092. Invest euros for one year and receive €90,909.09 × 1.05 = €95,454.553. Convert euros back to dollars and receive €95,454.55 × $1.00 = $95,454.55The percentage return is $95,454.55/$100,000 – 1 = –4.55%.c.1. Convert dollars to euros: $100,000/$1.10 = €90,909.092. Invest euros for one year and receive €90,909.09 × 1.05 = €95,454.553. Convert euros back to dollars and receive €95,454.55 × $1.08 = $103,090.91The percentage return is $103,090.91/$100,000 – 1 = 3.09%.d. Beth’s strategy would be successful if the spot rate of the euro in one year is greater than$1.079.25. Integrating IRP and IFE. Assume the following information is available for the U.S. andEurope:U.S. Europe Nominal interest rate 4% 6%Expected inflation 2% 5%Spot rate ----- $1.13One-year forward rate ----- $1.10a. Does IRP hold?b. According to PPP, what is the expected spot rate of the euro in one year?c. According to the IFE, what is the expected spot rate of the euro in one year?d. Reconcile your answers to parts (a). and (c).ANSWER:a.%89.11)06.1()04.1(1)1()1(−=−=−++=f h i i pTherefore, the forward rate of the euro should be $1.13 × (1 – 1.89%) = $1.109. IRP does not hold in this case.b.%86.21)05.1()02.1(1)1()1(−=−=−++=f h f I I eAccording to PPP, the expected spot rate of the euro in one year is $1.13 × (1 – 2.86%) = $1.098.c.%89.11)06.1()04.1(1)1()1(−=−=−++=f h f i i eAccording 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 theexpectedpercentage appreciation or depreciation of the euro.26. IRP. The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in theUK is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is £0.14.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 thenext year?d.If the spot rate changes as expected according to the IFE, what will be the spot rate in oneyear?pare your answers to (b) and (d) and explain the relationship.ANSWER:a. According to interest rate parity, the forward premium is07273.1)10.1()02.1(−=−++b. The forward rate is £0.14 × (1 – .07273) = £0.1298.c. According to the IFE, the expected change in the peso is:07273.1)10.1()02.1(−=−++or –7.273%d. £.14 × (1 – .07273) = £0.1298e. 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.27. Testing the PPP. How could you use regression analysis to determine whether therelationship 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.ANSWER: A regression model could be applied to historical data to test PPP. The model isspecified as:()e a a 1+I 1 + I u f 01U.S.f =+−⎡⎣⎢⎤⎦⎥+1where e f is the percentage change in the foreign currency’s exchange rate, I U.S. and I f are U.S.and foreign inflation rates, a 0 is a constant, a 1 is the slope coefficient, and u is an error term. If PPP holds, a 0 should equal zero, and a 1 should equal 1. A t-test on a 0 and a 1 is shown below.t -test for a : t = a 0s.e. of a t -test for a : t = a1s.e. of a 0001 1 1−−。

CHAPTER 10 MANAGEMENT OF TRANSLATION EXPOSURESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. Explain the difference in the translation process between the monetary/nonmonetary method and the temporal method.Answer: Under the monetary/nonmonetary method, all monetary balance sheet accounts of a foreign subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at the historical rate exchange rate in effect when the account was first recorded. Under the temporal method, monetary accounts are translated at the current exchange rate. Other balance sheet accounts are also translated at the current rate, if they are carried on the books at current value. If they are carried at historical value, they are translated at the rate in effect on the date the item was put on the books. Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary/nonmonetary method will typically provide the same translation.2. How are translation gains and losses handled differently according to the current rate method in comparison to the other three methods, that is, the current/noncurrent method, the monetary/nonmonetary method, and the temporal method?Answer: Under the current rate method, translation gains and losses are handled only as an adjustment to net worth through an equity account named the “cumulative translation adjustment” account. Nothing passes through the income statement. Th e other three translation methods pass foreign exchange gains or losses through the income statement before they enter on to the balance sheet through the accumulated retained earnings account.3. Identify some instances under FASB 52 when a foreign enti ty’s functional currency would be the same as the parent firm’s currency.Answer: Three examples under FASB 52, where the foreign entity’s functional currency will be the same as the parent firm’s currency, are: i) the foreign entity’s cash flows directly affect the parent’s cash flows and are readily available for remittance to the parent firm; ii) the sales prices for the foreign entity’s products are responsive on a short-term basis to exchange rate changes, where sales prices are determined through worldwide competition; and, iii) the sales market is primarily located in the parent’s country or sales contracts are denominated in the parent’s currency.4. Describe the remeasurement and translation process under FASB 52 of a wholly owned affiliate that keeps its books in the local currency of the country in which it operates, which is different than its functional currency.Answer: For a foreign entity that keeps its books in its local currency, which is different from its functional currency, the translation process according to FASB 52 is to: first, remeasure the financial reports from the local currency into the functional currency using the temporal method of translation, and second, translate from the functional currency into the reporting currency using the current rate method of translation.5. It is, generally, not possible to completely eliminate both translation exposure and transaction exposure. In some cases, the elimination of one exposure will also eliminate the other. But in other cases, the elimination of one exposure actually creates the other. Discuss which exposure might be viewed as the most important to effectively manage, if a conflict between controlling both arises. Also, discuss and critique the common methods for controlling translation exposure.Answer: Since it is, generally, not possible to completely eliminate both transaction and translation exposure, we recommend that transaction exposure be given first priority since it involves real cash flows. The translation process, on-the-other hand, has no direct effect on reporting currency cash flows, and will only have a realizable effect on net investment upon the sale or liquidation of the assets.There are two common methods for controlling translation exposure: a balance sheet hedge and a derivatives hedge. The balance sheet hedge involves equating the amount of exposed assets in an exposure currency with the exposed liabilities in that currency, so the net exposure is zero. Thus when an exposure currency exchange rate changes versus the reporting currency, the change in assets will offset the change in liabilities. To create a balance sheet hedge, once transaction exposure has been controlled, often means creating new transaction exposure. This is not wise since real cash flow losses can result. A derivatives hedge is not really a hedge, but rather a speculative position, since the size of the “hedge” is based on the future expected spot rate of exchange for the exposure currency with the reporting currency. If the actual spot rate differs from the expected rate, the “hedge” may result in the loss of real cash flows.PROBLEMS1. Assume that FASB 8 is still in effect instead of FASB 52. Construct a translation exposure report for Centralia Corporation and its affiliates that is the counterpart to Exhibit 10.7 in the text. Centralia and its affiliates carry inventory and fixed assets on the books at historical values.Solution: The following table provides a translation exposure report for Centralia Corporation and its affiliates under FASB 8, which is essentially the temporal method of translation. The difference between the new report and Exhibit 10.7 is that nonmonetary accounts such as inventory and fixed assets are translated at the historical exchange rate if they are carried at historical costs. Thus, these accounts will not change values when exchange rates change and they do not create translation exposure.Examination of the table indicates that under FASB 8 there is negative net exposure for the Mexican peso and the euro, whereas under FASB 52 the net exposure for these currencies is positive. There is no change in net exposure for the Canadian dollar and the Swiss franc. Consequently, if the euro depreciates against the dollar from €1.1000/$1.00 to €1.1786/$1.00, as the text example assumed, exposed assets will now fall in value by a smaller amount than exposed liabilities, instead of vice versa. The associated reporting currency imbalance will be $239,415, calculated as follows:Reporting Currency Imbalance=-€3,949,0000€1.1786/$1.00--€3,949,0000€1.1000/$1.00=$239,415.Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates, December 31, 2005 (in 000 Currency Units)Canadian Dollar MexicanPeso EuroSwissFrancAssetsCash CD200 Ps 6,000 € 825SF 0 Accounts receivable 0 9,000 1,045 0Inventory 0 0 0 0Net fixed assets 0 0 0Exposed assets CD200 Ps15,000 € 1,870SF 0LiabilitiesAccounts payable CD 0 Ps 7,000 € 1,364SF 0 Notes payable 0 17,000 935 1,400Long-term debt 0 27,000 3,520ExposedliabilitiesCD 0 Ps51,000 € 5,819SF1,400Net exposure CD200 (Ps36,000) (€3,949)(SF1,400)2. Assume that FASB 8 is still in effect instead of FASB 52. Construct a consolidated balance sheet for Centralia Corporation and its affiliates after a depreciation of the euro from €1.1000/$1.00 to €1.1786/$1.00 that is the counterpart to Exhibit 10.8 in the text. Centralia and its affiliates carry inventory and fixed assets on the books at historical values.Solution: This problem is the sequel to Problem 1. The solution to Problem 1 showed that if the euro depreciated there would be a reporting currency imbalance of $239,415. Under FASB 8 this is carried through the income statement as a foreignexchange gain to the retained earnings on the balance sheet. The following table shows that consolidated retained earnings increased to $4,190,000 from $3,950,000 in Exhibit 10.8. This is an increase of $240,000, which is the same as the reporting currency imbalance after accounting for rounding error.Consolidated Balance Sheet under FASB 8 for Centralia Corporation and its Mexican anda This includes CD200,000 the parent firm has in a Canadian bank, carried as $150,000. CD200,000/(CD1.3333/$1.00) = $150,000.b$1,750,000 - $300,000 (= Ps3,000,000/(Ps10.00/$1.00)) intracompany loan = $1,450,000.c,d Investment in affiliates cancels with the net worth of the affiliates in the consolidation.e The Spanish affiliate owes a Swiss bank SF375,000 (÷ SF1.2727/€1.00 = €294,649). This is carried on the books,after the exchange rate change, as part of €1,229,649 = €294,649 + €935,000. €1,229,649/(€1.1786/$1.00) = $1,043,313.3. In Example 10.2, a f orward contract was used to establish a derivatives “hedge” to protect Centralia from a translation loss if the euro depreciated from €1.1000/$1.00 to €1.1786/$1.00. Assume that an over-the-counter put option on the euro with a strike price of €1.1393/$1.00 (or $0.8777/€1.00) can be purchased for $0.0088 per euro. Show how the potential translation loss can be “hedged” with an option contract.Solution: As in example 10.2, if the potential translation loss is $110,704, the equivalent amount in functiona l currency that needs to be hedged is €3,782,468. If in fact the euro does depreciate to €1.1786/$1.00 ($0.8485/€1.00), €3,782,468 can be purchased in the spot market for $3,209,289. At a striking price of €1.1393/$1.00, the €3,782,468 can be sold throu gh the put for $3,319,993, yielding a gross profit of $110,704. The put option cost $33,286 (= €3,782,468 x $0.0088). Thus, at an exchange rate of €1.1786/$1.00, the put option will effectively hedge $110,704 - $33,286 = $77,418 of the potential translation loss. At terminal exchange rates of €1.1393/$1.00 to €1.1786/$1.00, the put option hedge will be less effective. An option contract does not have to be exercised if doing so is disadvantageous to the option owner. Therefore, the put will not be exercised at exchange rates of less than €1.1393/$1.00 (more than $0.8777/€1.00), in which case the “hedge” will lose the $33,286 cost of the option.MINI CASE: SUNDANCE SPORTING GOODS, INC.Sundance Sporting Goods, Inc., is a U.S. manufacturer of high-quality sporting goods--principally golf, tennis and other racquet equipment, and also lawn sports, such as croquet and badminton-- with administrative offices and manufacturing facilities in Chicago, Illinois. Sundance has two wholly owned manufacturing affiliates, one in Mexico and the other in Canada. The Mexican affiliate is located in Mexico City and services all of Latin America. The Canadian affiliate is in Toronto and serves only Canada. Each affiliate keeps its books in its local currency, which is also the functional currency for the affiliate. The current exchange rates are: $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800. The nonconsolidated balance sheets for Sundance and its two affiliates appear in the accompanying table.Nonconsolidated Balance Sheet for Sundance Sporting Goods, Inc. and Its Mexican anda The parent firm is owed Ps1,320,000 by the Mexican affiliate. This sum is included in the parent’s accounts receivable as $400,000, translated at Ps3.30/$1.00. The remainder of the parent’s (Mexican affiliate’s) accounts receivable (payable) is denominated in dollars (pesos).b The Mexican affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $2,400,000. This represents the sum of the comm on stock (Ps4,500,000) and retained earnings (Ps3,420,000) on the Mexican affiliate’s books, translated at Ps3.30/$1.00.c The Canadian affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $3,600,000. This represents the sum of the common stock (CD2,900,000) and the retained earnings (CD1,600,000) on the Canadian affiliate’s books, translated at CD1.25/$1.00.d The parent firm has outstanding notes payable of ¥126,000,000 due a Japanese bank. This sum is carried on th e parent firm’s books as $1,200,000, translated at ¥105/$1.00. Other notes payable are denominated in U.S. dollars.e The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This sum is carried on the Mexican affi liate’s books as Ps396,000, translated at A1.00/Ps3.30. Other accounts receivable are denominated in Mexican pesos.f The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This sum is carried on the Canadian affilia te’s books as CD300,000, translated at W800/CD1.25. Other accounts receivable are denominated in Canadian dollars.You joined the International Treasury division of Sundance six months ago after spending the last two years receiving your MBA degree. The corporate treasurer has asked you to prepare a report analyzing all aspects of the translation exposure faced by Sundance as a MNC. She has also asked you to address in your analysis the relationship between the firm’s translation exposure and its transa ction exposure. After performing a forecast of future spot rates of exchange, you decide that you must do the following before any sensible report can be written.a. Using the current exchange rates and the nonconsolidated balance sheets for Sundance and its affiliates, prepare a consolidated balance sheet for the MNC according to FASB 52.b. i. Prepare a translation exposure report for Sundance Sporting Goods, Inc., and its two affiliates.ii. Using the translation exposure report you have prepared, determine if any reporting currency imbalance will result from a change in exchange rates to which thefirm has currency exposure. Your forecast is that exchange rates will change from $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800 to $1.00 = CD1.30 = P s3.30 = A1.03 = ¥105 = W800.c. Prepare a second consolidated balance sheet for the MNC using the exchange rates you expect in the future. Determine how any reporting currency imbalance will affect the new consolidated balance sheet for the MNC.d. i. Prepare a transaction exposure report for Sundance and its affiliates. Determine if any transaction exposures are also translation exposures.ii. Investigate what Sundance and its affiliates can do to control its transaction and translation exposures. Determine if any of the translation exposure should be hedged.Suggested Solution to Sundance Sporting Goods, Inc.Note to Instructor: It is not necessary to assign the entire case problem. Parts a. and b.i. can be used as self-contained problems, respectively, on basic balance sheet consolidation and the preparation of a translation exposure report.a. Below is the consolidated balance sheet for the MNC prepared according to the current rate method prescribed by FASB 52. Note that the balance sheet balances. That is, Total Assets and Total Liabilities and Net Worth equal one another. Thus, the assumption is that the current exchange rates are the same as when the affiliates were established. This assumption is relaxed in part c.Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates,December 31, 2005: Pre-Exchange Rate Change (in 000 Dollars) Sundance, Inc.Mexican Affiliate Canadian AffiliateConsolidated Balance a$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.b,c The investment in the affiliates cancels with the net worth of the affiliates in the consolidation.d The parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)).e The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate’s books as Ps396,000 (= A120,000 x Ps3.30/A1.00).f The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This is carried on the Canadian affiliate’s books as CD300,000 (= W192,000,000/(W800/CD1.25)).b. i. Below is presented the translation exposure report for the Sundance MNC. Note, from the report that there is net positive exposure in the Mexican peso, Canadian dollar, Argentine austral and Korean won. If any of these exposure currencies appreciates (depreciates) against the U.S. dollar, exposed assets denominated in these currencies will increase (fall) in translated value by a greater amount than the exposed liabilities denominated in these currencies. There is negative net exposure in the Japanese yen. If the yen appreciates (depreciates) against the U.S. dollar, exposed assets denominated in the yen will increase (fall) in translated value by smaller amount than the exposed liabilities denominated in the yen.Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates, December 31, 2005 (in 000 Currency Units)b. ii. The problem assumes that Canadian dollar depreciates from CD1.25/$1.00 to CD1.30/$1.00 and that the Argentine austral depreciates from A1.00/$1.00 to A1.03/$1.00. To determine the reporting currency imbalance in translated value caused by these exchange rate changes, we can use the following formula:Net Exposure Currency i S(i/reporting)-Net Exposure Currency i S(i/reporting)new old = Reporting Currency Imbalance.From the translation exposure report we can determine that the depreciation in the Canadian dollar will cause aCD4,200,000 CD1.30/$1.00-CD4,200,000CD1.25/$1.00= -$129,231reporting currency imbalance.Similarly, the depreciation in the Argentine austral will cause aA120,000 A1.03/$1.00-A120,000A1.00/$1.00= -$3,495reporting currency imbalance.In total, the depreciation of the Canadian dollar and the Argentine austral will cause a reporting currency imbalance in translated value equal to -$129,231 -$3,495= -$132,726.c. The new consolidated balance sheet for Sundance MNC after the depreciation of the Canadian dollar and the Argentine austral is presented below. Note that in order for the new consolidated balance sheet to balance after the exchange rate change, it is necessary to have a cumulative translation adjustment account balance of -$133 thousand, which is the amount of the reporting currency imbalance determined in part b. ii (rounded to the nearest thousand).Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates,December 31, 2005: Post-Exchange Rate Change (in 000 Dollars)a$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.b,c The investment in the affiliates cancels with the net worth of the affiliates in the consolidation.d The parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)).e The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate’s books as Ps384,466 (= A120,000 x Ps3.30/A1.03).f The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This is carried on the Canadian affiliate’s books as CD312,000 (=W192,000,000/(W800/CD1.30)).d. i. The transaction exposure report for Sundance, Inc. and its two affiliates is presented below. The report indicates that the Ps1,320,000 accounts receivable due from the Mexican affiliate is not also a translation exposure because this is netted out in the consolidation. However, the ¥126,000,000 notes payable of the parent is also a translation exposure. Additionally, the A120,000 accounts receivable of the Mexican affiliate and the W192,000,000 accounts receivable of the Canadian affiliate are both translation exposures.Transaction Exposure Report for Sundance Sporting Goods, Inc. andits Mexican and Canadian Affiliates, December 31, 2005d. ii. Since transaction exposure may potentially result in real cash flow losses while translation exposure does not have an immediate direct effect on operating cash flows, we will first address the transaction exposure that confronts Sundance and its affiliates. The analysis assumes the depreciation in the Canadian dollar and the Argentine austral have already taken place.The parent firm can pay off the ¥126,000,000 loan from the Japanese bank using funds from the cash account and money from accounts receivable that it will collect. Additionally, the parent firm can collect the accounts receivable of Ps1,320,000 from its Mexican affiliate that is carried on the books as $400,000. In turn, the Mexican affiliate can collect the A120,000 accounts receivable from the Argentine importer, valued at Ps384,466 after the depreciation in the austral, to guard against further depreciation and to use to partially pay off the peso liability to the parent. The Canadian affiliate can eliminate its transaction exposure by collecting the W192,000,000 accounts receivable as soon as possible, which is currently valued at CD312,000.The elimination of these transaction exposures will affect the translation exposure of Sundance MNC. A revised translation exposure report follows.Revised Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates, December 31, 2005 (in 000 Currency Units)Note from the revised translation exposure report that the elimination of the transaction exposure will also eliminate the translation exposure in the Japanese yen, Argentine austral and the Korean won. Moreover, the net translation exposure in the Mexican peso has been reduced. But the net translation exposure in the Canadian dollar has increased as a result of the Canadian affiliate’s collection of the won receivable.The remaining translation exposure can be hedged using a balance sheet hedge or a derivatives hedge. Use of a balance sheet hedge is likely to create new transaction exposure, however. Use of a derivatives hedge is actually speculative, and not a real hedge, since the size of the “hedge” is based on one’s expectation as to the future spot exchange rate. An incorrect estimate will result in the “hedge” losing money for the MNC.。

C H A P T E R8M A N A G E M E N T O F T R A N S A C T I O N E X P O S U R ESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS ANDPROBLEMSQUESTIONS1. How would you define transaction exposure How is it different from economic exposureAnswer: Transaction exposure is the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates. Unlike economic exposure, transaction exposure is well-defined and short-term.2. Discuss and compare hedging transaction exposure using the forward contract vs. money market instruments. When do the alternative hedging approaches produce the same resultAnswer: Hedging transaction exposure by a forward contract is achieved by selling or buying foreign currency receivables or payables forward. On the other hand, money market hedge is achieved by borrowing or lending the present value of foreign currency receivables or payables, thereby creating offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are equivalent.3. Discuss and compare the costs of hedging via the forward contract and the options contract. Answer: There is no up-front cost of hedging by forward contracts. In the case of options hedging, however, hedgers should pay the premiums for the contracts up-front. The cost of forward hedging, however, may be realized ex post when the hedger regrets his/her hedging decision.4. What are the advantages of a currency options contract as a hedging tool compared with the forward contractAnswer: The main advantage of using options contracts for hedging is that the hedger can decide whether to exercise options upon observing the realized future exchange rate. Options thus provide a hedge against ex post regret that forward hedger might have to suffer. Hedgers can only eliminate the downside risk while retaining the upside potential.5. Suppose your company has purchased a put option on the German mark to manage exchange exposure associated with an account receivable denominated in that currency. In this case, your company can be said to have an ‘insurance’ policy on its receivable. Explain in what sense this is so.Answer: Your company in this case knows in advance that it will receive a certain minimum dollar amount no matter what might happen to the $/€exchange rate. Furthermore, if the German mark appreciates, your company will benefit from the rising euro.6. Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. How would you explain this resultAnswer: There can be many possible reasons for this. First, many firms may feel that they are not really exposed to exchange risk due to product diversification, diversified markets for their products, etc. Second, firms may be using self-insurance against exchange risk. Third, firms may feel that shareholders can diversify exchange risk themselves, rendering corporate risk management unnecessary.7. Should a firm hedge Why or why notAnswer: In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to their value by hedging if markets are imperfect. First, if management knows about the firm’s exposure better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to hedge at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable because it reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce tax obligations by hedging which stabilizes corporate earnings.8. Using an example, discuss the possible effect of hedging on a firm’s tax obligations.Answer: One can use an example similar to the one presented in the chapter.9. Explain contingent exposure and discuss the advantages of using currency options to manage this type of currency exposure.Answer: Companies may encounter a situation where they may or may not face currency exposure. In this situation, companies need options, not obligations, to buy or sell a given amount of foreign exchange they may or may not receive or have to pay. If companies either hedge using forward contracts or do not hedge at all, they may face definite currency exposure.10. Explain cross-hedging and discuss the factors determining its effectiveness.Answer: Cross-hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging would depend on the strength and stability of the relationship between the two assets.PROBLEMS1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced €10 million payable in six months. Currently, the six-month forward exchange rate is $€ and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $€ in six months.(a) What is the expected gain/loss from the forward hedging(b) If you were the financial manager of Cray Research, would you recommend hedging this euro receivable Why or why not(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case Why or why not Solution: (a) Expected gain($) = 10,000,000 –= 10,000,000(.05)= $500,000.(b) I would recommend hedging because Cray Research can increase the expected dollar receipt by $500,000 and also eliminate the exchange risk.(c) Since I eliminate risk without sacrificing dollar receipt, I still would recommend hedging.2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ￥250 million payable in three months. Currently, the spot exchange rate is ￥105/$ and the three-month forward rate is ￥100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen account payable.(a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.(b) Conduct the cash flow analysis of the money market hedge.Solution: (a). Let’s first compute the PV of ￥250 million, .,250m/ = ￥245,700,So if the above yen amount is invested today at the Japanese interest rate for three months, the maturity value will be exactly equal to ￥25 million which is the amount of payable.To buy the above yen amount today, it will cost:$2,340, = ￥250,000,000/105.The dollar cost of meeting this yen obligation is $2,340, as of today.(b)___________________________________________________________________Transaction CF0 CF1____________________________________________________________________1. Buy yens spot -$2,340,with dollars ￥245,700,2. Invest in Japan - ￥245,700, ￥250,000,0003. Pay yens - ￥250,000,000Net cash flow - $2,340,____________________________________________________________________3. You plan to visit Geneva, Switzerland in three months to attend an international business conference.You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $SF and the three-month forward rate is $SF. You can buy the three-month call option on SF with the exercise rate of $SF for the premium of $ per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF.(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.(c) At what future spot exchange rate will you be indifferent between the forward and option market hedges(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.Solution: (a) Total option premium = (.05)(5000) = $250. In three months, $250 is worth $ = $250. At the expected future spot rate of $SF, which is less than the exercise price, you don’t expect to exercise options. Rather, you expect to buy Swiss franc at $SF. Since you are going to buy SF5,000, you expect to spend $3,150 (=.63x5,000). Thus, the total expected cost of buying SF5,000 will be the sum of $3,150 and $, ., $3,.(b) $3,150 = (.63)(5,000).(c) $3,150 = 5,000x + , where x represents the break-even future spot rate. Solving for x, we obtain x = $SF. Note that at the break-even future spot rate, options will not be exercised.(d) If the Swiss franc appreciates beyond $SF, which is the exercise price of call option, you will exercise the option and buy SF5,000 for $3,200. The total cost of buying SF5,000 will be $3, = $3,200 + $.This is the maximum you will pay.4. Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. Air France will be billed €20million which is payable in one year. The current spot exchange rate is $€ and the one -year forward rateis $€. The annual interest rate is % in the U.S. and % in France. Boeing is concerned with the volatile exchange rate between the dollar and the euro and would like to hedge exchange exposure.(a) It is considering two hedging alternatives: sell the euro proceeds from the sale forward or borrow euros from the Credit Lyonnaise against the euro receivable. Which alternative would you recommend Why(b) Other things being equal, at what forward exchange rate would Boeing be indifferent between the two hedging methodsSolution: (a) In the case of forward hedge, the future dollar proceeds will be (20,000,000) = $22,000,000. In the case of money market hedge (MMH), the firm has to first borrow the PV of its euro receivable, ., 20,000,000/ =€19,047,619. Then the firm should exchange this euro amount into dollars at the current spot rate to receive: (€19,047,619)($€) = $20,000,000, which can be in vested at the dollar interest rate for one year to yield:$20,000,000 = $21,200,000.Clearly, the firm can receive $800,000 more by using forward hedging.(b) According to IRP, F = S(1+i $)/(1+i F ). Thus the “indifferent” forward rate will be: F = / = $€.5. Suppose that Baltimore Machinery sold a drilling machine to a Swiss firm and gave the Swiss client a choice of paying either $10,000 or SF 15,000 in three months.(a) In the above example, Baltimore Machinery effectively gave the Swiss client a free option to buy up to $10,000 dollars using Swiss franc. What is the ‘implied’ exercise exchange rate(b) If the spot exchange rate turns out to be $SF, which currency do you think the Swiss client will choose to use for payment What is the value of this free option for the Swiss client (c) What is the best way for Baltimore Machinery to deal with the exchange exposure Solution: (a) The implied exercise (price) rate is: 10,000/15,000 = $SF .(b) If the Swiss client chooses to pay $10,000, it will cost SF16,129 (=10,000/.62). Since the Swiss client has an option to pay SF15,000, it will choose to do so. The value of this option is obviously SF1,129 (=SF16,129-SF15,000).(c) Baltimore Machinery faces a contingent exposure in the sense that it may or may not receive SF15,000 in the future. The firm thus can hedge this exposure by buying a put option on SF15,000. 6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the .$ Cost Options hedgeForward hedge$3,$3,1500 (strike price)$/SF$PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of .014 cents per yen.(a) Compute the future dollar costs of meeting this obligation using the money market hedge and the forward hedges.(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used.(c) At what future spot rate do you think PCC may be indifferent between the option and forward hedge Solution: (a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In the case of money market hedge, the future dollar cost will be: 500,000,000/(124)= $4,147,465.(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000 = $75,600.At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC will exercise its call option and buy ￥500,000,000 for $4,050,000 (=500,000,.The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.(c) When t he option hedge is used, PCC will spend “at most” $4,125,000. On the other hand, when the forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This means that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between forward and options hedges.7. Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company, and billed $30 million payable in six months. Airbus is concerned with the euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $€ and six-month forward exchange rate is $€ at the moment. Airbus can buy a six-month put option on . dollars with a strike price of €$ for a premium of € per . dollar. Currently, six-month interest rate is % in the euro zone and % in the U.S.pute the guaranteed euro proceeds from the American sale if Airbus decides to hedge using aforward contract.b.If Airbus decides to hedge using money market instruments, what action does Airbus need to takeWhat would be the guaranteed euro proceeds from the American sale in this casec.If Airbus decides to hedge using put options on . dollars, what would be the ‘expected’ europroceeds from the American sale Assume that Airbus regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate.d.At what future spot exchange rate do you think Airbus will be indifferent between the option andmoney market hedgeSolution:a. Airbus will sell $30 million for ward for €27,272,727 = ($30,000,000) / ($€).b. Airbus will borrow the present value of the dollar receivable, ., $29,126,214 = $30,000,000/, and then sell the dollar proceeds spot for euros: €27,739,251. This is the euro amount that Airbus is going to ke ep.c. Since the expected future spot rate is less than the strike price of the put option, ., €< €, Airbus expects to exercise the option and receive €28,500,000 = ($30,000,000)(€$). This is gross proceeds. Airbus spent €600,000 (=,000,000) upfront for the option and its future cost is equal to €615,000 = €600,000 x . Thus the net europroceeds from the American sale is €27,885,000, which is the difference between the gross proceeds and the option costs.d. At the indifferent future spot rate, the following will hold:€28,432,732 = S T (30,000,000) - €615,000.Solving for S T, we obtain the “indifference” future spot exchange rate, ., €$, or $€. Note that €28,432,732 is the future value of the proceeds under money market hedging:€28,432,732 = (€27,739,251) .Suggested solution for Mini Case: Chase Options, Inc.[See Chapter 13 for the case text]Chase Options, Inc.Hedging Foreign Currency Exposure Through Currency OptionsHarvey A. PoniachekI. Case SummaryThis case reviews the foreign exchange options market and hedging. It presents various international transactions that require currency options hedging strategies by the corporations involved. Seven transactions under a variety of circumstances are introduced that require hedging by currency options. The transactions involve hedging of dividend remittances, portfolio investment exposure, and strategic economic competitiveness. Market quotations are provided for options (and options hedging ratios), forwards, and interest rates for various maturities.II. Case Objective.The case introduces the student to the principles of currency options market and hedging strategies. The transactions are of various types that often confront companies that are involved in extensive international business or multinational corporations. The case induces students to acquire hands-on experience in addressing specific exposure and hedging concerns, including how to apply various market quotations, which hedging strategy is most suitable, and how to address exposure in foreign currency through cross hedging policies.III. Proposed Assignment Solution1. The company expects DM100 million in repatriated profits, and does not want the DM/$ exchange rate at which they convert those profits to rise above . They can hedge this exposure using DM put options with a strike price of . If the spot rate rises above , they can exercise the option, while if that rate falls they can enjoy additional profits from favorable exchange rate movements.To purchase the options would require an up-front premium of:DM 100,000,000 x = DM 1,640,000.With a strike price of DM/$, this would assure the U.S. company of receiving at least:DM 100,000,000 – DM 1,640,000 x (1 + x 272/360)= DM 98,254,544/ DM/$ = $57,796,791by exercising the option if the DM depreciated. Note that the proceeds from the repatriated profits are reduced by the premium paid, which is further adjusted by the interest foregone on this amount. However, if the DM were to appreciate relative to the dollar, the company would allow the option to expire, and enjoy greater dollar proceeds from this increase.Should forward contracts be used to hedge this exposure, the proceeds received would be:DM100,000,000/ DM/$ = $59,790,732,regardless of the movement of the DM/$ exchange rate. While this amount is almost $2 million more than that realized using option hedges above, there is no flexibility regarding the exercise date; if this date differs from that at which the repatriate profits are available, the company may be exposed to additional further current exposure. Further, there is no opportunity to enjoy any appreciation in the DM. If the company were to buy DM puts as above, and sell an equivalent amount in calls with strike price , the premium paid would be exactly offset by the premium received. This would assure that the exchange rate realized would fall between and . If the rate rises above , the company will exercise its put option, and if it fell below , the other party would use its call; for any rate in between, both options would expire worthless. The proceeds realized would then fall between:DM 100,00,000/ DM/$ = $60,716,454andDM 100,000,000/ DM/$ = $58,823,529.This would allow the company some upside potential, while guaranteeing proceeds at least $1 million greater than the minimum for simply buying a put as above.Buy/Sell OptionsDM/$SpotPut Payoff “Put”Profits Call Payoff“Call”Profits Net Profit(1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 60,606,061 1,742,846 0 60,606,061 (1,742,846) 60,240,964 1,742,846 0 60,240,964 (1,742,846) 59,880,240 1,742,846 0 59,880,240 (1,742,846) 59,523,810 1,742,846 0 59,523,810 (1,742,846) 59,171,598 1,742,846 0 59,171,598 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529(1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529Since the firm believes that there is a good chance that the pound sterling will weaken, locking them into a forward contract would not be appropriate, because they would lose the opportunity to profit from this weakening. Their hedge strategy should follow for an upside potential to match their viewpoint. Therefore, they should purchase sterling call options, paying a premium of:5,000,000 STG x = 88,000 STG.If the dollar strengthens against the pound, the firm allows the option to expire, and buys sterling in the spot market at a cheaper price than they would have paid for a forward contract; otherwise, the sterling calls protect against unfavorable depreciation of the dollar.Because the fund manager is uncertain when he will sell the bonds, he requires a hedge which will allow flexibility as to the exercise date. Thus, options are the best instrument for him to use. He can buy A$ puts to lock in a floor of A$/$. Since he is willing to forego any further currency appreciation, he can sell A$ calls with a strike price of A$/$ to defray the cost of his hedge (in fact he earns a net premium of A$ 100,000,000 x –= A$ 2,300), while knowing that he can’t receive less than A$/$ when redeeming his investment, and can benefit from a small appreciation of the A$.Example #3:Problem: Hedge principal denominated in A$ into US$. Forgo upside potential to buy floor protection.I. Hedge by writing calls and buying puts1) Write calls for $/A$ @Buy puts for $/A$ @# contracts needed = Principal in A$/Contract size100,000,000A$/100,000 A$ = 1002) Revenue from sale of calls = (# contracts)(size of contract)(premium)$75,573 = (100)(100,000 A$)(.007234 $/A$)(1 + .0825 195/360)3) Total cost of puts = (# contracts)(size of contract)(premium)$75,332 = (100)(100,000 A$)(.007211 $/A$)(1 + .0825 195/360)4) Put payoffIf spot falls below , fund manager will exercise putIf spot rises above , fund manager will let put expire5) Call payoffIf spot rises above .8025, call will be exercised If spot falls below .8025, call will expire6) Net payoffSee following Table for net payoff Australian Dollar Bond HedgeStrikePrice Put Payoff “Put”Principal Call Payoff“Call”Principal Net Profit(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 73,000,000 75,573 0 73,000,241(75,332) 74,000,000 75,573 0 74,000,241(75,332) 75,000,000 75,573 0 75,000,241(75,332) 76,000,000 75,573 0 76,000,241(75,332) 77,000,000 75,573 0 77,000,241(75,332) 78,000,000 75,573 0 78,000,241(75,332) 79,000,000 75,573 0 79,000,241(75,332) 80,000,000 75,573 0 80,000,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241 4. The German company is bidding on a contract which they cannot be certain of winning. Thus, the need to execute a currency transaction is similarly uncertain, and using a forward or futures as a hedge is inappropriate, because it would force them to perform even if they do not win the contract.Using a sterling put option as a hedge for this transaction makes the most sense. For a premium of:12 million STG x = 193,200 STG,they can assure themselves that adverse movements in the pound sterling exchange rate will not diminish the profitability of the project (and hence the feasibility of their bid), while at the same time allowing the potential for gains from sterling appreciation.5. Since AMC in concerned about the adverse effects that a strengthening of the dollar would have on its business, we need to create a situation in which it will profit from such an appreciation. Purchasing a yen put or a dollar call will achieve this objective. The data in Exhibit 1, row 7 represent a 10 percent appreciation of the dollar strike vs. forward rate) and can be used to hedge against a similar appreciation of the dollar.For every million yen of hedging, the cost would be:Yen 100,000,000 x = 127 Yen.To determine the breakeven point, we need to compute the value of this option if the dollar appreciated 10 percent (spot rose to , and subtract from it the premium we paid. This profit would be compared with the profit earned on five to 10 percent of AMC’s sales (which would be lost as a result of the dollar appreciation). The number of options to be purchased which would equalize these two quantities would represent the breakeven point.Example #5:Hedge the economic cost of the depreciating Yen to AMC.If we assume that AMC sales fall in direct proportion to depreciation in the yen ., a 10 percent decline in yen and 10 percent decline in sales), then we can hedge the full value of AMC’s sales. I have assumed $100 million in sales.1) Buy yen puts# contracts needed = Expected Sales *Current ￥/$ Rate / Contract size9600 = ($100,000,000)(120￥/$) / ￥1,250,0002) Total Cost = (# contracts)(contract size)(premium)$1,524,000 = (9600)( ￥1,250,000)($￥)3) Floor rate = Exercise – Premium￥/$ = ￥/$ - $1,524,000/12,000,000,000￥4) The payoff changes depending on the level of the ￥/$ rate. The following table summarizes thepayoffs. An equilibrium is reached when the spot rate equals the floor rate.AMC ProfitabilityYen/$ Spot Put Payoff Sales Net Profit120 (1,524,990) 100,000,000 98,475,010121 (1,524,990) 99,173,664 97,648,564122 (1,524,990) 98,360,656 96,835,666123 (1,524,990) 97,560,976 86,035,986124 (1,524,990) 96,774,194 95,249,204125 (1,524,990) 96,000,000 94,475,010126 (1,524,990) 95,238,095 93,713,105127 (847,829) 94,488,189 93,640,360128 (109,640) 93,750,000 93,640,360129 617,104 93,023,256 93,640,360130 1,332,668 92,307,692 93,640,360131 2,037,307 91,603,053 93,640,360132 2,731,269 90,909,091 93,640,360133 3,414,796 90,225,664 93,640,360134 4,088,122 89,552,239 93,640,360135 4,751,431 88,888,889 93,640,360136 5,405,066 88,235,294 93,640,360137 6,049,118 87,591,241 93,640,360138 6,683,839 86,966,522 93,640,360139 7,308,425 86,330,936 93,640,360140 7,926,075 85,714,286 93,640,360141 8,533,977 85,106,383 93,640,360142 9,133,318 84,507,042 93,640,360143 9,724,276 83,916,084 93,640,360144 10,307,027 83,333,333 93,640,360145 10,881,740 82,758,621 93,640,360146 11,448,579 82,191,781 93,640,360147 12,007,707 81,632,653 93,640,360148 12,569,279 81,081,081 93,640,360149 13,103,448 80,536,913 93,640,360150 13,640,360 80,000,000 93,640,360The parent has a DM payable, and Lira receivable. It has several ways to cover its exposure; forwards, options, or swaps.The forward would be acceptable for the DM loan, because it has a known quantity and maturity, but the Lira exposure would retain some of its uncertainty because these factors are not assured.The parent could buy DM calls and Lira puts. This would allow them to take advantage of favorable。

Chapter 3International Financial Markets Lecture OutlineMotives for Using International Financial Markets Motives for Investing in Foreign MarketsMotives for Providing Credit in Foreign MarketsMotives for Borrowing in Foreign MarketsForeign Exchange MarketHistory of Foreign ExchangeForeign Exchange TransactionsExchange QuotationsForeignInterpretingCurrency Futures and Options MarketsInternational Money MarketOrigins and DevelopmentStandardizing Global Bank RegulationsInternational Credit MarketSyndicated LoansInternational Bond MarketEurobond MarketDevelopment of Other Bond MarketsComparing Interest Rates Among CurrenciesInternational Stock MarketsIssuance of Foreign Stock in the U.S.Issuance of Stock in Foreign MarketsComparison of International Financial MarketsHow Financial Markets Affect an MNC’s ValueChapter ThemeThis chapter identifies and discusses the various international financial markets used by MNCs. These markets facilitate day-to-day operations of MNCs, including foreign exchange transactions, investing in foreign markets, and borrowing in foreign markets.Topics to Stimulate Class Discussion1. Why do international financial markets exist?2. How do banks serve international financial markets?3. Which international financial markets are most important to a firm that consistently needsshort-term funds? What about a firm that needs long-term funds?Critical debateShould firms that go public engage in international offerings?Proposition Yes. When a firm issues shares to the public for the first time in an initial public offering (IPO), it is naturally concerned about whether it can place all of its shares at a reasonable price. It will be able to issue its shares at a higher price by attracting more investors. It will increase its demand by spreading the shares across countries. The higher the price at which it can issue shares, the lower is its cost of using equity capital. It can also establish a global name by spreading shares across countries.Opposing view No. If a firm spreads its shares across different countries at the time of the IPO, there will be less publicly traded shares in the home country. Thus, it will not have as much liquidity in the secondary market. Investors desire shares that they can easily sell in the secondary market, which means that they require that the shares have liquidity. To the extent that a firm reduces its liquidity in the home country by spreading its share across countries, it may not attract sufficient home demand for the shares. Thus, its efforts to create global name recognition may reduce its name recognition in the home country.With whom do you agree? State your reasons. 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: The key is that students recognize the tradeoff involved. A firm that engages in a relatively small IPO will have limited liquidity even when all of the stock is issued in the home country. Thus, it should not consider issuing stock internationally. However, firms with larger stock offerings may be in a position to issue a portion of their shares outside the home country. They should not spread the stocks across several countries, but perhaps should target one or two countries where they conduct substantial business. They want to ensure sufficient liquidity in each of the foreign countries where they sell shares.Stock Markets are inefficientPropositionI cannot believe that if the value of the euro in terms of, say, the British pound increases three days in a row, on the fourth day there is still a 50:50 chance that it will go up or down in value. I think that most investors will see a trend and will buy, therefore the price is morelikely to go up. Also, if the forward market predicts a rise in value, on average, surely it is going to rise in value. In other words, currency prices are predictable. And finally, if it were so unpredictable and therefore unprofitable to the speculator, how is it that there is such a vast sum of money being traded every day for speculative purposes – there is no smoke without fire.The simple answer is that if that is what you believe, buy currencies that have viewOpposingincreased three days in a row and on average you should make a profit, buy currencies where the forward market shows an increase in value. The fact is that there are a lot of investors with just your sort of views. The market traders know all about such beliefs and will price the currency so that such easy profit (their loss) cannot be made. Look at past currency rates for yourself, check all fourth day changes after three days of rises, any difference is going to be not enough to cover transaction costs or trading expenses and the slight inaccuracy in your figures which are likely to be closing day mid point of the bid/ask spread. No, all currency movements are related to information and no-one knows if tomorrows news will be better or worse than expected.With whom do you agree? Could there be undiscovered patterns? Could some movements not be related to information? Could some private news be leaking out?ANSWER: Clearly there are no obvious patterns. Discussion on the impossibility of obvious patterns is worth emphasizing. However, does market inefficiency necessarily involve patterns, could market manipulation be occasional. There is worrying evidence from share price movements that there is unusual movement before announcements on many occasions, so the ideathat traders do not occasionally collude and move the price without supporting economic evidence is not an unreasonable view. Proof is however difficult as we have to separate anticipation from prior knowledge, the lucky speculator from the speculator who was in the know.Answers to End of Chapter Questions1. Motives for Investing in Foreign Money Markets. Explain why an MNC may invest fundsin 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.2. Motives for Providing Credit in Foreign Markets. Explain why some financial institutionsprefer 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.3. Exchange Rate Effects on Investing. Explain how the appreciation of the Australian dollaragainst the euro would affect the return to a French firm that invested in an Australian money market security.ANSWER: If the Australian dollar appreciates over the investment period, this implies that the French firm purchased the Australian dollars to make its investment at a lower exchange rate than the rate at which it will convert A$ to euros when the investment period is over.Thus, it benefits from the appreciation. Its return will be higher as a result of this appreciation.4. Exchange Rate Effects on Borrowing. Explain how the appreciation of the Japanese yenagainst the UK pound would affect the return to a UK firm that borrowed Japanese yen and used the proceeds for a UK project.ANSWER: If the Japanese yen appreciates over the borrowing period, this implies that the UK firm converted yen to pounds 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.5. Bank Services. List some of the important characteristics of bank foreign exchange servicesthat MNCs should consider.ANSWER: The important characteristics are (1) competitiveness of the quote, (2) the firm’s relationship with the bank, (3) speed of execution, (4) advice about current market conditions, and (5) forecasting advice.6. Bid/ask Spread. Delay Bank’s bid price for US dollars is £0.53 and its ask price is £0.55.What is the bid/ask percentage spread?ANSWER: (£0.55– £0.53)/£0.55 = .036 or 3.6%7. Bid/ask Spread. Compute the bid/ask percentage spread for Mexican peso in which the askrate is 20.6 New peso to the dollar and the bid rate is 21.5 New peso to the dollar.ANSWER: direct rates are 1/20.6 = $0.485:1 peso as the ask rate and 1/21.5 = $0.465:1 peso as the bid rate so the spread is[($0.485 – $0.465)/$0.485] = .041, or 4.1%. Note that the spread is fro the Mexiccan peso not the dollar.8. Forward Contract. The Wolfpack ltd is a UK exporter that invoices its exports to the UnitedStates in dollars. If it expects that the dollar will appreciate against the pound 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 dollar when it converts the dollars to pounds.9. Euro. Explain the foreign exchange situation for countries that use the euro when theyengage in international trade among themselves.ANSWER: There is no foreign exchange. Euros are used as the medium of exchange.10. Indirect Exchange Rate. If the direct exchange rate of the euro is worth £0.685, what is theindirect rate of the euro? That is, what is the value of a pound in euros?ANSWER: 1/0.685 = 1.46 euros.11. Cross Exchange Rate. Assume Poland’s currency (the zloty) is worth £0.17 and theJapanese yen is worth £0.005. What is the cross (implied) rate of the zloty with respect to yen?ANSWER: £0.17/£0.005 = 34 zloty:1 yen12. Syndicated Loans. Explain how syndicated loans are used in international markets.ANSWER: A large 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.13. Loan Rates. Explain the process used by banks in the Eurocredit market to determine the rateto 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.14. International Markets. What is the function of the international money market? Brieflydescribe 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).15. Evolution of Floating Rates. Briefly describe the historical developments that led to floatingexchange 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).16. International Diversification. Explain how the Asian crisis would have affected the returnsto a UK. firm investing in the Asian stock markets as a means of international diversification.[See the chapter appendix.]ANSWER: The returns to the UK 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 against the U.S. dollar by 84%.17.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?ANSWER:a. Large 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 theborrower 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 lendto each other. It is used as a base from which loan rates on other loans are determined in the Eurocredit market.18. Foreign Exchange. You just came back from Canada, where the Canadian dollar was worth£0.43. You still have C$200 from your trip and could exchange them for pounds at the airport, but the airport foreign exchange desk will only buy them for £0.40. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for £0.055 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$200 for 1500 New Pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain.ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange desk, the C$200 is multiplied by £0.40 and then divided by £0.055 ie a ratio of £0.40/0.055 = 7.27 pesos to the C$. The total pesos would be 200 x 7.27 = 1454 pesos, a little less than is being offered by the tourist.19. Foreign Stock Markets. Explain why firms may issue stock in foreign markets. Why mightMNCs 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.20. Stock Market Integration. Bullet plc a UK firm, is planning to issue new shares on theLondon Stock Exchange this month. The only decision still to be made is the specific day on which the shares will be issued. Why do you think Bullet monitors results of the Tokyo stock market every morning?ANSWER: The UK stock market prices sometimes follow Japanese market prices. Thus, the firm would possibly be able to issue its stock at a higher price in the UK if it can use the Japanese market as an indicator of what will happen in the UK market. However, this indicator will not always be accurate.Advanced Questions21. Effects of September 11. Why do you think the terrorist attack on the U.S. was expected tocause 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.22. International Financial Markets. Carrefour the French Supermarket chain has established retail outlets worldwide. These outlets are massive and contain products purchased locally as well as imports. As Carrefour generates earnings beyond what it needs abroad, it may remit those earnings back to France. Carrefour is likely to build additional outlets especially in China.a. Explain how the Carrefour outlets in China would use the spot market in foreign exchange.ANSWER:The Carrefour 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 euros, which would be remitted to the French parent.b. Explain how Carrefour might utilize the international money markets when it isestablishing other Carrefour stores in Asia.ANSWER: Carrefour may need to maintain some deposits in the Eurocurrency market that can be used (when needed) to support the growth of Carrefour stores in various foreign markets. When some Carrefour 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 Carrefour and other MNCs on a short-term basis. (Eurocurrency refers to international currencies, most likely the dollar, not just the euro!)c. Explain how Carrefour could use the international bond market to finance theestablishment of new outlets in foreign markets.ANSWER: Carrefour 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.23.Interest Rates. Why do interest rates vary among countries? Why are interest rates normallysimilar 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.Blades plc Case Study。

Solutions Manualto accompanyPrinciples of Accounting2nd editionbyJerry Weygandt, Keryn Chalmers, Lorena Mitrione Michelle Fyfe, Susana Yuen, Donald Kieso, Paul KimmelChapter 14Companies: share capitalJohn Wiley & Sons Australia, LtdCHAPTER 14Companies: Share Capital ASSIGNMENT CLASSIFICATION TABLELearning Objectives QuestionsBriefExercises Exercises Problems1. Identify the majorcharacteristics of acompany.1, 2, 3, 4, 9 12. Differentiate betweenshare capital andretained earnings. 5, 6, 8, 10,11, 14, 152 3A, 4A3. Record the issue ofordinary shares. 7, 11, 12,133, 4, 5, 6 1, 2, 3, 4,5, 61A, 2A, 3A,4A, 6A, 7A4. Explain the accountingfor share buy-backs.15, 16 7 2, 4, 6, 8 6A5. Differentiate preferenceshares from ordinaryshares. 17 4, 8 3, 5, 8 1A, 4A, 6A,7A6. Prepare a shareholder s’equity section. 20 9 2, 7, 8, 9,10, 111A, 2A, 3A,4A, 5A, 6A,7A7. Compute book valueper share.18, 19 10 12, 13ASSIGNMENT CHARACTERISTICS TABLEProblemNumber Description DifficultyLevelTimeAllotted (min.)1 Journalise shares transactions, post, and prepare sharecapital section.Simple 30-402 Journalise share transactions, and prepareshareholder s’ equity section.Moderate 30-403 Journalise and post transactions, and prepare theshareholder s’ equity section.Moderate 30-404 Journalise and post ordinary and preference sharetransactions, and prepare shareholder s’ equity section.Moderate 30-405 Prepare shareholder s’ equity section.Simple 20-306 Prepare entries for share transactions and prepareshareholder s’ e quity section.Moderate 20-307 Journalise share transactions and prepare share capitalsection.Moderate 40-50BLOOM’S TAXONOMY TABLECorrelation Chart between Bloom’s Taxonomy, Learning Objectives and End-of-Chapter Exercisesand ProblemsANSWERS TO QUESTIONS1.(a) Separate legal entity. A company is separate and distinct from its owners and it acts inits own name rather than in the name of its shareholders. In contrast to a partnership, the acts of the owners (shareholders) do not bind the company unless the owners are duly appointed agents of the company.(b) Limited liability of shareholders. Because of its separate legal existence, creditors of acompany ordinarily have recourse only to company assets to satisfy their claims. Thus,the liability of shareholders is normally limited to their investment in the company.(c) Transferable ownership rights. Ownership of a company is held in shares. The sharesare transferable units. Shareholders may dispose of part or all of their interest by simplyselling their shares. The transfer of ownership to another party is entirely at thediscretion of the shareholder.2.(a) The separation of ownership and management is an advantage to a company becauseit can hire professional managers to run the company. It is also a disadvantage to a company because it prevents owners from having an active role in directly managingthe company.(b) Two other disadvantages of a company form of ownership are government regulationsand company taxation. A company is subject to numerous regulations. Companies must pay income taxes. These taxes are substantial. Publicly owned companies are alsorequired to make adequate disclosures of their financial affairs.3.(a) (1) The articles of incorporation is a document that creates a company.(2) The company constitution is the internal rules and procedures for conducting theaffairs of a company. They also indicate the powers of the shareholders, directorsand senior executives.(3) Preliminary expenses are costs incurred in the formation of a company. Thesecosts include legal fees and promotional expenditure involved in the organisationof the business. Preliminary costs are capitalised as it would be expected thatthese costs will provide future economic benefits to the company.4.In the absence of restrictive provisions, the basic ownership rights of ordinary shareholdersare the rights to:(1) vote in the election of a board of directors and in company actions that requireshareholder s’ approval.(2) share in company profits through the receipt of dividends.(3) keep the same percentage ownership when new shares of ordinary shares are issued(the preemptive right).(4) share in assets upon liquidation.5.(a) The two principal components of shareholder s’ equity for a company are share capital(the investment of cash and other assets in the company by shareholders in exchange for shares) and retained earnings. The principal source of retained earnings is profit.(b) Share capital is the term used to describe the total amount paid-up on shares. Sharecapital may result through the issue of ordinary shares and/or preference shares.6.Each of the three basic financial statements for a company differs from those for aproprietorship. The income statement for a company will have income tax expense. For a company, a retained earnings statement is prepared to show the changes in retained earnings during the period. In the statement of financial position, the owner’s equity section is called the shareholder s’ e quity section.7.Shareholders’ EquityShare Capital100 000 ordinary shares, fully paid ............................................................... 500 00050 000 ordinary shares, paid to $4 ................................................................ 200 000Total Share Capital .............................................................................. 700 000 Retained Earnings ........................................................................................ 44 000 Total Shareholders’ Equity......................................................................... $744 000 8.Par value is an arbitrary amount assigned to each share. The share issue price is the pricerequired to be paid in order to purchase the shares. Countries like Australia and New Zealand have removed the use of par value because par value is an immaterial value in relation to the issue price with no relationship with the market value of the share issued.9.Among the factors which influence the market value of shares are the company’s profits andanticipated future earnings, its expected dividend rate per share, its current financial position, the current state of the economy, and the current state of the share markets.10.When a company issue shares, cash is received by the company and the share capitalaccount is credited with the amount of shares issued, therefore increasing share capital.This is very different to stock exchange transactions where one shareholder sells some or all of their shares to another shareholder or investor. These type of transactions, known as stock exchange transactions, are not recorded by the company and therefore share capital remains the same. In these transactions, the company simply records the change in ownership of those shares often via the share registry service.11.When the board of directors of Unforgettable Houseboats Ltd makes the call theshareholders are obliged to pay the amount called. When shares are allotted, a legally binding contract is created, therefore shareholders are required to pay the amount owing as and when required. The amount per share required to be paid is $2 per share.12. If a shareholder fails to pay a call on a share the company can do one of two things:(a) take legal action against the shareholder to ensure the money is paid; or,(b) forfeit the shares. If the shares are forfeited, the shareholder who owned the sharesloses any amount paid to the company and is no longer a shareholder of the company.13.When shares are issued for services or non-cash assets, the cost should be measured at thefair value of the consideration given up (in this case, the shares). The fair value of the shares is objectively determinable than that of the land, since the shares are actively traded on the stock exchange. Therefore, the land should be recorded at $90 000.14. A company may repurchase its own shares for one of the following reasons:1. The company has surplus cash, and it does not have or is not aware of a sufficientprofitable investment opportunity.2. Management may want to avoid a takeover of the company by an outside party.3. The buy back of shares may support the shares’ market price by decreasing thenumber of shares available.4. Management may be making a financing decision, that is, it may wish to replace someof the company’s share capital with borrowed funds.15.When a company buys back its shares, the cost of the share buy-back is debited againstshareholders’ equity, normally to the sha re capital account. Cash is credited at the cost of the buy-back. Thus, this transaction: (a) has no effect on profit, (b) decreases total assets,(c) reduces share capital, and (d) decreases total shareholder s’ equity.16.Under the accounting standards, namely IAS 1 101 and AASB 101Presentation of FinancialStatements,when a company buys back its shares it requires the following disclosures:∙number of shares bought back∙price paid per share bought back∙amount debited to the shareholders’ equity accounts.The disclosure would normally be made in the notes to the financial statements.17.(a) Ordinary shares and preference shares both represent ownership of the company.Ordinary shares signifies the basic residual ownership; preference shares is ownershipwith certain privileges or preferences. Preference shareholders typically have apreference as to dividends and as to assets in the event of liquidation. However,preference shareholders generally do not have voting rights.(b) Some preference shares possess the additional features of being cumulative. Ifpreference shares are cumulative, the preference shareholders must be paid bothcurrent-year dividends and unpaid prior year dividends before ordinary shareholdersreceive any dividends.(c) Dividends in arrears are disclosed in the notes to the financial statements.18.The formula for computing book value per share when a company has only ordinary sharesissued is:TotalShareholder s’Equity ÷Number ofOrdinary SharesIssued=BookValueper ShareBook value per share represents the equity an ordinary shareholder has in the net assets of the company from owning one share.19.Book value per share represents the equity an ordinary shareholder has in the net assets ofthe company from owning one share. Market value is generally only remotely related to book value. A shares market value will reflect many factors, including the company’s profits and anticipated future earnings, its expected dividend rate per share, its current financial position, the current state of the economy, and the current state of the securities or share markets.20.The answers are summarised in the table below:Account Classification(a)(b)(c)(d)(e)(f) Ordinary sharesShare CapitalRetained EarningsPreference SharesOrdinary Share CapitalOrdinary Share CapitalShare capital — ordinary sharesShare capitalRetained earningsShare Capital — Preference SharesShare capital — Ordinary SharesShare capital — Ordinary Shares partly paidSOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 14-1The advantages and disadvantages of a company are as follows:Advantages DisadvantagesSeparate legal existenceLimited liability of shareholders Transferable ownership rights Ability to acquire capital Continuous lifeNo mutual agency for shareholders Professional managers Separation of ownership and management Government regulationsCompany taxationBRIEF EXERCISE 14-230 June Profit and Loss Summary ............................................................ 450 000Retained Earnings ............................................................. 450 000BRIEF EXERCISE 14-310 May Cash (1000 × $10) ...................................................................... 10 000Ordinary share capital (1000 × $10)................................... 10 000BRIEF EXERCISE 14-4Cash (10 000 × $6) ................................................................................... 60 000 Ordinary Share Capital .................................................................... 60 000 Cash (3000 × $12) .................................................................................... 36 000 Preference Share Capital ................................................................ 36 000BRIEF EXERCISE 14-520 June Cash (Trust Account) .................................................................. 12 000Application ......................................................................... 12 000(Record of receipt of application monies)25 June Application (3000 × $4) ............................................................... 12 000Allotment (3000 × $2) ................................................................. 6 000Ordinary Share Capital ...................................................... 18 000(To record issue of 3000 shares)25 June Cash .......................................................................................... 12 000Cash (Trust Account) ......................................................... 12 000(Transfer application money to bank account)BRIEF EXERCISE 14-6Land (5000 × $8) .......................................................................................... 40 000 Ordinary share capital (5000 × $8) ...................................................... 40 000 BRIEF EXERCISE 14-71 May Ordinary Share Capital (500 × $9) .............................................. 4 500Cash ................................................................................. 4 500 Record buy-back of sharesBRIEF EXERCISE 14-8Cash (5000 × $60) ........................................................................................ 300 000 Preference Share Capital (5000 × $60) ............................................... 300 000 BRIEF EXERCISE 14-9INGHAM LTDStatement of Financial Position (partial)as at 30 JuneShareholders’ equityShare capitalShares5000 Ordinary shares, fully paid ..................................................... $ 50 0003000 Preference shares, fully paid .................................................. 300 000 Total share capital ................................................................. 350 000 Retained earnings ...................................................................................................... 45 000 Total Shareholders’ equity .............................................................. $395 000 BRIEF EXERCISE 14-10Book value per share = $20.25 or ($810 000 ÷ 40 000).SOLUTIONS TO EXERCISESEXERCISE 14-1(a) 10 Jan Cash (70 000 × $10) .......................................................... 700 000Ordinary share capital(70 000 × $10)....................... 700 00010 June Cash (40 000 × $16) .......................................................... 640 000Ordinary share capital(40 000 × $16)....................... 640 000(b) Share Capital70 000 Ordinary Shares, fully paid ..................................... 700 00040 000 Ordinary Shares, fully paid ..................................... 640 000 1340 000EXERCISE 14-2(a)10 July Cash (Trust Account) (100 000 × $10) ..................... 1 000 000Application ...................................................... 1 000 00010 Aug Application (100 000 × $10) ..................................... 1 000 000Allotment (100 000 × $10) ........................................ 1 000 000Ordinary Share Capital .................................... 2 000 00010 Aug Cash ....................................................................... 1 000 000Cash (Trust Account) ...................................... 1 000 00030 Aug Cash ....................................................................... 1 000 000Allotment ......................................................... 1 000 00010 Sep Call (100 000 × $10)................................................. 1 000 000Ordinary Share Capital .................................... 1 000 00030 Sep Cash ....................................................................... 1 000 000Call ................................................................. 1 000 000(b)XYZ LIMITEDStatement of Financial Position (partial)as at 30 JuneShareholders’ equityShare capital100 000 ordinary shares, fully paid .................................................. $3 000 000 Total share capital ............................................................... 3 000 000 Retained earnings ......................................................................................... 70 000 Total shareholders’ equity.................................................... $3 070 0001 July Cash (Trust Account) (40 000 × $4) .......................... 160 000Application..................................................... 160 0001 Aug Application (40 000 × $4) ......................................... 160 000Allotment (40 000 × $4) ............................................ 160 000Ordinary Share Capital .................................. 320 0001 Aug Cash ...................................................................... 160 000Cash (Trust Account) .................................... 160 00015 Aug Cash ...................................................................... 160 000Allotment ....................................................... 160 00030 Aug Call (40 000 × $4) ..................................................... 160 000Ordinary Share Capital .................................. 160 00015 Sep Cash ...................................................................... 160 000Call ................................................................ 160 0001 Jan Cash ...................................................................... 1 000 000Preference Share Capital .............................. 1 000 0001 March Land ...................................................................... 140 000Ordinary Share Capital .................................. 140 0001 June Ordinary Share Capital (5000 x $10) ........................ 50 000Cash.............................................................. 50 000 (b)A. LIMITEDStatement of Financial Position (partial)as at 30 JuneShareholders’ e quityShare capital45 000 ordinary shares, fully paid .......................................................... $ 570 00040 000 preference shares, fully paid ...................................................... 1 000 000Total share capital ...................................................................... 1 570 000 Retained earnings ............................................................................................. 45 000 Total shareholders’ equity .......................................................... $1 615 00015 May Call (10 000 × $4) .............................................................. 40 000Ordinary Share Capital ........................................... 40 00030 May Cash (8000 × $4) ............................................................... 32 000Call ......................................................................... 32 00030 May Ordinary Share Capital (2000 × ($8 + $8 +$4)) .................. 40 000Call (2000 × $4) ...................................................... 8 000Forfeited Shares Account (2000 × ($8 + $8) ........... 32 00010 June Cash (2000 × $16) ............................................................. 32 000Forfeited Shares Account (2000 × $4) ............................... 8 000Ordinary Share Capital (2000 × $20) ...................... 40 000 (b)Forfeited Shares AccountNo. 612 Date Explanation Ref. Debit Credit Balance30 May 32 000 32 000 10 June 8 000 24 000EXERCISE 14-52 March Equipment .................................................................................. 60 000Ordinary Share Capital (5000 × $12) ................................. 60 000 12 June Cash .......................................................................................... 750 000Ordinary Share Capital (60 000 × $12.50) ......................... 750 000 11 July Cash (1000 × $55) ...................................................................... 55 000Preference Share Capital (1000 × $55) ............................. 55 000 28 Nov. Ordinary Share Capital (2000 × $10) .......................................... 20 000Cash ............................................................................ 20 000EXERCISE 14-6(1) Land ................................................................................................... 110 000Ordinary Share Capital ............................................................... 110 000 (2) Land (20 000 × $11) ............................................................................ 220 000Ordinary Share Capital (20 000 × $11) ....................................... 220 000(a) Mar. 1 Ordinary Share Capital (25 000 × $8.50) ......................... 212 500Cash....................................................................... 212 500 (b)SMALL LTDStatement of Financial Position (partial)as at 1 May 2010Shareholders’ equityShare Capital75 000 ordinary shares, fully paid ............................................................ 37 500Retained earnings ............................................................................................. 125 000 Total Shareholders’ equity .............................................................. 162 500 EXERCISE 14-8(a) 1 Feb. Cash (20 000 × $51) ..................................................... 1 020 000Preference Share Capital .................................... 1 020 000(20 000 × $51)1 June Cash (10 000 × $57) ..................................................... 570 000Preference Share Capital .................................... 570 000(10 000 × $57)(b)Preference Share CapitalDate Explanation Ref. Debit Credit BalanceFeb. 1 June 1 1 020 000570 0001 020 0001 590 000(c) Preference Share Capital — listed under Share Capital in the shareholders’ equity section ofthe balance sheet.EXERCISE 14-9CORAL LTDPartial Statement of Financial Positionas at 30 June 2010Shareholders’ equityShare capital100 000 Ordinary shares, fully paid........................................................ 1 500 00030 000 Ordinary shares, partly paid ....................................................... 280 00050 000 Preference shares, 8% dividend, fully paid ................................. 500 000Total share capital ......................................................... 2 280 000 Retained earnings ........................................................................... 1 134 000 T otal shareholders’ equity............................................. $3 414 000MEMOTo: CEO __________________________From: Your name , Chief AccountantRe: Questions about Shareholders’ Equity SectionYour memorandum about the shareholders’ equity section was received this morning. I hope the following will answer your questions.(a) 600 000 ordinary shares have been issued.(b) The issue price is $4 per share. (Ordinary shares issued $2 400 000 ÷ 600 000 shares.)(c) The issue price of the preference shares is $100 per share. (Preference share $1 200 000 ÷12 000 shares.)(d) The dividend rate is 5% or ($60 000 ÷ $1 200 000).(e) The Retained Earnings balance is still $3 716 000. Cumulative dividends in arrears are onlydisclosed in the notes to the financial statements.If I can be of further help, please contact me.COMMUNICATIONS LTDStatement of Financial Position (partial)Shareholde rs’ equityShare capital60 000 ordinary shares, fully paid1 ................................................ $ 925 00015 000 preference shares, fully paid ............................................. 300 000Total share capital ............................................................... 1 225 000 Retained earnings .................................................................................. 120 000 Total shareholders’ equity ............................................................. $1 345 0001 Ordinary share capital made up as follows:30 000 issued at $15 per share $450 00020 000 issued at $16 per share 320 00010 000 issued at $15.50 per share 155 000$925 000EXERCISE 14-12Total shareholders’ equity................................................................................. $2 500 000 Ordinary shares issued ..................................................................................... ÷ 125 000 Book value per share ........................................................................................ $ 20 EXERCISE 14-13Total shareholders’ equity (after deducting preference share capital) ................ $300 000 Ordinary shares issued ..................................................................................... ÷ 100 000 Book value per ordinary share .......................................................................... $ 3SOLUTIONS TO PROBLEMSPROBLEM 14-1(a) Jan. 10 Cash (100 000 × $6) ........................................................ 600 000Ordinary Share Capital (100 000 × $6) ..................... 600 000 Mar. 1 Cash (10 000 × $55) ........................................................ 550 000Preference Share Capital (10 000 × $55) ................. 550 000 Apr. 1 Land ................................................................................ 180 000Ordinary Share Capital (25 000 × $7.20) .................. 180 000 May 1 Cash (75 000 × $8) .......................................................... 600 000Ordinary Share Capital (75 000 × $8) ....................... 600 000 Aug. 1 Equipment ....................................................................... 100 000Ordinary Share Capital (10 000 × $10) ..................... 100 000 Sept. 1 Cash (5000 × $12)........................................................... 60 000Ordinary Share Capital (5000 × $12) ........................ 60 000 Nov. 1 Cash (2000 × $58)........................................................... 116 000Preference Share Capital (2000 × $58) .................... 116 000 (b)Preference Share CapitalDate Explanation Ref. Debit Credit BalanceMar. 1 Nov. 1 J1J1550 000116 000550 000666 000Ordinary Share CapitalDate Explanation Ref. Debit Credit BalanceJan. 10 Apr. 1 May 1 Aug. 1 Sept. 1 J1J1J1J1J1600 000180 000600 000100 00060 000600 000780 001380 0001 480 0001 540 000(c) HOUMBLE LTDStatement of Financial Position (partial)as at 31 Dec 2010Shareholders’ equ ityShare capital215 000 ordinary shares, fully paid ............................................. $ 1 540 00012 000 preference shares, fully paid ........................................... 666 000Total share capital ............................................................. $2 206 000。

CHAPTER 1 GLOBALIZATION AND THE MULTINATIONAL FIRM SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONSQUESTIONS1. Why is it important to study international financial managementAnswer: We are now living in a world where all the major economic functions i.e. consumptionproduction and investment are highly globalized. It is thus essential for financial managers to fullyunderstand vital international dimensions of financial management. This global shift is in markedcontrast to a situation that existed when the authors of this book were learning finance some twenty yearsago.At that time most professors customarily and safely to some extent ignored international aspectsof finance. This mode of operation has become untenable since then.2. How is international financial management different from domestic financial managementAnswer: There are three major dimensions that set apart international finance from domestic finance.They are: 1. foreign exchange and political risks 2. market imperfections and 3. expanded opportunity set.3. Discuss the three major trends that have prevailed in international business during the last two decades.Answer: The 1980s brought a rapid integration of international capital and financial markets. Impetus forglobalized financial markets initially came from the governments of major countries that had begun toderegulate their foreign exchange and capital markets. The economic integration and globalization thatbegan in the eighties is picking up speed in the 1990s via privatization. Privatization is the process bywhich a country divests itself of the ownership and operation of a business venture by turning it over tothe free market system. Lastly trade liberalization and economic integration continued to proceed at boththe regional and global levels.4. How is a country‟s economic well-being enhanced through free international trade in goods andservicesAnswer: According to David Ricardo with free international trade it is mutually beneficial for twocountries to each specialize in the production of the goods that it can produce relatively most efficientlyand then trade those goods. By doing so the two countries can increase their combined productionwhich allows both countries to consume more of both goods. This argument remains valid even if acountry can produce both goods more efficiently than the other country. International trade is not a …zero-sum‟ game in which one country benefits at the expense of another country. Rather international tradecould be an …increasing-sum‟ game at which all players become winners.5. What considerations might limit the extent to which the theory of comparative advantage is realisticAnswer: The theory of comparative advantage was originally advanced by the nineteenth centuryeconomist David Ricardo as an explanation for why nations trade with one another. The theory claimsthat economic well-being is enhanced if each country‟s citizens produce what they have a comparativeadvantage in producing relative to the citizens of other countries and then trade products. Underlying thetheory are the assumptions of free trade between nations and that the factors of production landbuildings labor technology and capital are relatively immobile. To the extent that these assumptions donot hold the theory of comparative advantage will not realistically describe international trade.6. What are multinational corporations MNCs and what economic roles do they playAnswer: A multinational corporation MNC can be defined as a business firm incorporated in onecountry that has production and sales operations in several other countries. Indeed some MNCs haveoperations in dozens of different countries. MNCs obtain financing from major money centers around theworld in many different currencies to finance their operations. Global operations force the treasurer‟soffice to establish international banking relationships to place short-term fundsin several currencydenominations and to effectively manage foreign exchange risk.7. Mr. Ross Perot a former Presidential candidate of the Reform Party which is a third political party inthe United States had strongly objected to the creation of the North American Trade AgreementNAFTA which nonetheless was inaugurated in 1994 for the fear of losing American jobs to Mexicowhere it is much cheaper to hire workers. What are the merits and demerits of Mr. Perot‟s position onNAFTA Considering the recent economic developments in North America how would you assess Mr.Perot‟s position on NAFTAAnswer: Since the inception of NAFTA many American companies indeed have invested heavily inMexico sometimes relocating production from the United States to Mexico. Although this might havetemporarily caused unemployment of some American workers they were eventually rehired by otherindustries often for higher wages. Currently the unemployment rate in the U.S. is quite low by historicalstandard. At the same time Mexico has been experiencing a major economic boom. It seems clear thatboth Mexico and the U.S. have benefited from NAFTA. Mr. Perot‟s concern appears to hav e been illfounded.8. In 1995 a working group of French chief executive officers was set up by the Confederation of FrenchIndustry CNPF and the French Association of Private Companies AFEP to study the French corporategovernance structure. The group reported the following among other things “The board of directorsshould not simply aim at maximizing share values as in the U.K. and the U.S. Rather its goal should be toserve the company whose interests should be clearly distinguished from those of its shareholdersemployees creditors suppliers and clients but still equated with their general common interest which isto safeguard the prosperity and continuity of the company”. Evaluate the above recommendation of theworking group.Answer: The recommendations of the French working group clearly show that shareholder wealthmaximization is not a universally accepted goal of corporate management especially outside the UnitedStates and possibly a few other Anglo-Saxon countries including the United Kingdom and Canada. Tosome extent this may reflect the fact that share ownership is not wide spread in most other countries. InFrance about 15 of households own shares.9. Emphasizing the importance of voluntary compliance as opposed to enforcement in the aftermath ofcorporate scandals e.g. Enron and WorldCom U.S. President George W. Bush stated that while tougherlaws might help “ultimately the ethics of American business depends on the conscience of America‟sbusiness leaders.” Describe your view on this statement.Answer: There can be different answers to this question. If business leaders always behave with a highethical standard many of the corporate scandals we have seen lately might not have happened. Since wecannot fully depend on the ethical behavior on the part of business leaders the society should protectitself by adopting therules/regulations and governance structure that would induce business leaders tobehave in the interest of the society at large.10. Suppose you are interested in investing in shares of Nokia Corporation of Finland which is a worldleader in wireless communication. But before you make investment decision you would like to learnabout the company. Visit the website of CNN Financial network and collectinformation about Nokia including the recent stock price history and analysts‟ views of the company.Discuss what you learn about the company. Also discuss how the instantaneous access to information viainternet would affect the nature and workings of financial markets.Answer: As students might have learned from visiting the website information is readily available evenfor foreign companies like Nokia. Ready access to international information helpsintegrate financialmarkets dismantling barriers to international investment and financing. Integration however may help afinancial shock in one market to be transmitted to other markets.MINI CASE: NIKE‟S DECISION Nike a U.S.-based company with a globally recognized brand name manufactures athletic shoes insuch Asian developing countries as China Indonesia and Vietnam using subcontractors and sells theproducts in the U.S. and foreign markets. The company has no production facilities in the United States.In each of those Asian countries where Nike has production facilities the rates of unemployment andunderemployment are quite high. The wage rate is very low in those countries by the U.S. standardhourly wage rate in the manufacturing sector is less than one dollar in each of those countries which iscompared with about 18 in the U.S. In addition workers in those countries often are operating in poorand unhealthy environments and their rights are not well protected. Understandably Asian host countriesare eager to attract foreign investments like Nike‟s to develop their economies and raise the livingstandards of th eir citizens. Recently however Nike came under a world-wide criticism for its practice ofhiring workers for such a low pay “next to nothing” in the words of critics and condoning poor workingconditions in host countries. Evaluate and discuss various …ethical‟ as well as economic ramifications of Nike‟s decision toinvest in those Asian countries.Suggested Solution to Nike‟s Decision Obviously Nike‟s investments in such Asian countries as China Indonesia and Vietnam weremotivated to take advantage of low labor costs in those countries. While Nike was criticized for the poorworking conditions for its workers the company has recognized the problem and has substantiallyimproved the working environments recently. Although Nike‟s workers get paid very low wages by theWestern standard they probably are making substantially more than their local compatriots who are eitherunder- or unemployed. While Nike‟s detractors may have valid points one should not ignore the fact thatthe company is making contributions to the economic welfare of those Asian countries by creating jobopportunities. CHAPTER 1A THEORY OF COMPARATIVE ADVANTAGE SUGGESTED SOLUTIONS TO APPENDIX PROBLEMSPROBLEMS1. Country C can produce seven pounds of food or four yards of textiles per unit of input. Compute theopportunity cost of producing food instead of textiles. Similarly compute the opportunity cost ofproducing textiles instead of food.Solution: The opportunity cost of producing food instead of textiles is one yard of textiles per 7/4 1.75pounds of food. A pound of food has an opportunity cost of4/7 .57 yards of textiles.2. Consider the no-trade input/output situation presented in the following table for Countries X and Y.Assuming that free trade is allowed develop a scenario that will benefit the citizens of both countries.INPUT/OUTPUT WITHOUT TRADE_________________________________________________________________ ______ Country X YTotal___________________________________________________________________ _____I. Units of Input000000_____________________________________________________Food 70 60Textiles 4030______________________________________________________________________ __II. Output per Unit of Inputlbs or yards____________________________________________________Food 17 5Textiles 52_______________________________________________________________________ _III. Total Outputlbs or yards000000____________________________________________________Food 1190 300 1490Textiles 200 60260_____________________________________________________________________ ___IV. Consumptionlbs or yards000000___________________________________________________Food 1190 300 1490Textiles 200 60260_____________________________________________________________________ ___Solution: Examination of the no-trade input/output table indicates that Country X has an absoluteadvantage in the production of food and textiles. Country X can “trade off” one unit of productionneeded to produce 17 pounds of food for five yards of textiles. Thus a yard of textiles has an opportunitycost of 17/5 3.40 pounds of food or a pound of food has an opportunity cost of 5/17 .29 yards oftextiles. Analogously Country Y has an opportunity cost of 5/2 2.50 pounds of food per yard oftextiles or 2/5 .40 yards of textiles per pound of food. In terms of opportunity cost it is clear thatCountry X is relatively more efficient in producing food and Country Y is relatively more efficient inproducing textiles. Thus Country X Y has a comparative advantage in producing food textile iscomparison to Country Y X. When there are no restrictions or impediments to free trade the economic-well being of thecitizens of both countries is enhanced through trade. Suppose that Country X shifts 20000000 unitsfrom the production of textiles to the production of food where it has a comparative advantage and thatCountry Y shifts 60000000 units from the production of food to the production of textiles where it has acomparative advantage. Total output will now be 90000000 x 17 1530000000 pounds of food and20000000 x 5 100000000 90000000 x 2 180000000 280000000 yards of textiles.Further suppose that Country X and Country Y agree on a price of 3.00 pounds of food for one yard oftextiles and that Country X sells Country Y 330000000 pounds of food for 110000000 yards of textiles.Under free trade the following table shows that the citizens of Country X Y have increased theirconsumption of food by 10000000 30000000 pounds and textiles by 10000000 10000000 yards.INPUT/OUTPUT WITH FREE TRADE_________________________________________________________________ _________ Country X YTotal___________________________________________________________________ _______I. Units of Input 000000_______________________________________________________Food 90 0Textiles 2090______________________________________________________________________ ____II. Output per Unit of Input lbs or yards______________________________________________________Food 17 5Textiles 52_______________________________________________________________________ ___III. Total Output lbs or yards 000000_____________________________________________________Food 1530 0 1530Textiles 100 180280_____________________________________________________________________ _____IV. Consumption lbs or yards 000000_____________________________________________________Food 1200 330 1530Textiles 210 70280_____________________________________________________________________ _____ CHAPTER 3 BALANCE OF PAYMENTS SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMSQUESTIONS1. Define the balance of payments.Answer: The balance of payments BOP can be defined as the statistical record of a country‟sinternational transactions over a certain period of time presented in the form of double-entry bookkeeping.2. Why would it be useful.。

CHAPTER 14 INTEREST RATE AND CURRENCY SWAPSSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. Describe the difference between a swap broker and a swap dealer.Answer: A swap broker arranges a swap between two counterparties for a fee without taking a risk position in the swap. A swap dealer is a market maker of swaps and assumes a risk position in matching opposite sides of a swap and in assuring that each counterparty fulfills its contractual obligation to the other.2. What is the necessary condition for a fixed-for-floating interest rate swap to be possible?Answer: For a fixed-for-floating interest rate swap to be possible it is necessary for a quality spread differential to exist. In general, the default-risk premium of the fixed-rate debt will be larger than the default-risk premium of the floating-rate debt.3. Discuss the basic motivations for a counterparty to enter into a currency swap.Answer: One basic reason for a counterparty to enter into a currency swap is to exploit the comparative advantage of the other in obtaining debt financing at a lower interest rate than could be obtained on its own. A second basic reason is to lock in long-term exchange rates in the repayment of debt service obligations denominated in a foreign currency.4. How does the theory of comparative advantage relate to the currency swap market?Answer: Name recognition is extremely important in the international bond market. Without it, even a creditworthy corporation will find itself paying a higher interest rate for foreign denominated funds than a local borrower of equivalent creditworthiness. Consequently, two firms of equivalent creditworthiness can each exploit their, respective, name recognition by borrowing in their local capital market at a favorable rate and then re-lending at the same rate to the other.5. Discuss the risks confronting an interest rate and currency swap dealer.Answer: An interest rate and currency swap dealer confronts many different types of risk. Interest rate risk refers to the risk of interest rates changing unfavorably before the swap dealer can lay off on an opposing counterparty the unplaced side of a swap with another counterparty. Basis risk refers to the floating rates of two counterparties being pegged to two different indices. In this situation, since the indexes are not perfectly positively correlated, the swap bank may not always receive enough floating rate funds from one counterparty to pass through to satisfy the other side, while still covering its desired spread, or avoiding a loss. Exchange-rate risk refers to the risk the swap bank faces from fluctuating exchange rates during the time it takes the bank to lay off a swap it undertakes on an opposing counterparty before exchange rates change. Additionally, the dealer confronts credit risk from one counterparty defaulting and its having to fulfill the defaulting party’s obligation to the other counterparty. Mismatch risk refers to the difficulty of the dealer finding an exact opposite match for a swap it has agreed to take. Sovereign risk refers to a country imposing exchange restrictions on a currency involved in a swap making it costly, or impossible, for a counterparty to honor its swap obligations to the dealer. In this event, provisions exist for the early termination of a swap, which means a loss of revenue to the swap bank.6. Briefly discuss some variants of the basic interest rate and currency swaps diagramed in the chapter.Answer: Instead of the basic fixed-for-floating interest rate swap, there are also zero-coupon-for-floating rate swaps where the fixed rate payer makes only one zero-coupon payment at maturity on the notional value. There are also floating-for-floating rate swaps where each side is tied to a different floating rate index or a different frequency of the same index. Currency swaps need not be fixed-for-fixed; fixed-for-floating and floating-for-floating rate currency swaps are frequently arranged. Moreover, both currency and interest rate swaps can be amortizing as well as non-amortizing.7. If the cost advantage of interest rate swaps would likely be arbitraged away in competitive markets, what other explanations exist to explain the rapid development of the interest rate swap market?Answer: All types of debt instruments are not always available to all borrowers. Interest rate swaps can assist in market completeness. That is, a borrower may use a swap to get out of one type of financing and to obtain a more desirable type of credit that is more suitable for its asset maturity structure.8. Suppose Morgan Guaranty, Ltd. is quoting swap rates as follows: 7.75 - 8.10 percent annually against six-month dollar LIBOR for dollars and 11.25 - 11.65 percent annually against six-month dollar LIBOR for British pound sterling. At what rates will Morgan Guaranty enter into a $/£ currency swap?Answer: Morgan Guaranty will pay annual fixed-rate dollar payments of 7.75 percent against receiving six-month dollar LIBOR flat, or it will receive fixed-rate annual dollar payments at 8.10 percent against paying six-month dollar LIBOR flat. Morgan Guaranty will make annual fixed-rate £ payments at 11.25 percent against receiving six-month dollar LIBOR flat, or it will receive annual fixed-rate £ payments at 11.65 percent against paying six-month dollar LIBOR flat. Thus, Morgan Guaranty will enter into a currency swap in which it would pay annual fixed-rate dollar payments of 7.75 percent in return for receiving semi-annual fixed-rate £ payments at 11.65 percent, or it will receive annual fixed-rate dollar payments at 8.10 percent against paying annual fixed-rate £ payments at 11.25 percent.*9. Assume a currency swap in which two counterparties of comparable credit risk each borrow at the best rate available, yet the nominal rate of one counterparty is higher than the other. After the initial principal exchange, is the counterparty that is required to make interest payments at the higher nominal rate at a financial disadvantage to the other in the swap agreement? Explain your thinking.Answer: Superficially, it may appear that the counterparty paying the higher nominal rate is at a disadvantage since it has borrowed at a lower rate. However, if the forward rate is an unbiased predictor of the expected spot rate and if IRP holds, then the currency with the higher nominal rate is expected to depreciate versus the other. In this case, the counterparty making the interest payments at the higher nominal rate is in effect making interest payments at the lower interest rate because the payment currency is depreciating in value versus the borrowing currency.PROBLEMS1. Alpha and Beta Companies can borrow for a five-year term at the following rates:Alpha BetaMoody’s credit rating Aa BaaFixed-rate borrowing cost 10.5% 12.0%Floating-rate borrowing cost LIBOR LIBOR + 1%a. Calculate the quality spread differential (QSD).b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. No swap bank is involved in this transaction.Solution:a. The QSD = (12.0% - 10.5%) minus (LIBOR + 1% - LIBOR) = .5%.b. Alpha needs to issue fixed-rate debt at 10.5% and Beta needs to issue floating rate-debt at LIBOR + 1%. Alpha needs to pay LIBOR to Beta. Beta needs to pay 10.75% to Alpha. If this is done, Alpha’s floating-rate all-in-cost is: 10.5% + LIBOR - 10.75% = LIBOR - .25%, a .25% savings over issuing floating-rat e debt on its own. Beta’s fixed-rate all-in-cost is: LIBOR+ 1% + 10.75% - LIBOR = 11.75%, a .25% savings over issuing fixed-rate debt.2. Do problem 1 over again, this time assuming more realistically that a swap bank is involved as an intermediary. Assume the swap bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat.Solution: Alpha will issue fixed-rate debt at 10.5% and Beta will issue floating rate-debt at LIBOR + 1%. Alpha will receive 10.7% from the swap bank and pay it LIBOR. Beta will pay 10.8% to the swap bank and receive from it LIBOR. If this is done, Alpha’s floating-rate all-in-cost is: 10.5% + LIBOR - 10.7% = LIBOR - .20%, a .20% savings over issuing floating-rate debt on its own. Beta’s fixed-rate all-in-cost is: LIBOR+ 1% + 10.8% - LIBOR = 11.8%, a .20% savings over issuing fixed-rate debt.3. Company A is a AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue FRNs at six-month LIBOR + .125 percent or at three-month LIBOR + .125 percent. Given its asset structure, three-month LIBOR is the preferred index. Company B is an A-rated firm that also desires to issue five-year FRNs. It finds it can issue at six-month LIBOR + 1.0 percent or at three-month LIBOR + .625 percent. Given its asset structure, six-month LIBOR is the preferred index. Assume a notional principal of $15,000,000. Determine the QSD and set up a floating-for-floating rate swap where the swap bank receives .125 percent and the two counterparties share the remaining savings equally.Solution: The quality spread differential is [(Six-month LIBOR + 1.0 percent) minus (Six-month LIBOR + .125 percent) =] .875 percent minus [(Three-month LIBOR + .625 percent) minus (Three-month LIBOR + .125 percent) =] .50 percent, which equals .375 percent. If the swap bank receives .125 percent, each counterparty is to save .125 percent. To effect the swap, Company A would issue FRNs indexed to six-month LIBOR and Company B would issue FRNs indexed three-month LIBOR. Company B might make semi-annual payments of six-month LIBOR + .125 percent to the swap bank, which would pass all of it through to Company A. Company A, in turn, might make quarterly payments of three-month LIBOR to the swap bank, which would pass through three-month LIBOR - .125 percent to Company B. On an annualized basis, Company B will remit to the swap bank six-month LIBOR + .125 percent and pay three-month LIBOR + .625 percent on its FRNs. It will receive three-month LIBOR - .125 percent from the swap bank. This arrangement results in an all-in cost of the six-month LIBOR + .825 percent, which is a rate .125 percent below the FRNs indexed to six-month LIBOR + 1.0 percent Company B could issue on its own. Company A will remit three-month LIBOR to the swap bank and pay six-month LIBOR + .125 percent on its FRNs. It will receive six-month LIBOR + .125 percent from the swap bank. This arrangement results in an all-in cost of three-month LIBOR for Company A, which is .125 percent less than the FRNs indexed to three-month LIBOR + .125 percent it could issue on its own. The arrangements with the two counterparties net the swap bank .125 percent per annum, received quarterly.*4. A corporation enters into a five-year interest rate swap with a swap bank in which it agrees to pay the swap bank a fixed rate of 9.75 percent annually on a notional amount of €15,000,000 and receive LIBOR. As of the second reset date, determine the price of the swap from the corporation’s viewpoint assuming that the fixed-rate side of the swap has increased to 10.25 percent.Solution: On the reset date, the present value of the future floating-rate payments the corporation will receive from the swap bank based on the notional value will be €15,000,000. The present value of a hypothetical bond issu e of €15,000,000 with three remaining 9.75 percent coupon payments at the newfixed-rate of 10.25 percent is €14,814,304. This sum represents the present value of the remaining payments the swap bank will receive from the corporation. Thus, the swap bank should be willing to buy and the corporation should be willing to sell the swap for €15,000,000 - €14,814,304 = €185,696.5. Karla Ferris, a fixed income manager at Mangus Capital Management, expects the current positively sloped U.S. Treasury yield curve to shift parallel upward.Ferris owns two $1,000,000 corporate bonds maturing on June 15, 1999, one with a variable rate based on 6-month U.S. dollar LIBOR and one with a fixed rate. Both yield 50 basis points over comparable U.S. Treasury market rates, have very similar credit quality, and pay interest semi-annually.Ferris wished to execute a swap to take advantage of her expectation of a yield curve shift and believes that any difference in credit spread between LIBOR and U.S. Treasury market rates will remain constant.a. Describe a six-month U.S. dollar LIBOR-based swap that would allow Ferris to take advantage of her expectation. Discuss, assuming Ferris’ expectation is correct, the change in the swap’s value and how that change would affect the value of her portfolio. [No calculations required to answer part a.] Instead of the swap described in part a, Ferris would use the following alternative derivative strategy to achieve the same result.b. Explain, assuming Ferris’ expectation is correc t, how the following strategy achieves the same result in response to the yield curve shift. [No calculations required to answer part b.]Settlement Date Nominal Eurodollar Futures Contract Value12-15-97 $1,000,00003-15-98 1,000,00006-15-98 1,000,00009-15-98 1,000,00012-15-98 1,000,00003-15-99 1,000,000c. Discuss one reason why these two derivative strategies provide the same result.CFA Guideline Answera.The Swap Value and its Effect on Ferris’ PortfolioBecause Karla Ferris believes interest rates will rise, she will want to swap her $1,000,000 fixed-rate corporate bond interest to receive six-month U.S. dollar LIBOR. She will continue to hold her variable-rate six-month U.S. dollar LIBOR rate bond because its payments will increase as interest rates rise. Because the credit risk between the U.S. dollar LIBOR and the U.S. Treasury market is expected to remain constant, Ferris can use the U.S. dollar LIBOR market to take advantage of her interest rate expectation without affecting her credit risk exposure.To execute this swap, she would enter into a two-year term, semi-annual settle, $1,000,000 nominal principal, pay fixed-receive floating U.S. dollar LIBOR swap. If rates rise, the swap’s mark-to-market value will increase because the U.S. dollar LIBOR Ferris receives will be higher than the LIBOR rates from which the swap was priced. If Ferris were to enter into the same swap after interest rates rise, she would pay a higher fixed rate to receive LIBOR rates. This higher fixed rate would be calculated as the present value of now higher forward LIBOR rates. Because Ferris would be paying a stated fixed rate that is lower than this new higher-present-value fixed rate, she could sell her swap at a premium. This premium is called the “replacement cost” value of the swap.b. Eurodollar Futures StrategyThe appropriate futures hedge is to short a combination of Eurodollar futures contracts with different settlement dates to match the coupon payments and principal. This futures hedge accomplishes the same objective as the pay fixed-receive floating swap described in Part a. By discussing how the yield-curve shift affects the value of the futures hedge, the candidate can show an understanding of how Eurodollar futures contracts can be used instead of a pay fixed-receive floating swap.If rates rise, the mark-to-market values of the Eurodollar contracts decrease; their yields must increase to equal the new higher forward and spot LIBOR rates. Because Ferris must short or sell the Eurodollar contracts to duplicate the pay fixed-receive variable swap in Part a, she gains as the Eurodollar futures contracts decline in value and the futures hedge increases in value. As the contracts expire, or if Ferris sells the remaining contracts prior to maturity, she will recognize a gain that increases her return. With higher interest rates, the value of the fixed-rate bond will decrease. If the hedge ratios are appropriate, the value of the portfolio, however, will remain unchanged because of the increased value of the hedge, which offsets the fixed-rate bond’s decrease.a. Why the Derivative Strategies Achieve the Same ResultArbitrage market forces make these two strategies provide the same result to Ferris. The two strategies are different mechanisms for different market participants to hedge against increasing rates. Some money managers prefer swaps; others, Eurodollar futures contracts. Each institutional marketparticipant has different preferences and choices in hedging interest rate risk. The key is that market makers moving into and out of these two markets ensure that the markets are similarly priced and provide similar returns. As an example of such an arbitrage, consider what would happen if forward market LIBOR rates were lower than swap market LIBOR rates. An arbitrageur would, under such circumstances, sell the futures/forwards contracts and enter into a received fixed-pay variable swap. This arbitrageur could now receive the higher fixed rate of the swap market and pay the lower fixed rate of the futures market. He or she would pocket the differences between the two rates (without risk and without having to make any [net] investment.) This arbitrage could not last.As more and more market makers sold Eurodollar futures contracts, the selling pressure would cause their prices to fall and yields to rise, which would cause the present value cost of selling the Eurodollar contracts also to increase. Similarly, as more and more market makers offer to receive fixed rates in the swap market, market makers would have to lower their fixed rates to attract customers so they could lock in the lower hedge cost in the Eurodollar futures market. Thus, Eurodollar forward contract yields would rise and/or swap market receive-fixed rates would fall until the two rates converge. At this point, the arbitrage opportunity would no longer exist and the swap and forwards/futures markets would be in equilibrium.6. Rone Company asks Paula Scott, a treasury analyst, to recommend a flexible way to manage the company’s financial risks.Two years ago, Rone issued a $25 million (U.S.$), five-year floating rate note (FRN). The FRN pays an annual coupon equal to one-year LIBOR plus 75 basis points. The FRN is non-callable and will be repaid at par at maturity.Scott expects interest rates to increase and she recognizes that Rone could protect itself against the increase by using a pay-fixed swap. However, Rone’s Board of Directors prohibits both short sales of securities and swap transactions. Scott decides to replicate a pay-fixed swap using a combination of capital market instruments.a. Identify the instruments needed by Scott to replicate a pay-fixed swap and describe the required transactions.b. Explain how the transactions in Part a are equivalent to using a pay-fixed swap.CFA Guideline Answera. The instruments needed by Scott are a fixed-coupon bond and a floating rate note (FRN).The transactions required are to:∙issue a fixed-coupon bond with a maturity of three years and a notional amount of $25 million, and∙buy a $25 million FRN of the same maturity that pays one-year LIBOR plus 75 bps.b. At the outset, Rone will issue the bond and buy the FRN, resulting in a zero net cash flow at initiation. At the end of the third year, Rone will repay the fixed-coupon bond and will be repaid the FRN, resulting in a zero net cash flow at maturity. The net cash flow associated with each of the three annual coupon payments will be the difference between the inflow (to Rone) on the FRN and the outflow (to Rone) on the bond. Movements in interest rates during the three-year period will determine whether the net cash flow associated with the coupons is positive or negative to Rone. Thus, the bond transactions are financially equivalent to a plain vanilla pay-fixed interest rate swap.7. Dustin Financial owns a $10 million 30-year maturity, noncallable corporate bond with a 6.5 percent coupon paid annually. Dustin pays annual LIBOR minus 1 percent on its three-year term time deposits.Vega Corporation owns an annual-pay LIBOR floater and wants to swap for three years. One-year LIBOR is now 5 percent.a. Diagram the cash flows between Dustin, Vega, Dustin’s depositors, and Dustin’s corporate bond. Label the following items:•Dustin, Vega, Dustin’s depositors, and Dustin’s corporate bond.• Applicable interest rate at each line and specify whether it is floating orfixed.•Direction of each of the cash flows.Answer problem a in the template provided.b. i. Calculate the first new swap payment between Dustin and Vega and indicate the direction of the net payment amount.ii. Identify the net interest rate spread that Dustin expects to earn.CFA Guideline Answera. The cash flows between Dustin, Vega, Dustin’s depositors, and Dustin’s corporate bond are asfollows:b. i. As the fixed rate payer, Dustin would owe Vega $10,000,000 x 6.5% = $650,000. As the floating rate payer, Vega would owe Dustin $10,000,000 x 5.0% = $500,000. On a net basis, Dustin would pay Vega $650,000 - $500,000 = $150,000. There is no exchange of principal, either at the beginning of the swap or at payment dates.b. ii. Dustin expects to earn 1 percent spread. Dustin receives 6.5 percent on the corporate bonds it owns. After entering the swap, it also pays 6.5 percent to Vega. Effectively, then Dustin receives the corporate bond interest and passes it through to Vega. Under the swap agreement, Dustin receives LIBOR flat. Fixed 6.5% Floating: LIBOR Floating LIBOR –1% Fixed: 6.5%From this cash flow, it pays its depositors LIBOR minus 1 percent. It makes no difference to Dustin how high short-term rates move, because it has locked in a 1 percent spread.8. Ashton Bishop is the debt manager for World Telephone, which needs €3.33 billion Euro financing for its operations. Bishop is considering the choice between issuance of debt denominated in: •Euros (€), or• U.S. dollars, accompanied by a combined interest rate and currency swap.a. Explain one risk World would assume by entering into the combined interest rate and currency swap.Bishop believes that issuing the U.S.-dollar debt and entering into the swap can lower World’s cost of debt by 45 basis points. Immediately after selling the debt issue, World would swap the U.S. dollar payments for Euro payments throughout the maturity of the debt. She assumes a constant currency exchange rate throughout the tenor of the swap.Exhibit 1 gives details for the two alternative debt issues. Exhibit 2 provides current information about spot currency exchange rates and the 3-year tenor Euro/U.S. Dollar currency and interest rate swap.Exhibit 1World Telephone Debt DetailsExhibit 2Currency Exchange Rate and Swap Informationb. Show the notional principal and interest payment cash flows of the combined interest rate and currency swap.Note: Your response should show both the correct currency ($ or €) and amoun t for each cash flow. Answer problem b in the template provided.Template for problem bc. State whether or not World would reduce its borrowing cost by issuing the debt denominated in U.S. dollars, accompanied by the combined interest rate and currency swap. Justify your response with one reason.CFA Guideline Answera. World would assume both counterparty risk and currency risk. Counterparty risk is the risk that Bishop’s counterparty will default on payment of principal or interest cash flows in the swap.Currency risk is the currency exposure risk associated with all cash flows. If the US$ appreciates (Euro depreciates), there would be a loss on funding of the coupon payments; however, if the US$ depreciates, then the dollars will be worth less at the swap’s maturity.1€ 193.14 million = € 3.33 billion x 5.8%2 $219 million = $3 billion x 7.3%c. World would not reduce its borrowing cost, because what Bishop saves in the Euro market, she loses in the dollar market. The interest rate on the Euro pay side of her swap is 5.80 percent, lower than the6.25 percent she would pay on her Euro debt issue, an interest savings of 45 bps. But Bishop is only receiving7.30 percent in U.S. dollars to pay on her 7.75 percent U.S. debt interest payment, an interest shortfall of 45 bps. Given a constant currency exchange rate, this 45 bps shortfall exactly offsets the savings from paying 5.80 percent versus the 6.25 percent. Thus there is no interest cost savings by selling the U.S. dollar debt issue and entering into the swap arrangement.MINI CASE: THE CENTRALIA CORPORATION’S CURRENCY SWAPThe Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale in the European Union. The plant is expected to cost €5,500,000, and to take about one year to complete. The plant is to be financed over its economic life of eight years. The borrowing capacity created by this capital expenditure is $2,900,000; the remainder of the plant will be equity financed. Centralia is not well known in the Spanish or international bond market; consequently, it would have to pay 7 percent per annum to borrow euros, whereas the normal borrowing rate in the euro zone for well-known firms of equivalent risk is 6 percent. Alternatively, Centralia can borrow dollars in the U.S. at a rate of 8 percent.Study Questions1. Suppose a Spanish MNC has a mirror-image situation and needs $2,900,000 to finance a capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed rate in the United States for dollars, whereas it can borrow euros at 6 percent. The exchange rate has been forecast to be $1.33/€1.00 in one year. Set up a currency swap that will benefit each counterparty.*2. Suppose that one year after the inception of the currency swap between Centralia and the Spanish MNC, the U.S. dollar fixed-rate has fallen from 8 to 6 percent and the euro zone fixed-rate for euros has fallen from 6 to 5.50 percent. In both dollars and euros, determine the market value of the swap if the exchange rate is $1.3343/€1.00.Suggested Solution to The Centralia Corporation’s Currency Swap1. The Spanish MNC should issue €2,180,500 of 6 percent fixed-rate debt and Centralia should issue $2,900,000 of fixed-rate 8 percent debt, since each counterparty has a relative comparative advantage in their home market. They will exchange principal sums in one year. The contractual exchange rate for the initial exchange is $2,900,000/€2,180,500, or $1.33/€1.00. Annually the counterparties will swap debt service: the Spanish MNC will pay Centralia $232,000 (= $2,900,000 x .08) and Centralia will pay the Spanish MNC €130,830 (= €2,180,500 x .06). The contractual exchange rate of the first seven annual debt service exchanges is $232,000/€130,830, or $1.7733/€1.00. At maturity, Centralia and the Spanish MNC will re-exchange the principal sums and the final debt service payments. The contractual exchange rate of the final currency exchange is $3,132,000/€2,311,330 = ($2,900,000 + $232,000)/(€2,180,500 + €130,830), or $1.3551/€1.00.*2. The market value of the dollar debt is the present value of a seven-year annuity of $232,000 and a lump sum of $2,900,000 discounted at 6 percent. This present value is $3,223,778. Similarly, the market value of the euro debt is the present value of a seven-year annuity of €130,830 and a lump sum of€2,180,500 discounted at 5.50 percent. This present value is €2,242,459. The dollar value of the swap is $3,223,778 - €2,242,459 x 1.3343 = $231,665. The euro value of the swap is €2,242,459 -$3,223,778/1.3343 = -€173,623.。

Chapter 5Currency Derivatives Lecture OutlineForward MarketHow MNCs Can Use Forward ContractsNon-Deliverable Forward ContractsCurrency Futures MarketContract SpecificationsFuturesTradingComparison of Currency Futures and Forward ContractsPricing Currency FuturesCredit Risk of Currency Futures ContractsSpeculation with Currency FuturesHow Firms Use Currency FuturesClosing Out a Futures PositionTransaction Costs of Currency FuturesCurrency Call OptionsFactors Affecting Call Option PremiumsHow Firms Use Currency Call OptionsSpeculating with Currency Call OptionsCurrency Put OptionsFactors Affecting Currency Put Option PremiumsHedging with Currency Put OptionsSpeculating with Currency Put OptionsContingency Graphs for Currency Options Conditional Currency OptionsEuropean Currency OptionsChapter ThemeThis chapter provides an overview of currency derivatives, which are sometimes referred to as “speculative.” Yet, firms are increasing their use of these instruments for hedging. The chapter does give speculation some attention, since this is a good way to illustrate the use of a particular instrument based on certain expectations. However, the key is that students have an understanding why firms would consider using these instruments and under what conditions they would use them.Topics to Stimulate Class Discussion1. Why would a firm ever consider futures contracts instead of forward contracts?2. What advantage do currency options offer that are not available with futures or forwardcontracts?3. What are some disadvantages of currency option contracts?4. Why do currency futures prices change over time?5. Why do currency options prices change over time?6. Set up several scenarios, and for each scenario, ask students to determine whether it would bebetter for the firm to purchase (or sell) forward contracts, futures contracts, call option contracts, or put options contracts.Critical debate:HedgingProposition: MNC’s should not protect against currency changes. Investors take into account currency risks and the diversification benefits from investing in companies that conduct international business. But if these companies are going to protect themselves against one of the main sources of diversification, namely currency changes, they are in effect denying investors the opportunity to benefit from such diversification in order to protect their own positions as directors.Opposing view: Companies specialize in certain activities that generally do not include currency speculation. Derivatives enable such companies to specialize in more clearly defined risks. The protection is in any case only short term, no protection is being offered for long term changes in the value of a currency. Derivatives simply avoid distortion to profits caused by unusual changes to currency values. Such currency shocks could lead to abnormal share price movements that might adversely affect individual shareholders who have to sell for personal reasons.With whom do you agree? How should the investment community view business risk?Should shareholders be more aware of the currency risk policy of the company? Are directors protecting their own positions at the expense of the shareholder? Offer your own opinion on this issue.ANSWER: The mian ppoint is trhat the company should heve a clearly defined foreign exchange rate policy. Annual reports states clearly the general poicy of companies. Often that they do not hedge translation risk as in this example from Renault 2004Renault does not generally hedge its future operating cash flows inforeign currencies. The operating margin is therefore subject in the futureto changes caused by exchange rate fluctuations. In this way, Renaultaverages out any impacts over a long period, while not assuming the risksinherent in forward currency hedging.Often an extimate of the impact of a change in the exchange rate on operation profits will also be given. For example from the same report:How shareholder probably has little say over such a detailed policy, but investing in Renault does make it clear as to how earnings if not share price reacts to the exchange rate. Later in the text itis shown that share prices react predominantly in relation to the home country share index, so the idea that one can buy exposure to foreign currencies in this way is a bit of a myth.Answers to End of Chapter Questions1. 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.2. 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.3. Currency Options. Differentiate between a currency call option and a currency put option.ANSWER: A currency 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.4. Forward Premium. Compute the forward discount or premium for the Mexican peso whose90-day forward rate is £0.05 and spot rate is £0.051. State whether your answer is a discount or premium.ANSWER: (F - S) / S= (0.05 – 0.051)/0.051 x 360/90 = -.078 or -7.8% a discount therefore5. 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.6. Hedging With Currency Options. When would a U.S. firm consider purchasing a calloption on euros for hedging? When would a U.S. firm consider purchasing a put option on euros for hedging?ANSWER: A call 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. Iteffectively locks in the minimum price at which it can exchange euros received.7. Speculating With Currency Options. When should a speculator purchase a call option onAustralian dollars? When should a speculator purchase a put option on Australian dollars?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 dollarvalue to depreciate substantially over the period specified by the option contract.8.Currency Call Option Premiums. List the factors that affect currency call option premiumsand 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 on dollars (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 dollar.9. Currency Put Option Premiums. List the factors that affect currency put options and brieflyexplain 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.10. Speculating with Currency Call Options. Randy Rudecki purchased a call option on Britishpounds for 0.02 euros per unit. The strike price was 1.45euros, and the spot rate at the time the option was exercised was 1.46 euros. 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 = 0.01 eurosPremium paid per unit = 0.02 eurosNet profit per unit = –0.01 eurosNet profit per option = 31,250 units × (–0.01 euros) = –312.50 euros11. Speculating with Currency Put Options. Alice Duever purchased a put option on dollarsfor £0.04 per unit. The strike price was £0.55, and the spot rate at the time the dollar option was exercised was £0.63. Assume there are 50,000 units in a US dollar option. What was Alice’s net profit on the option?ANSWER:Profit per unit on exercising the option = £0.00 option not exercisedPremium paid per unit = £0.04Net profit per unit = - £0.04Net profit for one option = 31,250 units × $.17 = -£1,25012. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for£0.01 per unit. The strike price was £0.42, and the spot rate at the time the option was exercised was £0.46. Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Mike’s net profit on the call option?ANSWER:Firstly, the call option will be exercisedPremium received per unit = £0.01Amount per unit received from selling C$ at strike = £0.42Amount per unit paid when purchasing C$ = £0.46Net profit per unit = -£0.03Net Profit = 50,000 units × (–£0.03) = –£1,50013. Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for £0.02per unit. The strike price was £0.42, and the spot rate at the time the option was exercised was £0.40. 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:Firstly, the put option will be exercisedPremium received per unit = £0.02Amount per unit received from selling C$ at spot = £0.40Amount per unit paid for C$ = £0.42Net profit per unit = £0.0014. Forward versus Currency Option Contracts. What are the advantages and disadvantagesto an MNC 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?ANSWER: A currency 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.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.15. Speculating with Currency Futures. Assume that the euro’s spot rate has moved in cyclesover 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 contractto the amount for which each contract was sold.We need to note that currencies do not move in patterns, it would be noticed by other traders!16. Hedging with Currency Derivatives. Assume that the transactions listed in the first columnof the following table are anticipated by UK 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. George ltdplans to purchase Japanese goods denominated in yen.b. Harvard ltd sold goods to Japan, denominated in yen.c. Yale plc has a subsidiary in Australia that will be remitting funds to the U.S. parent.d. Brown ltd needs to pay off existing loans that are denominated in Canadian dollars.e.Princeton ltd may purchase a company in Japan in the near future (but the deal may notgo through).ANSWER:Forward Contract Futures Contract Options ContractForward Forward Buy Sell Purchase Purchase Purchase Sale Futures Futures Calls Putsa.X X Xb. X X Xc. X X Xd. X X Xe. X17. Price Movements of Currency Futures. Assume that on November 1, the spot rate of the British pound was £0.63 and the price on a December futures contract was £0.64. Assume that the pound depreciated during November so that by November 30 it was worth £0.60.a. What do you think happened to the futures price over the month of November? Why?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 £0.60, the spot rate expected on the December futures settlement date is likely to be near £0.60 as well. As you get closer to the maturity date so the difference between buying at spot and buying using a futures decreases, so as the law of one price dictates, the price should be nearly the same for nearly the same service.b. If you had known that this would occur, would you have purchased or sold a Decemberfutures contract in pounds on November 1? Explain.ANSWER: You would have sold futures at the existing futures price of £0.64. 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 at £0.60, and fulfill the futures obligation by delivering pounds at the price of £0.64 per dollar.18. Speculating with Currency Futures. Assume that a March futures contract on Mexicanpesos 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.19. Speculating with Currency Call Options. LSU Corp. purchased Canadian dollar calloptions 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 $.75. LSU plans to wait until the expiration date before deciding whether to exercise the options. Of course, LSU will exercise the options at that time only if it is feasible to do so. In the following table, fill in the net profit (or loss) per unit to LSU Corp. based on the listed possible spot rates of the Canadian dollar on the expiration date.ANSWER:Possible Spot Rate Net Profit (Loss) perof Canadian Dollar Unit to LSU Corporationon Expiration Date if Spot Rate Occurs$.76 –$.02.78 .00.80 .02.82 .04.85 .07.87 .0920. Speculating with Currency Put Options. Auburn ltd has purchased Canadian dollar putoptions for speculative purposes. Each option was purchased for a premium of £0.02 per unit, with an exercise price of £0.48 per unit. Auburn ltd will purchase the Canadian dollars just before it 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 ltd based on the listed possible spot rates of the Canadian dollar on the expiration date.Possible spot rate on Canadian dollar on expiration dateNet profit (loss) perunit to Auburnltd£0.42 0.04£0.44 0.02£0.46 0.00£0.48 -0.02£0.50 -0.02£0.52 -0.0221. Speculating with Currency Call Options. Bama plc has sold dollar call options for speculative purposes. The option premium was £0.04 per unit, and the exercise price was £0.54. Bama will purchase the dollars 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 plc if the listed spot rate exists at the time the purchaser of the call options considers exercising them.Possible spot rate at the time the purchaser of the Call option(Americanstyle) considersexercising themNet profit (loss) perunit to BamaCorp.£0.480.04 £0.500.04 £0.520.04 £0.54 0.04 £0.560.02 £0.580.00 £0.60-0.0222. Speculating with Currency Put Options. Bulldog ltd has sold Australian dollar put optionsat a premium of £0.01 per unit, and an exercise price of £0.42 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 ltd if each level occurs and the put options are exercised at that time.Possible value of Australian dollar Net profit (loss) perunit to Bulldogltd if valueoccurs.£0.38 -£0.03£0.39 -£0.02£0.40 -£0.01£0.41 £0.00£0.42 £0.0123. Hedging with Currency Derivatives. A U.S. professional football team plans to play anexhibition 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. Advanced Questions24. Risk of Currency Futures.Currency futures markets are commonly used as a means ofcapitalizing 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 dollars value would continue to decline. However, the Fed intervened in the foreign exchange market by immediately buying dollars with foreign currency, causing an abrupt halt in the decline in the value of the dollar. Participants that had sold dollar futures contracts for a range of other currencies incurred large losses.a. Explain why the central bank’s intervention caused such panic among currency futurestraders 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. Some traders with buy positions may have responded immediately to the central bank’sintervention 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.25. Currency Straddles. Reska ltd has constructed a long euro straddle. A call option on euroswith an exercise price of £0.61 has a premium of £0.015 per unit. A euro put option has a premium of £0.008 per unit. Some possible euro values at option expiration are shown in the following table. (See Appendix B in this chapter.)a. Complete the worksheet and determine the net profit per unit toValue of Euro at option Expiration£0.50 £0.55 £0.60 £0.65Call -0.015 -0.015 -0.015 0.025Put 0.102 0.052 0.002 -0.008Net 0.087 0.037 -0.013 0.017Reska, ltd for each possible future spot rate.b. Determine the break-even point(s) of the long straddle. What are the break-even points of ashort straddle using these options?ANSWER: the cost is the combined premiums so 0.008 + 0.015 = 0.023, so the difference above and below the strike price of £0.61 must cosver this cost i.e. 0.61 + 0.023 = 0.633 and 0.61 – 0.023 = 0.587 so the breakeven points are £0.633 and £0.587. The short straddle for the same exercise price is the other side, the seller of the call and seller of the put. The breakeven points are the same.26. C urrency Straddles. Refer to the previous question, but assume that the call and putoption premiums are £0.01 per unit and £0.006 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.a.profitLossb.ANSWER:profitLoss27. C urrency Option Contingency Graphs. (See Appendix B in this chapter.) The current spot rate of the Singapore dollar (S$) is £0.34. The following option information is available: ☐ Call option premium on Singapore dollar (S$) = £0.015☐ Put option premium on Singapore dollar (S$) = £0.009☐ Call and put option strike price = £0.36☐ One option contract represents S$70,000.Construct a contingency graph for a short straddle using these options.ANSWER:profitLoss28. Speculating with Currency Straddles. Maggie Hawthorne is a currency speculator. She hasnoticed that recently the dollar has depreciated substantially against the euro. The current exchange rate of the dollar is 0.78 euro. After reading a variety of articles on the subject, she believes that the dollar will continue to fluctuate substantially in the months to come.Although most forecasters believe that the dollar will depreciate against the euro in the near future, Maggie thinks that there is also a good possibility of further appreciation. Currently, a call option on dollars is available with an exercise price of 0.80 euro and a premium of 0.04 euro. A dollar put option with an exercise price of 0.80 euro and a premium of 0.03 euro is also available. (See Appendix B in this chapter.)a. Describe how Maggie could use straddles to speculate on the dollar’s value.b. At option expiration, the value of the dollar is 0.90 euro. What is Maggie’s total profit or lossfrom a long straddle position?c. What is Maggie’s total profit or loss from a long straddle position if the value of the dollar is0.60 euro at option expiration?d. What is Maggie’s total profit or loss from a long straddle position if the value of the dollar atoption expiration is still 0.78 euro?e. Given your answers to the questions above, when is it advantageous for a speculator to engagein a long straddle? When is it advantageous to engage in a short straddle?ANSWERa.Since Maggie believes the dollar will either appreciate or depreciate substantially, shemay consider purchasing a straddle on dollar.b.Per UnitSelling Price of $ 0.90 euro– Purchase price of $ -0.80 euro– Premium paid for call option -0.04 euro– Premium paid for put option -0.03euro= Net profit 0.03 euroc.Per UnitSelling Price of € 0.80 euro– Purchase price of € -0.60 euro– Premium paid for call option -0.04 euro– Premium paid for put option -0.03euro= Net profit 0.17 eurod.Per UnitSelling Price of € 0.80– Purchase price of € 0.78– Premium paid for call option -0.04 euro– Premium paid for put option -0.03euro= Net profit -0.05 euroe. It is advantageous for a speculator to engage in a long straddle if the underlying currency isexpected 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.。

国际财务管理（英⽂版）课后习题答案7CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPSSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. Give a full definition of arbitrage.Answer:Arbitrage can be defined as the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits.2. Discuss the implications of the interest rate parity for the exchange rate determination.Answer: Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot rate, IRP can be written as:S = [(1 + I￡)/(1 + I$)]E[S t+1 I t].The exchange rate is thus determined by the relative interest rates, and the expected future spot rate, conditional on all the available information, I t, as of the present time. One thus can say that expectation is self-fulfilling. Since the information set will be continuously updated as news hit the market, the exchange rate will exhibit a highly dynamic, random behavior.3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate.Answer: The forward exchange rate will be an unbiased predictor of the future spot rate if (I) the risk premium is insignificant and (ii) foreign exchange markets are informationally efficient.4. Explain the purchasing power parity, both the absolute and relative versions. What causes the deviations from the purchasing power parity?Answer: The absolute version of purchasing power parity (PPP):S = P$/P￡.The relative version is:e = π$ - π￡.PPP can be violated if there are barriers to international trade or if people in different countries have different consumption taste. PPP is the law of one price applied to a standard consumption basket.5. Discuss the implications of the deviations from the purchasing power parity for countries’ competitive positions in the world market.Answer: If exchange rate changes satisfy PPP, competitive positions of countries will remain unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative competitiveness of countries. If a country’s currency appreciates (depreciates) by more than is warranted by PPP, that will hurt (strengthen) the country’s competitive position in the world market.6. Explain and derive the international Fisher effect.Answer: The international Fisher effect can be obtained by combining the Fisher effect and the relative version of PPP in its expectational form. Specifically, the Fisher effect holds thatE(π$) = I$ - ρ$,E(π￡) = I￡ - ρ￡.Assuming that the real interest rate is the same between the two countries, i.e., ρ$ = ρ￡, and substituting the above results into the PPP, i.e., E(e) = E(π$)- E(π￡), we obtain the international Fisher effect: E(e) = I$ - I￡.7. Researchers found that it is very difficult to forecast the future exchange rates more accurately than the forward exchangerate or the current spot exchange rate. How would you interpret this finding?Answer: This implies that exchange markets are informationally efficient. Thus, unless one has private information that is not yet reflected in the current market rates, it would be difficult to beat the market.8. Explain the random walk model for exchange rate forecasting. Can it be consistent with the technical analysis?Answer: The random walk model predicts that the current exchange rate will be the best predictor of the future exchange rate. An implication of the model is that past history of the exchange rate is of no value in predicting future exchange rate. The model thus is inconsistent with the technical analysis which tries to utilize past history in predicting the future exchange rate.*9. Derive and explain the monetary approach to exchange rate determination.Answer: The monetary approach is associated with the Chicago School of Economics. It is based on two tenets: purchasing power parity and the quantity theory of money. Combing these two theories allows for stating, say, the $/￡ spot exchange rate as:S($/￡) = (M$/M￡)(V$/V￡)(y￡/y$),where M denotes the money supply, V the velocity of money, and y the national aggregate output. The theory holds that what matters in exchange rate determination are:1. The relative money supply,2. The relative velocities of monies, and3. The relative national outputs.10. CFA question: 1997, Level 3.A.Explain the following three concepts of purchasing power parity (PPP):a. The law of one price.b. Absolute PPP.c. Relative PPP.B.Evaluate the usefulness of relative PPP in predicting movements in foreign exchange rates on:a.Short-term basis (for example, three months)b.Long-term basis (for example, six years)Answer:A. a. The law of one price (LOP) refers to the international arbitrage condition for the standardconsumption basket. LOP requires that the consumption basket should be selling for the same price ina given currency across countries.A. b. Absolute PPP holds that the price level in a country is equal to the price level in another countrytimes the exchange rate between the two countries.A. c. Relative PPP holds that the rate of exchange rate change between a pair of countries is aboutequalto the difference in inflation rates of the two countries.B. a. PPP is not useful for predicting exchange rates on the short-term basis mainly becauseinternational commodity arbitrage is a time-consuming process.B. b. PPP is useful for predicting exchange rates on the long-term basis.PROBLEMS1. Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months. The six-month interest rate is 8 percent per annum in the United States and 6 percent per annum in Germany. Currently, the spot exchange rate is €1.01 per dollar and the six-month forward exchange rate is €0.99 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return?The market conditions are summarized as follows:I$ = 4%; i€= 3.5%; S = €1.01/$; F = €0.99/$.If $100,000,000 is invested in the U.S., the maturity value in six months will be$104,000,000 = $100,000,000 (1 + .04).Alternatively, $100,000,000 can be converted into euros and invested at the German interest rate, with the euro maturity value sold forward. In this case the dollar maturity value will be$105,590,909 = ($100,000,000 x 1.01)(1 + .035)(1/0.99)Clearly, it is better to invest $100,000,000 in Germany with exchange risk hedging.2. While you were visiting London, you purchased a Jaguar for ￡35,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35% interest per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/￡and the three-month forward exchange rate is $1.40/￡. In London, the money market interest rate is 2.0% for a three-month investment. There are two alternative ways of paying for your Jaguar.(a) Keep the funds at your bank in the U.S. and buy ￡35,000 forward.(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity value becomes equal to ￡35,000.Evaluate each payment method. Which method would you prefer? Why?Solution: The problem situation is summarized as follows:A/P = ￡35,000 payable in three monthsi NY = 0.35%/month, compounding monthlyi LD = 2.0% for three monthsS = $1.45/￡; F = $1.40/￡.Option a:When you buy ￡35,000 forward, you will need $49,000 in three months to fulfill the forward contract. The present value of $49,000 is computed as follows:$49,000/(1.0035)3 = $48,489.Thus, the cost of Jaguar as of today is $48,489.Option b:The present value of ￡35,000 is ￡34,314 = ￡35,000/(1.02). To buy ￡34,314 today, it will cost $49,755 = 34,314x1.45. Thus the cost of Jaguar as of today is $49,755.You should definitely choose to use “option a”, and save $1,266, which is the difference between $49,755 and $48489.3. Currently, the spot exchange rate is $1.50/￡ and the three-month forward exchange rate is $1.52/￡. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as$1,500,000 or ￡1,000,000.a. Determine whether the interest rate parity is currently holding.b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.c. Explain how the IRP will be restored as a result of covered arbitrage activities.Solution: Let’s summarize the given data first:S = $1.5/￡; F = $1.52/￡; I$ = 2.0%; I￡ = 1.45%Credit = $1,500,000 or ￡1,000,000.a. (1+I$) = 1.02(1+I￡)(F/S) = (1.0145)(1.52/1.50) = 1.0280Thus, IRP is not holding exactly.b. (1) Borrow $1,500,000; repayment will be $1,530,000.(2) Buy ￡1,000,000 spot using $1,500,000.(3) Invest ￡1,000,000 at the pound interest rate of 1.45%;maturity value will be ￡1,014,500.(4) Sell ￡1,014,500 forward for $1,542,040Arbitrage profit will be $12,040c. Following the arbitrage transactions described above,The dollar interest rate will rise;The pound interest rate will fall;The spot exchange rate will rise;The forward exchange rate will fall.These adjustments will continue until IRP holds.4. Suppose that the current spot exchange rate is €0.80/$ and the three-month forward exchange rate is €0.7813/$. The three-month interest rate is5.6 percent per annum in the United States and 5.40 percent per annum in France. Assume that you can borrow up to $1,000,000 or €800,000.a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit.b. Assume that you want to realize profit in terms of euros. Show the covered arbitrage process and determine the arbitrage profit in euros.Solution:a.(1+ i $) = 1.014 < (F/S) (1+ i € ) = 1.053. Thus, one has to borrow dollars and invest in euros tomake arbitrage profit.1.Borrow $1,000,000 and repay $1,014,000 in three months.2.Sell $1,000,000 spot for €1,060,000.3.Invest €1,060,000 at the euro interest rate of 1.35 % for three months and receive€1,074,310 atmaturity.4.Sell €1,074,310 forward for $1,053,245.Arbitrage profit = $1,053,245 - $1,014,000 = $39,245.b.Follow the first three steps above. But the last step, involving exchange risk hedging, will be5.Buy $1,014,000 forward for €1,034,280.Arbitrage profit = €1,074,310 - €1,034,280 = €40,0305. In the issue of October 23, 1999, the Economist reports that the interest rate per annum is 5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based on the reported interest rates, how would you predict the change of the exchange rate between the U.S. dollarand the Turkish lira?Solution: A high Turkish interest rate must reflect a high expected inflation in Turkey. According to international Fisher effect (IFE), we haveE(e) = i$ - i Lira= 5.93% - 70.0% = -64.07%The Turkish lira thus is expected to depreciate against the U.S. dollar by about 64%.6. As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is R$1.95/$. The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6% and 20.0%, respectively. How would you forecast the exchange rate to be at around November 1, 2000?Solution: Since the inflation rate is quite high in Brazil, we may use the purchasing power parity to forecast the exchange rate.E(e) = E(π$) - E(πR$)= 2.6% - 20.0%= -17.4%E(S T) = S o(1 + E(e))= (R$1.95/$) (1 + 0.174)= R$2.29/$7. (CFA question) Omni Advisors, an international pension fund manager, uses the concepts of purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates. Omni gathers the financial information as follows:Base price level 100Current U.S. price level 105Current South African price level 111Base rand spot exchange rate $0.175Current rand spot exchange rate $0.158Expected annual U.S. inflation 7%Expected annual South African inflation 5%Expected U.S. one-year interest rate 10%Expected South African one-year interest rate 8%Calculate the following exchange rates (ZAR and USD refer to the South African and U.S. dollar, respectively).a. The current ZAR spot rate in USD that would have been forecast by PPP.b. Using the IFE, the expected ZAR spot rate in USD one year from now.c. Using PPP, the expected ZAR spot rate in USD four years from now.a. ZAR spot rate under PPP = [1.05/1.11](0.175) = $0.1655/rand.b. Expected ZAR spot rate = [1.10/1.08] (0.158) = $0.1609/rand.c. Expected ZAR under PPP = [(1.07)4/(1.05)4] (0.158) = $0.1704/rand.8. Suppose that the current spot exchange rate is €1.50/? and the one-year forward exchange rate is €1.60/?. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e., ? 666,667, at the current spot exchange rate.a.Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are aeuro-based investor. Also determine the size of the arbitrage profit.b.Discuss how the interest rate parity may be restored as a result of the abovetransactions.c.Suppose you are a pound-based investor. Show the covered arbitrage process anddetermine the pound profit amount.Solution:a. First, note that (1+i €) = 1.054 is less than (F/S)(1+i €) = (1.60/1.50)(1.052) = 1.1221.You should thus borrow in euros and lend in pounds.1)Borrow €1,000,000 and promise to repay €1,054,000 in one year.2)Buy ?666,667 spot for €1,000,000.3)Invest ?666,667 at the pound interest rate of 5.2%; the maturity value will be ?701,334.4)To hedge exchange risk, sell the maturity value ?701,334 forward in exchange for €1,122,134.The arbitrage profit will be the difference between €1,122,134 and €1,054,000, i.e., €68,134.b. As a result of the above arbitrage transactions, the euro interest rate will rise, the poundinterest rate will fall. In addition, the spot exchange rate (euros per pound) will rise and the forward rate will fall. These adjustments will continue until the interest rate parity is restored.c. The pound-based investor will carry out the same transactions 1), 2), and 3) in a. But to hedge, he/she will buy €1,054,000 forward in exchange for ?658,750. The arbitrage profit will then be ?42,584 = ?701,334 - ?658,750.9. Due to the integrated nature of their capital markets, investors in both the U.S. and U.K. require the same real interest rate, 2.5%, on their lending. There is a consensus in capital markets that the annual inflation rate is likely to be 3.5% in the U.S. and 1.5% in the U.K. for the next three years. The spot exchange rate is currently $1.50/￡./doc/595318ce05087632311212e1.html pute the nominal interest rate per annum in both the U.S. and U.K., assuming that the Fishereffect holds.b.What is your expected future spot dollar-pound exchange rate in three years from now?c.Can you infer the forward dollar-pound exchange rate for one-year maturity?Solution.a. Nominal rate in US = (1+ρ) (1+E(π$)) – 1 = (1.025)(1.035) – 1 = 0.0609 or 6.09%.Nominal rate in UK= (1+ρ) (1+E(π?)) – 1 = (1.025)(1.015) – 1 = 0.0404 or 4.04%.b. E(S T) = [(1.0609)3/(1.0404)3] (1.50) = $1.5904/?.c. F = [1.0609/1.0404](1.50) = $1.5296/?.Mini Case: Turkish Lira and the Purchasing Power ParityVeritas Emerging Market Fund specializes in investing in emerging stock markets of the world. Mr. Henry Mobaus, an experienced hand in international investment and your boss, is currently interested in Turkish stock markets. He thinks that Turkey will eventually be invited to negotiate its membership in the European Union. If this happens, it will boost the stock prices in Turkey. But, at the same time, he is quite concerned with the volatile exchange rates of the Turkish currency. He would like to understand what drives the Turkish exchange rates. Since the inflation rate is much higher in Turkey than in the U.S., he thinks that the purchasing power parity may be holding at least to some extent. As a research assistant for him, you were assigned to check this out. In other words, you have to study and prepare a report on the following question: Does the purchasing power parity hold for the Turkish lira-U.S. dollar exchange rate? Among other things, Mr. Mobaus would like you to do the following:Plot the past exchange rate changes against the differential inflation rates betweenTurkey and the U.S. for the last four years.Regress the rate of exchange rate changes on the inflation rate differential to estimatethe intercept and the slope coefficient, and interpret the regression results.Data source: You may download the consumer price index data for the U.S. and Turkey from the following website:/doc/595318ce05087632311212e1.html /home/0,2987,en_2649_201185_1_1_1_1_1,00.html, “hot file”(Excel format) . You may download the exchange rate data from the website:/doc/595318ce05087632311212e1.html merce.ubc.ca/xr/data.html.Solution:a. In the current solution, we use the monthly data from January 1999 – December 2002.b. We regress exchange rate changes (e) on the inflation rate differential and estimate the intercept (α ) and slope coefficient (β):3.095) (t 1.472β?0.649)- (t 0.011αε Inf_US) -Inf_Turkey (β?αe t t ===-=++=The estimated intercept is insignificantly different from zero, whereas the slope coefficient is positive and significantly different from zero. In fact, the slope coefficient is insignificantly different from unity. [Note that t-statistics for β = 1 is 0.992 = (1.472 – 1)/0.476 where s.e. is 0.476] In other words, we cannot reject the hypothesis that the intercept is zero and the slope coefficient is one. The results are thus supportive of purchasing power parity.。

国际财务管理课后习题答案c h a p t e rLast updated on the afternoon of January 3, 2021C H A P T E R8M A N A G E M E N T O F T R A N S A C T I O N E X P O S U R ESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS ANDPROBLEMSQUESTIONS1. How would you define transaction exposure How is it different from economic exposureAnswer: Transaction exposure is the sensitivity of realized domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates. Unlike economic exposure, transaction exposure is well-defined and short-term.2. Discuss and compare hedging transaction exposure using the forward contract vs. money market instruments. When do the alternative hedging approaches produce the same result?Answer: Hedging transaction exposure by a forward contract is achieved by selling or buying foreign currency receivables or payables forward. On the other hand, money market hedge is achieved by borrowing or lending the present value of foreign currency receivables or payables, thereby creating offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are equivalent.3. Discuss and compare the costs of hedging via the forward contract and the options contract. Answer: There is no up-front cost of hedging by forward contracts. In the case of options hedging, however, hedgers should pay the premiums for the contracts up-front. The cost of forward hedging, however, may be realized ex post when the hedger regrets his/her hedging decision.4. What are the advantages of a currency options contract as a hedging tool compared with the forward contract?Answer: The main advantage of using options contracts for hedging is that the hedger can decide whether to exercise options upon observing the realized future exchange rate. Options thus provide a hedge against ex post regret that forward hedger might have to suffer. Hedgers can only eliminate the downside risk while retaining the upside potential.5. Suppose your company has purchased a put option on the German mark to manage exchange exposure associated with an account receivable denominated in that currency. In this case, your company can be said to have an ‘insurance’ policy on its re ceivable. Explain in what sense this is so. Answer: Your company in this case knows in advance that it will receive a certain minimum dollar amount no matter what might happen to the $/€exchange rate. Furthermore, if the German mark appreciates, your company will benefit from the rising euro.6. Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. How would you explain this result?Answer: There can be many possible reasons for this. First, many firms may feel that they are not really exposed to exchange risk due to product diversification, diversified markets for their products, etc. Second, firms may be using self-insurance against exchange risk. Third, firms may feel that shareholders can diversify exchange risk themselves, rendering corporate risk management unnecessary.7. Should a firm hedge Why or why notAnswer: In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to their value by hedging if markets are imperfect. First, if management knows about the firm’s exposure better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to hedge at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable because it reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce tax obligations by hedging which stabilizes corporate earnings.8. Us ing an example, discuss the possible effect of hedging on a firm’s tax obligations.Answer: One can use an example similar to the one presented in the chapter.9. Explain contingent exposure and discuss the advantages of using currency options to manage this type of currency exposure.Answer: Companies may encounter a situation where they may or may not face currency exposure. In this situation, companies need options, not obligations, to buy or sell a given amount of foreign exchange they may or may not receive or have to pay. If companies either hedge using forward contracts or do not hedge at all, they may face definite currency exposure.10. Explain cross-hedging and discuss the factors determining its effectiveness.Answer: Cross-hedging involves hedging a position in one asset by taking a position in another asset. The effectiveness of cross-hedging would depend on the strength and stability of the relationship between the two assets.PROBLEMS1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced €10 million payable in six months. Currently, the six-month forward exchange rate is $€ and the foreign exchange advisor for Cray Research predicts that th e spot rate is likely to be $€ in six months.(a) What is the expected gain/loss from the forward hedging?(b) If you were the financial manager of Cray Research, would you recommend hedging this euro receivable Why or why not(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case Why or why notSolution: (a) Expected gain($) = 10,000,000 –= 10,000,000(.05)= $500,000.(b) I would recommend hedging because Cray Research can increase the expected dollar receipt by $500,000 and also eliminate the exchange risk.(c) Since I eliminate risk without sacrificing dollar receipt, I still would recommend hedging.2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ￥250 million payable in three months. Currently, the spot exchange rate is ￥105/$ and the three-month forward rate is ￥100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen account payable.(a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.(b) Conduct the cash flow analysis of the money market hedge.Solution: (a). Let’s first compute the PV of ￥250 million, .,250m/ = ￥245,700,So if the above yen amount is invested today at the Japanese interest rate for three months, the maturity value will be exactly equal to ￥25 million which is the amount of payable.To buy the above yen amount today, it will cost:$2,340, = ￥250,000,000/105.The dollar cost of meeting this yen obligation is $2,340, as of today.(b)___________________________________________________________________Transaction CF0 CF1____________________________________________________________________1. Buy yens spot -$2,340,with dollars ￥245,700,2. Invest in Japan - ￥245,700, ￥250,000,0003. Pay yens - ￥250,000,000Net cash flow - $2,340,____________________________________________________________________3. You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $SF and the three-month forward rate is $SF. You can buy the three-month call option on SF with the exercise rate of $SF for the premium of $ per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF.(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.(c) At what future spot exchange rate will you be indifferent between the forward and option market hedges?(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.Solution: (a) Total option premium = (.05)(5000) = $250. In three months, $250 is worth $ = $250. At the expected future spot rate of $SF, which is less than the exercise price, you don’t expect to exercise options. Rather, you expect to buy Swiss franc at $SF. Since you are going to buy SF5,000, you expect to spend $3,150 (=.63x5,000). Thus, the total expected cost of buying SF5,000 will be the sum of $3,150 and $, ., $3,.(b) $3,150 = (.63)(5,000).(c) $3,150 = 5,000x + , where x represents the break-even future spot rate. Solving for x, we obtain x = $SF. Note that at the break-even future spot rate, options will not be exercised.(d) If the Swiss franc appreciates beyond $SF, which is the exercise price of call option, you will exercise the option and buy SF5,000 for $3,200. The total cost of buying SF5,000 will be $3, = $3,200 + $.This is the maximum you will pay. 4. Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. Air France will be billed€20 million which is payable in one year. The current spot exchange rate is $€ and the one -year forward rate is $€. The annual interest rate is % in the U.S. and % in France. Boeing is concerned with the volatile exchange rate between the dollar and the euro and would like to hedge exchange exposure. (a) It is considering two hedging alternatives: sell the euro proceeds from the sale forward or borroweuros from theCredit Lyonnaise against the euro receivable. Which alternative would you recommend Why(b) Other things being equal, at what forward exchange rate would Boeing be indifferent between the two hedging methods?Solution: (a) In the case of forward hedge, the future dollar proceeds will be (20,000,000) = $22,000,000. In the case of money market hedge (MMH), the firm has to first borrow the PV of its euro receivable, ., 20,000,000/ =€19,047,619. Then the firm should exchange this euro amount into dollars at the current spot rate to receive: (€19,047,619)($€) = $20,000,000, which can be invested at the dollar interest rate for one year to yield:$20,000,000 = $21,200,000.Clearly, the firm can receive $800,000 more by using forward hedging.(b) According to IRP, F = S(1+i $)/(1+i F ). Thus the “indifferent” forward rate will be:F = / = $€.5. Suppose that Baltimore Machinery sold a drilling machine to a Swiss firm and gave the Swiss client a choice of paying either $10,000 or SF 15,000 in three months.(a) In the above example, Baltimore Machinery effectively gave the Swiss client a free option to buy up to $10,000 dollars using Swiss franc. What is the ‘implied’ exercise exchange rate?(b) If the spot exchange rate turns out to be $SF, which currency do you think the Swiss client will choose to use for payment What is the value of this free option for the Swiss client(c) What is the best way for Baltimore Machinery to deal with the exchange exposure?Solution: (a) The implied exercise (price) rate is: 10,000/15,000 = $SF .(b) If the Swiss client chooses to pay $10,000, it will cost SF16,129 (=10,000/.62). Since the Swiss client has an option to pay SF15,000, it will choose to do so. The value of this option is obviously SF1,129 (=SF16,129-SF15,000).(c) Baltimore Machinery faces a contingent exposure in the sense that it may or may not receive $ Cost Options hedge Forward hedge$3, $3,150 0 (strike price) $/SF $SF15,000 in the future. The firm thus can hedge this exposure by buying a put option on SF15,000.6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the . PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a premium of .014 cents per yen.(a) Compute the future dollar costs of meeting this obligation using the money market hedge and the forward hedges.(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the expected future dollar cost of meeting this obligation when the option hedge is used.(c) At what future spot rate do you think PCC may be indifferent between the option and forward hedge?Solution: (a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In the case of money market hedge, the future dollar cost will be: 500,000,000/(124)= $4,147,465.(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000 = $75,600.At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC will exercise its call option and buy ￥500,000,000 for $4,050,000 (=500,000,.The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.(c) When the option hedge is used, PCC will spend “at most” $4,125,000. On the other hand, when the forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This means that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between forward and options hedges.7. Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company, and billed $30 million payable in six months. Airbus is concerned with the euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $€ and six-month forward exchange rate is $€ at the moment. Airbus can buy a six-month put option on . dollars with a strike price of €$ f or a premium of € per . dollar. Currently, six-month interest rate is % in the euro zone and % in the U.S.pute the guaranteed euro proceeds from the American sale if Airbus decides to hedge usinga forward contract.b.If Airbus decides to hedge using money market instruments, what action does Airbus need totake What would be the guaranteed euro proceeds from the American sale in this casec.d.If Airbus decides to hedge using put options on . dollars, what would be the ‘expected’ europroceeds from the American salee.Assume that Airbus regards the current forward exchange rate as an unbiased predictor of thefuture spot exchange rate.f.g.At what future spot exchange rate do you think Airbus will be indifferent between the option andmoney market hedge?Solution:a. Airbus will sell $30 million forward for €27,272,727 = ($30,000,000) / ($€).b. Airbus will borrow the present value of the dollar receivable, ., $29,126,214 = $30,000,000/, and then sell the dollar proceeds spot for euros: €27,739,251. This is the euro amount that Airbus is going to keep.c. Since the expected future spot rate is less than the strike price of the put option, ., €< €, Airbus expects to exercise the option and receive €28,500,000 = ($30,000,000)(€$). This is gross proceeds. Airbus spent €600,000 (=,000,000) upfront for the option and its future cost is equal to €615,000 = €600,000 x . Thus the net euro proceeds from the American sale is €27,885,000, which is the difference between the gross proceeds and the option costs.d. At the indifferent future spot rate, the following will hold:€28,432,732 = S T (30,000,000) - €615,000.Solving for S T, we obtain the “indifference” future spot exchange rate, ., €$, or $€. Note that €28,432,732 is the future value of the proceeds under money market hedging:€28,432,732 = (€27,739,251) .Suggested solution for Mini Case: Chase Options, Inc.[See Chapter 13 for the case text]Chase Options, Inc.Hedging Foreign Currency Exposure Through Currency OptionsHarvey A. PoniachekI. Case SummaryThis case reviews the foreign exchange options market and hedging. It presents various international transactions that require currency options hedging strategies by the corporations involved. Seven transactions under a variety of circumstances are introduced that require hedging by currency options. The transactions involve hedging of dividend remittances, portfolio investment exposure, and strategic economic competitiveness. Market quotations are provided for options (and options hedging ratios), forwards, and interest rates for various maturities.II. Case Objective.The case introduces the student to the principles of currency options market and hedging strategies. The transactions are of various types that often confront companies that are involved in extensive international business or multinational corporations. The case induces students to acquire hands-on experience in addressing specific exposure and hedging concerns, including how to apply various market quotations, which hedging strategy is most suitable, and how to address exposure in foreign currency through cross hedging policies.III. Proposed Assignment Solution1. The company expects DM100 million in repatriated profits, and does not want the DM/$ exchange rate at which they convert those profits to rise above . They can hedge this exposure using DM put options with a strike price of . If the spot rate rises above , they can exercise the option, while if that rate falls they can enjoy additional profits from favorable exchange rate movements.To purchase the options would require an up-front premium of:DM 100,000,000 x = DM 1,640,000.With a strike price of DM/$, this would assure the U.S. company of receiving at least:DM 100,000,000 – DM 1,640,000 x (1 + x 272/360)= DM 98,254,544/ DM/$ = $57,796,791by exercising the option if the DM depreciated. Note that the proceeds from the repatriated profits are reduced by the premium paid, which is further adjusted by the interest foregone on this amount. However, if the DM were to appreciate relative to the dollar, the company would allow the option to expire, and enjoy greater dollar proceeds from this increase.Should forward contracts be used to hedge this exposure, the proceeds received would be:DM100,000,000/ DM/$ = $59,790,732,regardless of the movement of the DM/$ exchange rate. While this amount is almost $2 million more than that realized using option hedges above, there is no flexibility regarding the exercise date; if this date differs from that at which the repatriate profits are available, the company may be exposed to additional further current exposure. Further, there is no opportunity to enjoy any appreciation in the DM.If the company were to buy DM puts as above, and sell an equivalent amount in calls with strike price , the premium paid would be exactly offset by the premium received. This would assure that the exchange rate realized would fall between and . If the rate rises above , the company will exercise its put option, and if it fell below , the other party would use its call; for any rate in between, both options would expire worthless. The proceeds realized would then fall between:DM 100,00,000/ DM/$ = $60,716,454andDM 100,000,000/ DM/$ = $58,823,529.This would allow the company some upside potential, while guaranteeing proceeds at least $1 million greater than the minimum for simply buying a put as above.Buy/Sell OptionsDM/$Spot Put Payoff “Put”Profits Call Payoff“Call”Profits Net Profit(1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 60,606,061 1,742,846 0 60,606,061 (1,742,846) 60,240,964 1,742,846 0 60,240,964 (1,742,846) 59,880,240 1,742,846 0 59,880,240 (1,742,846) 59,523,810 1,742,846 0 59,523,810 (1,742,846) 59,171,598 1,742,846 0 59,171,598 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529Since the firm believes that there is a good chance that the pound sterling will weaken, locking them into a forward contract would not be appropriate, because they would lose the opportunity to profit from this weakening. Their hedge strategy should follow for an upside potential to match their viewpoint. Therefore, they should purchase sterling call options, paying a premium of:5,000,000 STG x = 88,000 STG.If the dollar strengthens against the pound, the firm allows the option to expire, and buys sterling in the spot market at a cheaper price than they would have paid for a forward contract; otherwise, the sterling calls protect against unfavorable depreciation of the dollar.Because the fund manager is uncertain when he will sell the bonds, he requires a hedge which will allow flexibility as to the exercise date. Thus, options are the best instrument for him to use. He can buy A$ puts to lock in a floor of A$/$. Since he is willing to forego any further currency appreciation, he can sell A$ calls with a strike price of A$/$ to defray the cost of his hedge (in fact he earns a net premium of A$ 100,000,000 x –= A$ 2,300), while knowing that he can’t receive less than A$/$ when redeeming his investment, and can benefit from a small appreciation of the A$. Example #3:Problem: Hedge principal denominated in A$ into US$. Forgo upside potential to buy floor protection.I. Hedge by writing calls and buying puts1) Write calls for $/A$ @Buy puts for $/A$ @# contracts needed = Principal in A$/Contract size100,000,000A$/100,000 A$ = 1002) Revenue from sale of calls = (# contracts)(size of contract)(premium)$75,573 = (100)(100,000 A$)(.007234 $/A$)(1 + .0825 195/360)3) Total cost of puts = (# contracts)(size of contract)(premium)$75,332 = (100)(100,000 A$)(.007211 $/A$)(1 + .0825 195/360)4) Put payoffIf spot falls below , fund manager will exercise putIf spot rises above , fund manager will let put expire5) Call payoffIf spot rises above .8025, call will be exercised If spot falls below .8025, call will expire6) Net payoffSee following Table for net payoff Australian Dollar Bond HedgeStrikePrice Put Payoff “Put”Principal Call Payoff“Call”Principal Net Profit(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 73,000,000 75,573 0 73,000,241(75,332) 74,000,000 75,573 0 74,000,241(75,332) 75,000,000 75,573 0 75,000,241(75,332) 76,000,000 75,573 0 76,000,241(75,332) 77,000,000 75,573 0 77,000,241(75,332) 78,000,000 75,573 0 78,000,241(75,332) 79,000,000 75,573 0 79,000,241(75,332) 80,000,000 75,573 0 80,000,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241 4. The German company is bidding on a contract which they cannot be certain of winning. Thus, the need to execute a currency transaction is similarly uncertain, and using a forward or futures as a hedge is inappropriate, because it would force them to perform even if they do not win the contract. Using a sterling put option as a hedge for this transaction makes the most sense. For a premium of: 12 million STG x = 193,200 STG,they can assure themselves that adverse movements in the pound sterling exchange rate will notdiminish the profitability of the project (and hence the feasibility of their bid), while at the same time allowing the potential for gains from sterling appreciation.5. Since AMC in concerned about the adverse effects that a strengthening of the dollar would have on its business, we need to create a situation in which it will profit from such an appreciation. Purchasing a yen put or a dollar call will achieve this objective. The data in Exhibit 1, row 7 represent a 10 percent appreciation of the dollar strike vs. forward rate) and can be used to hedge against a similar appreciation of the dollar.For every million yen of hedging, the cost would be:Yen 100,000,000 x = 127 Yen.To determine the breakeven point, we need to compute the value of this option if the dollar appreciated 10 percent (spot rose to , and subtract from it the premium we paid. This profit would be compared with the profit earned on five to 10 percent of AMC’s sales (which would be lost as a result of the dollar appreciation). The number of options to be purchased which would equalize these two quantities would represent the breakeven point.Example #5:Hedge the economic cost of the depreciating Yen to AMC.If we assume that AMC sales fall in direct proportion to depreciation in the yen ., a 10 percent decline in yen and 10 percent decline in sales), then we can hedge the full value of AMC’s sales. I have assumed $100 million in sales.1) Buy yen puts# contracts needed = Expected Sales *Current ￥/$ Rate / Contract size9600 = ($100,000,000)(120￥/$) / ￥1,250,0002) Total Cost = (# contracts)(contract size)(premium)$1,524,000 = (9600)( ￥1,250,000)($￥)3) Floor rate = Exercise – Premium￥/$ = ￥/$ - $1,524,000/12,000,000,000￥4) The payoff changes depending on the level of the ￥/$ rate. The following table summarizes thepayoffs. An equilibrium is reached when the spot rate equals the floor rate.AMC ProfitabilityYen/$ Spot Put Payoff Sales Net Profit120 (1,524,990) 100,000,000 98,475,010121 (1,524,990) 99,173,664 97,648,564122 (1,524,990) 98,360,656 96,835,666123 (1,524,990) 97,560,976 86,035,986124 (1,524,990) 96,774,194 95,249,204125 (1,524,990) 96,000,000 94,475,010126 (1,524,990) 95,238,095 93,713,105127 (847,829) 94,488,189 93,640,360128 (109,640) 93,750,000 93,640,360129 617,104 93,023,256 93,640,360130 1,332,668 92,307,692 93,640,360131 2,037,307 91,603,053 93,640,360132 2,731,269 90,909,091 93,640,360133 3,414,796 90,225,664 93,640,360134 4,088,122 89,552,239 93,640,360135 4,751,431 88,888,889 93,640,360136 5,405,066 88,235,294 93,640,360137 6,049,118 87,591,241 93,640,360138 6,683,839 86,966,522 93,640,360139 7,308,425 86,330,936 93,640,360140 7,926,075 85,714,286 93,640,360141 8,533,977 85,106,383 93,640,360142 9,133,318 84,507,042 93,640,360143 9,724,276 83,916,084 93,640,360144 10,307,027 83,333,333 93,640,360145 10,881,740 82,758,621 93,640,360146 11,448,579 82,191,781 93,640,360147 12,007,707 81,632,653 93,640,360148 12,569,279 81,081,081 93,640,360149 13,103,448 80,536,913 93,640,360150 13,640,360 80,000,000 93,640,360The parent has a DM payable, and Lira receivable. It has several ways to cover its exposure; forwards,。

国际财务管理（英文版）第11版马杜拉答案Chapter19Chapter 19International Cash Management Lecture OutlineCash Flow Analysis: Subsidiary PerspectiveSubsidiary ExpensesRevenueSubsidiarySubsidiary Dividend PaymentsSubsidiary Liquidity ManagementCentralized Cash ManagementTechniques to Optimize Cash FlowsAccelerating Cash InflowsMinimizing Currency Conversion CostsManaging Blocked FundsManaging Intersubsidiary Cash Transfers Complications in Optimizing Cash Flow CharacteristicsCompany-RelatedRestrictionsGovernmentCharacteristics of Banking SystemsInvesting Excess CashHow to Invest Excess CashCentralized Cash ManagementDetermining the Effective YieldImplications of Interest Rate ParityUse of the Forward Rate as a ForecastUse of Exchange Rate ForecastsDiversifying Cash Across CurrenciesHedgingDynamicChapter ThemeThis chapter emphasizes the decisions involved in the management of cash by an MNC. The additional opportunities and risks of cash management for an MNC versus a domestic firm should be stressed. There are actually three key components of the chapter. The first is distinguishing between subsidiary control over excess cash versus centralized control. An argument is made in favor of centralized control. The second component is optimizing cash flow. Several techniques are recommended to optimize cash flow. Finally, the decision of where to invest excess cash should be discussed with consideration of all factors that need to be incorporated for this decision.Topics to Stimulate Class Discussion1. Should international cash management be conducted at the subsidiary level or at the centralizedlevel? Elaborate.2. What is the use of netting to an MNC?3. How can a firm deal with blocked funds?4. Assume that as a treasurer of a U.S. corporation, you believe that the British pound’s forward rateis an accurate forecast of the pound’s future spot rate. What does this imply about your decision of whether to invest cash in the U.S. or in the U.K.?Critical debateShould a MNC’s subsidiaries operate their own cash management policies?Yes. Ultimately cash management means that everything is controlled from the Propositioncentre. Different countries and indeed different products have very different working capital requirements. Centralization could easily lead to poor working capital management and cash flow difficulties.No. Trade between subsidiaries accounts for about a large percentage of Opposingviewworld exports, there has to be coordination between subsidiaries, also customers can be MNC’s so coordination is also required in debt collection. Also, there are considerable exchangerate savings to be madeWith whom do you agree? Think carefully about the arguments for and against allowing subsidiaries to manage their own cash. What are the problems with each of the arguments? Is there a solution that avoids the main drawbacks?ANSWER: For is the argument that the business is more efficient when such matters are run centrally. There are many systems nowadays run centrally from road tax to supermatrket clubcards. However, against is the argument that motivation is lost by running the business from the centre. Is autonomy worth the loss of efficiency if it means a better motivated workforce. Does this answer depend on the type of business?Answers to End of Chapter Questions1. International Cash Management. Discuss the general functions involved in international cashmanagement. Explain how the MNC’s optimization of cash flow can distort the profits of each subsidiary.ANSWER: The general functions of international cash management are optimizing cash flows and investing excess cash. These functions combined will lead to efficient usage of funds.When subsidiaries adjust their cash transactions between each other to reduce taxes or financing costs, their individual performances are distorted. For example, a subsidiary that makes a late payment to another subsidiary (due to its shortage of funds) benefits in that it avoided a short-term loan by delaying payment. The recipient subsidiary was hampered due to not receiving funds earlier (since the present value of the late payment is lower).2. Netting. Explain the benefits of netting. How can a centralized cash management system bebeneficial to the MNC?ANSWER: Netting is a centralized compilation of inter-subsidiary cash flows. It is designed to reduce currency conversion costs and processing costs associated with payments between subsidiaries. By specifying a single net payment to be made instead of all individual payments owed between subsidiaries, transactions costs are reduced and cash flows may be forecasted more accurately.A centralized cash management system is beneficial in that it allows for netting, which can reducetransactions costs and improve cash budgeting. In addition, it can increase yields on short-term investments by pooling excess cash of various subsidiaries.3. Leading and Lagging. How can an MNC implement leading and lagging techniques to helpsubsidiaries in need of funds?ANSWER: A subsidiary in need of funds would receive cash inflows from another subsidiary sooner than is required. This early payment provides the necessary funds. If the subsidiary in need of funds is making payment, it may be allowed by the MNC parent or recipient subsidiary to delay on its payment.4. International Fisher Effect. If a U.S. firm believes that the international Fisher effect holds, whatare the implications regarding a strategy of continually attempting to generate high returns from investing in currencies with high interest rates?ANSWER: High interest rate currencies will typically depreciate to offset their interest rate advantage (on average) according to the IFE. Therefore, this strategy will on average provide similar returns as a domestic investment, and the strategy is not worthwhile.5. Investing Strategy. Trumpington ltd has ￡2 million in excess cash that it has invested in Mexicoat an annual interest rate of 60 percent. The UK interest rate is 9 percent. By how much would the Mexican peso have to depreciate to cause such a strategy to backfire?1 +9%-1 = -31.875%1 +60%ANSWER: If the peso depreciates by more than 31.875 percent, the effective yield on the Mexican deposit will be less than the domestic yield.6. Investing Strategy. Why would a UK firm consider investing short-term funds in euros evenwhen it does not have any future cash outflows in euros?ANSWER: The interest rate on the euro may be higher, or the euro may have a high probability of appreciating. Also the firm may invest in euros today to hedge a future payment in euros.7. Covered Interest Arbitrage. Granville SA has 2 million euro in cash available for 90 days. It isconsidering the use of covered interest arbitrage, since theeuro’s 90-day interest rate is higher than the euro interest rate. What will determine whether this strategy is feasible?ANSWER: If interest rate parity exists, then the forward rate of the euro contains a discount that sufficiently offsets the higher interest rate on euros. Consequently, the act of covered interest arbitrage would not be feasible.8. Effective Yield. Corlins plc has ￡1 million in cash available for 30 days. It can earn 1 percent on a30-day investment in the United Kingdom. Alternatively, if it converts the pounds to South African rand, it can earn 1 ? percent on a rand deposit. The spot rate of the rand is ￡0.09. The spot rate 30 days from now is expected to be ￡0.08. Should Corlins invest its cash in the United Kingdom or in South Africa? Explain your answer.ANSWER: If Corlins plc invests in a Mexican deposit, it will convert ￡1 million to 11,111,111R which will accumulate to 11,277,778R after one month (due to the 1 1/2% interest rate). If the spot rate of the rand is ￡0.08 after one month, the rand will be converted to ￡902,222, which is less than the amount of pounds the firm started with. Thus, the Corlins plc should invest its cash in the UK. An alternative approach is to note that the value of the rand is going to fall by (0.08 –0.09)/0.09 = -11.1% much greater than the difference in interest rates.9. Effective Yield. Rollins plc has ￡3 million in cash available for 180 days. It can earn 7 percent ona UK Treasury bill or 9 percent on a US Treasury bill. The US investment does require conversionof pounds to dollars. Assume that interest rate parity holds and that Rollins believes the 180-day forward rate is a reliablepredictor of the spot rate to be realized 180 days from now. Would the British investment provide an effective yield that is below, above, or equal to the yield on the U.S.investment? Explain your answer.ANSWER: If the forward rate is an accurate forecast of the future spot rate, then the return on a foreign investment without covering the currency exposure will be the same as if it was covered.The uncovered foreign investment, like the act of covered interest arbitrage, will generate a return similar to the domestic return (given that interest rate parity exists).10. Effective Yield. Repeat question 9, but this time assume that Rollins plc expects the 180-dayforward rate of the dollar to substantially overestimate the spot rate to be realized in 180 days.ANSWER: In this case, the future spot rate will be less than the forward rate. If it was equal to the forward rate, the foreign return would have been similar to the domestic return for Rollins Inc.(as explained in the answer to question 9). If the future spot rate is lower than the forward rate, the U.S. firm will receive less when converting the pounds back to dollars. Thus, the foreign return is expected to be less than the domestic return.11. Effective Yield. Repeat question 9, but this time assume that the Rollins plc expects the 180-dayforward rate of the pound to substantially underestimate the spot rate to be realized in 180 days.ANSWER: In this case, Rollins will receive more when converting the pounds back to dollars than the amount necessary to match the domestic return. Thus, the foreign returnis expected to be greater than the domestic return.12. Effective Yield. Assume that the one-year UK interest rate is 10 percent and the one-year USinterest rate is 13 percent. If a UK firm invests its funds in the US, by what percentage will the dollar have to depreciate to make its effective yield the same as the UK interest rate from the UK firm’s perspective?ANSWER:(1 + 10%) – 1 = about –2.65%(113%)+13. Investing in a Currency Portfolio. Why would a firm consider investing in a portfolio of foreigncurrencies instead of just a single foreign currency?ANSWER: A portfolio of currencies reduces the probability of the foreign investment backfiring due to depreciation in the currencies denominating the investment. If all funds are in an investment denominated in a single foreign currency, risk of that currency substantially depreciating is relatively high (compared to an entire portfolio of currencies substantially depreciating).14. Interest Rate Parity. Trellis ltd has determined that the interest rate on euros is 16 percent whilethe UK interest rate is 11 percent for one-year Treasury bills. The one-year forward rate of the euro has a discount of 7 percent. Does interest rate parity exist? Can Trellis achieve a higher effective yield by using covered interest arbitrage than by investing in UK Treasury bills? Explain.ANSWER: If interest rate parity (IRP) existed, the forward rate of the euro should have a discount reflecting the interest ratedifferential:(1 + 11%) – 1 = –4.31% (discount)=Forwarddiscount(1 + 16%)Since the euro’s actual discount exceeds that percentage, IRP does not exist. However, Dallas Company would achieve a lower effective yield if attempting covered interest arbitrage than if it invests in UK Treasury bills, because the euro’s forward discount more than offsets the interest rate differential.15. Diversified Investments. Hofstra ltd has no business outside the UK but has cash invested in sixEuropean countries, each of which uses the euro as its local currency. Are Hofstra’s short-term investments well diversified and subject to a low degree of exchange rate risk? Explain.ANSWER: The short-term investments are not well diversified, because the entire portfolio of investments is denominated in euros. If the euro weakens against the pound, the return on all short-term securities denominated in euros will decline from the perspective of the UK firm.16. Investing Strategy. Should McNeese ltd consider investing funds in Latin American countrieswhere it may expand facilities? The interest rates are high, and the proceeds from the investments could be used to help support the expansion. When would this strategy backfire?ANSWER: McNeese could benefit from investing at a high interest rate. However, this strategy could backfire if the currency weakens over time, because McNeese could have converted pounds later (at the time of expansion) at a more favourableexchange rate. The tradeoff is a higher interest rate if it invests funds now, versus a more favourable exchange rate if it invests funds later.17. Impact of a crisis. Palos SA (Spain) commonly invests some of its excess euros in foreigngovernment short-term securities in order to earn a higher short-term interest rate on its cash. Describe how the potential return and risk of this strategy may be affected by financial crisis.ANSWER: A financial crisis si likely to mean higher interest rates due to the greater risk. If the euros invested are excesss, then Palos might like to a certain extent to take the risk if it feels that the financial crisis is unwarranted. In this respect ti might use information from its local interests if there are any. Using specialist information in this way would lead to Palos earning excess returns as a reward for the information.Advanced Questions18. Investing in a Portfolio. Poppleton ltd plans to invest its excess cash in South African rand forone year. The one-year South African interest rate is 19 percent. The probability of the rand’s percentage change in value during the next year is shown below:Possible rate of change in the South African rand overthe life of theinvestmentProbability ofoccurrence-15% 20%-4 50%0 30%What is the expected value of the effective yield based onthis information? Given that the UKinterest rate for one year is 7 percent, what is the probability that a one-year investment in pesos will generate a lower effective yield than could be generated if Poppleton ltd simply invested domestically?ANSWER:Effective Yield if thisP ossible Rate of Rate of Change in theChange in Peso Probability Peso Does Occur –15% 20% (1.19) [1 + (–15%)] – 1 = 1.15% –4% 50% (1.19) [1 + (–4%)] – 1 = 14.24% 0% 30% (1.19) [1 + (0%)] – 1 = 19.00%E(r) = 20% (1.15%) + 50% (14.24%) + 30% (19.00%)= 0.23% + 7.12% + 5.70%= 13.05%There is a 20% probability that the rand’s effective yield will be less than the domestic yield.19. Effective Yield of Portfolio. Ithaca (Greece) considers placing 30 percent of its excess funds in a one-year Singapore dollar deposit and the remaining 70 percent of its funds in a one-year US dollar deposit. The Singapore one-year interest rate is 15 percent, while the US one-year interest rate is 10 percent. The possible percentage changes in the two currencies for the next year are forecasted as follows:currency Possible percentage change in the spot rate over the investmenthorizonProbability of that change in the spot rateoccurringSingapore dollar -2% 20%Singapore dollar 1 60Singapore dollar 3 20US dollar 1 50US dollar 4 40US dollar 6 10Given this information, determine the possible effective yields of the portfolio and the probability associated with each possible portfolio yield. Given a one-year euro interest rate of 8 percent, what is the probability that the portfolio’s effective yield will be lower than the yield achieved from investing in the United States? (assume that the movements on the two currencies are not correlated)ANSWER:Possible % Change Effective Yield Based on thein the Singapore Dollar% Change in the Singapore Dollar –2% (1.15) [1 + (–2%)] – 1 = 12.7%1% (1.15) [1 + (1%)] – 1 = 16.15%3% (1.15) [1 + (3%)] – 1 = 18.45%Possible % Change in Effective Yield Based on thethe US Dollar % Change in the US Dollar1% (1.13) [1 + (1%)] – 1 = 14.13%4% (1.13) [1 + (4%)] – 1 = 17.52%6% (1.13) [1 + (6%)] – 1 = 19.78%Possible JointEffective Yield Computation of Computation of EffectiveS$ C$ Joint Probability Yield of Portfolio12.7% 14.13% (20%)(50%) = 10% .3(12.7%) + .7(14.13%) =13.701%12.7 17.52 (20%)(40%) = 8% .3(12.7%) + .7(17.52%) = 16.074%12.7 19.78 (20%)(10%) = 2% .3(12.7%) + .7(19.78%) = 17.656%16.15 14.13 (60%)(50%) = 30% .3(16.15%) + .7(14.13%) =14.736%16.15 17.52 (60%)(40%) = 24% .3(16.15%) + .7(17.52%) =17.109%16.15 19.78 (60%)(10%) = 6% .3(16.15%) + .7(19.78%) =18.691%18.45 14.13 (20%)(50%) = 10% .3(18.45%) + .7(14.13%) =15.426%18.45 17.52 (20%)(40%) = 8% .3(18.45%) + .7(17.52%) =17.799%18.45 19.78 (20%)(10%) = 2% .3(18.45%) + .7(19.78%) =19.381%100%There is a 0% chance that the portfolio will generate a lower return than a euro investment (determined by the table above).。