72783538 Multinational Business Finance Solution Manual 12th Edition by Etiman Stone Hill Moffitt...

Multinational Business Finance 10th Edition Solution Manual

IM Science, KUST, Solution Manual of MBF 10tth Edition Prepared By Wasim Uddin Orakzai

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Chapter-1 Financial Goals & Corporate Governance 8

Problem # 1.1: Shareholder Returns……………………………………… 9 Problem # 1.2: Shareholder Choices…………………………………….. 9Problem # 1.3: Microsoft's Dividend…………………………………….... 10 Problem # 1.4: Dual Classes of Common Stock………………………… 10 Problem # 1.5: Corporate Governance: Minority Shareholder Control… 11Problem # 1.6: Price/Earnings Ratios and Acquisitions………………… 12 Problem # 1.7: Corporate Governance: Overstating Earnings…………. 13Problem # 1.8: Carlton Corporation's Consolidated Results…………… 14Problem # 1.9: Carlton's EPS Sensitivity to Exchange Rates………..… 15Problem # 1.10: Carlton’s Earnings & Global Taxation…………….....… 17

Chapter-2 The International Monetary System (IMS) 19

Problem # 2.1: Frankfurt & New York................................................. 20 Problem # 2.2: Peso Exchange Rate Changes……………………….. 20

Problem # 2.3: Good as Sold……………………………………………. 22Problem # 2.4: Gold Standard…………………………………………… 22Problem # 2.5: Spot Rate Customer……………………………………. 22Problem # 2.6: Forward Rate……………………………………………. 23 Problem # 2.7: Forward Discount on the dollars………………………. 23Problem # 2.8: Forward Premium on the euro………………………… 24Problem # 2.9: Iraqi Imports…………………………………………….. 26

Chapter-3 Balance of Payments (BOP) 28

Problems # 3.1 - 3.4: Australia's Current Account…………………… 29Problems # 3.5 - 3.9: Uruguay's Current Account…………………… 30Problems # 3.10 - 3.13: Myanmar's Balance of Payments……………. 31Problems # 3.14 - 3.20: Argentina's Balance of Payments………….… 32


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Chapter-4 Foreign Exchange Market (FEM) 35

Problem # 4.1: Ringgit up or down?............................................... 36Problem # 4.2: Forward Premium & Discounts……………………. 37Problem # 4.3: Trading in Switzerland……………………………… 41Problem # 4.4: Yen Forward Premium……………………………… 42Problem # 4.5: Euro Forward Premium…………………………….. 43Problem # 4.6: Traveling: Copenhagen to St. Petersburg……….. 44Problem # 4.7: Riskless Profit on the Franc……………………….. 45Problem # 4.8: Trans Atlantic Arbitrage……………………………. 47 Problem # 4.9: Wall Street Journal quotes and premiums………. 48 Problem # 4.10: Finanial Times quotes……………………………… 49 Problem # 4.11: Venezuelan Bolivar (A)…………………………….. 50 Problem # 4.12: Venezuelan Bolivar (B)…………………………….. 51Problem # 4.13: Indirect Quotation on the Dollar…………………… 54 Problem # 4.14: Direct Quotation on the Dollar…………………….. 55 Problem # 4.15: Mexican Peso - European Euro Cross Rates…… 57

Problem # 4.16: Around the Horn……………………………………. 58

Chapter-5 Foreign Currency Derivatives (FCD) 60

Problem # 5.1: Peso Futures…………………………………………. 61Problem # 5.2: Pounds Futures………………………………………. 62Problem # 5.3: Hans Schmidt, euro Speculator…………………….. 63Problem # 5.4: Hans Schmidt, Swiss franc Speculator……………. 65Problem # 5.5: Katya & the yen………………………………………. 68Problem # 5.6: Samuel’s bet………………………………………….. 70Problem # 5.7: How much profit – calls?……………………………. 71Problem # 5.8: How much profit – puts?......................................... 72Problem # 5.9: Falling Canadian dollar……………………………….. 73Problem # 5.10: Braveheart's Put on Pounds………………………… 75Problem # 5.11: Call Options on British pounds……………………… 78 Problem # 5.12: Put Options on euros………………………………… 79Problem # 5.13: Solar Turbines and Venezuelan bolivares………… 80Problem # 5.14: Vitro de Mexico……………………………………… 81Problem # 5.15: Put Options on Chinese Renminbi………………... 82

Chapter-6 International Parity Conditions (IPC) 83

Problem # 6.1: Big Mac Hamburger Standard……………………… 84


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Problem # 6.2: Exchange Rate Pass-Through…………………….. 85Problem # 6.3: Argentine pesos…………………………………….. 87Problem # 6.4: International Fisher Effect…………………………. 89Problem # 6.5: Covered Interest Arbitrage (CIA) - Denmark I…… 92Problem # 6.6: CIA Denmark B – Part (a) & Part (b)……………… 94Problem # 6.7: CIA– Japan………………………………………….. 97Problem # 6.8: Uncovered Interest Arbitrage – Japan……………. 98Problem # 6.9: International Parity Conditions in Equilibrium……. 99Problem # 6.10: Mary Smyth – CIA…………………………………… 102Problem # 6.11: Mary Smyth – UIA…………………………………… 103Problem # 6.12: Mary Smyth -- one month later…………………….. 105Problem # 6.13: Langkawi Island Resort…………………………….. 106Problem # 6.14: Covered Interest against the Norwegian krone…... 107Problem # 6.15: Frankfurt and New York…………………………….. 109Problem # 6.16: Chamonix chateau rentals…………………………. 110Problem # 6.17: East Asiatic Company – Thailand…………………. 111Problem # 6.18: Maltese Falcon: 2003-2004………………………… 114Problem # 6.19: London Money Fund………………………………… 115

Problem # 6.20: The African Beer standard of PPP…………………. 118

Chapter-7 Foreign Exchange Rate Determination 120

Problem # 7.1: Current spot rates………………………………….… 122Problem # 7.2: Purchasing power parity forecasts…………….…… 123Problem # 7.3: International Fisher forecasts………………………. 125Problem # 7.4: Implied real interest rates…………………………… 127Problem # 7.5: Forecasting with real interest rates………….…….. 129Problem # 7.6: Forward rates………………………………….……… 131Problem # 7.7: Real economic activity and misery………….……… 133Problem # 7.8: Balance of payments approach……………….……. 135Problem # 7.9: Current accounts and spot rates…………………… 135Problem # 7.10: Exchange Rate Trends and Bounds……………….. 135

Chapter-8 Transaction Exposure 136

Problem # 8.1: Lipitor in Indonesia…………………………………… 137Problem # 8.2: Embraer of Brazil…………………………………….. 138Problem # 8.3: Mattel Toys…………………………………………… 139Problem # 8.4: Hindustan Lever……………………………………… 140Problem # 8.5: Tek - Italian Account Receivable…………………… 141Problem # 8.6: Tek - Japanese Account Payable………………….. 143


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Problem # 8.7: Tek - British Telecom Bid…………………………… 145Problem # 8.8: Tek -- Swedish Price List…………………………… 146Problem # 8.9: Tek -- Swiss Dividend Payable…………………….. 148Problem # 8.10: Northern Rainwear…………………………………... 150Problem # 8.11: Vamo Road Industries………………………………. 151Problem # 8.12: Worldwide Travel……………………………………. 152Problem # 8.13: Seattle Scientific, Inc……………………………….. 153Problem # 8.14: Wilmington Chemical Company…………………… 154Problem # 8.15: Dawg-Grip, Inc……………………………………..... 155Problem # 8.16: Aqua-Pure……………………………………………. 157 Problem # 8.17: Botox Watch Company……………………………… 159Problem # 8.18: Redwall Pump Company…………………………… 160Problem # 8.19: Pixel's Financial Metrics……………………………. 162Problem # 8.20: Scout Finch and Dayton Manufacturing (A)………. 163Problem # 8.21: Scout Finch and Dayton Manufacturing (B)………. 165Problem # 8.22: Siam Cement………………………………………… 167Problem # 8.23: Aswan Project: Mitsubishi's Exp. (Part a & b)…… 168Problem # 8.24: Aswan Project: Fluor's Exposure………………….. 171Problem # 8.25: Aswan Project: DaSilva's Contingency Lever…….. 173

Chapter-9 Operating Exposure 174

Problem # 9.1: Carlton Germany - Case 4…………………………… 175Problem # 9.2: Carlton Germany - Case 5…………………………… 176Problem # 9.3: Denver Plumbing Company (A)……………………… 178Problem # 9.4: Denver Plumbing Company (B)……………………... 178Problem # 9.5: Hawaiian Macadamia Nuts………………………….. 179Problem # 9.6: Cellini Fashionwear…………………………………… 180Problem # 9.7: Autocars, Ltd………………………………………….. 181Problem # 9.8: High-Profile Printers, Inc. (A)………………………… 182Problem # 9.9: High-Profile Printers, Inc. (B)………………………… 183Problem # 9.10: Hedging Hogs: Risk-Sharing at Harley Davidson…. 185

Chapter-10 Translation Exposure (Accounting Exposure) 187

Problem # 10.1: Carlton Germany (A)……………………………….. 188Problem # 10.2: Carlton Germany (B)……………………………….. 189Problem # 10.3: Carlton Germany (C)……………………………….. 191Problem # 10.4: Carlton Germany (D)……………………………….. 192Problem # 10.5: Montevideo Products, S.A. (A)……………………. 193Problem # 10.6: Montevideo Products, S.A. (B)……………………. 194


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Problem # 10.7: Montevideo Products, S.A. (C)……………………. 196Problem # 10.8: Siam Toys, Ltd. (A)…………………………………. 198Problem # 10.9: Siam Toys, Ltd. (B)…………………………………. 200 Problem # 10.10: Egyptian Ingot, Ltd………………………………….. 202

Chapter-11 Sourcing Equity Globally 205

Problem # 11.1: Novo’s cost of equity prior to April 1980…………. 206Problem # 11.2: Novo’s WACC prior to April 1980……………….... 206Problem # 11.3: Novo’s cost of equity after July 1981…………….. 207Problem # 11.4: Novo’s WACC after July 1981…………………….. 207Problem # 11.5: Novo’s cost of equity in 2004……………………… 208Problem # 11.6: Novo’s WACC in 2004……………………………… 208Problem # 11.7: HangSung before equity issue abroad……………. 209Problem # 11.8: HangSung’s WACC before equity issue abroad… 209Problem # 11.9: HangSung after equity issue abroad……………… 210Problem # 11.10: HangSung’s WACC after equity issue abroad…… 210

Annexure of Currencies Used in Solution Manual……………………… 212 Table of Contents of All Formula list……………………..................... 213


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“Read and Lord is the most bounteous, who teaches by the pen, teaches man that which he knew not.

(Al-Quran)


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Chapter-1

Financial Goals & Corporate Governance


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Chapter # 1 “Financial Goals & Corporate Governance”

Problem # 1.1: Shareholder returns. Solution: What are the shareholder's returns?

Assumptions Value Part (a) Value Part (b) Share price, P1 $ 16.00 $ 16.00 Share price, P2 $ 18.00 $ 18.00 Dividend paid, D2 $ ---- $ 1.00

a. If the company paid no dividend (plugging zero in for the dividend): Return = (P2 - P1 + D2) / (P1) Return = $18.00 - $ 16.00 / $16.00 = $2.00 / $16.00 Return = 12.50%

b. Total shareholder return, including dividends, is: Return = (P2 - P1 + D2) / (P1) Return = (P2 - P1 + D2) / (P1) Return = $18.00 - $ 16.00 + $1.00 / $16.00 = $2.00 / $16.00 Return = 18.75%

Problem # 1.2: Shareholder choices. Solution:

Assumptions ValueShare price, P1 $ 62.00 Share price, P2 $ 74.00 Dividend paid, D2 $ 2.25

Return = (P2 - P1 + D2) / (P1) Return = $74.00 - $ 62.00 + 2.25 / $62.00 = $14.25.00 / $62.00 Return = 22.98%


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The share's expected return of 22.98% far exceeds the required return by Mr. Fong of 12%. He should therefore make the investment.

Problem # 1.3: Microsoft's dividend. Solution: What would the return have been on Microsoft shares if it had paid a constant dividend in the recent past?

Assumptions

ClosingSharePrice

IfDividend Paid

ShareholderReturn(without Dividend )

ShareholderReturn

(with Dividend)

1998 (January 2) $131.13 1999 (January 4) $141.00 $0.16 7.53% 7.65%2000 (January 3) $116.56 $0.16 -17.33% -17.22%2001 (January 2) $ 43.38 $0.16 -62.78% -62.65%2002 (January 2) $ 67.04 $0.16 54.54% 54.91%2003 (January 2) $ 53.72 $0.16 -19.87% -19.63%

a. Average shareholder return for the period : Return = (P2 - P1 + D2) / (P1) Return = $74.00 - $ 62.00 + 0 / $62.00 = $14.25.00 / $62.00 Return = -7.58%

b. Total shareholder return if Microsoft had paid a constant dividend: Return = (P2 - P1 + D2) / (P1) Return = $74.00 - $ 62.00 + 0 / $62.00 = $14.25.00 / $62.00 Return = -7.39%Problem # 1.4: Dual Classes of Common Stock. Solution:

What are the implications for the distribution of voting rights and dividend distributions for Powlitz?

Powlitz Manufacturing

Local Currency(millions)

Votes per share

Total Votes

Long-term debt 200 0 0Retained earnings 300 0 0Paid-in common stock: 1 million A-shares 100 10 *1,000 Paid-in common stock: 4 million B-shares 400 1 ** 400


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Total long-term capital 1,000 --- 1,400 Notes: *100 x 10 = 1,000 votes ** 400 x 1 = 400 votes

a. What proportion of the total long-term capital has been raised by A-shares?

A-shares / Total long-term capital = 100 / 1,000 = 10.00%

b. What proportion of voting rights is represented by A-shares?

A-share total votes / Total Votes = 1,000 / 1,400 = 71.43%

c. What proportion of the dividends should the A-shares receive?

A-shares in local currency / Total equity shares in local currency = 100 / (100 + 400) = 20.00%

Problem # 1.5: Corporate Governance: Minority Shareholder ControlSolution: Distribution of profits versus distribution of voting rights and power.

a) Investor Group

Solpart ParticpacoesVotingShares

PreferredShares

TotalShares

Telecom Italia 38.00% 38.00% 38.00%Pension Funds 32% of Techold Particpacoes shares 3.52% 19.84% 10.88% (0.32 (11%); 0.32 (62%); and 0.32 (34%) Combined Telecom Italia & Pension Funds 41.52% 57.84% 48.88%

Opportunity 100% of Timepart Particpacoes shares 51.00% 0.00% 28.00% 68% of Techold Particpacoes shares 7.48% 42.16% 23.12% Combined Opportunity 58.48% 42.16% 51.12%

Total Shares 100.00% 100.00% 100.00%

b) Opportunity would continue to control the voting rights of SolPart, which in turn continues to own 58.48% of the voting shares in Brasil Telecom Participacoes,


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which in turn owns 93.6% of the voting shares in Brasil Telecom. Thus Opportunity is able to use its control of holding companies to control Brasil Telecom.

Problem # 1.6: Price/Earnings Ratios and Acquisitions Solution:

CompanyP/E Ratio

Numberof shares

Marketvalueper share Earnings EPS

TotalMarketValue

Pharm-Italy 20

10,000,000 $20.00 $10,000,000 $1.00 $200,000,000

Pharm-USA 40

10,000,000 $40.00 $10,000,000 $1.00 $400,000,000

Rate of exchange: Pharm-USA shares per Pharm-Italy share = 5,500,000

a. How many shares would Pharm-USA have outstanding after the acquisition of Pharm-Italy?

$10,000,000 + 5,500,000 = 15,500,000

Because Pharm-Italy shares are worth $20 per share, they are only worth one-half the value per share of Pharm-USA's $40 per share. So, on a straight exchange, 1 Pharm-USA share is worth 2 Pharm-Italy shares. But, Pharm-USA also needs to pay a premium for gaining control of Pharm-Italy, so it pays an additional 10% over market. So, Pharm-USA pays:

10 million / 2 x (1 + 10% premium) =

b. What would be the consolidated earnings of the combined Pharm-USA and Pharm-Italy?

Pharm-Italy earnings + Pharm-USA earnings = $20,000,000c. Assuming the market continues to capitalize Pharm-USA's earnings at a P/E ratio of 40, what would be;


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P/E x Consolidated earnings = 40 x $20,000,000 = $800,000,000.

d. What is the new earnings per share of Pharm-USA?

$20,000,000 / 15,500,000 shares = $1.29

e. What is the new market value of a share of Pharm-USA?New market value / Total shares outstanding= $800,000,000 /15,500,000 = $51.61

f. How much did Pharm-USA's stock price increase? Share price rose from $40.00 to $51.61. Percentage increase = 29.03%

g. Assume that the market takes a negative view of the acquisition and lowers Pharm-USA's P/E ratio to 30. What would be the new market price per share of stock? What would be its percentage loss?

New market value = Total earnings x P/E = $20,000,000 x 30 = $600,000,000

New market price per share = total market value / shares outstanding = $38.71 Percentage loss to original Pharm-USA shareholders = ($38.71 - $40.00) / ($40.00) = - 3.23%

Problem # 1.7: Corporate Governance: Overstating Earnings Solution:

CompanyP/E ratio

Numberof shares

Marketvalueper share Earnings EPS

TotalMarketValue

Pharm-Italy 20 10,000,000 $ 20.00 $10,000,000 $1.00 $200,000,000

Pharm-USA 40 10,000,000 $20.00 $5,000,000 $1.00

$200,000,000

If earnings were lowered to $5 million from the previously reported $10 million, could Pharm-USA still do the deal?


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To do the deal, Pharm-Italy's shareholders need to be paid their market value plus a 10% premium = $220,000,000

At new market rates for Pharm-USA, this would require the offer of ($220 million/$20 per share) = 11,000,000.00 Shares

These 11 million shares would exceed Pharm-USA's existing shares outstanding, effectively giving Pharm-Italy control. Therefore the acquisition would probably not take place.

Problem # 1.8: Carlton Corporation's Consolidated ResultsSolution:

S.No.

1 2 1 x 2 = 3

Amount Tax rate

Corporate Income taxes

US Parent Company (US$) 4,500.00 35% $ 1,575.00Brazilian Subsidiary (reais, R$) 6,250.00 25% R$ 1,562.50German Subsidiary (Euros, €) 4,500.00 40% € 1,800.00Chinese Subsidiary (Renminbi, Rmb) 2,500.00 30% Rmb 750.00

Business Performance (000s)

US ParentCompany

(US$)

BrazilianSubsidiary(reais, R$)

GermanSubsidiary

(euros, €)

ChineseSubsidiary(renminbi,

Rmb)Earnings before taxes, EBT ( local currency)

4,500.00

6,250.00

4,500.00

2,500.00

Less: Corporate income taxes (1,575.00)

(1,562.50)

(1,800.00)

(750.00)

Net profits of individual subsidiary

2,925.00

4,687.50

2,700.00

1,750.00

Average exchange rate for the period (foreign currency / $) ------

3.5000

0.92600

8.5000

Net profits of individual subsidiary (US$) $ 2,925.00 $ 1,339.29 $ 2,915.77 $ 205.88


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Consolidated profits (total across units) $ 7,385.93 Total diluted shares outstanding (000s)

650.00

a. Consolidated earnings per share (EPS) $ 11.36 b. Proportion of total profits originating by country 39.6% 18.1% 39.5% 2.8%c. Proportion of total profits originating from outside the US. 60.4%

Problem # 1.9: Carlton's EPS Sensitivity to Exchange RatesSolution:

S.No.

1 2 1 x 2 = 3

Amount Tax rate


US Parent Company (US$) 4,500.00 35% $ 1,575.00Brazilian Subsidiary (reais, R$) 6,250.00 25% R$ 1,562.50German Subsidiary (Euros, €) 4,500.00 40% € 1,800.00Chinese Subsidiary (Renminbi,Rmb) 2,500.00 30% Rmb 750.00


US ParentCompany

(US$)


GermanSubsidiary

(euros, €)

ChineseSubsidiary(renminbi,Rmb)

Earnings before taxes, EBT (local currency) 4,500.00 6,250.00

4,500.00 2,500.00


(1,562.50)

(1,800.00)

(750.00)


2,925.00

4,687.50

2,700.00

1,750.00

Avg exchange rate for the ------ 4.5000 8.


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period (fc/$) 0.92600 5000 Net profits of individual subsidiary (US$) $2,925.00 $1,041.67 $2,915.77 $205.88 Consolidated profits (total across units) $ 7,088.32 Total diluted shares outstanding (000s)

650.00

Baseline EPS $11.36

a. If Brazilian real falls to R$4.50/$: EPS = $ 10.91 EPS has fallen 4 percent from baseline = - 4.0%


US ParentCompany

(US$)


GermanSubsidiary

(euros, €)



4,500.00 2,500.00


(1,562.50)

(1,800.00)

(750.00)


2,925.00 4,350.00

2,700.00

1,750.00

Avg exchange rate for the period (fc/$) ------ 4.5000

0.92600

8.5000

Net profits of individual subsidiary (US$) $2,925.00 $966.67 $2,915.77 $205.88 Consolidated profits (total across units) $ 7,013.32 Total diluted shares outstanding (000s)

650.00

Baseline EPS $11.36

b. If Brazilian real falls to R$4.50/$: EPS = $ 10.79 EPS has fallen 4 percent from baseline = - 5.0%


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Problem # 1.10: Carlton's Earnings & Global TaxationSolution:

S.No.

1 2 1 x 2 = 3 4 3 ÷ 4 = 5

Amount Tax rate


Exchange Rate

Corporate Income taxes in $

US Parent Company (US$) 4,500.00 35% $ 1,575.00 ----- $1,575.00Brazilian Subsidiary (reais, R$) 6,250.00 25% R$ 1,562.50 R$3.5000 /$ $ 446.43 German Subsidiary (Euros, €) 4,500.00 40% € 1,800.00 €0.92600 /$ $1,943.84Chinese Subsidiary (Renminbi, Rmb) 2,500.00 30% Rmb 750.00 Rmb 8.5000 $ 88.24


US ParentCompany

(US$)


GermanSubsidiary

(euros, €)



4,500.00 2,500.00


(1,562.50)

(1,800.00)

(750.00)


2,925.00

4,687.50

2,700.00

1,750.00

Average exchange rate for the period (foreign currency / $) ------ 3.5000

0.92600

8.5000

Net profits of individual subsidiary (US$) $2,925.00 $1,339.29 $ 2,915.77 $205.88 Consolidated profits (total across units) $ 7,385.93Total diluted shares outstanding (000s)

650.00

Baseline EPS $11.36 Tax payments by country in $1,575.00 $ 446.43 $ 1,943.84 $ 88.24


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US dollars

a. Total global tax bill, US$ = $1,575.00 + $ 446.43 + $ 1,943.84 + $ 88.24 Total global tax bill, US$ = $ 4,053.51

Part b. Business Performance (000s)

US ParentCompany

(US$)


GermanSubsidiary

(euros, €)


EBT by country, US$ $ 4,500.00 $1,785.71 $4,859.61 $ 294.12 Consolidated EBT $11,439.44 Total Global tax bill in $ $ 4,053.51 Carlton's Effective tax rate 35.43%

Calculation Notes: Consolidated EBT = $ 4,500.00 + $1,785.71 + $4,859.61 + $ 294.12Consolidated EBT = $11,439.44 Total global tax bill, US$ = $ 4,053.51

=> $ 4,053.51 ÷ $11,939.44 = 35.43% c. What would be the impact on Carlton's EPS and global effective tax rate if

Germany instituted tax cut to 28% and German subsidiary earnings rose to 5 million euros?

After plugging in the new values, EPS = $ 12.86 Effective tax rate = 30.20%

S.No.

1 2 1 x 2 = 3 4 3 ÷ 4 = 5

Amount Tax rate


Exchange Rate

Corporate Income taxes in $

US Parent Company (US$) 4,500.00 35% $ 1,575.00 ----- $1,575.00Brazilian Subsidiary (reais, R$) 6,250.00 25% R$ 1,562.50 R$3.5000 /$ $ 446.43 German Subsidiary (Euros, €) 4,500.00 28% € 1,260.00 €0.92600 /$ $ 1,360.69 Chinese Subsidiary (Renminbi, Rmb) 2,500.00 30% Rmb 750.00 Rmb 8.5000 $ 88.24

Total global tax bill, US$ = $1,575.00 + $ 446.43 + $ 1,360.69 + $ 88.24Total global tax bill, US$ = $ 3,470.39 Consolidated EBT = $ 4,500.00 + $1,785.71 + $ 4,911.53 + $ 294.12Consolidated EBT = $11,491. 36


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=> $ 3,470.39 ÷ $11,491..36 = 30.20% Effective tax rate

Chapter-2

The International Monetary System (IMS)


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Chapter # 2 “The International Monetary System”

Problem # 2.1: Frankfurt & New York. In Frankfurt & New York one can buy a U.S. dollar for €0.9200. In New York, one can buy a euro for $1.0870. What is the foreign exchange rate between the dollar & the euro?

Given Data

One can buy a U.S. dollar = €0.9200 / $ (Indirect Quotation) One can buy a Euro = $1.0870 / € (Direct Quotation) Foreign Exchange Rate between = ?

Solution: €0.9200 / $ or $ 1.087 / € $1.0870 / € or € 0.92 / $

Problem # 2.2 : Peso Exchange Rate Changes. In December 1994 the govt. of Mexico officially changed the value of Mexican peso from 3.20 peso per dollar to 5.50 peso per dollar. Was this devaluation, revaluation, depreciation, or appreciation? What was the percentage change?

Solution: Given Data

Initial Exchange Rate = Ps 3.20 / $Devalued Exchange Rate = Ps 5.50 / $

To find percentage change, we use indirect quotation formula, which is given as under;


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Anytime a government sets or resets the value of its currency, it is a managed or fixed exchange rate. If that is the case, any change in its official value must be either a "revaluation" or "devaluation." In this case, devaluation is occurred. This is evident from the fact that it now takes more pesos per U.S. dollar, so its value is less or devalued. In terms of the percentage change calculation, this is indicated by the negative percentage change.

Rechecking Method: To find percentage change, we use direct quotation formula in U.S., which is given as under; Initial Exchange Rate = Ps3.20 / $ or $ 0.1818/ Ps Devalued Exchange Rate = Ps5.50 / $ or $ 0.3125/ Ps

In this case, devaluation is occurred. Hence, verified.


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Problem #2.3: Good as Sold. Under the gold standard the price of the ounce of gold of U.S. dollars was $20.67 while the price of the same ounce of British pounds was £4.2474. What would the exchange rate between the dollar and the pound be if the U.S. dollar price had been $38.00 per ounce? Solution: Given Data The U.S. dollar price = $20.67 per ounce The U.S. dollar price = $38.00 per ounce The British pounds price = £4.2474 per ounce

Problem # 2.4: Gold Standard. Before World War I, $20.67 was needed to buy one ounce of gold. If, at the same time one ounce of gold can be purchased in France for FF310.00 what was the exchange rate between French francs & U.S dollars?


The U.S. dollar price = $20.67 per ounce The French franc price = FF 310.0 0 per ounce

Problem # 2.5: Spot Rate Customer. The spot rate for Mexican pesos is Ps9.5200/$. If your company buys Ps 100,000 spot from bank on Monday, how much must your company pay & on what day? Solution: Given Data The spot rate for Mexican pesos = Ps 9.5200 / $ or $0.105042 / Ps If your company buys = Ps 100,000 spot on Monday


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It depends on company that the amount pays in pesos or dollars on Monday.

Problem # 2.6: Forward Rate. The 180-day forward rate for the euro is quoted at €0.9210/$. If your company buys € 100,000 forward 180-days on September 6, 2003, how much must your company pay & on what date to settle the forward agreement? Solution: Given Data

180-day forward rate for the Euro is quoted = € 0.9210/ $ or $ 1.0857 / € If your company buys = €100,000 forward 180-days on September 6, 2003

It depends on company that the amount pays in euro or dollars. The forward agreement will settle on March 8, 2004 on Monday.

Problem # 2.7: Forward Discount on the dollars. What is the forward discount on the dollar if the spot rate is $ 1.0200 / € & 180-days forward rate is $ 1.0858 / €? Solution: Given Data Spot rate is =1.0200 / € 180-days forward rate is = $ 1.0858 / €


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Problem #2.8: Forward Premium on the euro. What is the forward premium on the euro if the spot rate on September 3, 2003 is € 0.9804 / $ & 180-days forward rate is € 0.9210 / $? Solution: Given Data Spot rate = € 0.9804 / $ 180-days Forward rate = € 0.9210 / $


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Note: Problem# 7 & 8 are opposite in rates. Both questions answer are same becauseSpot Rate = $ 1.0200 / € or € 0.9804 / $ 180 Days Forward Rate = $ 1.0858 / € or € 0.9210 / $


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Problem # 2.9: Iraqi Imports. A European-based manufacturer ships a machine tool to a buyer in Jordan at a sale price of €375,000. Jordan imposes a 12% import duty on all products purchased from the European Union. The Jordanian importer then re-exports the product to an Iraqi importer, but only after imposing their own resale fee of 22%. Given the following spot exchange rates on January 30, 2003, what is the total cost to the importer in Iraqi dinar, and what is the U.S. dollar equivalent of that price?Spot rate, Jordanian dinar (JD) per euro (€) JD 0.7597 / €Spot rate, Jordanian dinar (JD) per dollar ($) JD 0.7051 / $Spot rate, Iraqi dinar(ID) per Jordanian dinar (JD) ID 3,843 / JD Spot rate, Iraqi dinar (ID) per dollar ($) ID 2,710 / $

Solution: Given DataSale price, in euros (€) = € 375,000Jordanian import duty on EU products = 12% Jordanian resale fees = 22% Spot rate, Jordanian dinar (JD) per euro (€) = JD 0.7597 / €Spot rate, Jordanian dinar (JD) per dollar ($) = JD 0.7051 / $Spot rate, Iraqi dinar(ID) per Jordanian dinar (JD) = ID 3,843 / JD Spot rate, Iraqi dinar (ID) per dollar ($) = ID 2,710 / $

What is the dollar price after all exchanges and fees?

Sale price, ( in JD) = Sale price ( in € ) x Spot rate JD/€ Sale price, ( in JD) = €375,000 x JD 0.7597 / € = JD 284887.50

Jordanian import duty = Sale price, ( in JD) x Import duty( in JD) Jordanian import duty = JD 284887.50 x 12% = JD 34,186.50

Total cost, (in JD) = Sale price, ( in JD) + Jordanian import duty Total cost, (in JD) = JD 284887.50 + JD 34,186.50 Total cost, (in JD) = JD 319,074 Jordanian resale fees= Total cost, (in JD) x Jordanian resale fees Jordanian resale fees = JD 319,074 x 22% = JD 70,196.28


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Resale price to Iraq , in JD = Total cost, (in JD) + Jordanian resale fees Resale price to Iraq , in JD = JD 319,074 + JD 70,196.28 Resale price to Iraq, in JD = JD 389,270.28

Price paid in Iraqi diner = Resale price to Iraq ( in JD ) X Spot rate ID / JD Price paid in Iraqi diner = JD 389,270.28 X ID 3,843 / JD Price paid in Iraqi diner = ID 1,495,965,686

US dollar equivalent of final price paid: US dollar equivalent = Price paid in Iraqi diner ÷ Spot rate ID / $ US dollar equivalent = ID 1,495,965,686 ÷ ID 2,710 / $ US dollar equivalent = $552,016.8583 = $552,017

Summary of all steps of Problem#2.9:

What is the dollar price after all exchanges and fees? Amount Purchase price, converted to Jordanian diner (JD) €375,000 x JD 0.8700 / € JD 284887.50Additional fees due on importationJD 284887.50 x 12% 34,186.50 Total cost, Jordanian diner (JD) JD 319,074.00 Resale fee in Jordan (JD 319,074 x 22%) 70,196.28 Resale price to Iraq , in JD JD 389,270.28 Price paid in Iraqi diner, converting JD to Iraq JD 389,270.28 X ID 3,843 / JD ID 1,495,965,686.00 US dollar equivalent of final price paid. ID 1,495,965,686 ÷ ID 2,710 / $ $552,017


27


Chapter-3

Balance of Payments


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Chapter # 3 “Balance of Payments”

Problems# 3.1 - 3.4: Australia's Current Account. Australia’s Current Account, Use the following data from the IMF Fund to answer questions 1 through 4.

Assumptions (millions of US dollars) 1998 1999 2000Goods: exports 55,884 56,096 64,041Goods: imports 61,215 65,826 68,752 Balance on goods -5,331 -9,730 -4,711Services: credit 16,181 17,354 18,346Services: debit 17,272 18,304 18,025 Balance on services -1,091 -950 321Income: credit 6,532 6,909 8,590Income: debit 17,842 19,211 19,516 Balance on income -11,310 -12,302 -10,926Current transfers: credit 2,651 3,003 2,629Current transfers: debit 2,933 3,032 2,629 Balance on current transfers -282 -29 0

Solution:

Assumptions (millions of US dollars) 1998 1999 20003.1 What is Australia's balance on goods? Goods: exports 55,884 56,096 64,041 Less: Goods: imports 61,215 65,826 68,752 Balance on goods -5,331 -9,730 -4,7113.2 What is Australia's balance on services? Services: credit 16,181 17,354 18,346 Less: Services: debit 17,272 18,304 18,025 Balance on services -1,091 -950 321


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3.3 What is Australia's Balance on goods & service? Balance on goods -5,331 -9,730 -4,711 Add : Balance on services -1,091 -950 321 Balance on goods & service -6,422 -10,680 -4,3903.4 What is Australia's current account balance? Add:Balance on goods -5,331 -9,730 -4,711 Balance on services -1,091 -950 321 Balance on income -11,310 -12,302 -10,926 Balance on current transfers -282 -29 0 Australia's C/A balance -18,014 -23,011 -15,316

Problems# 3.5 - 3.9: Uruguay's Current Account.

Assumptions (millions of US dollars) 1998 1999 2000Goods: exports 2,829 2,291 2,380Less: Goods: imports 3,601 3,187 3,316 Balance on goods -772 -896 -936Services: credit 1,319 1 ,262 1,354Less: Services: debit 884 802 900 Balance on services 435 460 454Income: credit 608 736 761Less: Income: debit 806 879 937 Balance on income -198 -143 -176Current transfers: credit 75 78 71Less: Current transfers: debit 16 5 5 Balance on current transfers 59 73 66

Solution:

Questions 1998 1999 20003.5 What is Uruguay's balance on goods? -772 -896 -9363.6 What is Uruguay's balance on services? 435 460 4543.7 What is Uruguay's balance on goods and services? -337 -436 -4823.8 What is Uruguay's balance on goods, services and income?


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Add: Balance on goods -772 -896 -936 Balance on services 435 460 454 Balance on income -198 -143 -176 Total -535 -579 -6583.9 What is Uruguay's current account balance?

Add: Balance on goods -772 -896 -936 Balance on services 435 460 454 Balance on income -198 -143 -176 Balance on current transfers 59 73 66 Uruguay's C/A balance -476 -506 -592

Problems#3.10 - 3.13: Myanmar's Balance of Payments

Assumptions (millions of US dollars) 1998 1999 2000A. Current account balance -494.2 -281.9 -243B. Capital account balance 0 0 0C. Financial account balance 535.1 248.8 160.1D. Net errors and omissions 18.8 -12.3 59.6E. Reserves and related items -59.7 45.4 23.3

Solution:

Questions 1998 1999 20003.10 Is Myanmar experiencing a net capital inflow (+) or outflow (-)?

535.1“inflow”

248.8 “inflow”

160.1 “inflow”

3.11 What is Myanmar's Total for Groups A and B? ( A+B) -494.2 -281.9 -2433.12 What is Myanmar's Total for Groups A through C? ( A+B+C) 40.9 -33.1 -82.93.13 What is Myanmar's Total for Groups A through D? ( A+B+C+D) 59.7 -45.4 -23.3


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Problems# 3.14 - 3.20 Argentina's Balance of PaymentsProblems 3.14 - 3.20 Argentina's Balance of Payments Assumptions (millions of US dollars) 1998 1999 2000A. Current Account Goods: exports 26,433 23,309 26,409 Less: Goods: imports 29,532 24,103 23,851 Balance on goods -3,099 -794 2,558 Services: credit 4,618 4,446 4,536 Services: debit 9,127 8,601 8,871 Balance on services -4,509 -4,155 -4,335 Income: credit 6,121 6,085 7,397 Income: debit 13,537 13,557 14,879 Balance on income -7,416 -7,472 -7,482 Current transfers: credit 711 688 641 Current transfers: debit 313 306 352 Balance on current transfers 398 382 289 Current Account Balance (Group A) -14,626 -12,039 -8,970B. Capital Account (Group B) 73 88 87C. Financial Account Direct investment in Argentina 7,292 23,984 11,665 Less: Direct investment abroad 2,326 1,354 1,113 Direct investment in Argentina, net 4,966 22,630 10,552 Portfolio investment assets, net -1,905 -2,129 -1,060 Portfolio investment liabilities, net 10,693 -4,782 -1,332 Balance on other investment assets &

liabilities, net 5,217 -1,026 -50D. Net Errors and Omissions -328 -729 -403E. Reserves and Related Items -4,090 -2,013 1,176


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Solution: Questions 1998 1999 2000

3.14 What is Argentina's balance on goods and services?

Balance on goods -3,099 -794 2,558 Balance on services -4,509 -4,155 -4,335 Total -7,608 -4,949 -1,777

3.15 What is Argentina's current account balance?

Balance on goods -3,099 -794 2,558 Balance on services -4,509 -4,155 -4,335 Balance on income -7,416 -7,472 -7,482 Balance on current transfers 398 382 289 Total -14,626 -12,039 -8,9703.16 What seems to have been the primary

driver in Argentina’s current account balance?

income debit

-7,416

Incomedebit

-7,472

income debit

-7,482

3.17 What is Argentina's financial account balance?

Add: Direct investment in Argentina, net 4,966 22,630 10,552 Portfolio investment assets, net -1,905 -2,129 -1,060 Portfolio investment liabilities, net 10,693 -4,782 -1,332 Balance on other investment assets &

liabilities, net 5,217 -1,026 -50 Total 18,971 14,693 8,110


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3.18 What is Argentina's Total for Groups A through C?

Current Account Balance (Group A) -14,626 -12,039 -8,970 Capital Account (Group B) 73 88 87 Financial Account ( Group C) 18,971 14,693 8,110 Total 4,418 2,742 -773

3.19 What is Argentina's Total for Groups A through D?

Current Account Balance (Group A) -14,626 -12,039 -8,970 Capital Account (Group B) 73 88 87 Financial Account ( Group C) 18,971 14,693 8,110 Net Errors and Omissions -328 -729 -403 Total 4,090 2,013 -1,176

3.20 Unless the financial account could grow a very large. Yes, the financial account could grow a very large as the amount is consider as

surplus & a crisis will ensue.

Argentina's financial account balance?

Add:Direct investment in Argentina, net 4,966 22,630 10,552 Portfolio investment assets, net -1,905 -2,129 -1,060 Portfolio investment liabilities, net 10,693 -4,782 -1,332 Balance on other investment assets &

liabilities, net 5,217 -1,026 -50 Total 18,971 14,693 8,110


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Chapter-4

Foreign Exchange Market (FEM)


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Chapter # 4 “Foreign Exchange Markets”

Problem#4.1: Ringgit up or down? Before the Asian currency crises the Malaysian ringgit traded at RM 2 .7000 /$. It currently traded at RM 3.8000 /$. Did the ringgit appreciate or depreciate & by what percentage?


Malaysian ringgit, before the crisis = RM 2 .7000 /$.Malaysian ringgit, after the crisis = RM 3.8000 /$. Calculation: We use indirect quotation formula for finding percentage change.


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Rechecking Method: We use direct quotation formula for finding percentage change.


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Problem#4.2: Forward Premium & Discounts. Spot & 180-day forward exchange rate for several major currencies follow. For each pair, calculate the percentage premium or discounts expressed as an annual rate. Quoted spot rate 180-days forward rate

Currencies Spot Rate

Forward Rate

European euro $ 0.8000/ € $0.81600/€British pound $1.562/£ $1.5300/£Japanese yen ¥ 120.00/ $ ¥118.00/$Swiss franc SF 1.6000/ $ SF1.6200/$Hong Kong dollar HK$ 8.0000/$ HK$7.8000/$


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39



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Summary:

Assumptions Quotation

QuotedSpot rate

180-dayForward rate

Percent premium or discount per annum

Premiumor Discount

Days forward 180 European euro ($/euro) Direct 0.8000

0.8160 + 4.0000% Premium

British pound ($/pound) Direct

1.5620

1.5300 - 4.0973% Discount

Japanese yen (yen/$) Indirect

120.00

118.00 + 3.3898% Premium

Swiss franc (SF/$) Indirect

1.6000

1.6200 - 2.4691% Discount

Hong Kong dollar (HK$/$) Indirect

8.0000

7.8000 + 5.1282% Premium


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Problem#4.3: Trading in Switzerland. Solution: You receive the following quotes for Swiss francs against the dollar for spot, one-month forward, 3-months forward, and 6 months forward. Calculate the outright quotes.

Assumptions ValuesSpot exchange rate: Bid rate (SF/$) 1.6075 Ask rate (SF/$ 1.6085 One-month forward 10 to 153-months forward 14 to 226-months forward 20 to 30

Mid Rate = 1.6075 + 1.6085 / 2 = 1.608 Spread = 1.6085 – 1.6075 = 0.001

b) What do you notice about the spread as quotes moves from six months forward? Why do you this occurs?

It widens, most likely a result of thinner and thinner trading volume.


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Problem# 4.4: Yen Forward Premium. Using the mid rate yen quotes in Exhibit 4.5: Solution: Calculate the forward premiums for the yen in Exhibit 4.5.

Terms

¥/$Bid Rate (spot)

¥/$Ask Rate(forward)

*Mid Rates(¥/$)

ImpliedDays

Forward ‘n’

a)Calculated**Forward Premium

Cash Rates

Spot 118.27 118.37 118.32

1 week -10 -9 118.23 7 3.9149%

1 month -51 -50 117.82 30 5.0925%

2 months -95 -93 117.38 60 4.8049%

3 months -143 -140 116.91 90 4.8242%

4 months - 195 -190 116.40

120 4.9485%

5 months - 240 -237 115.94

150 4.9267%

6 months -288 -287 115.45

180 4.9718%

9 months -435 -429 114.00

270 5.0526%

1 year -584 -581 112.50

360 5.1733%

Swap Rates

2 year -1150 -1129 106.93

720 5.3259%

3 year -1748 -1698 101.09 1,080 5.6814%

4 year -2185 -2115 96.82

1,440 5.5515%

5 year -2592 -2490

92.91

1,800 5.4698%


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* Mid rate = Bid + Ask / 2** Forward Premium = (S – F / F) x (360 / n) x 100 (Indirect Quotation)

b) Explain how the forward perineum of discount changes as maturities gets longer? The premium is gradually getting larger as the maturity lengthens to one year. After one year it seemingly stabilizes at about 5.5% to 5.6%. The forward rates progressively require fewer and fewer Japanese yen per dollar than the current spot rate. Therefore the yen is selling forward at a premium and the dollar is selling forward at a discount. The 24 month forward rate has the smallest premium, while the 1 month forward possesses the largest premium. Problem #4.5: Euro Forward Premium. Using the mid rate euros quotes in Exhibit 4.5:Solution: Calculate the forward premiums for the euro in Exhibit 4.5.

Terms

$/€Bid Rate (spot)

$/€Ask Rate(forward)

*Mid Rates$/€

ImpliedDays

Forward ‘n’

a)Calculated**Forward Premium

Cash Rates

Spot 1.0897 1.0901 1.0899

1 week 3 4 1.0903 7 1.8875%

1 month 17 19 1.0917 30 1.9818%

2 months 35 36 1.0934 60 1.9268%

3 months 53 54 1.0953 90 1.9818%

4 months 72 76 1.0973

120 2.0369%

5 months 90 95 1.0992

150 2.0479%

6 months 112 113 1.1012

180 2.0736%

9 months 175 177 1.1075

270 2.1531%

1 year 242 245 2.2387%


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1.1143 360

Swap Rates

2 year 481 522 1.1401

720 2.3030%

3 year 750 810 1.1679 1,080 2.3855%

4 year 960 1,039 1.1899

1,440 2.2938%

5 year 1,129 1,276

1.2102

1,800 2.2075%

* Mid rate = Bid + Ask / 2 ** Forward Premium = (F- S / S) x (360 / n) x 100 (Direct Quotation)

b). Explain how the forward perineum of discount changes as maturities gets longer? The premium is getting larger, but then diminishes somewhat for years 4 and 5.

Problem# 4.6: Traveling: Copenhagen to St. Petersburg. On your post-graduation celebratory trip you are leaving Copenhagen, Denmark for St. Petersburg, Russia. Denmark’s currency is the krone (Denmark, although an EU member, is not a participant in the euro itself, but rather maintains a managed rate against the euro.)You leave Copenhagen with 10,000 Danish kroner still in your wallet. Wanting to exchange all of these for Russian rubles, you obtain the following quotes.Solution:Assumptions ValuesBeginning your trip with Danish krone DKr 10,000.00 Spot rate (Dkr/$) DKr 8.5515 / $ Spot rate (Ruble/$) Ruble 30.962/ $


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Problem#4.7: Riskless Profit on the Franc. The following exchange rates are available to you. (You can buy or sell at the stated rates.)

Assumptions ValuesBeginning funds in Swiss francs (SF) 10,000,000.00 Mt. Fuji Bank (yen/$) ¥120.00 /$Mt. Rushmore Bank (SF/$) SF1.6000 /$Matterhorn Bank (yen/SF) ¥ 80.00 / SF or SF 0.0125

Solution:


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Problem# 4.8: Trans Atlantic Arbitrage. A corporate treasury with operations in New York simultaneously calls Citibank in mid-town New York City and Barclays in London. The two banks give the following quotes at the same time on the euro. Citibank NYC quotes = $ 0.9650 – 70 / € Barclays London quotes = $ 0.9640 – 60 / € Explain, using $1 million or its euro equivalent, how the corporate treasury could make geographic arbitrage profit with the two different exchange rates quotes.


Beginning funds = $1,000,000.00

S.No. Citibank NYC quotes:

Barclays London quotes:

Bid (Buying) $0.9650 / € $0.9640 / € Ask (selling ) $0.9670 /€ $0.9660 / €


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Problem# 4.9: Wall Street Journal quotes and premiums. Calculate the percentage premium or discount from the data in Exhibit 4.6.Solution: Exhibit 4.6.

Assumptions

US$ equivalent

Thu

US$ equivalent

Wed£ / US$

Thu£ / US$

Wed

Britain (Pound) 1.4443

1.4475 0.6924 0.6908 1-month forward ( n=30days)

1.4418

1.4452

0.6936

0.6919

3-months forward( n=90days)

1.4371

1.4401

0.6958

0.6944

6-months forward( n=180days)

1.4301

1.4336

0.6993

0.6975


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a) Forward premium (discount). To calculate the forward premium or discount for $/£, we use direct quotation formula, which is given as under; % premium or discount = (F-S) / (S) x (360/ n) x 100

To calculate the forward premium or discount for £/$, we use indirect quotation formula, which is given as under; % premium or discount = (S-F) / (F) x (360 / n) x 100 Forward premium (discount)

Assumptions

US$ equivalent

Thu

US$ equivalent

WedPound/US$

ThuPound/US$

Wed 1-month forward -2.0771% -1.9067% -2.0761% -1.9078% 3-months forward -1.9940% -2.0449% -1.9546% -2.0737% 6-months forward -1.9664% -1.9206% -1.9734% -1.9211%

b) Why are the forward discounts not identical? Yes, the forward discounts of dollar & pounds are not identical. They would be if

the "£/$" quote is calculated as the reciprocal of "US$ equivalent" carrying the digits.

Problem#4.10: Finanial Times quotes. Solution: Using the spot and forward quotes on the British pound in Exhibit 4.5 in the chapter, demonstrate how the Financial Times is calculating the forward premiums on the:One month forward rateThree months forward rateOne year forward rate

From Exhibit 4.5 ValuesSpot rate, closing mid-point $1.4446 / £One month forward rate 1.4421 % PA (per annum) 2.1%Three months forward rate 1.4374 % PA (per annum) 2.0%One year forward rate 1.4183


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% PA (per annum) 1.8%

Direct quotation formula is used for calculating the forward premium:(F-S)/(S) x (360 / n) x 100

One month rate (n=30). 2.0767%Three months rate (n=90). 1.9936%One year rate (n=180). 1.8206%

Note. These premiums are all actually "negative" in the precise calculation formula, but are reported as positives in Financial Times quotes.

Problem# 4.11: Venezuelan Bolivar (A)Solution: The Venezuelan government officially floated the Venezuelan bolivar (Bs) in February 2002. Within weeks, its value had moved from the pre-float fix of BS778/$ to Bs1025/$. Beginning rate = S1= Bs 778 / $ Ending rate = S2 = Bs 1,025 / $

a) Is this a devaluation or depreciation?This is a case in which a government has changed its currency from a governmentally determined fixed rate, to a regime in which the currency is allowed to change in value based on supply and demand forces in the market. As a result of the move, the currency's value in this case was “depreciation” against the U.S. dollar.

b) By what percentage did its value change? We use indirect quotation formula for percentage change:


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Problem# 4.12: Venezuelan Bolivar (B). The Venezuelan political and economic crisis deepened in late 2002 and early 2003. On January 1st, 2003, the bolivar was trading at Bs1400/$. By February 1st, its value had fallen to Bs1950/$. Many currency analysts and forecasters were predicting that the bolivar would fall an additional 40% from its February 1st value by early summer 2003.Solution: Given Data Exchange rate, January 1, 2003 = Bs 1,400 / $ Exchange rate, February 1, 2003 = Bs 1,950 / $ Forecast fall in value from Feb 1 to early summer, 2003 = - 40.0%

a) What was the percentage change in January? Calculation:


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b) Forecast value for June 2003?


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Problem# 4.13: Indirect Quotation on the DollarSolution: Given Data Quoted Spot rate = € 1.0200/$ 90-day Forward rate = € 1.0300/$ Days forward = 90-dayCalculation:

The euro would be selling forward at a premium against the dollar, or equivalently, the dollar selling forward against the euro at a discount. In a way, the terminology is a bit tricky. One might say that the "forward premium is a premium."

Rechecking Method: One way to check percentage change calculations is to invert each of the currency quotes (1 ÷ €/$ ), and recalculate the quote using the direct quotation formula.


55


Hence, rechecked

Problem#4.14: Direct Quotation on the DollarSolution: Quoted Spot rate = $ 1.5500 / £ 6-month Forward rate = $ 1.5600 / £ Days forward = 180-day

Calculation:


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The forward rate requires fewer US dollars in exchange for pounds than the current spot rate. The dollar is therefore selling forward at a premium against the pound & the pound is simultaneously selling forward at a discount versus the US dollar.Checking Method: One way to check percentage change calculations is to invert each of the currency quotes (1 ÷ $/£), and recalculate the quote using the indirect quotation formula.


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Problem# 4.15: Mexican Peso - European Euro Cross Rates. Given the following two exchange rates: Mexican peso Ps: Ps10.20 / $ Euro €: & € 1.02 / $.Calculate the cross rate between the Mexican peso (Ps) and the euro (€). Solution:Calculations:


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Problem# 4.16: Around the Horn. Assuming the following quotes, calculate how a market trader at Citibank with $1,000,000 can make an inter-market arbitrage profit.

Assumptions Exchange rateCitibank quote: ($/£) $ 1.5400 / £National Westminster quote: (€/£) € 1.6000 / £ or £ 0.6250 / €Deutschebank quote: ($/€) $ 0.9700 / €Initial investment $ 1,000,000.00

Solution:


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60


Chapter # 5

Foreign Currency Derivatives


61


Chapter # 5 “Foreign Currency Derivatives”

Problem#5.1: Peso Futures. Amber McClain, the currency speculator we met earlier in the chapter, sells eight June futures contracts for 500,000 pesos at the closing price quoted in Exhibit 5.1.

a. What is the value of her position at maturity if the ending spot rate is$0.12000/Ps? b. What is the value of her position at maturity if the ending spot rate is $0.09800/Ps? c. What is the value of her position at maturity if the ending spot rate is $0.11000/Ps?

Solution: Assumptions

a) b) c)Values Values Values

Number of pesos per futures contract 500,000 500,000 500,000Number of contracts 8 8 8Buy or sell the peso futures? Sell Sell SellEnding spot rate $0.12 / Ps $0.10 / Ps $0.11 / Ps June futures settle price from Exhibit 5.1 ($/ Ps) Note: Short Position will gain if spot price fall below future price $0.11 $0.11 $0.11


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Interpretation: Amber buys at the spot price and sells at the futures price. If the futures price is greater than the ending spot price, she makes a profit otherwise she makes loss.Problem# 5.2: Pounds Futures. Michael Palin, a currency trader for a New York investment firm, uses the following futures quotes on the British pound to speculate on the value of the British pound.

a. If he buys 5 June pound futures, and the spot rate at maturity is $1.3980/pound, what is the value of his position?b. If he sells 12 March pound futures, and the spot rate at maturity is $1.4560/pound, what is the value of his position?c. If he buys 3 March pound futures, and the spot rate at maturity is $1.4560/pound, what is the value of his position?d. If he sells 12 June pound futures, and the spot rate at maturity is $1.3980/pound, what is the value of his position?

British Pound Futures, US$/pound (CME) Contract = 62,500₤

Maturity Open High Low Settle Change High

Open Interest

March 1.4246 1.4268 1.4214 1.4228 0.0032 1.470

25,605

June 1.416 1.4188 1.4146 1.4162 0.0030 1.455 809

Solution:

Assumptionsa) b) c) d)

Values Values Values ValuesNumber of pounds (₤) per futures contract £62,500 £62,500 £62,500 £62,500Maturity month June March March JuneNumber of contracts 5 12 3 12Given condition in question. buys sells buys sellsEnding spot rate ($/₤) $1.39.80/₤ $1.4560/₤ $1.4560/₤ $1.39.80/₤Pound futures contract, settle price (given in table ) $1.4162/₤ $1.4228/₤ $1.4228/₤ $1.4162/₤ Spot – Future $ (0.0182) $ 0.0332 $0.0332 $ (0.0182)Analysis of spot & futures rate S<F S>F S>F S<F


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Problem#5.3: Hans Schmidt, euro Speculator. Hans is once again speculating on the movement of currencies. Hans has $10 million to begin with, and he must state all profits at the end of any speculation in U.S. dollars. The spot rate on the euro is $0.8850/€, while the 30-day forward rate is $0.9000/€.

a. If Hans believes the euro will continue to slide in value against the U.S. dollar, so that he expects the spot rate to be $0.8440/€ at the end of 30 days, what should he do?

b. If Hans believes the euro will appreciate in value against the U.S. dollar, so that he expects the spot rate to be $0.9440/€ at the end of 30 days, what should he do?


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Solution:


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Problem# 5.4: Hans Schmidt, Swiss franc Speculator. Similar to the situation Hans saw in the chapter, Hans believes the Swiss franc will appreciate versus the U.S. dollar in the coming three-month period. He has $100,000 to invest. The current spot rate is $0.5820/SF, the three-month forward rate is $0.5640/SF, and he expects the spot rates to reach $0.6250/SF in three months.


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a. Calculate Hans’ expected profit assuming a pure spot market speculation strategy.b. Calculate Hans’ expected profit assuming he buys or sells SF three months forward.

Solution: Hans Schmidt uses $100,000 to speculate on the Swiss franc.

Assumptions Part (a) Values

Part (b)Values

Initial investment (funds available) $100,000 $100,000 Current spot rate ($/SF) $ 0.5820 / SF $ 0.5820 / SF Six-month forward rate ($/SF) $ 0.5640 / SF $ 0.5640 / SF Expected spot rate in six months ($/SF) $ 0.6250 / SF $ 0.6250 / SF


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Problem# 5.5: Katya & the yen. Katya Berezovsky works in the currency trading unit of Sumara Workers Bank in Togliatti, Russia. Her latest speculative position is to profit from her expectation that the U.S. dollar will rise significantly against the Japanese yen. The current spot rate is ¥120.00/$. She must choose between the following 90-day options on the Japanese yen: Option Strike price Premium Put on yen ¥125/$ $0.00003/¥Call on yen ¥125/$ $0.00046/¥

a) Should Katya buy a call on yen or a put on yen?b) Using your answer in part a, what is Katya’s break even price?


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c) What is Katya’s gross profit and net profit (including premium) if the ending spot rate is 140 ¥/$?

Given Data

Current spot rate = ¥ 120/$ or $0.00833/¥Expected ending spot rate in 90 days = ¥ 140/$ or $0.00714/¥Maturity of option = 90 daysStrike price on Put on Yen = ¥125/$ or $0.00800/¥Strike price on call on Yen = ¥125/$ or $0.00800/¥Premium on Put on Yen = 33,333/$ or $0.00003/¥Premium on call on Yen = 2,174 or $0.00046/¥

Solution: a) Ans. Katya should buy a put on yen to profit from the rise of the dollar (the fall of

the yen). Katetya should buy a put on yen because the strike rate is greater then the spot rate.

Strike rate > Spot rate ¥125/$ > ¥ 120/$

b). Using your answer in part a, what is Katya’s break even price?Ans. Katya buys a put on yen. She pays premium today. In 90 days, to exercises the

put, receiving US dollar. (Note: We take values in terms of $/¥ to find Break even point, Gross profit & Net profit)

=> Break Even Price = Strike Price on put on Yen - Premium

Break Even Price = $0.00800/¥ - $0.00003/¥ Break Even Price = $0.00797/¥

c). What is Katya’s gross profit and net profit (including premium) if the ending spot

rate is ¥140 /$?

Ans. => Gross Profit = Strike Price – Ending spot rate

Gross Profit = $0.00800/¥ - $0.00714/¥ Gross Profit = $0.00086/¥

=> Net Profit = Strike Price – Ending spot rate – Premium Net Profit = $0.00800/¥ – $0.00714/¥ – $0.00003/¥


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Net Profit = $0.00800/¥ – $0.00717/¥ Net Profit = $ 0.00083/¥

Problem# 5.6: Samuel’s bet. Samuel Samosir of Peregrine Investments in Jakarta, Indonesia, focuses nearly all of his time and attention on the U.S. dollar/Singapore dollar ($/S$) cross-rate. The current spot rate is $0.6000/S$. After considerable study this week, he has concluded that the Singapore dollar will appreciate versus the U.S. dollar in the coming 90 days, probably to about $0.7000/S$. He has the following options on the Singapore dollar to choose form: Option Strike price Premium Put on S$ $0.6500/S$ $0.00003/S$Call on S$ $0.6500/S$ $0.00046/S$

a). Should Samuel buy a put on Singapore dollar or call on Singapore dollar?b). Using your answer in part a, what is Samuel’s break even price?c). Using your answer in part a, what is Samuel’s gross profit and net profit (including

premium) if the ending spot rate at the end of 90 days is $0.7000/S$?d). Using your answer in part a, what is Samuel’s gross profit and net profit (including

premium) if the ending spot rate at the end of 90 days is indeed $0.8000/S$?

Given DataCurrent spot rate = $0.6000/S$ or S$1.6667/$Expected ending spot rate in 90 days = $0.7000/S$ or S$1.4286/$Maturity of option = 90 daysStrike price on Put on Yen = $0.6500/S$ or S$1.5385/SStrike price on Call on Yen = $0.6500/S$ or S$1.5385/SPremium on Put on Yen = $0.00003/S$ Premium on call on Yen = $0.00046/S$Solution:

a). Should Samuel buy a put on Singapore dollar or call on Singapore dollar? Ans. Samuel should buy a call on Singapore dollar to appreciate versus the US

dollar. Samuel should buy a put on yen because the strike rate is lower then the spot rate. In this case spot rate is greater then the Strike rate.

Spot rate > Strike rate S$1.6667/$ > S$1.5385/S

b). Ans. => Break Even Price = Strike Price on Call on S$ + Premium

Break Even Price = $0.6500/S$ + 0.00046/S$ Break Even Price = $0.65046/S$


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c). Ans.

=> Gross Profit = Ending Spot Rate - Strike Price

Gross Profit = $0.7000/S$ - $0.6500/S$ Gross Profit = $0.05000/S$

=> Net Profit = Ending Spot Rate - Strike Price – Premium

Net Profit = $0.7000/S$ - $0.6500/S$ – 0.00046/S$ Net Profit = $0.7000/S$ – $65046/S$ Net Profit = $0.04954/S$ d. Ans.


Gross Profit = $0.8000/S$ - $0.6500/S$ Gross Profit = $0.15000/S$


Net Profit = $0.8000/S$ - $0.6500/S$ – 0.00046/S$ Net Profit = $0.8000/S$ – $65046/S$ Net Profit = $0.14954/S$

Problem# 5.7: How much profit – calls? assume a call option on euros is written with a strike price of $0.9400/ € at a premium of 0.90000Cents per euro ($0.0090/€) and with an expiration date three months from now. The option is for € 100,000. Calculate your profit or loss if you exercise before maturity at a time when the euro is traded spot at:

a) $0.9000/€ b) $1.0000/€c) $1.0200/€d) $0.9800/€e) $0.9200/€f) $0.9400/€


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g) $0.9600/€

A call option is written on euros. Assumptions

a) b) c) d) e) f) g)Values Values Values Values Values Values Values

Notional principal (euros) 100000 100000 100000 100000 100000 100000 100000Maturity (days) 90 90 90 90 90 90 90Strike price (US$/euro) $0.94 $0.94 $0.94 $0.94 $0.94 $0.94 $0.94 Premium (US$/euro) $0.01 $0.01 $0.01 $0.01 $0.01 $0.01 $0.01 Ending spot rate (US$/euro) $0.90 $0.92 $0.94 $0.96 $0.98 $1.00 $1.02 Gross profit on option $ - $ - $ - $0.02 $0.04 $0.06 $0.08 Less premium -0.009 -0.009 -0.009 -0.009 -0.009 -0.009 -0.009Net profit (US$/euro) ($0.01) ($0.01) ($0.01) $0.01 $0.03 $0.05 $0.07 Net profit, total ($900) ($900) ($900.) $1,100 $3,100 $5,100 $7,100

Problem# 5.8: How much profit – puts? Assume a put option on Japanese yen is written with a strike price of $0.008000¥ (¥125.00/$) at a premium of 0.0080cents per yen and with an expiration date six months from now. The option is for ¥12,500,000. Calculate your profit or loss if you exercise before maturity at a time when the yen is traded spot at

a) ¥110/$b) ¥115/$c) ¥120/$d) ¥125/$e) ¥130/$f) ¥135/$g) ¥140/$


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Solution:

A put option on yen is written.

Assumptions a) b) c) d) e) f) g)Notional principal (¥) 12,500,000 12,500,000 12,500,000 12,500,000 12,500,000 12,500,000 12,500,000Maturity (days) 180 180 180 180 180 180 180Strike price ($/¥) $0.01 $0.01 $0.01 $0.01 $0.01 $0.01 $0.01 Premium ($/¥) $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 Ending spot rate (¥/$) 110 115 120 125 130 135 140in US$/yen $0.01 $0.01 $0.01 $0.01 $0.01 $0.01 $0.01 Gross profit $ - $ - $ - $ - $0.00 $0.00 $0.00 Less premium -0.00008 -0.00008 -0.00008 -0.00008 -0.00008 -0.00008 -0.00008Net profit ($/¥) ($0.00) ($0.00) ($0.00) ($0.00) $0.00 $0.00 $0.00 Net profit, total ($1,000) ($1,000) ($1,000) ($1,000) $2,846.15 $6,407.41 $9,714.29

Problem# 5.9: Falling Canadian dollar.. Giri Patel works for CIBC Currency Funds in Toronto. Giri is something of a contrarians - as opposed to most of the forecasts, he believes the Canadian dollar (C$) will appreciate versus the U.S. dollar over the coming 90 days. The current spot rate is $0.6750/C$. Giri may choose between the following options on the Canadian dollar: Option Strike price Premium Put on S$ $0.7000/C$ $0.00003/C$Call on S$ $0.7000/C$ $0.00249/C$

a). Should Giri buy a put on Canadian dollars or call on Singapore dollars?b). Using your answer in part a, what is Giri’s break even price?c). Using your answer in part a, what is Giri’s gross profit and net profit (including

premium) if the ending spot rate at the end of 90 days is indeed $0.7600/C$?d). Using your answer in part a, what is Giri’s gross profit and net profit (including

premium) if the spot rate at the end of 90 days is indeed $0.8250/C$?


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Current spot rate = $0.6750/C$ or C$1.4815/$Maturity of option = 90 daysStrike price on Put on Yen = $0.7000/C$ or C$1.4286/$Strike price on Call on Yen = $0.7000/C$ or C$1.4286/$ Premium on Put on Yen = $0.00003/C$ Premium on call on Yen = $0.00249/C$

a). Since Giri expects the Canadian dollar to appreciate versus the US dollar, he should buy a call on Canadian dollars. Giri should buy a call on Canadian dollar because the spot rate is greater then the strike rate.

Spot rate > Strike rate C$1.4815/$ > C$1.4286/$

b). Ans. => Break Even Price = Strike Price on Call on S$ + Premium

Break Even Price = $0.70000/C$ + $0.0249/C$ Break Even Price = $0.7249/C$

c). Ans.


Gross Profit = $0.7600/C$ - $0.7000/C$ Gross Profit = $0.0600/C$


Net Profit = $0.7600/C$ - $0.7000/C$ – 0.0249/C$ Net Profit = $0.7600/C$ – $0.7249/C$ Net Profit = $0.0351/C$ d). Ans.


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Gross Profit = $0.8250/C$ - $0.7000/C$ Gross Profit = $0.1250/C$


Net Profit = $0.8250/C$ - $0.7000/C$ – 0.0249/C$ Net Profit = $0.8250/C$ – $0.7249/C$ Net Profit = $0.1001C$

Problem#5.10: Braveheart's Put on Pounds. Andy Furstow is a speculator for a currency fund in London named Braveheart. Braveheart’s clients are a collection of wealthy private investors who, with a minimum stake of £250,000 each, wish to speculate on the movement of currencies. The investors expect annual returns in excess of 25%. Although officed in London, all accounts and expectations are based in U.S. dollars.

Andy Furstow is convinced that the British pound will slide significantly -- possibly to $1.3200/£ -- in the coming 30 to 60 days. The current spot rate is $1.4260/£. Andy wishes to buy a put on pounds which will yield the 25% return expected by his investors. Which of the following put options would you recommend he purchase. Prove your choice is the preferable combination of strike price, maturity, and up-front premium expense.Solution: Andy Furstow of Braveheart wishes to speculate on the fall of the ponds(£);- Given DataCurrent spot rate = $1.4260 / ₤ (£ 0.7012623 / $ ) Expected endings spot rate in 30 to 60 days = $1.3200 /£ (₤0.7575758/ $ )Potential investment principal per person = £250,000.00

Put on Pound Put #1 Put #2 Put #3 Put #4 Put #5 Put #6Strike price ($/£) $1.36 $1.34 $1.32 $1.36 $1.34 $1.32 Maturity (days) 30 30 30 60 60 60

Premium ($/£) $0.00081 $0.0002

1 $0.00004 $0.00333 $0.00150 $0.00060

Solution: Issues for Andy to consider:


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1. Because his expectation is for "30 to 60 days" he should confine his choices to the 60 day options to be sure and capture the timing of the exchange rate change. (We have no explicit idea of why he believes this specific timing.)

2. The choice of which strike price is an interesting debate. The lower the strike price (1.34 or 1.32), the cheaper the option price.

The reason they are cheaper is that, statistically speaking, they are increasingly less likely to end up in the money The choice, given that all the options are relatively "cheap," is to pick the strike price which will yield the required return. The $1.32 strike price is too far 'down,' given that Andy only expects the pound to fall to about $1.32

S.No. Strike RateExpected Spot Rate Strike Rate

Current Spot Rate

Put #1 $1.36/£ < $1.3200/£ $1.36/£ < $1.4260/£Put #2 $1.34/£ > $1.3200/£ $1.34/£ > $1.4260/£Put #3 $1.32/£ = $1.3200/£ $1.32/£ = $1.4260/£ Put #4 $1.36/£ > $1.3200/£ $1.36/£ > $1.4260/£Put #5 $1.34/£ < $1.3200/£ $1.34/£ < $1.4260/£Put #6 $1.32/£ = $1.3200/£ $1.32/£ = $1.4260/£

Buyer of put on pound: Profit = Strike price – (Expected spot rate + Premium )

S.No. Maturity (days)

Strike price

Less: Expected spot rate

Less premium = Net Profit

Put #1 30 $1.36/£ -$1.32/£ -$0.00333 $0.0392Put #2 30 $1.34/£ -$1.32/£ -$0.0015 $0.001979Put #3 30 $1.32/£ -$1.32/£ -$0.0006 ($0.00004)Put #4 60 $1.36/£ -$1.32/£ -$0.00333 $0.03667Put #5 60 $1.34/£ -$1.32/£ -$0.0015 $0.0185Put #6 60 $1.32/£ -$1.32/£ -$0.0006 ($0.0006)

S.No. Maturity (days)

Current Spot Rate

Initial Investment

Initial Investment


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At Current Spot Rate

Put #4 60 $1.4260 / £ £ 250,000.00 $ 356,500Put #5 60 $1.4260 / £ £ 250,000.00 $ 356,500Put #6 60 $1.4260 / £ £ 250,000.00 $ 356,500

S.No.

1 2 3 4 5

Notional Principal (£)

Net Profit or Profit Rate

Total Expectedprofit

Initial Investment At Current Spot Rate ROI

Put #4 £75,075,075.08 $0.03667 $2,753,003.00 $ 356,500.00 772%Put #5 £166,666,666.67 $0.0185 $3,083,333.33 $ 356,500.00 865%Put #6 £416,666,666.67 ($0.0006) ($250,000.00) $ 356,500.00 -70%

Risk: They could lose it all (full premium)

Notes: 1 # If Andy invested an individual's principal purely in this specific option, they would buy

an option of the following notional principal (pounds).2 # Net Profit = Strike price – (Expected spot rate + Premium ) 3 # Long position = Notional Principal x profit rate 4 # Initial investment at current spot rate = £ 250,000 x $1.4260 / £ = $ 356,500 5 # ROI = Total profit ÷ Initial investment at Current Spot rate.


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Problem#5.11: Call Options on British pounds.

Calculating call option premiums for lengthening maturities.

AMERICAN MODEL

PARAMETERSINPU

T Price 3.289Current Spot Rate (US cents/fc) 170 Delta 0.503Foreign Interest Rate (5% as .05) 8.00% Gamma 0.0481Domestic Interest Rate (10% as .1) 8.00% Theta 6.6954

Option (1, CALL; -1, PUT) 1

EUROPEAN MODEL

Strike Rate (US cents/fc) 170 Price 3.302Days to Maturity 90 Delta 0.4999Annual Volatility (10% as .1) 10.00% Gamma 0.0463 Theta 6.4294

The call option premium (baseline calculation shown here), changes with maturity as follows:

MaturityEuropean

Price30 1.93260 2.71490 3.302120 3.787150 4.206


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180 4.578210 4.912240 5.216270 5.496300 5.755330 5.996360 6.222

Days call option on premium (US cents/ pound) is a function of maturity.

Problem#5.12: Put Options on euros.

Calculating put option premiums on two different volatilities.

PARAMETERSINPUT

AMERICAN MODEL

Price 0.402Current Spot Rate (US cents/fc) 1.0840 Delta -0.1692Foreign Interest Rate (5% as .05) 4.00% Gamma 0.0591Domestic Interest Rate (10% as.1) 2.00% Theta 2.582

Option (1, CALL; -1, PUT) -1

EUROPEAN MODEL

Strike Rate (US cents/fc) 104 Price 0.046 Days to Maturity 90 Delta -0.1722 Annual Volatility (10% as .1) 8% Gamma 0.059 Theta 0.4023

The input set shown here is for the 8.00% volatility valuation. Replacing 8% with 12% will yield the following.

Results: The put option premium based on volatility:

Volatility Premium(cents/euro) Premium($/€)


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8% 0.406 $0.00 12% 1.037 $0.01

Problem# 5.13: Solar Turbines and Venezuelan bolivares.

Calculating put option premiums on a devaluing currency.

Assumptions Bolivares/$ $/BolivaresCents/Boliv

aresSpot rate 1,600.00 $0.00 0.0625Strike rate 1,800.00 $0.00 0.05555556Notional principal (US$) $250,000.00 Notional principal (bolivares) 400,000,000

AMERICAN MODEL

PARAMETERS INPUT Current Spot Rate (US cents/fc) 0.0625 Price 0.001Foreign Interest Rate (5% as .05) 24.00% Delta -0.2279Domestic Interest Rate (10% as .1) 2.00% Gamma 48.1162

Theta 0.0069


EUROPEAN MODEL

Strike Rate (US cents/fc) 0.0556 Price 0.001Days to Maturity 90 Delta -0.2336Annual Volatility (10% as .1) 20.00% Gamma 48.0299 Theta 0.0009


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The calculated put option premium: (cents per bolivar) 0.001 Divided by 100 for cents/$ (this is $/bolivar, premium) $0.00 Notional principal of bolivares 400,000,000 Total cost of put option $4,000

Problem# 5.14: Vitro de Mexico.

Calculating a call option premium on the Mexican peso.

AssumptionsCanadian

$/pesoAMERICAN MODEL

Spot rate C$ 0.1390 Price 0.277Strike rate C$ 0.1500 Delta 0.3217

Notional principal (US$)C$

350,000.00 Gamma 0.2628

Notional principal (Mexican pesos)2,517,985.6

1 Theta 0.733

EUROPEAN MODEL

PARAMETERS INPUT Current Spot Rate (US cents/fc) 13.9 Price 0.28Foreign Interest Rate (5% as .05) 6.00% Delta 0.3258Domestic Interest Rate (10% as .1) 12.00% Gamma 0.259Option (1, CALL; -1, PUT) 1 Theta 0.7286Strike Rate (US cents/fc) 15

Days to Maturity 180 Annual Volatility (10% as .1) 14.00%


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Put option premium on peso 0.28 (Canadian cents per peso) Put option premium on peso C$ 0.002800 (Canadian dollars per peso)

Notional principal in pesos2,517,985.6

1Total cost of put option (C$) C$ 7,050.36

Problem# 5.15: Put Options on Chinese Renminbi

Calculating put option premiums on the Rmb. Assumptions Rmb/$ $/Rmb Cents/RmbSpot rate 8.5 $0.12 11.7647Strike rate 9 $0.11 11.1111

AMERICAN MODEL

PARAMETERS INPUT Price 0.003Current Spot Rate (US cents/fc) 11.7647 Delta -0.0355Foreign Interest Rate (5% as .05) 14.00% Gamma 0.3344Domestic Interest Rate (10% as .1) 4.00% Theta 0.0765


EUROPEAN MODEL

Strike Rate (US cents/fc) 11.1111 Price 0.005Days to Maturity 90 Delta -0.0482Annual Volatility (10% as .1) 4.00% Gamma 0.4254Put option premium, US$ cents/Rmb 0.005 Theta 0.0035Put option premium, US$/Rmb $0.00


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Chapter-6

International Parity Conditions (IPC)


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Chapter # 6 “International Parity Conditions”

Problem # 6.1: Big Mac Hamburger StandardSolution:

(1) (2) (1) ÷ (2)= (3) (1) ÷ $2.80 = (4) (4) ÷ (2) = (5)\

Big MacPrice in LocalCurrency

ActualExchange

Rate

Big MacPrices inDollars

Implied PPP of the Dollars

Local currencyunder (-) / over (+)Valuation

U.S. $ 2.80 ----- $2.80 1 -------Argentina Ps 7.50 Ps 3.60 / $ $2.08 Ps2.68 / $ - 25.60%Canada C$ 3.50 C$1.63 / $ $2.15 C$ 1.25 / $ - 23.30%Euro Area € 2.90 $1.02 / € $2.96 $ 0.97 / € 5.64%Japan ¥ 300 ¥ 122 / $ $2.46 ¥ 107.14 / $ - 12.20%

Calculation notes: Column 3 = Column 1 ÷ Column 2; except for the euro, which is

Column 1 x Column 2 ( € 2.90 x $1.02 = $2.96 ) Column 4 = Column 1 ÷ $2.80; except for the euro, which is

$2.80 ÷ Column 1 ($2.80 ÷ €2.90 =$ 0.97) Column 5 = Column 4 - Column 2 ÷ Column 2


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or

In above formula of percentage change for indirect quotation, the Implied PPP becomes beginning rate (S1) and actual exchange rate becomes ending rate (S2).

Problem # 6.2: Exchange Rate Pass-Through

Solution:

Assumptions ValueInitial spot exchange rate in yen per dollar ¥122/$Initial price of a Nissan ¥3,000,000Expected US dollar inflation rate for the coming year 2.00%Expected Japanese yen inflation rate for the coming year 0.00%Desired rate of pass through by Nissan 70.00%


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Problem # 6.3: Argentine pesosSolution:

Assumptions ValueSpot exchange rate, fixed peg, early January 2002 Ps 1 / $Spot exchange rate, January 29, 2003 Ps 3.2 / $ US inflation for year (per annum) 2.20%Argentine inflation for year (per annum) 20.00%


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Problem # 6.4: International Fisher Effect. Solution: Assumptions ValueOne year interest rate, US dollars 3.00%One year interest rate, Euro Zone 5.00%Current spot exchange rate € 1.02 / $


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For International Fisher Effect, we use below formula;


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Problem # 6.5: Covered Interest Arbitrage (CIA) - Denmark ISolution: James Chang needs to determine whether the returns from the arbitrage exceed the opportunity costs of the U.S. dollar funds. The direction of potential profitability is determined by comparing the difference in interest rates (5.00% - 3.00% = 2.00%) and the forward discount, -1.974%. Arbitrage Rule of Thumb: Here, the difference in interest rates is greater than the forward premium or discount (2% > -1.97%), so James Chang should borrow dollars (lower interest rate) and invest for CIA in Danish kroner. Difference in interest rates (i kr – i $) 2.00%Less: Forward discount on the kroner - 1.97% CIA profit potential 0.03%

This tells James Chang that he should borrow dollars and invest (CIA) in Danish kroner for profit.Therefore


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James Chang generates a covered interest arbitrage profit of $13.93 because he is able to generate an even higher interest return in Danish kroner than he "gives up" by selling the proceeds forward at the forward rate.


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Problem # 6.6: Covered Interest Arbitrage (CIA) Denmark B – Part (a). Solution: The U.S. dollar 3-month interest rate now rises from 3.000% to 4.000%. (4.00% - 3.00% = 1.00%). Note that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make CIA profit one way or another. Arbitrage Rule of Thumb: Here, the difference in interest rates is less than the forward discount (1.00% < 0.97%), so James Chang should start by borrowing Danish kroner, exchanging into US dollars, investing in dollar interest and selling the dollar proceeds forward to lock in a CIA profit.

Difference in interest rates (i kr – i $) 1.00%Less: Forward discount on the kroner - 1.97% CIA profit potential - 0.97%

This tells James Chang that he should borrow Danish kroner and and invest (CIA) in U.S. dollars for profit.


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a) James Chang generates a covered interest arbitrage profit of kr94,110 because, although U.S. dollar rates are lower, the U.S. dollar is selling forward at a premium against the Danish kroner.

CIA- Denmark B – Part ( b). .The U.S. dollar 3-month interest rate now rises from 3.000% to 4.000%. Note that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make CIA profit one way or another. Here, the difference in interest rates is LESS than the forward discount, so James Chang should start by borrowing Danish kroner, exchanging into US dollars, investing in dollar interest and selling the dollar proceeds forward to lock in a CIA profit.

Difference in interest rates (i kr – i $) 3.00%


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Less: Forward discount on the kroner - 1.97% CIA profit potential 1.93%

b) This is a bit of a tricky question. Denmark is not a member of the euro zone itself, but its central bank does pay a great deal of attention to neighboring interest rates and monetary policy in the euro zone. If the Danish the central bank of Denmark uses the euro as its reference rate. If the Danish authorities did increase interest rates to that of


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the euro zones, CIA profit potential is now reversed: CIA profit would be generated by starting with US dollars and investing in kroner.

Problem # 6.7: Covered Interest Arbitrage – Japan. Solution: Here, the difference in interest rates is less than the forward premium, so Yukiko Miyaki should borrow Japanese yen, exchange to dollars, invest in dollars for 6 months, and sell the dollar proceeds forward. (-2.00% < 1.63%) Difference in interest rates (i ¥ – i $) -2.00%Less: Forward premium on the yen 1.63% CIA profit potential 0.37%

This tells Yukiko Miyahki that she should borrow yen and invest (CIA) in U.S. dollars for profit.


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Yukiko generates a CIA profit by investing in the higher interest rate currency, the dollar, and at the same time selling the dollar proceeds forward at a forward premium which does not completely negate the interest.Problem # 6.8: Uncovered Interest Arbitrage -- JapanSolution: Here, the difference in interest rates is not offset at all by using forwards, because Yukiko is not covering. She expects the spot exchange rate at the end of the period to be the same as at the beginning. Difference in interest rates (i$ - i¥) = 2.00% Not Using Forward cover = 0.00% UIA profit potential = 2.00%


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Problem # 6.9: International Parity Conditions in EquilibriumSolution: Assumptions ValueForecast annual rate of inflation for Canada 3.62%Forecast annual rate of inflation for United States 3.00%One-year interest rate for Canada 5.62%One-year interest rate for United States 5.00%Spot exchange rate C$1.60/$One-year forward exchange rate C$1.61/$


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Note that the differentials are not exactly equal, reflecting the application of the approximate form.

Problem # 6.10: Mary Smyth -- CIASolution: Here, the difference in interest rates is less than the forward premium, so Mary Smyth should borrow dollars, exchange them into Swiss francs, invest for 90 days, and sell the francs forward. Forward premium on the Swiss franc = 5.06% Difference in interest rates (I SF – I $) = -2.00% CIA profit potential = 3.06%This tells Mary Smyth she should borrow U.S. dollars and invest (CIA) in Swiss francs for profit.


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Mary Smyth makes a CIA profit of $7,848.10 on each million she invests.Problem # 6.11: Mary Smyth -- UIASolution: Now Mary Smyth is wishing to take her chances with the future spot rate. Given the fact that Swiss franc interest rates are actually lower than dollar rates, the only real way Mary Smyth can come out ahead here is if the Swiss franc ends up appreciating significantly against the dollar over 90 days. Difference in interest rates (i SF - i$) = (6%-8%) = -2.00% Not Using Forward cover = 0.00%


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UIA profit potential with no change in spot rate = -2.00%

The ending spot rate needs to be SF 1.5922/$ or more (larger) less in order for Mary to turn an uncovered interest arbitrage profit.


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Problem # 6.12: Mary Smyth -- one month laterSolution: The fact that the difference in interest rates does not exactly offset the forward premium indicates that a covered interest arbitrage potential exists. Because the forward premium is greater than the interest differential, Mary Smyth she invest in the lower interest rate currency (SF) after borrowing in the relatively high interest rate currency (US$). Forward premium on the Swiss franc = 3.79.0% Difference in interest rates (iSF – i$) = ( 4.80% - 8%) = -3.20% CIA profit potential = 0.596%This tells Mary Smyth she should borrow U.S. dollars and invest (CIA) in Swiss francs for profit.


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Mary Smyth makes a CIA profit of $1,577.29 on each $1,000,000, she invests.Problem # 6.13: Langkawi Island ResortSolution: Assumptions ValueCharge for suite plus meals (in ringgit) 760Spot exchange rate (ringgit per US$) 3.8US$ cost today for a 30 day stay $6,000.00 Malaysian ringgit inflation rate expected to be 4.00%U.S. dollar inflation rate expected to be 1.00%


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a. How many dollars might you expect to need one year hence for your 30-day vacation?

Spot exchange rate RM 3.8 /$Malaysian ringgit inflation rate expected to be 4.00%U.S. dollar inflation rate expected to be 1.00% Expected spot rate one year from now based on PPP RM 3.9129/$ Hotel charges expected to be paid 1 year from now for a 30-day stay 23,712.00US dollars needed on the basis of these two expectations: $6,060.00

b. By what percent has the dollar cost gone up? Why?

New dollar cost $6,060.00 Original dollar cost $6,000.00 Percent change in US$ cost 1.00%

Calculation Notes: $6,060.00 ÷ $6,000.00 = *1.01 or a 1.00% increase

=> 1+1.00% = 1+ 0.01= *1.01 ( 1.00% is inflation of U.S. )

The dollar cost has risen by the US dollar inflation rate. This is a result of your estimation of the future suite costs and exchange rate changing in relation to inflation.

Problem# 6.14: Covered Interest against the Norwegian krone. Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it considers the U.S. dollar as its functional currency, not the Norwegian krone. Ari Karlsen is a currency trader for Statoil, and has immediate use of either $4 million or the Norwegian krone equivalent). He is faced with the following market rates, and wonders whether he can make some arbitrage profits in the coming 90 days.

Solution: Assumptions Values


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Arbitrage funds available $4,000,000 Spot exchange rate (Nkr/$) 6.5523-month forward rate (Nkr/$) 6.5264U.S. dollar 3-month interest rate 5.63%Norwegian krone 3-month interest rate 4.25%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i Nkr - i $) -1.38%Less: Forward premium on the krone 1.57% CIA profit potential 0.19%

This tells Ari Karlsen he should borrow U.S. dollars and invest in the lower yielding currency, the Norwegian krone, selling the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.


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Ari Karlsen can make $2,106.83 for Statoil on each $4 million he invests in this covered interest arbitrage (CIA) transaction. Note that this is a very slim rate of return on an investment of such a large amount. => Annualized rate of return = 0.21%

Problem # 6.15: Frankfurt and New York


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Solution: Money and foreign exchange markets in Frankfurt and New York are very efficient. Using the following market information, answer the following questions:

Assumptions Frankfurt New YorkSpot exchange rate ($/€) 1.2 1.2One-year Treasury bill rate 6.50% 3.20%Expected inflation rate Unknown 2.00%

a. What do the financial markets suggest for inflation in Europe next year? According to the Fisher effect, real interest rates should be the same in both Europe

and the US. Since the formula for nominal rate is given as; Nominal rate = [( 1+real ) x ( 1+expected inflation ) ] - 1

Hence, 1 + real rate = (1 + nominal) ÷ (1 + expected inflation)

Frankfurt New York1 + nominal rate 106.50% 103.20%

1 + expected inflation Unknown 1

02.00% 1 + real 101.18% < --- 101.18%Therefore the real rate in the US is: 1.18%The expected rate of inflation in Berlin is then: 5.26%

b. Estimate today's one-year forward exchange rate between the dollar and the euro.

Spot exchange rate ($/€) 1.2 US dollar one-year Treasury bill rate 3.20% European euro one-year Treasury bill rate 6.50% One year forward rate ($/€) 1.1628


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Problem # 6.16: Chamonix chateau rentals. You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are negotiating over the rental of a chateau. The chateau's owner wishes to preserve his real income against both inflation and exchange rate changes, and so the present weekly rent of €8,000 (Christmas season) will be adjusted upwards or downwards for any change in the French cost of living between now and then. You are basing your budgeting on PPP. French inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is expected to be 2.5%. The current spot rate is $1.1840/€. What should you budget as the U.S. dollar cost of the one week rental?

Assumptions ValuesSpot exchange rate ($/€) $1.18 Expected US inflation for coming year 2.50%Expected French inflation for coming year 3.50%Current chateau nominal weekly rent (€) 8000

Forecasting the future rent amount and exchange rate: ValuesPPP exchange rate forecast ($/€) 1.1726Spot (one year) = Spot x ( 1 + US$ inflation ) / ( 1 + French inflation )Nominal monthly rent, in euros, one year from now 8,280.00Rent now x ( 1 + France inflation )Cost of rent one year from now in US dollars $9,708.80 Rent one year from now / PPP forecasted spot rate

Note: students may inquire as to whether the euro, a currency for a multitude of countries which may actually have substantial differences in inflation locally, really will react to inflationary pressures and differentials as PPP would predict a good question.


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Problem # 6.17: East Asiatic Company – Thailand. The East Asiatic Company (EAC), a Danish company with subsidiaries all over Asia, has been funding its Bangkok subsidiary primarily with U.S. dollar debt because of the cost and availability of dollar capital as opposed to Thai baht (฿) denominated debt. The treasure of EAC-Thailand is considering a one-year bank loan for $350,000. The current spot rate is ฿ 42.84/$. One year loans are 14.00% in baht but only 8.885% in dollars.

Assumptions ValuesCurrent spot rate, ฿41.358/$Expected Thai Baht inflation ( part a ) 4.50%Expected dollar inflation ( part a ) 2.20%Loan principal in U.S. dollars $350,000.00 US dollar interest rate, 1-year loan 8.85%

a).First, it is necessary to forecast the future spot exchange rate for the ฿/$.

Different expectations of the future spot exchange rate, either PPP for part a), or an expected devaluation for part b), allow the isolation of exactly how many Thai baht would be required to repay the dollar loan.


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a) Assuming a PPP forecast of the future spot rate, ฿43.8039/$, it will take 16,693,579.00 baht to repay the U.S. dollar loan. The implied cost of funds, in baht terms, is 11.34%.

b) Assuming a future spot rate for the baht which is 5% weaker than the current spot rate ฿42.84/$ that will leads to rises the implied cost to 14.60%.

Current Spot Rate ฿42.84/$Pct. Change ( the value of Baht down against the dollar) -5.00%New Forecast rate: New spot (S2) = old spot rate / (1 – 5%) New spot (S2) = ฿42.84/$ / (1 – 0.05%) ฿45.09/$

Calculation Notes:

$350,000.00 x 1.0889 = $381,098.00$350,000.00 x ฿42.84/$ = ฿14,994,000.00 (Initial investment ) $381,098.00 x ฿45.09/$ = ฿17,183,709.00 (Repaid in baht)

Implied cost = Repaid ÷ Initial investment – 1 Implied cost = ฿17,183,709.00 ÷ ฿14,994,000.00 – 1 Implied cost = 1.1460 – 1 Implied cost = 0.1460Implied cost = 14.60%

c) In part a, the cost of funds is expected to be 11.34%, cheaper than borrowing locally at 14.00%. In part b, however, the expected cost of 14.60% would indicate it would be cheaper to borrow locally--in baht.


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Problem # 6.18: Maltese Falcon: 2003-2004. The infamous solid gold falcon, initially intended as a tribute by the Knights of Rhodes to the King of Spain in appreciation for his gift of the island of Malta to the order in 1530, has recently been recovered. The falcon is 14 inches in height and solid gold, weighing approximately 48 pounds. Gold prices in late 2002 and early 2003, primarily as a result of increasing political tensions, have risen to $440/ounce. The falcon is currently held by a private investor in Istanbul, who is actively negotiating with the Maltese government on its purchase and prospective return to its island home. The sale and payment are to take place in March 2004, and the parties are negotiating over the price and currency of payment. The investor has decided, in a show of goodwill, to base the sales price only on the falcon's specie value -- its gold value. The current spot exchange rate is 0.39 Maltese lira (ML) per U.S. dollar. Maltese inflation is expected to be about 8.5% for the coming year, while U.S. inflation, on the heels of a double-dip recession, is expected to come in at only 1.5%. If the investor bases value in the U.S. dollar, would he be better off receiving Maltese lira in one year -- assuming purchasing power parity, or receiving a guaranteed dollar payment assuming a gold price of $420 per ounce?

S.NO. Mar-03 Mar-04Weight of falcon, in pounds 48 48Total number of ounces in weight 768 768Price of gold, $/ounce $440.00 $420.00 Falcon value based on price of gold $337,920.00 $322,560.00

The PPP forecast of the ML/$ exchange rate:

Current spot rate, Maltese lira/dollar 0.39Expected Maltese inflation 8.50%Expected dollar inflation 1.50%PPP forecast of Maltese lira/dollar 0.4169

If the investor bases his gross sales proceeds in U.S. dollars, the guaranteed dollar payment at $420/ounce yields a larger amount ($322,560) than accepting Maltese lira assuming PPP ($316,116).


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Problem # 6.19: London Money Fund. Tom Hogan is the manager of an international money market fund managed out of London. Unlike many money funds that guarantee their investors a near risk-free investment with variable interest earnings, Tim Hogan's fund is a very aggressive fund that searches out relatively high interest earnings around the globe, but at some risk. The fund is pound-denominated. Tim is currently evaluating a rather interesting opportunity in Malaysia. The Malaysian government has been enforcing a number of currency and capital restrictions since the Asian Crisis of 1997 to protect and preserve the value of the Malaysian ringgit (RM). The current spot rate of RM3.75/$ has been adjusted only recently (July 2005) from its previously fixed value of RM3.80/$. Local currency time deposits of 180-day maturities are earning 9.600% per annum. The London Eurocurrency market for pounds is yielding 4.200% per annum on similar 180-day maturities. The current spot rate on the British pound is $1.7640/£, and the 180-day forward rate is $1.7420/£.


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Solution: Assumptions ValuesPrincipal investment, British pounds £1,000,000.00Spot exchange rate ($/£) $1.76 / £180-day forward rate ($/£) $1.74 Malaysian ringgit 180-day yield 9.60%Spot exchange rate, RM / $ 3.75

The initial pound investment implicitly passes through the dollar into Malaysian ringgit. The ringgit is fixed against the dollar, hence the ending RM/$ rate is the same as the current spot rate. The pound, however, is not fixed to either the dollar or ringgit. Tim Hogan can purchase a forward against the dollar, allowing him to cover the dollar/pound exchange rate.


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If Tim Hogan invests in the Malaysian ringgit deposit, and accepts the uncovered risk associated with the RM/$ exchange rate (managed by the govt.), and sells the dollar proceeds forward, he should expect a return of 6.124% on his 180-day pound investment. This is better than the 4.200% he can earn in the euro-pound market. Interestingly, if Tim Hogan chose to not sell the dollars forward, and accepted the uncovered risk of the $/£ exchange rate as well, he may or may not do better than 6.124%. For example, if the spot rate remained unchanged at $1.7640/£, Tim's return would only be 4.800%. This demonstrates that much of the added return Tim is earning is arising from the forward rate itself, and not purely from the nominal interest differentials.

Problem # 6.20: The African beer standard of PPP. In 1999 the Economist magazine reported the creation of an index or standard for the evaluation of African currency values using the local prices of beer. Beer was chosen as the product for comparison because McDonald's had not penetrated the African continent beyond South Africa, and beer met most of the same product and market characteristics required for the construction of a proper currency index. Investec, a South African investment banking firm, has replicated the process of creating a measure of PPP like that of the Big Mac Index of the Economist, for Africa. The index compares the cost of a 375 milliliter bottle of clear lager beer across sub-Sahara Africa. As a measure of PPP the beer needs to be relatively homogeneous in quality across countries, needs to possess substantial elements of local manufacturing, inputs, distribution, and service, in order to actually provide a measure of relative purchasing power. The beers are first priced in local currency (purchased in the taverns of the local man, and not in the high-priced tourist centers), then converted to South African rand. The prices of the beers in rand are then compared to form one measure of whether the local currencies are undervalued (- %) or overvalued (+ %) versus the South African rand. Use the data in the exhibit and complete the calculation of whether the individual currencies are under- or over-valued.


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Beer Prices

Country Beer

In Localcurrency

In Localcurrency

Inrand

ImpliedPPP rate

Spot Rate(3/15/99)

Under orovervaluedto rand (%)

South Africa Castle Rand 2.3 ---- ---- ---- ----Botswana Castle Pula 2.2 2.94 0.96 0.75 27.90%Ghana Star Cedi 1,200.00 3.17 521.74 379.1 37.60%Kenya Tusker Shilling 41.25 4.02 17.93 10.27 74.60%Malawi Carlsberg Kwacha 18.5 2.66 8.04 6.96 15.60%Mauritius Phoenix Rupee 15 3.72 6.52 4.03 61.80%Namibia Windhoek N$ 2.5 2.5 1.09 1 8.70%Zambia Castle Kwacha 1,200.00 3.52 521.74 340.68 53.10%Zimbabwe Castle Z$ 9 1.46 3.91 6.15 -36.40%

Notes: 1. Beer price in South African rand = Price in local currency / spot rate on 3/15/99.2. Implied PPP exchange rate = Price in local currency / 2.30.3. Under or overvalued to rand = Implied PPP rate / spot rate on 3/15/99.


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Chapter-7

Foreign Exchange Rate Determination


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Chapter # 7 Foreign Exchange Rate Determination

Problems # Using the following economic, financial, & business indicators from February 3,2003, issue of The Economist to answer the problem 1 through 10.


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Problem # 7.1: Current spot rates. What are the current spot exchange rates for the following cross rates?

a. Japanese yen/US dollar exchange rate. (¥/$)b. Japanese yen/Australian dollar exchange rate, (¥/A$)


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c. Australian dollar/US dollar exchange rate, (A$/$)Solution:

Country

Currency per pound Feb 5th

Calculation of Current spot exchange rates

Australia A$ 2.78 / £ ¥ 197 / £ ÷ $ 1.65 / £ = ¥ 119.39 / $ Japan ¥ 197 / £ ¥ 197 / £ ÷ A$ 2.78 / £ = ¥ 70.86 / A$ U.S. $ 1.65 / £ A$ 2.78 / £ ÷ $ 1.65 / £ = A$ 1.68 / $

Problem # 7.2: Purchasing power parity forecasts. Assuming purchasing power parity, and assuming that the forecasted change in consumer prices is a good proxy of predicted inflation, forecast the following cross rates:

a. Japanese yen/US dollar in 1 year b. Japanese yen/Australian dollar in 1 year c. Australian dollar/US dollar in 1 year Solution:

Country

Inflation 2003e

(Given in table)Australia 2.7% or 0.027Japan -0.7% or -0.0 07U.S. 2.1% or 0.021

Spot Rate (calculation given above in problem#7.1)

¥ 119.39 / $ ¥ 70.86 / A$

A$ 1.68 / $


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Problem # 7.3: International Fisher forecasts. Assuming International Fisher applies to the coming year; forecast the following future spot exchange rates using the government bond rates for the respective country currencies:

a. Japanese yen/US dollar in 1 year b. Japanese yen/Australian dollar in 1 year c. Australian dollar/US dollar in 1 year

Solution:

Country 2-year Govt Bonds interest RatesAustralia 5.14% or 0.0514Japan 0.80% or 0.008 U.S. 3.76% or 0.0376

Spot Rate (calculation given above in problem#7.1) ¥ 119.39 / $ ¥ 70.86 / A$ A$ 1.68 / $


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Problem # 7.4: Implied real interest rates. If the nominal interest rate is the government bond rate, and the current change in consumer prices is used as expected inflation, calculate the implied "real" rates of interest by currency. a). Australian dollar "real" rate b). Japanese yen "real" rate c). US dollar "real" rate Solution:

Country

Nominal Rate (2-year Govt. Bonds interest Rates)

Change in consumer prices (the change in consumer prices is used as expected inflation)

Australia 5.14% or 0.0514 2.7% or 0.027Japan 0.80% or 0.008 -0.7% or -0.0 07U.S. 3.76% or 0.0376 2.1% or 0.021


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Problem # 7.5: Forecasting with real interest rates. Using the real interest rates calculated in problem 7.4; forecast the following future spot exchange rates using real interest rate differentials: a. Japanese yen/US dollar exchange rate in 1 year b. Japanese yen/Australian dollar exchange rate in 1 year

c. Australian dollar/US dollar exchange rate in 1 yearSolution:

Country Real interest rate Australia 2.38% or 0.0238 Japan 1.51% or 0.0151U.S. 1.63% or 0.0163



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Problem # 7.6: Forward rates. Using the spot rates and three-month interest rates above, calculate the 90-day forward rates for:

a. Japanese yen/US dollar exchange rateb. Japanese yen/Australian dollar exchange ratec. Australian dollar/US dollar exchange rate

Country 3-month money market Year Ago

Australia 4.28% or 0.0428Japan 0.30% or 0.003 U.S. 1.79% or 0.0179



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Note: All interest rates need to be adjusted for a 90 day period of a 360 day year for the calculation.

Problem # 7.7: Real economic activity and misery. Calculate the country's Misery Index (unemployment + inflation) and then use it like interest differentials to forecast the future spot exchange rate, one year into the future.

Country

Unemployment Recent

Quarter

Inflation 2003e(Given in table)

Misery Index

Australia's Misery Index 6.2% 2.7% 8.9% or 0.089Japan's Misery Index 5.5% -0.7% 4.8% or 0.048U.S. Misery Index 6.0% 2.1% 8.1% or 0.081

Forecast spot = Spot x ( 1 + Misery-1) / ( 1 + Misery-2)


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Summary S. No. Starting Spot Rate Forecast Spot Ratea. ¥/$ exchange rate in 1 year ¥ 119.39 / $ ¥ 115.75 / $b. ¥/A$ exchange rate in 1 year ¥ 70.86 / A$ ¥ 69.18 / A$ c. A$ /$ exchange rate in 1 year A$ 1.68 / $ A$ 1.69/ $


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Problem # 7.8: Balance of payments approach. Using the trade and current account information, forecast the direction of the spot exchange rates for the coming year. a. Japanese yen/US dollar exchange rate in 1 year

Japan is running a trade & current account surplus. US is running a trade & current account deficit. Dollar should weaken against the Japanese yen.

b. Japanese yen/Australian dollar exchange rate in 1 year Japan is running a trade & current account surplus. Australia is running a trade & current account deficit. Australian dollar should weaken against the yen.

c. Australian dollar/US dollar exchange rate in 1 year Australia is running a trade & current account US is running a trade & current account deficit Indeterminate.

Problem # 7.9: Current accounts and spot rates. Are the current account forecasts from the previous question consistent with the exchange rate trends shown above?

Ans. Japanese yen appreciated in value against the US dollar over 2002. This is consistent with the trade and current account balances being run by the two countries. The Australian dollar consistently strengthened against the US dollar over 2002. Although Australia and the United States have similar current and forecast rates of inflation, and similar trade and current account deficits, Australia has demonstrated stronger economic growth (GDP) over the past year than the US.

Problem # 7.10: Exchange rate trends and bounds. Use the graphs to determine trends, mean values, and upper and lower bounds to spot exchange rate movements.

Cross Rates Trend up or down

Mean

UpperBound

LowerBound

Yen/US$ US$ down 115-120 132.50 106.00 A$/US$ US$ down 1.65-1.80 2.00 1.55


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Chapter-8

Transaction Exposure


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Chapter # 8 Transaction Exposure

Problem # 8.1: Lipitor in Indonesia. Evaluating the costs of hedging a transaction exposure.

Assumptions ValuesReceivable due in 3 months, in Indonesian rupiah (Rp) Rp750,000,000Spot rate, Rp/$ 8,800

Expected spot rate in 90 days, Rp/$ 9,4003-month forward rate, Rp/$ 9,800Minimum dollar amount acceptable at settlement $78,000.00

Alternatives

Values

RiskAssessment

1. Remain Uncovered. Settle A/R in 90 days at current spot rate.If spot rate in 90 days is same as current(Rp750,000,000 /Rp8,800/$) $85,227.27 RiskyIf spot rate in 90 days is Rp9,400/$(Rp750,000,000 / Rp9,400/$) $79,787.23 RiskyIf spot rate in 90 days is Rp9,800/$(Rp750,000,000 / Rp9,800/$) $76,530.61 Risky

2. Sell Indonesian rupiah forward.

A/R sold forward 90 days $76,530.61 Certain"Cost of cover" is the forward discount on Rp -40.80%

Analysis: The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period, any variety of economic or political or social events could lead to an upward bounce in the exchange rate, reducing the dollar proceeds at settlement to an unacceptable level. Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin. The forward cover yields dollar proceeds of only $76,530.61, short of the needed $78,000. The cost of forward cover, 40.8%, is indicative of the "artificial interest rates" used by some financial institutions while pricing derivatives in emerging, illiquid, and volatile markets. In the end, Pfizer will have to decide whether making


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the sale into this specific market is worth breaking a company policy on minimum proceeds (forward cover) or taking significant currency risk by not using forward cover.

Problem # 8.2: Embraer of Brazil.

Advise Embraer on currency exposure.Assumptions ValuesReceivable due in one year, US dollars $80,000,000 Payable due in one year, US dollars $20,000,000 Spot rate, R$/$ 3.4One-year US dollar eurocurrency interest rate 4.00%One-year Brazilian govt deposit note 14.00% Implied one year forward rate = spot x ( 1 + iR$ ) / ( 1 + i$ ) 3.7269

Analysis; Net exposure at time of cash settlements:

Values

RiskAssessment

One year A/R due $80,000,000 Less: One year A/P due ($20,000,000)

Net exposure $60,000,000 Certain

This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of the Brazilian real, that it has traditionally suffered from rapid depreciation and occasional devaluation, a net long position in dollars by most Brazilian companies is considered a good thing.

Cash settlement of the net position: Values Risk Assessment

Brazilian reais in one year at current spot rate R$ 204,000,000.00 RiskyBrazilian reais in one year at one year forward rate R$ 223,615,384.62 Certain

In this case, however, because the real is selling forward at a considerable discount, the net long position -- if sold forward -- yields considerably more real than the current spot rate. It should also be noted, however, that if the real were to fall considerably over the year, to a value greater than R$3.73/$, by remaining unhedged Embraer would enjoy greater reais returns.


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Problem # 8.3: Mattel Toys. Advise Mattel on its European sales.

Assumptions Values90-day A/R, euros 20000000Current spot rate, $/euro $1.06 Credit Suisse 90-day forward rate, $/euro $1.06 Barclays 90-day forward rate, $/euro $1.06 Expected spot rate in 90 days, $/euro $1.03 90-day eurodollar interest rate 3.60%90-day euro-euro interest rate 4.60% Implied 90-day forward rate (calculated), $/euro $1.06 90-day eurodollar borrowing rate 7.60%90-day euro-euro borrowing rate 8.40%Mattel Toys weighted average cost of capital 10.00%

Hedging Alternatives Values Risk Assessment

1. Remain Uncovered, settling A/R in 90 days at market rate (20 million euros / future spot rate) If spot rate in 90 days is same as current $21,200,000.00 RiskyIf spot rate in 90 days is same as Credit Suisse forward rate $21,160,000.00 RiskyIf spot rate in 90 days is same as Barclays forward rate $21,120,000.00 RiskyIf spot rate in 90 days is expected spot rate $20,600,000.00 Risky

2. Sell euros forward 90 days Settlement amount at Credit Suisse forward rate $21,160,000.00 Certain

Settlement amount at Barclays forward rate $21,120,000.00 Certain

3. Money Market Hedge


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Principal A/R in euros 20000000 Discount factor for euro borrowing rate for 90

days 0.9794 1/(1 + (.084 x 90/360))

Borrow euros against 90-day A/R 19588638.59 Current spot rate, $/euro $1.06 US dollar current value $20,763,956.90

Mattel's WACC carry-forward factor for 90 days 1.025

1 + (.1000 x 90/360)

Future value of money market hedge $21,283,055.83 Certain

Evaluation of Alternatives: The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate (carry-forward rate). Problem # 8.4: Hindustan Lever. Advise Hindustan Lever on its Japanese yen purchase.

Assumptions Values 180-day account payable, Japanese yen 8,500,000 Spot rate, yen/$ 120.6 Spot rate, rupees/$ 47.75

Implied (calculated) spot rate, yen/rupee 2.5257(120.60 /

47.75) 180-day forward rate, yen/rupees 2.4 Expected spot rate in 180 days, yen/rupees 2.6 180-day Indian rupee investing rate 8.00% 180-day Japanese yen investing rate 1.50% Currency agent's exchange rate fee 4.85% Hindustan Lever's cost of capital 12.00%

Hedging Alternatives

Values

Spot Rate

(Rp/$)

RiskAssessment

1. Remain Uncovered, settling A/P in 180 days at spot rate If spot rate in 180 days is same as current spot 3,365,464.34 2.5257 RiskyIf spot rate in 180 days is same as forward rate 3,541,666.67 2.4 RiskyIf spot rate in 180 days is expected spot rate 3,269,230.77 2.6 Risky


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2. Buy Japanese yen forward 180 days Settlement amount at forward rate (Rs) 3,541,666.67 2.4 Certain


Principal A/P (yen) 8,500,000.00 discount factor for yen investing rate for 180 days 0.9926 Principal needed to meet A/P in 180 days (yen) 8,436,724.57 Current spot rate, yen/rupee 2.5257 Indian rupee, current amount (Rs) 3,340,411.26 Hindustan Lever's WACC carry-forwad factor for 180 days 1.06 Future value of money market hedge (Rs) 3,540,835.94 Certain4. Indian Currency Agent Hedge Principal A/P (yen) 8,500,000.00 Current spot rate, yen/rupee 2.5257 Current A/P (Rs) 3,365,464.34 Plus agent's fee (4.850%) 163,225.02 Hindustan's WACC carry-forwad factor for 180 days on fee 1.06 Total future value of agent's fee (Rs) 173,018.52 Total A/P, future value, A/P + fee (Rs) 3,538,482.87 Certain

Evaluation of Alternatives: The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives.

Problem#8.5: Tek - Italian account receivable.

Hedging foreign exchange risk: a receivable

Assumptions ValuesAccount receivable due in 3 months, in euros 4000000Spot rate ($/euro) 0.983-month forward rate ($/euro) 0.985


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3-month euro interest rate 6.00%3-month put option on euros: Strike rate ($/euro) 0.98 Premium, percent per year 3.00%Tek's weighted average cost of capital 12.00%

What are the costs and risk of each alternative?

(a) Value

(b)Certainty?

1. Do nothing and exchange euros for dollars at end of 3 months

Amount of euro receivable 4000000 If spot rate in 3 months is the same as the

forward rate 0.985 Very uncertain;

US dollar proceeds of receivable would be$3,940,000.0

0 RiskyAmount of euro receivable 4000000

If spot rate in 3 months is the same as the current spot rate 0.98 Very uncertain;


0 Risky

2. Sell euro receivable forward at the 3-month forward rate

Amount of euro receivable 4000000 forward rate 0.985 Certain;


0 Locked-in

3. Buy a put option on euros

Amount of euro receivable 4000000 Current spot rate ($/euro) 0.98

Premium on put option, % 3.00% Cost of put option (amount x spot rate x

percent premium) $117,600.00 If the spot rate at end of 3-months is less than

strike rate Minimum isthe option is exercised yielding gross dollars

of$3,920,000.0

0 guaranteed;


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Less cost of option (premium) plus US$ interest on premium ($121,128.00) could be

Net proceeds of A/R if option is exercised (this is Minimum)

$3,798,872.00 greater.

Summary of Alternatives Value Certainty?

Do Nothing$3,920,000.0

0 Risky

Sell A/R forward$3,940,000.0

0 Certain

Buy Put Option$3,798,872.0

0 Minimum

c) If Tek wishes to play it safe, it should lock in the forward rate.d) If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the dollar is going to depreciate versus the euro over the 3 month period -- past $0.98/euro, then Tek might consider purchasing the put option.

Problem#8.6: Tek - Japanese account payable. Hedging foreign exchange risk: a payable

Assumptions ValuesAccount payable to Japan Sony-Tek, in Japanese yen 8,000,000.00Spot rate (yen/$) 1256-month forward rate (yen/$) 1226-month yen deposit rate 1.50%6-month dollar interest rate 4.00%6-month call option on yen: Strike rate (yen/$) 125 Premium, percent per year 4.00%Tek's weighted average cost of capital 12.00%

What are the costs and risk of each alternative?

a) Value

b) Certainty

1. Do nothing and exchange dollars for yen at end of 6 months

Amount of yen payable 8,000,000.00 If spot rate in 3 months is the same as the forward

rate 122Very

uncertain;US dollar cost of settling payable would be $65,573.77 Risky


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Amount of yen payable 8,000,000.00

If spot rate in 3 months is the same as the current spot rate 125

Very uncertain;

US dollar cost of settling payable would be $64,000.00 Risky

2. Buy yen forward 6-months to lock in cost of settling payable

Amount of yen payable 8,000,000.00 forward rate 122 Certain;

US dollar cost of settling payable would be $65,573.77 Locked-in

3. Money market hedge -- invest funds in yen deposit now

Principal needed at the end of 6-months, yen 8,000,000

Discount factor, 6-months @ yen deposit rate 0.99261/(1 + (.015 x

180/360))Yen deposit needed, now 7,940,447

Current spot rate, yen/$ 125 US dollars needed now, for exchange into yen $63,523.57

Carry-forward rate, 6 months @ Tek's WACC 1.061 + (.12 x 180/360)

US cost of money market hedge at end of 6-months $67,334.99

4. Buy a call option on Japanese yen

Amount of yen payable 8,000,000.00 Current spot rate (yen/$) 125

Premium on call option, % 4.00% Cost of call option $2,560.00

If the spot rate at end of 3-months is greater than strike rate Maximum cost

the option is exercised yielding gross dollars of $64,000.00 guaranteed; Plus cost of option (premium) plus US$ interest

on premium $2,713.60 could beTotal cost of exercising call option on yen $66,713.60 less.

Summary of Alternatives: Cost of settling A/P Value Certainty?


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Do Nothing $64,000.00 RiskyBuy yen forward $65,573.77 Certain

Deposit yen now (money market hedge) $67,334.99 CertainBuy call option on yen $66,713.60 Maximum

c). If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the yen may be depreciating versus the dollar over the 6 month period -- to below a value of Y125/$, then Tek might consider purchasing the call option.

Problem#8.7: Tek - British Telecom bid. Hedging foreign exchange risk of a contract bid

Assumptions Values Account receivable of bid, supply & install (British pounds) £1,000,000 Spot rate (dollars per pound) 1.57 Tek's weighted average cost of capital 12.00% 1-month 4-monthForward rate (dollars per pound) 1.572 1.575British pound investment rate 4.00% 4.25%British pound borrowing rate 9.00% 9.20%Put option on pound: Strike rate (dollars per pound) 1.58 1.58 Premium, US dollars per pound $0.01 $0.01

Analysis and Evaluation: If Tek wins the bid, it will be long foreign currency, having a 1 million pound position which is first backlog the an A/R. If and when Tek is awarded the bid, it would have 4 months (120 days) until cash settlement of the 1 million pound position.

a) Value

b) Certainty

1. Do Nothing -- Remaining Uncovered Wait 120 days and exchange pounds for dollars

spot


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If the ending spot rate is the same as current spot rate $1,570,000.00 Risky

If the ending spot rate is the same as the 4 month forward rate It could, however,

be much lower. $1,575,000.00 Risky

2. Sell the 1 million pounds forward

Selling 1 million pounds forward at the 4-month forward rate $1,575,000.00 Certain Value

The primary problem with this is that if Tek does not win the bid, it has a forward contract

to sell pounds which it will not earn. If Tek Wins Bid

3. Money market hedge -- borrow against expected receipts

Expected receipts, pounds £1,000,000 Discount factor for 4-months at pound

borrowing rate 0.97021/(1+(0.092 x

120/360))Proceeds from borrowing, now, in pounds £970,246

Current spot rate, US$ per pound 1.57 Proceeds from borrowing, now, in US$ $1,523,285.90

Carry-forward rate, 4 months @ Tek's WACC 1.041 + (.12 x 120/360)

Value in 4 months of money market hedge, US$ $1,584,217.34

Option, if exercised (if ending spot rate less than $1.58) $1,580,000.00

Put option premium, up-front $12,000.00 and the 4-months opportunity cost of premium 480

Total premium expense $12,480.00 Minimum;

Minimum dollars received if put option purchased $1,567,520.00 Could be More

The money market hedge provides the largest US$ value at the end of 4 months, but it assumes certainty of bid's award. The advantage of the option is if Tek does not win the bid, the option can easily be sold.

Problem# 8.8: Tek -- Swedish price list.


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Hedging foreign currency price quotes and potential sales.Assumptions ValuesExpected sale over 90-day period, Swedish krona 5,000,000.00Spot rate, SKr/$ 9.290-day forward rate, SKr/$ 9.253-month dollar interest rate 4.00%3-month krone deposit interest rate 6.15%3-month krone borrowing interest rate 12.50%3-month put option on krone: Strike rate, SKr/$ 9.2 Premium 3.50%Tek's weighted average cost of capital 12.00%

Hedging Alternatives: This is an uncertain exposure. Although sales will most likely occur, it is not known what total quantity of sales will occur, and therefore what Tek's actual long position in Swedish krone will be.

S.No. Value Certainty?

1. Do Nothing -- Remain Uncovered.

The ending spot rate at the time of settlement could be nearly anything.

If the ending spot rate is the same as current spot rate (SKr/$) $543,478.26 Risky

If the ending spot rate is the same as forward (SKr/$) $540,540.54 Risky

2. Sell Swedish krone forward

Sold forward 3-months at forward rate (SKr/$) $540,540.54 CertainHowever, remember that Tek does not know total

sales.

3. Money market hedge Tek would borrow now against expected proceeds

of (SKr) 5,000,000.00 Discount rate of SKr interest rate for 90-days 0.9697

SKr proceeds from borrowing received up-front 4,848,484.85


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Exchanged at current spot rate (SKr/$) 9.2 US dollars received now $527,009.22

Tek carry-forward rate for US$ for 90 days 1.03 Money market hedge proceeds in 90-days $542,819.50

4. Buy a 3-month put option on Swedish krone If exercisedIf not

exercisedProceeds will be option less premium if exercised

(minimum) (random choice)

Exchange rate if exercised/not exercised (SKr/$) 9.2 8.89Amount of Swedish krone 5,000,000.00 5,000,000.00

If exercised, it will yield a gross dollar amount of $543,478.26 $562,429.70 Put option premium $19,021.74 $19,021.74

Opportunity cost of premium 570.65 570.65Total future value of premium $19,592.39 $19,592.39

Minimum net dollar proceeds at end of 90 days $523,885.87 $542,837.30 (exercised gross amount less future value of

premium) Minimum

The money market hedge provides the highest certain US dollar receipts. (This is again a result of the significant increase in relative value arising from carrying-forward the dollars at Tek's WACC. If Tek sincerely believes in its directional view, and is willing to take some currency risk, the SKr would have to fall to about SKr8.89/$ in order for the put option hedge to yield more US dollars than the money market hedge.

Problem# 8.9: Tek -- Swiss dividend payable. Hedging an intra-company dividend payment.Assumptions ValuesDividend declared, Swiss francs SFr. 5,000,000Spot rate, SFr/$ 1.590-day forward rate, SFr/$ 1.523-month US dollar interest rate 4.00%3-month Swiss franc interest rate 5.25%3-month put option on Swiss francs: Strike rate, SFr/$ 1.54 Premium, $/SFr $0.02 Tek's weighted average cost of capital 12.00%Tek's expected spot rate in 90 days, SFr/$ 1.47

Hedging Alternatives Value Certainty?


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1. Do Nothing -- Remain Uncovered.If the ending spot rate is the same as current

spot rate (SFr/$) $3,333,333.33 RiskyIf the ending spot rate is the same as

forward (SKr/$) $3,289,473.68 RiskyRealistically, the ending spot rate could vary between SFr1 and SFr2 per $.

2. Sell Swiss francs forward

Sold forward 3-months at forward rate (SFr/$) $3,289,473.68 Certain


Borrow SFr now against future receipt Principal SFr. 5,000,000

Borrow SFr at SFr interest rate for 90-days 0.987 SFr proceeds received now via borrowing SFr. 4,935,225

Exchanged into US$ at spot rate of (SFr/$) 1.5 Dollars received now $3,290,150.11

Carry-forward rate for US$ at Tek's WACC for 90-days 1.03

Money Market Hedged proceeds in 90 days $3,388,854.62 4. Buy a 3-month put option on Swiss francs If exercised

If not exercised

Proceeds = option - premium, if exercised (minimum)

Effective exchange rate if exercised/not exercised, SFr/$ 1.54 1.47

Principal of payment, SFr SFr. 5,000,000SFr.

5,000,000If exercised, it will yield a gross dollar

amount of $3,246,753.25 $3,401,360.54 Put option premium $75,000.00 $75,000.00

Opportunity cost of premium 2,250.00 2,250.00Total future value of premium $77,250.00 $77,250.00

Minimum net dollar proceeds at end of 90 days $3,169,503.25 $3,324,110.54


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(exercised gross amount less future value of premium) Minimum

Analysis. The Money market hedge yields the highest certain US dollar proceeds. If, however, Tek wishes to accept some degree of currency risk, and believes in the direction of a stronger SFr, it may choose the 3-month put option. Note that the official expectation is SFr1.47/$. This is still not superior to the Money Market Hedge. (The ending spot rate would need to be SFr1.44/$ or stronger to end up superior to the Money Market Hedge.)

Problem# 8.10: Northern Rainwear. Hedging foreign exchange risk: A/R & forward points

Assumptions

Values

Forward

Discount

Days

Spot rate, DKr/C$ 4.7 3-month forward rate, DKr/C$ 4.71 -0.85% 6-month forward rate, DKr/C$ 4.72 -0.85% 12-month forward rate, DKr/C$ 4.74 -0.84%

Northern's Exposures 0-90 days 91-180 days> 180 days

A/R due in 3 months, DKr 3,000,000 A/R due in 6 months, DKr 2,000,000 A/R due in 12-months, DKr 1,000,000Northern's Manadatory Forward Cover 0-90 days 91-180 days

> 180 days

Paying the points forward 75% 60% 50%Receiving the points forward 100% 90% 50%

Analysis & Exposure Management: The Danish krone is selling forward at a discount versus the Canadian dollar: it takes more DKr/C$ forward. Northern Rainwear is receiving foreign currency, DKr, at future dates ("long DKr"). Northern Rainwear is therefore expecting to PAY THE POINTS FORWARD.


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Required Forward Cover for Northern: 0-90 days91-180

days > 180 daysA/R due in 3 months, DKr 75% A/R due in 6 months, DKr 60% A/R due in 12-months, DKr 50%DKr Forward Cover A/R due in 3 months, DKr 2,250,000 A/R due in 6 months, DKr 1,200,000 A/R due in 12-months, DKr 500,000Expected Canadian dollar value of DKr sold forward 477,707.01

254,237.29 105,485.23

Problem# 8.11: Vamo Road Industries. Hedging foreign exchange risk: a payableAssumptions ValuesConstruction payment due in six-months (A/P, quetzals) 8,400,000Present spot rate (quetzals/$) 7Six-month forward rate (quetzals/$) 7.1Guatemalan six-month interest rate (per annum) 14.00%U.S. dollar six-month interest rate (per annum) 6.00%Vamo's weighted average cost of capital (WACC) 20.00%Expected spot rate in six-months (quetzals/$): Highest expected rate 8 Expected rate 7.3 Lowest expected rate 6.4

a) What realistic alternatives are available to Vamo? Cost Certainty

1. Wait six months and make payment at spot rate Highest expected rate $1,050,000.00 Risky Expected rate $1,150,684.93 Risky Lowest expected rate $1,312,500.00 Risky2. Purchase quetzals forward six-months (A/P divided by the forward rate) $1,183,098.59 Certain


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3. Transfer dollars to quetzals today, invest for six-months quetzals needed today (A/P discounted 180 days) 7,850,467.29 Cost in dollars today (quetzals to $ at spot rate) $1,121,495.33 factor to carry dollars forward 180 days (1 + (WACC/2)) 1.1 Cost in dollars in six-months ($ carried forward 180 days ) $1,233,644.86 Certain

The second choice, the forward contract, results in the lowest cost alternative among certain alternatives.

Problem# 8.12: Worldwide Travel. Hedging foreign exchange risk: a payableAssumptions Values Acquisition price & 3-month A/P, NewTaiwan dollars (NT$) 7,000,000 Spot rate (NT$/$) 35 3-month forward rate (NT$/$) 36 3-month Taiwan dollar deposit rate 1.50% 3-month dollar borrowing rate 8.00% 3-month call option on NT$ not available Evaluation of Alternatives Cost Certainty

1. Do Nothing -- Wait 3 months and buy NT$ spot

If spot rate is the same as current spot rate $200,000.00 RiskyIf spot rate is the same as 3-month forward rate $194,444.44 RiskyAlthough this would do nothing to cover the currency risk, there would be no required payment or borrowing for 3 -months.

2. Buy NT$ forward 3-months

Assured cost of NT$ at 3-month forward rate $194,444.44 Certain The purchase of a forward contract would not require any cash up-front line by the


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amount of the forward. This is a non-cash expense., but the Bank of Hawaii would reduce his available credit line by the amount of the forward. This is a non-cash expense.

3. Money Market Hedge: Exchanging US$ for NT$ now, depositing for 3-months until paymentAcquisition price in NT$ needed in 3-months 7,000,000 Discounted back 3-months at NT$ deposit rate 0.9963 Amount of NT$ needed now for deposit 6,973,848 Spot rate, NT$/$ 35 US$ needed now for exchange $199,252.80 US$ carry-forward rate (3-month dollar borrowing rate) 8.00% CertainCarry-forward factor of US$ for 3-month period 1.02 Total cost in US$ of settling A/P in 3-months with Money Market Hedge $203,237.86

The currency risk is eliminated, but since Matt Morita would have to exchange the money up-front, it requires Matt Morita to increase his debt outstanding for the entire 3-months. Hence, forward contract hedge is best alternative.

Problem#8.13: Seattle Scientific, Inc.Costs and benefits of cash versus cover.

Assumptions ValuesSeattle's 30-day account receivable, Japanese yen 12,500,000Spot rate, yen/$ 120.2330-day forward rate, yen/$ 119.7390-day forwrad rate, yen/$ 118.78180-day forward rate, yen/$ 117.21Yokasa's WACC 8.85%Seattle Scientific's WACC 12.50%Desired discount on purchase price by Yokasa 4.50%

Josh Miller should compare two basic alternatives, both of which eliminate the currency risk.1. Allow the discount and receive payment in Japanese yen in cash Account recievable (yen) 12,500,000 Discount for cash payment up-front (4.500%) -562,500 Amount paid in cash net of discount 11,937,500 Current spot rate 120.23


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Amount received in U.S. dollars by Seattle Scientific $99,288.86 2. Not offer any discounts for early payment and cover exposure with forwards Account receivable (yen) 12,500,000 30-day forward rate 119.73 Amount received in cash in dollars, in 30 days $104,401.57 Discount factor for 30 days @ Seattle's WACC 0.9897 Present value of dollar cash received $103,325.27

Josh Miller should politely decline Yokasa's offer to pay cash in exchange for cash payment.

Problem# 8.14: Wilmington Chemical Company. Hedging foreign exchange risk: a payableAssumptions Values Shipment of phosphates from Morocco, Moroccan dirhams 6,000,000 Wilmington's cost of capital (WACC) 14.00% Spot exchange rate, dirhams/$ 10 Six-month forward rate, dirhams/$ 10.4 Options on Moroccan dirhams: Call Option Put Option Strike price, dirhams/$ 10 10 Option premium (percent) 2.00% 3.00% United States MoroccoSix-month interest rate for borrowing (per annum) 6.00% 8.00%Six-month interest rate for investing (per annum) 5.00% 7.00%Risk Management Alternatives Values Certainty1. Remain uncovered, making the dirham payment in six months at the spot rate in effect at that date

Account payable (dirhams) 6,000,000 Possible spot rate in six months -- the current

spot rate (dirhams/$) 10 Cost of settlement in six months (US$) $600,000.00 Uncertain.


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Account payable (dirhams) 6,000,000

Possible spot rate in six months -- forward rate (dirhams/$) 10.4

Cost of settlement in six months (US$) $576,923.08 Uncertain.

2. Forward market hedge. Buy dirhams forward six months.

Account payable (dirhams) 6,000,000 Six month forward rate, dirhams/$ 10.4

Cost of settlement in six months (US$) $576,923.08 Certain. 3. Money market hedge. Exchange dollars for dirhams now, invest for six months.

Account payable (dirhams) 6,000,000.00 Discount factor at the dirham investing rate for 6

months 1.035 Dirhams needed now for investing

(payable/discount factor) 5,797,101.45 Current spot rate (dirhams/$) 10

US dollars needed now $579,710.14 Carry forward rate for six months (WACC) 1.07 US dollar cost, in six months, of settlement $620,289.86 Certain.

4. Call option hedge. (Need to buy dirhams = call on dirhams)

Option principal 6,000,000.00 Current spot rate, dirhams/$ 10

Premium cost of option 2.00% Option premium (principal/spot rate x % pm) $12,000.00

If option exercised, dollar cost at strike price of 10.00 dirhams/$ $600,000.00

Plus premium carried forward six months (pm x 1.07, WACC) 12,840.00

Total net cost of call option hedge if exercised $612,840.00 Maximum.The lowest cost certain alternative is the forward. If Wilmington were to expect the dirham to depreciate significantly over the next six months, it may choose the call option.

Problem# 8.15: Dawg-Grip, Inc. Hedging foreign exchange risk: a payable


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Assumptions ValuesPurchase price of Korean manufacturer, in Korean won 7,030,000,000Less initial payment, in Korean won -1,000,000,000Net settlement needed, in Korean won, in six months 6,030,000,000Current spot rate (Won/$) 1,200Six month forward rate (Won/$) 1,260Plasti-Grip's cost of capital (WACC) 25.00%

Options on Korean won: Call Option Put Option Strike price, won 1,200.00 1,200.00 Option premium (percent) 3.00% 2.40%

U.S KoreaSix-month investment interest rate (per annum) 4.00% 16.00%Six-month borrowing rate (investment rate + 2%) 6.00% 18.00%Risk Management Alternatives Values Certainty

1. Remain uncovered, making the won payment in 6 months at the spot rate in effect at that date

Account payable (won) 6,030,000,000 Possible spot rate in six months: current spot rate

(won/$) 1,200

Cost of settlement in six months (US$) $5,025,000.00 Uncertain.Account payable (won) 6,030,000,000

Possible spot rate in six months: forward rate (won/$) 1,260

Cost of settlement in six months (US$) $4,785,714.29 Uncertain.

2. Forward market hedge. Buy won forward six months

Account payable (won) 6,030,000,000 Forward rate (won/$) 1,260.00

Cost of settlement in six months (US$) $4,785,714.29 Certain.

3. Money market hedge. Exchange dollars for won now, invest for six months.

Account payable (won) 6,030,000,000 Discount factor at the won interest rate for 6

months 1.08


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Won needed now (payable/discount factor)5,583,333,333.

33 Current spot rate (won/$) 1,200.00

US dollars needed now $4,652,777.78 Carry forward rate for six months (WACC) 1.125 US dollar cost, in six months, of settlement $5,234,375.00 Certain.

4. Call option hedge. (Need to buy won = call on won)

If exercised If not exercised

Option principal 6,030,000,000 Current spot rate (won/$) 1,200.00 1,307.00

Premium cost of option (%) 3.00% Option premium (principal/spot rate x % pm) $150,750.00

If option exercised/not exercised, dollar cost of won $5,025,000.00 $4,613,618.97

Premium carried forward six months (pm x 1.125, WACC) 169,593.75 169,593.75

Total net cost of call option hedge if exercised $5,194,593.75 $4,783,212.72 Maximum.

The forward contract provides the lowest cost hedging method for payment settlement. If, however, the firm believes the ending spot rate will be Won 1307/$ or higher, the call option hedge could prove lower cost. This would require the firm, however, to accept the foreign exchange risk and suffering the higher cost of the call option hedge in the event their spot rate expectations proved incorrect.

Problem# 8.16: Aqua-Pure. Hedging foreign exchange risk: a receivableAssumptions Values Amount of receivable, Japanese yen 20,000,000 Spot exchange rate at time of sale (yen/$) 118.255 Booked value of sale (amount/spot rate) $169,126.04 Days receivable due 90 Aqua-Pure's WACC 16.00% Competitor borrowing premium, yen 2.00% Forward rates and premiums Forward Rate PremiumOne-month forward rate (yen/$) 117.76 5.04%Three-month forward rate (yen/$) 116.83 4.88%


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One-year forward rate (yen/$) 112.45 5.16% Investment rates, % per annum United States Japan1 month 4.88% 0.09%3 months 4.94% 0.09%12 months 5.19% 0.31% Purchased options Strike (yen/$) Premium3-month call option on yen 118 1.00%3-month put option on yen 118 3.00% a. Alternative Hedges Values Certainty

1. Remain uncovered.

Account receivable (yen) 20,000,000 Possible spot rate in 90 days (yen/$) 118.255

Cash settlement in 90 days (US$) $169,126.04 Uncertain.2. Forward market hedge.

Account receivable (yen) 20,000,000 Forward rate (won/$) 116.83

Cash settlement in 90 days (US$) $171,188.91 Certain.

3. Money market hedge.

Account receivable (yen) 20,000,000

Discount factor for 90 days 1.005231 + ((.0009375 + .

02) x 90/360)Yen proceeds up front 19,895,858

Current spot rate (won/$) 118.255 US dollars received now $168,245.38

Carry forward at Aqua-Pure's WACC 1.04 1 + (.16 x 90/360)Proceeds in 90 days $174,975.20 Certain.

4. Put option hedge. (Need to sell yen = put on yen)

Option principal 20,000,000 Current spot rate (won/$) 118.255


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Premium cost of option (%) 3.00% Option pm (principal/spot rate x %

pm) $5,073.78

If option exercised, dollar proceeds $169,491.53

Less Pm carried forward 90 days -5,276.731.04 carry-forward

rateNet proceeds in 90 days $164,214.79 Minimum.

The put option does not GUARANTEE the company of settling for the booked amount. The money market and forward hedges do; the money market yielding the higher proceeds.

b) Breakeven rate between the money market and the forward hedge is determined by the reinvestment rate:

Money market, US$ up-front $168,245.38 Forward contract, US$, end of 90

days $171,188.91

(1 + x) 101.75%$168,245 (1+x) =

$171,189x 1.75% For 90 days

Breakeven rate, % per annum 7.00%

Problem# 8.17: Botox Watch Company. Hedging policy

Assumptions ValuesAccount recievable in 90 days (euros) 1,560,000Initial spot exchange rate ($/euro) $0.97 Forward rate, 90 days ($/euro) $0.95 Expected spot rate in 90 to 120 days ($/euro): Case #1 $0.93 Expected spot rate in 90 to 120 days ($/euro): Case #2 $1.00

If Botox Watch Company ……

Hedgedthe

Minimum

Hedgedthe

MaximumProportion of exposure to be hedged 70% 120%Total exposure (euros) 1,560,000 1,560,000hedged proportion 70% 120%Minimum hedge in euros (exposure x min prop) 1,092,000 1,872,000


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at the forward rate ($/euro) $0.95 $0.95 locking in ($) $1,033,032 $1,770,912

Case #1: Ending spot rate is $0.93/€ Proportion uncovered (short) 468,000 -312,000If ending spot rate is ($/€) $0.93 $0.93 Value of uncovered proportion ($) $435,240 ($290,160)Value of covered proportion (from above) $1,033,032 $1,770,912 Total net proceeds, covered + uncovered $1,468,272 $1,480,752

Case #2: Ending spot rate is $1.0000/€Proportion uncovered (short) 468,000 -312,000If ending spot rate is ($/€) $1.00 $1.00 value of uncovered proportion ($) $468,000 ($312,000)Value of covered position (from above) $1,033,032 $1,770,912 Total net proceeds, covered + uncovered $1,501,032 $1,458,912 Benchmark: Full (100%) forward cover $1,475,760 $1,475,760

This is not a conservative hedging policy. Any time a firm may choose to leave any proportion uncovered, or purchase cover for more than the exposure (creating a short position) the firm could experience nearly unlimited losses or gains.

Problem#8.18: Redwall Pump Company. Hedging foreign exchange risk: a receivable

Assumptions ValuesToday is March 1

Exchange Rate ($/euro)

90-day Forward rate, $/euro $1.11 180-day Forward rate, $/euro $1.11 Date ($/euro)US Treasury bill rate 3.60% 1-Feb $1.08 Redwall's borrowing rate, euros, per annum 8.00% 1-Mar $1.10 Redwall's cost of equity 12.00%

Options on eurosStrike

($/euro) Call Option Put OptionJune maturity options $1.10 3.00% 2.00%September maturity options $1.10 2.60% 1.20%Valuation of Alternative Hedges June Sept


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Receivable ReceivableAmount of receivable, in euros 2000000 2000000

a. Hedge in the forward market

Amount of receivable, in euros 2000000 2000000

Respective forward rates ($/euro) $1.11 $1.11

US dollar proceeds as hedged ($) $2,212,000 $2,226,000

Carry forward to Sept 1st at WACC 1.03 -----

Total US$ proceeds on Sept 1st $2,278,360 $2,226,000

Total of both payments $4,504,360

b. Hedge in the money market

Amount of receivable, in euros 2000000 2000000

Discount factor for euro funds, period 1.02 1.04

Current proceeds from discounting, euros 1960784 1923077

Current spot rate ($/euro) $1.10 $1.10 Current US dollar proceeds $2,156,863 $2,115,385

Carry forward rate for the period 1.06 1.06

US dollar proceeds on future date $2,286,275

$2,242,308

Total of both payments $4,528,582

c. Hedge with options

Amount of receivable, in euros 2000000 2000000Buy put options for maturities (% x

spot value) ($44,000) ($26,400)Carry forward for the period 1.06 1.06


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Premium cost carried forward to Sept 1 ($46,640) ($27,984)

Gross put option value if exercised $2,200,000 $2,200,000 Carried forward 3 months to Sept 1 1.03 ----

Gross proceeds, Sept 1 $2,266,000 $2,200,000 Total net proceeds, after premium

deduction, Sept 1 $4,391,376

d. Do nothing (remain uncovered)

Amount of receivable, in euros 2000000 2000000Ending spot exchange rate ($/euro) ??? ???

The money market hedge provides the highest certain outcome. If Redwall believes the euro will strengthen versus the dollar over the coming months, and it is willing to take the currency risk, the put option hedges could be considered.

Problem#8.19: Pixel's Financial Metrics. Transaction exposure life-span and accounting treatment.

Date Event Spot RateForward

Rate

Days Forward of Forward Rate

1-Feb Price quotation by Metrica 1.785 1.7771 2101-Mar Contract signed for sale 1.7465 1.7381 180 Contract amount, pounds £1,000,000 1-Jun Product shipped to Grand Met 1.7689 1.7602 901-Aug Product received by Grand Met 1.784 1.7811 301-Sep Grand Met makes payment 1.729 --------- ---------

Analysis: a). The sale is booked at the exchange rate existing on June 1, when the product is shipped to Grand Met, and the shipment is categorized as an account receivable. This sale is then compared to that value in effect on the date of cash settlement, the difference being the foreign exchange gain (loss). Value as settled 1 million pounds @ $1.7290/£ $1,729,000


165


Value as booked 1 million pounds @ $1.7689/£ $1,768,900 FX gain (loss) ($39,900)

The value of the foreign exchange gain (loss) will depend upon when Leo actually purchases the forward contract. Because many firms do not define an "exposure" as arising until the date that the product is shipped (loss of physical control over the goods) and the sale is booked on the income statement that is a common date for the purchase of the forward contract.

Forward contract purchased on June 1 Value of forward settlement 1 million pounds @ $1.7602/£ $1,760,200 Less: Value as booked 1 million pounds @ $1.7689/£ $1,768,900 FX gain (loss) ($8,700)

A more aggressive alternative is for Leo to purchase the forward contract on the date that the contract was signed, March 1, locking- in Pixel's US dollar settlement amount a full 90 days earlier in the transaction exposure's life span.

Forward contract purchased on March 1 Value of forward settlement 1 million pounds @ $1.7381/£ $1,738,100 Less: Value as booked 1 million pounds @ $1.7689/£ $1,768,900 FX gain (loss) ($30,800)

Note that in this case if Leo had covered forward on March 1st rather than June 1st, the amount of the foreign exchange loss would have been even greater, although "fully hedged." The difference is of course the result of the forward rate changing with spot rates and interest differentials.

Problem# 8.20: Scout Finch and Dayton Manufacturing (A). Assumptions Value 90-day A/R in pounds 3,000,000 Spot rate, US$ per pound 1.762 90-day forward rate, US$ per pound 1.755 3-month U.S. dollar investment rate 6.00% 3-month U.S. dollar borrowing rate 8.00% 3-month UK investment interest rate 8.00% 3-month UK borrowing interest rate 14.00% Put options on the British pound: Strike rates, US$/pound 1.75 1.71 Put option premium 1.50% 1.00%Dayton's WACC 12.00% Scout Finch's expected spot rate in 90-days, US$ per pound 1.785


166


Alternative #1: Remain UncoveredRate

($/pound) ProceedsValue of A/R will be (3 million pounds x ending spot rate ($/pound))

If spot rate is the same as current spot rate $1.76 $5,286,000.00 If ending spot rate is the same as current forward

rate $1.76 $5,265,000.00 If ending spot rate is the expected spot rate $1.79 $5,355,000.00

Alternative #2: Forward Contract HedgeRate

($/pound) ProceedsSell the pounds forward 3-months locking in the forward rate

Pound A/R at the forward rate (pounds x forward) $1.76 $5,265,000.00

Alternative #3: Money Market HedgeRate

($/pound) ProceedsDayton borrows against the A/R, receiving pounds up-front, exchanging into US$.

Amount of A/R in 90-days, in pounds 3,000,000.00Discount factor, pound borrowing rate, for 3-months 0.9662

Proceeds of borrowing, up-front, in pounds 2,898,550.72Exchanged to US$ at current spot rate of $1.76

US$ received against A/R, up-front $5,107,246.38 US$ need to be carried forward for comparison:

Carry-forward rate, WACC for 90-days 1.03Money Market Hedge, US$, at end of 90-days $5,260,463.77

Alternative #4: Put Option HedgesStrike Rate

($/pnd)Strike Rate

($/pnd) Strike Rate 1.75 1.71

Option premium 1.50% 1.00%Notional principal of option (pounds) 3,000,000 3,000,000

Spot rate ($/pound) 1.762 1.762Option premium, US$ $79,290.00 $52,860.00

Carry-forward factor, WACC, for 90-days 1.03 1.03Total premium cost, in 90-days $81,668.70 $54,445.80

Proceeds from put option if exercised $5,250,000.00 $5,130,000.00

Less cost of premium, including time-value -81,668.70 -54,445.80


167


Net proceeds from put options, in 90-days: Minimum $5,168,331.30 $5,075,554.20

Ending spot rate needed to be superior to forward: $1.78 $1.77

Proceeds from exchanging pounds for US$ spot $5,347,500.00 $5,319,600.00 Less cost of option (allowed to expire OTM) -81,668.70 -54,445.80

Net proceeds from put option, unexercised $5,265,831.30 $5,265,154.20

Analysis: Scout Finch would receive the most certain US$ from the forward contract, $5,265,000; the money market hedge is less attractive as a result of the higher borrowing costs in the UK now. The two put options yield unattractive amounts-- if they have to be exercised. As shown, the $1.75 strike price put would be superior to the forward if the ending spot rate were $1.7825 or higher; the $1.71 strike price would be superior to the forward if the ending spot rate were $1.7732 or higher.

Problem # 8.21: Scout Finch and Dayton Manufacturing (B)Solution:

Construction of Dayton's income statement, wit h foreign exchange losses and EPS by strategy.

Exchange Rate Assumptions Assumption Assumption Assumption

Part c) Positions

Spot exchange rates at booking: US dollars per euro 1.0560 1.0560 1.0560 US dollars per pound 1.5900 1.5900 1.5900 Japanese yen per dollar 122.43 122.43 122.43 90-day forward rates:

US dollars per euro 1.0250 1.0250 1.0250Paying points

US dollars per pound 1.5875 1.5875 1.5875 Paying


168


points

Japanese yen per dollar 120.85 120.85 120.85Receiving

pointsSpot rate forecasts: US dollars per euro 1.0660 1.0660 1.0660 US dollars per pound 1.5600 1.5600 1.5600 Japanese yen per dollar 126.00 126.00 126.00 Settlement spot rates: US dollars per euro ---------- ---------- 1.048 US dollars per pound ---------- ---------- 1.6 Japanese yen per dollar ---------- ---------- 122.5 Export sales in currency of invoice:

Sales in European euros 2340000 2340000 234000050% Fwd

Cover

Sales in British pounds £1,780,000 £1,780,000 £1,780,00050% Fwd

Cover

Sales in Japanese yen 125,000,000 125,000,000 125,000,000100% Fwd

Cover

S. No. a) b) c)

FX gains (losses) by sale:Settled at Forecast

Settled at Forward

Forwards on Points

Sales in European euros $23,400 ($72,540) ($45,630)Sales in British pounds ($53,400) ($4,450) $6,675 Sales in Japanese yen ($28,928) $13,349 $13,349

($58,928) ($63,641) ($25,606)

S. No.

%age Uncovered100%

ForwardForward

Cover

Income Statement (US$) Settled at Forecast Cover

Based on Points

Sales $13,622,232 $13,622,232 $13,622,232 Domestic sales 7,300,000 7,300,000 7,300,000 Export sales 6,322,232 6,322,232 6,322,232


169


Less cost of goods sold 65% -8,854,451 -8,854,451 -8,854,451Gross profit $4,767,781 $4,767,781 $4,767,781 Less G&A expenses 9% -1,226,001 -1,226,001 -1,226,001Less depreciation -248,750 -248,750 -248,750Foreign exchange gains (losses) -58,928 -63,641 -25,606EBIT $3,234,102 $3,229,389 $3,267,424 Less US corporate taxes 40% -1,293,641 -1,291,755 -1,306,969Net income $1,940,461 $1,937,633 $1,960,454 Shares outstanding 1,000,000 1,000,000 1,000,000Earnings per share (EPS) $1.94 $1.94 $1.96

Dayton's EPS is highest in part c), where it determined its forward cover by whether it would receive or pay the forward points. In part c), for both the euro and the pound, Dayton is paying the points, and would therefore decide to cover only 50% of the exposure with forwards (the yen is receiving the points, and is 100% covered with forwards). The foreign exchange loss for the pound is smaller in part c) because the pound moved in the company's favor. Although the euro moves against the firm, the loss is not as large as what the forward would have imposed.

Problem # 8.22: Siam CementSolution: Assumptions ValueUS dollar debt taken out in June 1997 $50,000,000 US dollar borrowing rate on debt 8.40%Initial spot exchange rate, baht/dollar, June 1997 25Average spot exchange rate, baht/dollar, June 1998 42

Calculation of Foreign Exchange Loss on Repayment of Loan: At the time the loan was acquired, the scheduled repayment of dollar and baht amounts would have been as follows:

S.No. Amount

Scheduled Repayment: Repayment of US dollar debt: Principal $50,000,000 Repayment of US dollar debt: Interest 4,200,000 Total repayment $54,200,000


170


Exchange rate at time of repayment, baht/dollar 25 Total repayment in Thai baht 1,355,000,000 Total proceeds from loan, up-front, in Thai baht 1,250,000,000 Net interest to be paid, in Thai baht 105,000,000 Actual Repayment: Repayment of US dollar debt: Principal $50,000,000 Repayment of US dollar debt: Interest 4,200,000 Total repayment $54,200,000 Exchange rate at time of repayment, baht/dollar 42 Total repayment in Thai baht 2,276,400,000 Less what Siam had EXPECTED or SCHEDULED to be repaid -1,355,000,000Amount of foreign exchange loss on debt 921,400,000

Problem # 8.23: Aswan Project: Mitsubishi's Exposure (Part a)Managing a foreign currency receivable.

Assumptions ValueOptions on Japanese yen Value

6-month receivable in Egyptian pounds (E£) 168,000,000

Call option: Strike rate (yen/$) 119

Spot rate, E£/$ 4.62 Premium 1.50%

Spot rate, yen/$ 120.64Call option: Strike rate (yen/$) 116

6-month forward rate, yen/$ 119.62

Premium 0.80%

6-month dollar investing rate 3.40%

Put option: Strike rate (yen/$) 122

6-month dollar 9.60% 1.60%


171


borrowing rate Premium6-month yen investing rate 1.25%

Put option: Strike rate (yen/$) 124

6-month yen borrowing rate 6.50%

Premium 0.90%

Mitsubishi's cost of capital 8.00%

Expected spot rate in 180-days, yen/$ 122

1. Do Nothing -- exchanging at spot rate in 6-months

2. Forward hedge -- sell dollars forward

Expected payment in Egyptian pounds 168,000,000


Expected spot rate, E£/$ 4.62 Expected spot rate, E£/$ 4.62

Expected payment in $ in 180 days $36,363,636.36


Expected spot rate, yen/$ 122


Payment in yen 4,436,363,636 Payment in yen 4,349,818,182

Analysis: Very Risky with uncertain exchange rates.

Analysis: Yen/$ exchange rate certain; amount of exposure in $ not.

3. Money market hedge -- borrow against payment

4. Call option hedge: out of the money strike rate (buying yen)



Expected spot rate, E£/$ 4.62 Expected spot rate, E£/$ 4.62



Borrowing rate against $ 9.60%

Borrowing (discount) factor, 180-days 0.9542

Call option strike rate, yen/$ 116

Dollar proceeds from borrowing, now $34,698,126.30

Proceeds if call option exercised 4,218,181,818

Current spot rate, yen/$ 120.64


172


Yen proceeds, now 4,185,981,957 Option premium 0.80%Mitsubishi carry-

forward Option premium, up-

front, in yen 33,745,455at WACC for 180-

days 1.04Mitsubishi carry-

forward Yen proceeds, 180-

days from now 4,353,421,235 at WACC for 180-days 1.04

Option premium cost, in

180-days 35,095,273 Analysis: Yen/$ exchange rate certain; amount of exposure in $ not.

Net option proceeds, in

180-days, yen 4,183,086,545 This is a MINIMUM.

If Call Option Not

Exercised Ending spot rate, yen/$ 122 Option expires OTM: Convert $ to yen spot 4,436,363,636

Less premium carried-

forward -35,095,273

Net option proceeds, in

180-days, yen 4,401,268,364

Analysis: If yen expected to fall in next 180 days against US$; this may be an attractive alternative.Final Discussion: If Mitsubishi does not wish to accept any exchange rate risk it does not have to, it should choose the money market hedge. If Mitsubishi will accept some exchange rate risk, and it believes the yen will fall to 122 or weaker versus the dollar, the call option is preferable. Regardless, the hedging analysis does not cover the Egyptian pound to US dollar exchange rate risk, which was the problem in the end.

Problem # 8.23: Aswan Project: Mitsubishi's Exposure (Part b)Post devaluation, managing the expected payment after the initial hedge is difficult (to say the least).

Assumptions Value Assumptions Value6-month receivable in Egyptian 168,000,000 Spot rate, EL/$ (pre- 4.62


173


pounds (EL) devaluation)

Spot rate, yen/$ 120.64Spot rate, EL/$ (post-devaluation) 5.35


Percent devaluation versus the dollar -13.65%

Expected spot rate in 180 days, yen/$ 122 1. Do Nothing -- exchanging at spot rate in 6-months

2. Forward hedge -- sell dollars forward



Expected spot rate, EL/$ 5.35Expected spot rate,

EL/$ 4.62Expected payment in $ in 180

days $31,401,869.16 Expected payment in

$ in 180 days $36,363,636.36

Expected spot rate, yen/$ 1226-month forward rate,

yen/$ 119.62Payment in yen 3,831,028,037 Payment in yen 4,349,818,182

Mitsubishi will now be short the difference between the forward agreement above and the actual settlement in now 5 months.

Amount

Amount of short-fall in US$ ($4,961,767.20)Amount of short-fall in yen ($518,790,144.44)

The problems this situation poses for Mitsubishi are complex.First, Mitsubishi would first go back to its contracts with the Aswan Project and the Egyptian government and push for the government itself to make good on the full amount of the original contract -- in foreign currency terms. Secondly, if Mitsubishi had not hedged in January, but left it uncovered, the value of their expected payment, all other values held constant, have now fallen by the amount of the devaluation, 13.645%. Third, if Mitsubishi had entered into any hedge agreements in January (forward, money market, or option hedges), each of those agreements would have been premised on a principal in U.S. dollars which is now no longer going to happen. This would mean that for each of the individual hedges Mitsubishi would now be "short" 13.645% of the derivative or contract principles.


174


Problem # 8.24: Aswan Project: Fluor's Exposure. Post devaluation, managing the currency exposure.Assumptions 3-months 6-months 9-months3-month expected payment, Egyptian pounds 56,000,000 44,000,000 120,000,000Spot rate, EL/$ (pre-devaluation) 4.62 4.62 4.62 Expected US dollar proceeds $12,121,212.12 $9,523,809.52 $25,974,025.97

Assumptions ValuesFluor's WACC 10.60%Forward insurance agreement range 8.00%Forward insurance agreement premium 0.80%Spot rate, EL/$ (post-devaluation) 5.35 Percent devaluation versus the dollar -13.65%Actual spot rate at 3-month settlement 5.58

a. What was the cost of the forward insurance agreement? Fluor had expected the three US dollar payments: $12,121,212.12 $9,523,809.52

$25,974,025.97

Cumulative total $47,619,047.62 Percent premium 0.80% Cost up-front paid to NY bank $380,952.38

b. What was the actual US$ proceeds to Fluor with forward agreement less allocated premium?

Expected US dollar payment$12,121,212.1

2 Forward agreement premium 0.80% Premium paid on 3-month payment $96,969.703-month payment, Egyptian pounds 56,000,000 Actual exchange rate at 3-month settlement (EL/$) 5.58


175


Actual cash settlement, US$$10,035,842.2

9 Gain (loss) on expected settlement

($2,085,369.83)

Forward agreement settles one-half difference

($1,042,684.91)

Final settlement: Actual - Premium + Forward

$10,981,557.51

Fluor was wise to take out the forward insurance agreement, even for what was considered a fixed exchange rate. The history of the Egyptian pound in the past 4 years had been a series of periodic devaluations. Although the agreement did not fully compensate Fluor, given the nominal cost up-front, the agreement saved Fluor $1,042,685 on the 3-month payment alone.

Problem # 8.25: Aswan Project: DaSilva's Contingency Lever. Price quotes and exchange rate contingencies

daSilva's Expected & Budgeted 3-months 6-months 9-months3-month expected payment, Egyptian pounds 28,000,000 66,000,000 24,000,000Spot rate, EL/$ (pre-devaluation) 4.62 4.62 4.62 Expected US dollar proceeds $6,060,606.06 $14,285,714.29 $5,194,805.19 Budgeted spot rate, Brazilian real/$

3.5 3.5 3.5


176


Budgeted Brazilian real proceeds 21,212,121.21 50,000,000.00 18,181,818.18Less contingency of -16.00% -16.00% -16.00% Budgeted proceeds, without contingency

R$ 17,818,181.82

R$ 42,000,000.00

R$ 15,272,727.27

Final Outcome

3-months

6-months

9-months

3-month payment, Egyptian pounds 28,000,000 66,000,000 24,000,000Spot rate, EL/$ 5.58 6.2 6.2 Expected US dollar proceeds $5,017,921.15 $10,645,161.29 $3,870,967.74 Actual spot rate, Brazilian real/$ 3.5 3.6 3.7 Expected Brazilian real proceeds

R$ 17,562,724.01

R$ 38,322,580.65

R$ 14,322,580.65

Actual devaluation of Egyptian pnd (effective) -17.20% -25.50% -25.50%Actual versus budget (contingency removed) -3,649,397 -11,677,419 -3,859,238

Even with the devaluation contingency built into the contract, the actual Egyptian pound rates proved to be worse than the 16% contingency. Although the gradual weakening of the Brazilian real versus the dollar helped the company, it was not enough to outweigh the degree of pound devaluation.

Chapter-9


177


Operating Exposure

Chapter # 9 Operating Exposure Problem 9.1 Carlton Germany - Case 4 Balance Sheet Information, End of Fiscal 2002

Assets Liabilities and net worthCash € 1,600,000 Accounts payable € 800,000Accounts receivable 3,200,000 Short-term bank loan 1,600,000Inventory 2,400,000 Long-term debt 1,600,000Net plant and equipment 4,800,000 Common stock 1,800,000 Retained earnings 6,200,000Total € 12,000,000 Total € 12,000,000

Important Ratios to be Maintained and Other Data


178


Cash Flows before Adjustments

Adjustments to Working Capital for 2003 and 2007 Caused by Changes in Conditions


Accounts receivable, as percent of sales 25.00%Inventory, as percent of annual direct costs 25.00%Cost of capital (annual discount rate) 20.00%Income tax rate 34.00%

Assumptions Base Case Case 1 Case 2 Case 3 Case 4Exchange rate, $/€ 1.2 1 1 1 1Sales volume (units) 1,000,000 1,000,000 2,000,000 1,000,000 500,000Export sales volume (case 4) 500,000Sales price per unit 12.8 12.8 12.8 15.36 12.8Export sales price per unit (case 4) 15.36Direct cost per unit 9.6 9.6 9.6 9.6 9.6

Assumptions Base Case Case 1 Case 2 Case 3 Case 4Direct cost of goods sold 9,600,000 9,600,000 19,200,000 9,600,000 9,600,000Cash operating expenses (fixed) 890,000 890,000 890,000 890,000 890,000Depreciation 600,000 600,000 600,000 600,000 600,000Pretax profit € 1,710,000 € 1,710,000 € 4,910,000 € 4,270,000 € 2,990,000Income tax expense 581,400 581,400 1,669,400 1,451,800 1,016,600Profit after tax € 1,128,600 € 1,128,600 € 3,240,600 € 2,818,200 € 1,973,400Add back depreciation 600,000 600,000 600,000 600,000 600,000Cash flow from operations, in euros € 1,728,600 € 1,728,600 € 3,840,600 € 3,418,200 € 2,573,400Cash flow from operations, in dollars $2,074,320 $1,728,600 $3,840,600 $3,418,200 $2,573,400

Assumptions Base Case Case 1 Case 2 Case 3 Case 4Accounts receivable € 3,200,000 € 3,200,000 € 6,400,000 € 3,840,000 € 3,520,000Inventory 2,400,000 2,400,000 4,800,000 2,400,000 2,400,000Sum € 5,600,000 € 5,600,000 € 11,200,000 € 6,240,000 € 5,920,000Change from base conditions in 2003 € - € - € 5,600,000 € 640,000 € 320,000

Year-End Cash Flows

Year Base Case Case 1 Case 2 Case 3 Case 41 (2003) $2,074,320 $1,728,600 ($1,759,400) $2,778,200 $2,253,400 2 (2004) $2,074,320 $1,728,600 $3,840,600 $3,418,200 $2,573,400 3 (2005) $2,074,320 $1,728,600 $3,840,600 $3,418,200 $2,573,400 4 (2006) $2,074,320 $1,728,600 $3,840,600 $3,418,200 $2,573,400 5 (2007) $2,074,320 $1,728,600 $9,440,600 $4,058,200 $2,893,400

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Problem 9.2 Carlton Germany - Case 5 Balance Sheet Information, End of Fiscal 2002

Assets Liabilities and net worthCash € 1,600,000 Accounts payable € 800,000Accounts receivable 3,200,000 Short-term bank loan 1,600,000Inventory 2,400,000 Long-term debt 1,600,000Net plant and equipment 4,800,000 Common stock 1,800,000 Retained earnings 6,200,000Sum € 12,000,000 Sum € 12,000,000

Important Ratios to be Maintained and Other Data

Accounts receivable, as percent of sales 25.00%Inventory, as percent of annual direct costs 25.00%Cost of capital (annual discount rate) 20.00%Income tax rate 34.00%

Assumptions Base Case Case 1 Case 2 Case 3 Case 4Exchange rate, $/€ 1.2 1 1 1 1Sales volume (units)

1,000,000

1,000,000

2,000,000 1,000,000 500,000

Export sales volume (case 4) 500,000Sales price per unit 12.8 12.8 12.8 15.36 15.36 Export sales price per unit (case 4) 15.36Direct cost per unit 9.6 9.6 9.6 9.6 11.52Exchange rate, $/€ 1.2 1 1 1 1Sales volume (units) 1,000,000 1,000,000 2,000,000 1,000,000 500,000

Annual Cash Flows before AdjustmentsAssumptions Base Case Case 1 Case 2 Case 3 Case 4Sales revenue € 12,800,000 €

12,800,000€

25,600,000€

15,360,00€ 15,360,000


Change in Year-End Cash Flows from Base Conditions

Year Base Case Case 1 Case 2 Case 3 Case 41 (2003) na ($345,720) ($3,833,720) $703,880 $179,080 2 (2004) na ($345,720) $1,766,280 $1,343,880 $499,080 3 (2005) na ($345,720) $1,766,280 $1,343,880 $499,080 4 (2006) na ($345,720) $1,766,280 $1,343,880 $499,080 5 (2007) na ($345,720) $7,366,280 $1,983,880 $819,080

Present Value of Incremental Year-End Cash Flows na ($1,033,914) $2,866,106 $3,742,892 $1,354,489

180


0Direct cost of goods sold 9,600,000 9,600,000 19,200,000 9,600,000 11,520,000Cash operating expenses (fixed) 890,000 890,000 890,000 890,000 1,068,000Depreciation 600,000 600,000 600,000 600,000 600,000

Pretax profit € 1,710,000 € 1,710,000€

4,910,000€

4,270,000 € 2,172,000Income tax expense 581,400 581,400 1,669,400 1,451,800 738,480

Profit after tax € 1,128,600 € 1,128,600€ 3,240,600

€ 2,818,200 € 1,433,520

Add back depreciation 600,000 600,000 600,000 600,000 600,000Cash flow from operations, in euros € 1,728,600 € 1,728,600

€ 3,840,600

€ 3,418,200 € 2,033,520

Cash flow from operations, in dollars $2,074,320 $1,728,600 $3,840,600

$3,418,200 $2,033,520

Adjustments to Working Capital for 2003 and 2007 Caused by Changes in Conditions

Assumptions Base Case Case 1 Case 2 Case 3 Case 4

Accounts receivable € 3,200,000 € 3,200,000€

6,400,000€

3,840,000 € 3,840,000Inventory 2,400,000 2,400,000 4,800,000 2,400,000 2,880,000

Sum € 5,600,000 € 5,600,000€

11,200,000€

6,240,000 € 6,720,000Change from base conditions in 2003 € - € -

€ 5,600,000

€ 640,000 € 1,120,000


Year-End Cash Flows

Year Base Case Case 1 Case 2 Case 3 Case 41 (2003) $2,074,320 $1,728,600 ($1,759,400) $2,778,200 $913,520 2 (2004) $2,074,320 $1,728,600 $3,840,600 $3,418,200 $2,033,520 3 (2005) $2,074,320 $1,728,600 $3,840,600 $3,418,200 $2,033,520 4 (2006) $2,074,320 $1,728,600 $3,840,600 $3,418,200 $2,033,520 5 (2007) $2,074,320 $1,728,600 $9,440,600 $4,058,200 $3,153,520

Change in Year-End Cash Flows from Base Conditions

Year Base Case Case 1 Case 2 Case 3 Case 41 (2003) na ($345,720) ($3,833,720) $703,880 ($1,160,800)2 (2004) na ($345,720) $1,766,280 $1,343,880 ($40,800)3 (2005) na ($345,720) $1,766,280 $1,343,880 ($40,800)4 (2006) na ($345,720) $1,766,280 $1,343,880 ($40,800)5 (2007) na ($345,720) $7,366,280 $1,983,880 $1,079,200

Present Value of Incremental Year-End Cash Flows na ($1,033,914) $2,866,106 $3,742,892 ($605,247)

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Problem 9.3 Denver Plumbing Company (A)Solution: Assumptions ValuesSales volume per year 1,000,000US dollar price per unit $24.00 Direct costs as % of US$ sales price 75% Direct costs per unit $18.00 Spot exchange rate, Rmb/$ 8.2Expected spot rate, Rmb/$ 10Unit volume decrease if price increased -10%

S.No. Case 1 Case 2

Sales to China Same Rmb PriceSame US$

Price US dollar price per unit $19.68 $24.00 Unit volume 1,000,000 900,000 Sales revenue, Rmb $19,680,000 $21,600,000 Less direct costs -18,000,000 -16,200,000Gross profits, Rmb $1,680,000 $5,400,000 Better.

Problem 9.4 Denver Plumbing Company (B).

Assumptions Values Assumptions ValuesSales volume per year 1,000,000 Volume change 1%US dollar price per unit $24.00 (if price increased)Direct costs as % of US$ price 75% Volume growth 12% Direct costs per unit $18.00 (same Rmb price)Spot exchange rate, Rmb/$ 8.2 WACC 10%Expected spot rate, Rmb/$

10

Alternative 1: Keep Same Chinese Sales Price

Year Volume Revenue Direct Costs Gross Margin

Present Value

Present Value of


182


Factor Margin1 1,000,000 $19,680,000 $18,000,000 $1,680,000 0.9091 $1,527,273 2 1,120,000 $22,041,600 $20,160,000 $1,881,600 0.8264 $1,555,041 3 1,254,400 $24,686,592 $22,579,200 $2,107,392 0.7513 $1,583,315 4 1,404,928 $27,648,983 $25,288,704 $2,360,279 0.683 $1,612,102 5 1,573,519 $30,966,861 $28,323,348 $2,643,513 0.6209 $1,641,413 6 1,762,342 $34,682,884 $31,722,150 $2,960,734 0.5645 $1,671,257 7 1,973,823 $38,844,830 $35,528,808 $3,316,022 0.5132 $1,701,644 8 2,210,681 $43,506,210 $39,792,265 $3,713,945 0.4665 $1,732,583

Cum PV of Gross Margin $13,024,628

Alternative 2: Raise Chinese Sales Price

Year

Volume

Revenue

Direct Costs

GrossMargin

Present Value

Factor

Present Value

of Margin1 900,000 $21,600,000 $16,200,000 $5,400,000 0.9091 $4,909,091 2 909,000 $21,816,000 $16,362,000 $5,454,000 0.8264 $4,507,438 3 918,090 $22,034,160 $16,525,620 $5,508,540 0.7513 $4,138,648 4 927,271 $22,254,502 $16,690,876 $5,563,625 0.683 $3,800,031 5 936,544 $22,477,047 $16,857,785 $5,619,262 0.6209 $3,489,119 6 945,909 $22,701,817 $17,026,363 $5,675,454 0.5645 $3,203,646 7 955,368 $22,928,835 $17,196,626 $5,732,209 0.5132 $2,941,529 8 964,922 $23,158,124 $17,368,593 $5,789,531 0.4665 $2,700,859

Cum PV of Gross Margin $29,690,361

Denver Plumbing is much better off raising the Chinese sales price to maintain the US dollar price, and suffering the lower volumes. The volume decrease does not offset the stronger US dollar price per unit receieved

Problem #9.5 Hawaiian Macadamia Nuts. a. How much should Hawaiian Macadamia Nuts (HMN) borrow in yen? HMN receives cash collections of one hundred million yen per month. This is the source of repayment of any balance sheet hedge. If HMN wants to be covered for one year at a time, it would need to borrow one year's cash flow plus interest, and convert the borrowed yen to US dollar at once. A sample calculation would be:

S. No. Sample Values Units

One month's cash flow 100,000,000 YenMonths per year 12


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One year's cash flow 1,200,000,000 YenPlus interest 4.00% per annumPrincipal and interest 1,248,000,000 YenSpot exchange rate 125 Yen/US$US dollars $9,984,000 US$

Realistically, HMN would probably want to be covered for the long term. In that case, the 1.2 billion yen loan could be structured so that it could be renewed annually with interest reset annually. This would only cover the foreign exchange and interest rate risk for a year at a time, but would probably be acceptable to a bank lender. Also unknown are the expected sales for year 2 and beyond.

b. What should be the terms of payment on the loan? The loan should be repaid out of the monthly cash flow, with payments on principal only. The interest payment one year hence has already been covered by borrowing both principal and interest up-front.

Note: HMN should not borrow 250 million yen to cover only its balance sheet exposure. Such a loan would cover only the accounting exposure, and not the cash flow exposure (operating exposure).

Problem 9.6 Cellini Fashionwear. The use of risk-sharing agreements.

a. If the exchange rate changes immediately to Ps6.00/$, what will be the dollar cost of 6 months of imports to Cellini Fashionwear?

Bottom TopThe allowable range of exchange rates is (Ps/$) 3.5 4.5Outside of this range the trading partners will share the extra risk equally. New exchange rate (Ps/$) 6 Allowable exchange rate (Ps/$) 4.5 Difference to be shared (Ps/$) 1.5 Cellini's share 0.75 Boselli's share 0.75 Therefore, Cellini will use the following effective exchange rate after risk-sharing:


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Top of range 4.5 Cellini's share 0.75 Effective total of risk-sharing 5.25 Assuming that 6 months of imports will still be (Ps) 8,000,000 Effective exchange rate for Cellini (Ps/$) 5.25 Cellini's cost in US dollars $1,523,809.52 However, the lower cost of importing might lead to higher Cellini sales and therefore a higher import total than Ps 8 million.

b. At Ps6.00/$, what will be the peso export sales in Boselli Leather goods to Cellini Fashionwear?

The export sales of Boselli would remain at Ps 8 million, unless the lower dollar cost encourages Cellini to import more from Boselli.

Problem 9.7 Autocars, Ltd.

Assumptions ValuesInvoice price of car £12,000Spot exchange rate, NZ$/£ 1.64Risk-sharing band, percentage 5.00%

Sales to New Zealand DistributorsLower Band Upper Band

a. What are the outside ranges? (initial spot rate + or - 5%) 1.722 1.558

b. Cost to the Kiwi distributor for 10 cars New current spot rate (N$/£) 1.7 Is this within the band? Yes Cost of 10 cars at this exchange rate (NZ$) 204,000 Receipts to Autocar in British pounds (Within the band Autocar receives £12,000/car,

as expected) £120,000 c. Cost to the Kiwi distributor for 10 cars


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New current spot rate (N$/£) =1.65 Is this within the band? = Yes Cost of 10 cars at this exchange rate (NZ$) = 198,000 Receipts to Autocars in British pounds = £120,000 (Within the band Autocars receives £12,000/car)

d. How does this shift the currency risk? The Autocars bears no risk within the 5% range. The distributor carries all of the risk within 5%.If the exchange rate falls outside the 5% range, Autocars shares the risk with distributor.

e. Who benefits from this risk-sharing agreement? Both parties are in practice of risk-sharing agreement. The manufacturer has predictable revenues within the range, while the distributor bears a moderate level of currency risk within the 5% range. The distributor will hopefully be able to provide a more stable pricing to pass on to the customer, which will also benefit the manufacturer through a more stable and sustainable distributor sales outlet.

Problem 9.8 High-Profile Printers, Inc. (A)

Pricing decisions in foreign markets experiencing devaluations.

Assumptions

US dollar

prices x

Exchange rate

(R$/$) =

Prices in Brazilian

reaisExisting sales price per unit $200.00 → 3.4 → 680If the real falls in value, the new implied US$ price: New dollar price if no real price change $170.00 ← 4 ← 680If the US$ price is changed to keep US$ price : New real price is current US$ price at new exchange rate: $200.00 → 4 → 800Direct cost per unit in the US, percent of price 60% Direct cost per unit in the US $120.00 3.4 408Unit volume 50,000


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Decrease in unit volume from price increase -20.00% New lower unit volume 40,000

Alternative #1: Maintain same price in reais: Sales revenue (R$680 x 50,000 ) / (R$4.000/$) $8,500,000 Less: Direct costs (US$120 x 50,000) 6,000,000 Contribution margin in US dollars $2,500,000

Alternative #2: Raise price in reais (and accept lower volume): Sales revenue (R$800 x 40,000 ) / (R$4.000/$) $8,000,000 Less: Direct costs (US$120 x 40,000) 4,800,000 Contribution margin in US dollars $3,200,000

Discussion: Alternative #2 is preferable. In the short run (one year), HPP would be better off to increase its sales price in reais in Brazil and accept the lower sales volume. The contribution margin if real prices are raised is $3,200,000, whereas if the price in reais is left unchanged HPP's contribution margin is only $2,500,000. This is a short-run solution, and does not consider possible longer-run effects that might come from raising the local price and/or accepting a smaller market share.

Problem# 9.9: High-Profile Printers, Inc. (B)

Pricing decisions on export sales when foreign currency denominated sales may decline from real price changes.Assumptions ValueInitial sales volume 50,000Sales volume growth 10%

Sales price, US$ $170.00 Direct cost per unit $120.00

Alternative #1: Maintain current Brazilian sales price and volume grows 10% per annum


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Endof year Sales

volume US$ Revenue

Direct Costs

Contribution Margin

12% PV Factor PV

1 50,000 8,500,000 6,000,000 2,500,000 0.8929 2,232,1432 55,000 9,350,000 6,600,000 2,750,000 0.7972 2,192,2833 60,500 10,285,000 7,260,000 3,025,000 0.7118 2,153,1354 66,550 11,313,500 7,986,000 3,327,500 0.6355 2,114,6865 73,205 12,444,850 8,784,600 3,660,250 0.5674 2,076,9246 80,526 13,689,335 9,663,060 4,026,275 0.5066 2,039,836

Present value of contribution margins = $12,809,008

Assumptions ValueInitial sales volume 40,000Sales volume growth 4%Sales price, US$ $200.00 Direct cost per unit $120.00

Alternative #2: Raise Brazilian sales price to R$400 and volume grows only 4% per annum from a lower volume base.

End of

YearSales volume

US$ Revenue

Direct Costs

ContributionMargin

12% PV Factor PV

1 40,000 8,000,000 4,800,000 3,200,000 0.8929 2,857,1432 41,600 8,320,000 4,992,000 3,328,000 0.7972 2,653,0613 43,264 8,652,800 5,191,680 3,461,120 0.7118 2,463,5574 44,995 8,998,912 5,399,347 3,599,565 0.6355 2,287,5895 46,794 9,358,868 5,615,321 3,743,547 0.5674 2,124,1896 48,666 9,733,223 5,839,934 3,893,289 0.5066 1,972,462

Present value of contribution margins = $14,358,000Alternative #2, is preferable, yielding a higher present value of total contribution margin over the expected remaining life of the export sales.

Problem# 9.10: Hedging Hogs: Risk-Sharing at Harley Davidson


188


Solution: Calculating boundaries for risk-sharing agreements is given as under; Assumption Set ValueSpot rate, central rate, A$/US$ 1.28Fixed rate zone, percent from central rate 2.50%Sharing zone boundaries, percent from central rate 5.00%

a. Fixed Rate & Risk Sharing Zones

Sharing Zone: upper boundary 1.219 5.00%

Fixed rate: upper boundary 1.2488 2.50%

CENTRAL RATE 1.28

Fixed rate: lower boundary 1.3128 -2.50%

Sharing Zone: lower boundary 1.3474 -5.00%

If the spot rate falls between the fixed rate boundaries, between A$1.2488/$ and A$1.3128/US$, the company guarantees its distributors prices in their local currency calculated using the central rate. If the spot rate falls between the fixed rate upper boundary and the sharing zone upper boundary, the company will "share" the exchange rate risk with the distributor. It calculates the effective rate as the fixed rate upper boundary + (0.5 x (spot - 1.2190)). If the spot rate falls between the fixed rate lower boundary and the sharing zone lower boundary, If the spot rate falls between the fixed rate lower boundary and the sharing zone lower boundary, the company will "share" the exchange rate risk with the distributor. It calculates the effective rate the company will "share" the exchange rate risk with the distributor. It calculates the effective rate the company will "share" the exchange rate risk with the distributor. It calculates the effective rate as: [fixed rate lower boundary + (0.5 x (spot - 1.2190)].

b. If Harley ships a hog costing US$8,500, and the spot exchange rate on the


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order date is A$1.3442/US$, what is the price to the Australian dealership?

The spot rate falls between the fixed rate lower boundary and the sharing zone lower boundary.This means that the effective rate is a "shared rate":

Spot rate, A$/US$ 1.3442Fixed rate: lower boundary A$/US$ 1.3128

Difference, A$/US$ 0.0314Effective rate = lower boundary + (.5 x (difference)) 1.3285

Hog price in US$ $8,500.00 Effective exchange rate, A$/US$ 1.3285

Hog price to distributor, A$ 11,292.34

c. If Harley ships a hog costing US$8,500, and the spot exchange rate on the order date is A$1.2442/US$, what is the price to the Australian dealership?

The spot rate falls between the central rate and fixed rate upper boundary, in the zone of fixed rate pricing. This means that the effective rate is the central rate.

Hog price in US$ $8,500.00 Effective exchange rate, A$/US$ 1.28

Hog price to distributor, A$ 10,880.00


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Chapter-10

Translation Exposure

or Accounting Exposure

Chapter # 10 “Translation Exposure or Accounting Exposure”

Problem # 10.1: Carlton Germany (A).


191


Using facts in the chapter for Carlton Germany, assume the exchange rate on January 2, 2006, in Exhibit 10.4 dropped in value from $1.2000/€ to $0.9000/€ rather than to $1.0000/€. Recalculate Carlton Germany’s translated balance sheet for January 2, 2006 with the new exchange rate using the current rate method.a). What is the amount of translation gain or loss?b). Where should it appear in the financial statements?

Translation Using the Current Rate Method: euro depreciates from $1.2000/euro to $0.9000/€.

Just before devaluation

Just after devaluation

EurosExchange

RateTranslated

AccountsExchange

RateTranslated

AccountsAssets Statement ($/€) US dollars ($/€)) US dollars

Cash 1,600,000 1.2 $1,920,000 0.9 $1,440,000 A/R 3,200,000 1.2 3,840,000 0.9 2,880,000Inventory 2,400,000 1.2 2,880,000 0.9 2,160,000Net plant & equipment 4,800,000 1.2 5,760,000 0.9 4,320,000 Total 12,000,000 $14,400,000 $10,800,000 Liabilities & Net Worth A/P 800,000 1.2 $960,000 0.9 $720,000 Short-term bank debt 1,600,000 1.2 1,920,000 0.9 1,440,000Long-term debt 1,600,000 1.2 1,920,000 0.9 1,440,000Common stock 1,800,000 1.276 2,296,800 1.276 2,296,800Retained earnings 6,200,000 1.2 7,440,000 1.2 7,440,000CTA account (loss) - ($136,800) ($2,536,800) Total 12,000,000 $14,400,000 $10,800,000

a). The translation gain (loss) = ($2,536,800) – $136,800 = ($240,000)


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b). The translation gain (loss) for the year is added to the balance in the Cumulative Translation adjustment account, which is carried as a separate balance sheet account within the equity section of the consolidated balance sheet. The lsos does not pass through the income statement under the Current Rate Method, in which the currency of the foreign subsidiary is local currency functional.

Problem#10.2: Carlton Germany (B). Using facts in the chapter for Carlton Germany, assume as in question Carlton Germany (A) that the exchange rate on January 2, 2006, in Exhibit 10.4 dropped in value from $1.2000/€ to $0.9000/€ rather than to $1.0000/€. Recalculate Carlton Germany’s translated balance sheet for January 2, 2006 with the new exchange rate using the temporal rate method.


193


a. The translation gain (loss) = ($240,000) – 0 = ($240,000)

b. Under the Temporal Method, the translation loss of $240,000 would be closed into retained earnings through the income statement, rather than as a separate line item. It is shown as a separate line item above for pedagogical purposes only. Actual year-end retained earnings would be $7,711,200 - $240,000 = $7,471,200.

c. The translation gain (loss) differs from the Current Rate Method because "exposed assets" under the Current Rate Method are larger than under the temporal method by the amount of inventory and net plant & equipment.

Problem#10.3: Carlton Germany (C). Using facts in the chapter for Carlton Germany, assume the exchange rate on January 2, 2006, in Exhibit 10.4 appreciated from $1.2000/€ to $1.500/€. Calculate Carlton


194


Germany’s translated balance sheet for January 2, 2006 with the new exchange rate using the current rate method..

Translation Using the Current Rate Method: euro appreciates from $1.2000/euro to $1.5000/euro.

Euros

Just before revaluation Just after revaluationExchange

RateTranslated

AccountsExchange Rate

Translated Accounts

Assets Statement ($/€) US dollars ($/€) US dollarsCash 1,600,000 1.2 $1,920,000 1.5 $2,400,000 A/R 3,200,000 1.2 3,840,000 1.5 4,800,000Inventory 2,400,000 1.2 2,880,000 1.5 3,600,000Net plant & equipment 4,800,000 1.2 5,760,000 1.5 7,200,000

Total12,000,00

0 $14,400,00

0 $18,000,000 Liabilities & Net Worth A/P 800,000 1.2 $960,000 1.5 $1,200,000 Short-term bank debt 1,600,000 1.2 1,920,000 1.5 2,400,000Long-term debt 1,600,000 1.2 1,920,000 1.5 2,400,000Common stock 1,800,000 1.276 2,296,800 1.276 2,296,800Retained earnings 6,200,000 1.2 7,440,000 1.2 7,440,000CTA account (loss) - ($136,800) $2,263,200

Total12,000,00

0 $14,400,00

0 $18,000,000

a. The translation gain (loss) = $2,263,200 + $136800 = $2,400,000

b. The translation gain for the year is added to the balance in the Cumulative Translation adjustment account, which is carried as a separate balance sheet account within the equity section of the consolidated balance sheet. The gain does not pass


195


through the income statement under the current rate method in which the currency of the foreign subsidiary is a local currency functional. Problem# 10.4: Carlton Germany (D). Using facts in the chapter for Carlton Germany, assume as in Carlton Germany (C) that the exchange rate on January 2, 2006, in Exhibit 10.4 appreciated from $1.2000/€ to $1.5000/€. Calculate Carlton Germany’s translated balance sheet for January 2, 2006 with the new exchange rate using the temporal method.

Translation Using the Temporal Method: euro appreciates from $1.2000/euro to $1.5000/euro.

Just before revaluation

Just after revaluation

Assets

Euros

Exchange

RateTranslated

Accounts

Exchange

RateTranslated

Accounts

Statement ($/€) (US dollars) ($/€)(US

dollars)Cash 1,600,000 1.2 $1,920,000 1.5 $2,400,000 A/R 3,200,000 1.2 3,840,000 1.5 4,800,000Inventory 2,400,000 1.218 2,923,200 1.218 2,923,200Net plant & equipment 4,800,000 1.276 6,124,800 1.276 6,124,800 Total 12,000,000 $14,808,000 $16,248,000 Liabilities & Net Worth Accounts payable 800,000 1.2 $960,000 1.5 $1,200,000 Short-term bank debt 1,600,000 1.2 1,920,000 1.5 2,400,000Long-term debt 1,600,000 1.2 1,920,000 1.5 2,400,000Common stock 1,800,000 1.276 2,296,800 1.276 2,296,800Retained earnings 6,200,000 1.2437 7,711,200 1.2437 7,711,200CTA account (loss) - $0 $240,000 Total 12,000,000 $14,808,000 $16,248,000

a). The Translation gain (loss) = $240,000 - $0 = $240,000


196


b). Under the Temporal Method, the translation loss of $240,000 would be closed into retained earnings through the income statement, rather than as a separate line item. It is shown as a separate line item above for pedagogical purposes only. Actual year-end retained earnings would be $7,711,200 - $240,000 = $7,471,200.

c). The translation gain (loss) differs from the Current Rate Method because "exposed assets" under the Current Rate Method are larger than under the temporal method by the amount of inventory and net plant & equipment.

Problem#10.5: Montevideo Products, S.A. (A). Montevideo Products, S.A., is the Uruguayan subsidiary of a U.S. manufacturing company. Its balance sheet for January 1 follows. The January 1st exchange rate between the U.S. dollar and the peso Uruguayo ($U) is $U20/$. Determine Montevideo’s contribution to the translation exposure of its parent on January 1, using the current rate method

Balance Sheet (thousands of pesos Uruguayo, $U)

AssetsExchange Rate

($U/US$)Exchange Rate

($U/US$)AssetsCash 60,000 20Accounts receivable 120,000 20Inventory 120,000 20Net plant & equipment 240,000 20 540,000 Liabilities & Net Worth Current liabilities 30,000 20Long-term debt 90,000 20Capital stock 300,000 15Retained earnings 120,000 15 540,000

Calculation of Accounting Exposures:

$U

January 1st$U/US$


197


(000s) 20.00 Exposed assets (all assets) 540,000 $27,000 Less: exposed liabilities (current Liabilities + debt) -120,000 -6,000 Net exposure 420,000 $21,000

Problem#10.6: Montevideo Products, S.A. (B).Calculate Montevideo’s contribution to its parent’s translation loss if the exchange rate on December 31st is $U22/$. Assume all peso accounts remain as they were at the beginning of the year. Balance Sheet (thousands of pesos Uruguayo, $U)

January 1st

($U/US$)

Before Devaluation After Devaluation Exchange Rate ($U/US

$)

Translated Accounts US

dollars

Exchange Rate

($U/US$)

Translated

Accounts US dollars

AssetsCash 60,000 20 $ 3,000 22 $ 2,727A/R 120,000 20 6,000 22 5,455 Inventory 120,000 20 6,000 22 5,455 Net plant & equipment 240,000 20 12,000 22 10,909

Total 540,000 $27,000

$24,546

Liabilities & Net Worth A/P 30,000 20 $ 1,500 22 $1,364 Long-term debt 90,000 20 4,500 22 4,091Capital Stock 300,000 20 15,000 15 5,455 Retained earnings 120,000 20 6,000 15 10,909 CTA account (loss) --- --- (2727) Total 540,000 $27,000 $24,546

The translation gain (loss) = (2727) – $0 = (2727)

But the translation gain (loss) of exposed asset & exposed liabilities are given as under;

Calculation of Accounting

$U

January 1st

January 1st$U/US$


198


Exposures: (000s)

$U/US$ 20.00Before

Devaluation

22.00After

Devaluation Exposed assets (current assets +

fixed assets) 540,000 $27,000* $24,546* Less: exposed liabilities (current

Liabilities + Long term debt) -120,000 (6,000)** (5455)** Net exposure 420,000 $21,000 $19,091

Alternatively, the translation loss arising from the fall in the value of the peso Uruaguayo can be found as follows:

Translation gain or (loss) = After Devaluation Before Devaluation net exposure – net exposure Translation gain or (loss) = $19,091 - $21,000 Translation gain or (loss) = $ (1,909) Notes: Before Devaluation: *Total Exposed Assets = Cash + A/R + Inventory + Net plant & equipment Total Exposed Assets = $ 3,000 + $6,000 + $6,000 + $ 12,000 Total Exposed Assets = $27,000

**Total Exposed Liabilities = Current Liabilities + Long term debt Total Exposed Liabilities= $1,500 + 4500 Total Exposed Liabilities = 6000

After Devaluation:

*Total Exposed Assets = Cash + A/R + Inventory + Net plant & equipment Total Exposed Assets = $2,727 + 5,455 + 5,455 + 10,909 Total Exposed Assets = $24,546

**Total Exposed Liabilities = Current Liabilities + Long term debt Total Exposed Liabilities = $1,364 + $4,091 Total Exposed Liabilities = $5455


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Problem#10.7: Montevideo Products, S.A. (C ). Calculate Montevideo’s contribution to its parent’s translation gain or loss using the current rate method if the exchange rate on December 31 is $U12/$. Assume all peso accounts remain as they were at the beginning of the year.

Balance Sheet (thousands of pesos Uruguayo, $U)

January 1st

($U/US$)

Before Devaluation After Devaluation Exchange Rate ($U/US

$)

Translated Accounts US

dollars

Exchange Rate

($U/US$)

Translated Accounts

US dollars

Assets

Cash 60,000 20

$3,000 12 $5,000

A/R 120,000 20 6,

000 12 10,000

Inventory 120,000 20 6,000 12 10,000

Net plant & equipment 240,000 20 12,000 12 20,000

Total 540,000 $27,000 $45,000

Liabilities & Net Worth A/P 30,000 20 $ 1,500 12 2500

Long-term debt 90,000 20 4,500 12 7500

Capital Stock 300,000 15 20,000 15

20,000

Retained earnings 120,000 15 8,000 15 8,000CTA account (gain or loss) --- 7000 7000 Total 540,000 $27,000 $45,000

The translation gain (loss) = $7000– $7000 = $0

But he translation gain or loss of exposed asset & exposed liabilities are given as under;


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Calculation of Accounting Exposures:

$U (000s)

January 1st

$U/US$ 20.00Before

Devaluation

January 1st$U/US$

22.00After

Devaluation Exposed assets (current assets +

fixed assets) 540,000 $27,000* $45,000* Less: exposed liabilities (current

Liabilities + Long term debt) -120,000 (6,000)** (10,000) ** Net exposure 420,000 $21,000 $35,000


Translation gain or (loss) = After Devaluation Before Devaluation net exposure – net exposure Translation gain or (loss) = $35,000 - $21,000 Translation gain or (loss) = $ 14,000 Notes: Before Devaluation: *Total Exposed Assets = Cash + A/R + Inventory + Net plant & equipment Total Exposed Assets = $ 3,000 + $6,000 + $6,000 + $ 12,000 Total Exposed Assets = $27,000

**Total Exposed Liabilities = Current Liabilities + Long term debt Total Exposed Liabilities= $1,500 + 4500 Total Exposed Liabilities = 6000

After Devaluation:

*Total Exposed Assets = Cash + A/R + Inventory + Net plant & equipment Total Exposed Assets = $5,000 + $10,000 + $10,000 + 20,000 Total Exposed Assets = $45,000

**Total Exposed Liabilities = Current Liabilities + Long term debt Total Exposed Liabilities= $2500 + $7500


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Total Exposed Liabilities = $10,000

Problem#10.8: Siam Toys, Ltd. (A). Siam Toys, Ltd., is the Thai affiliate of a U.S. toy manufacturer. Siam Toys manufacture plastic injection molding equipment for making toy cars. Sales are primarily in the United States and Europe. Siam Toys’ balance sheet in thousands of Thai bahts (฿) as of March 31st is as follows. Using the data presented on Siam Toys, assume that the Thai baht dropped in value from ฿ 30/$ to ฿40/$ between March 31 and April 1. Assuming no change in balance sheet accounts between these two days, calculate the gain or loss from translation by both the current rate method and the temporal method. Explain the translation gain or loss in terms of changes in the value of exposed accounts.

TRANSLATION BY THE CURRENT RATE METHOD

Balance Sheet (thousands)

Thai baht

Before Devaluation After Devaluation

Exchange

RateTranslated

AccountsExchange Rate

TranslatedAccounts

Assets Statement (/฿/$)US

dollars (/฿/$)US

dollarsCash ฿24,000 30 $800 40 $600 Accounts receivable 36,000 30 1,200 40 900Inventory 48,000 30 1,600 40 1,200Net plant & equipment 60,000 30 2,000 40 1,500 Total ฿168,000 $5,600 $4,200 Liabilities & Net Worth Accounts payable ฿18,000 30 $600 40 $450 Bank loans 60,000 30 2,000 40 1,500Common stock 18,000 20 900 20 900Retained earnings 72,000 34 2,100 34 2,100CTA account (loss) 0 - ($750) Total ฿168,000 $5,600 $4,200

Note: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of


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those years. This cumulative translation account (CTA) loss of$750,000 would be entered into the company's consolidated balance sheet under equity.

TRANSLATION BY THE TEMPORAL METHOD

Balance Sheet (thousands)

Before Devaluation After Devaluation

Thai baht

Exchange Rate

TranslatedAccounts

Exchange

RateTranslated

Accounts

Assets Statement (/฿$)US

dollars ( ฿/$)US

dollarsCash ฿24,000 30 $800 40 $600 Accounts receivable 36,000 30 1,200 40 900Inventory 48,000 30 1,600 30 1,600Net plant & equipment 60,000 20 3,000 20 3,000 Total ฿168,000 $6,600 $6,100 Liabilities & Net Worth Accounts payable ฿18,000 30 $600 40 $450 Bank loans 60,000 30 2,000 40 1,500Common stock 18,000 20 900 20 900Retained earnings 72,000 23 3,100 23 3,100CTA account (loss) 0 - $150 Total ฿168,000 $6,600 $6,100

Note a: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of those years. Note b: Retained earnings after devaluation are translated at the same effective rate (see Note a) as before devaluation.The translation gain of $150,000 would be passed-through to the consolidated income statement.

EXPLANATION OF DIFFERENT OUTCOME BY TRANSLATION METHODOLOGY: The Temporal Method results in a translation gain, as opposed to


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the CTA loss found under the Current Rate Method, because of the different exchange rates used against Net plant & equipment and the inventory line items. This gain would be impossible under the Current Rate Method because ALL assets are exposed under that method, whereas the Temporal Method carries Net plant & equipment and inventory at relevant historical exchange rates.

Problem#10.9: Siam Toys, Ltd. (B).Using the original data provided for Siam Toys, assume that the Thai baht appreciated in value from B30/$ to B25/$ between March 31 and April 1. Assuming no change in balance sheet accounts between those two days, calculate the gain or loss from translation by both the current rate method and the temporal method. Explain the translation gain or loss in terms of changes in the value of exposed accounts.

TRANSLATION BY THE CURRENT RATE METHODBalance Sheet (thousands) Before Devaluation After Devaluation

Assets

Thai bahtExchange

RateTranslated Accounts

Exchange Rate

Translated Accounts

Statement (Baht/US$) US dollars (Baht/US$) US dollarsCash ฿24,000 30 $800 25 $960 A/R 36,000 30 1,200 25 1,440Inventory 48,000 30 1,600 25 1,920Net plant & equipment 60,000 30 2,000 25 2,400 Total ฿168,000 $5,600 $6,720 Liabilities & Net Worth Accounts payable ฿18,000 30 $600 25 $720 Bank loans 60,000 30 2,000 25 2,400Common stock 18,000 20 900 20 900Retained earnings 72,000 34 2,100 34 2,100CTA account (loss) 0 - $600 Total ฿168,000 $5,600 $6,720

Note: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of


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those years. This cumulative translation account (CTA) gain of $600,000 would be entered into the company's consolidated balance sheet under equity.

TRANSLATION BY THE TEMPORAL METHOD

Balance Sheet (thousands) Before Devaluation

After Devaluation

Thai bahtExchange

RateTranslated

AccountsExchange

RateTranslated Accounts

Assets Statement (Baht/US$) US dollars (Baht/US$) US dollarsCash ฿24,000 30 $800 25 $960 Accounts receivable 36,000 30 1,200 25 1,440Inventory 48,000 30 1,600 30 1,600Net plant & equipment 60,000 20 3,000 20 3,000 Total ฿168,000 $6,600 $7,000 Liabilities & Net Worth Accounts payable ฿18,000 30 $600 25 $720 Bank loans 60,000 30 2,000 25 2,400Common stock 18,000 20 900 20 900Retained earnings 72,000 23 3,100 23 3,100CTA account (loss) 0 - ($120) Total ฿168,000 $6,600 $7,000

Note a: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of those years.

Note b: Retained earnings after devaluation are translated at the same effective rate (see Note a) as before devaluation.The translation loss of $120,000 would be passed-through to the consolidated income statement.


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EXPLANATION OF DIFFERENT OUTCOME BY TRANSLATION METHODOLOGY: The Temporal Method results in a translation gain, as opposed to the CTA loss found under the Current Rate Method, because of the different exchange rates used against Net plant & equipment and the inventory line items. This gain would be impossible under the Current Rate Method because ALL assets are exposed under that method, whereas the Temporal Method carries Net plant & equipment and inventor at relevant historical exchange rates.

Problem#10.10: Egyptian Ingot, Ltd.Egyptian Ingot, Ltd., is the Egyptian subsidiary of Tran Mediterranean Aluminum, a British multinational that fashions automobile engine blocks from aluminum. Trans-Mediterranean’s home reporting currency is the British pound. Egyptian Ingot’s December 31st balance sheet is shown below. At the date of this balance sheet the exchange rate between Egyptian pounds and British pounds sterling was ŁE5.50/UKŁ.a). What is Egyptian Ingot’s contribution to the translation exposure of Trans-

Mediterranean on December 31st, using the current rate method?b). Calculate the translation exposure loss to Trans-Mediterranean if the exchange rate

at the end of the following quarter is ŁE6.00/Ł. Assume all balance sheet accounts are the same at the end of the quarter as they were at the beginning.


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Balance Sheet of Egyptian Ingot, Ltd.

Egyptian

pounds

Before Exchange Rate Change

After Exchange Rate Change

Exchange Rate

Translated Accounts

Exchange Rate

Translated Accounts

Assets Statement(Egyptian

L/UKL) US dollars(Egyptian

L/UKL) US dollarsCash 16,500,000 5.5 $3,000,000 6 $2,750,000 A/R 33,000,000 5.5 6,000,000 6 5,500,000Inventory 49,500,000 5.5 9,000,000 6 8,250,000Net plant & equipment 66,000,000 5.5 12,000,000 6 11,000,000

Total 165,000,000 $30,000,00

0 $27,500,000 Liabilities & Net Worth A/P 24,750,000 5.5 $4,500,000 6 $4,125,000 Long-term debt 49,500,000 5.5 9,000,000 6 8,250,000Invested capital 90,750,000 5.5 16,500,000 5.5 16,500,000CTA account (loss) - - ($1,375,000)

Total 165,000,000 $30,000,00

0 $27,500,000

a. Calculation of Actg Exposures:

Serial Number Egyptian pounds

Dec. 31stEnd of

Quarter5.5 6

Exposed assets (all assets) 165,000,000 $30,000,000 $27,500,000 Less: Exposed Liabilities &

Current Liabilities + debt) -74,250,000 -13,500,000-12,375,000


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Net exposure 90,750,000 $16,500,000 $15,125,000

b). Change in translation exposure:

Translation Gain (Loss) = ($1,375,000) – 0 = ($1,375,000)


Net exposed assets (US$) $16,500,000 Percentage change in the value of the dollar -8.30% Translation gain (loss) ($1,375,000)


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Chapter-11

Sourcing Global Equity


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Chapter # 11 Sourcing Equity Globally

Problem# 11.1: Novo’s cost of equity prior to April 1980.Solution:

Assumptions ValuesDanish risk free rate of interest, krf 10.00%Danish stock market return, km 18.00%Novo’s beta before internationalization 1.00

Calculation: What was Novo’s cost of equity? ke = krf + (km – krf) β = 18.00%

Problem# 11.2: Novo’s WACC prior to April 1980.Solution:

Assumptions ValuesNovo’s cost of debt, kd 12.0%Novo’s cost of equity, ke 18.0%Novo’s debt to capital ratio, D/V 70.0%Novo’s equity to capital ratio, E/V 30.0%Novo’s effective tax rate, t 40.0%

Calculation: What was Novo’s weighted average cost of capital? WACC = (D/V × kd (1 – t)) + (E/V × ke) = 10.44%


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b). How did this affect its capital budget? The relatively high debt ratio and the tax shelter of interest led to a modest WACC despite the relatively high cost of equity. Thus the WACC was probably a reasonable hurdle rate for capital investments. However, the bigger problem was that the marginal cost of capital would increase significantly if Novo did not gain access to the liquidity provided by international portfolio investors

Problem# 11.3: Novo’s cost of equity after July 1981.

Assuming the following data now apply, calculate Novo’s cost of equity. International portfolio investors dominated the trading activity in Novo’s stock. Most of the volume was executed on the New York Stock Exchange. Therefore we use international norms rather than Danish norms.

Assumptions ValuesInternational risk free rate of interest, krf 8.00%International stock market return, km 12.00%Novo’s beta after internationalization 0.80

What was Novo’s cost of equity now?

ke = krf + (km – krf)β = 11.20%

This was a very significant drop from the 18% cost of equity observed before April 1980.

Problem# 11.4: Novo’s WACC after July 1981.

Assumptions ValuesNovo’s new cost of debt, kd 10.0%Novo’s cost of equity, ke 11.2%Novo’s debt to capital ratio, D/V 50.0%Novo’s equity to capital ratio, E/V 50.0%Novo’s effective tax rate, t 40.0%


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a). What was Novo’s weighted average cost of capital?

WACC = (D/V × kd (1 – t)) + (E/V × ke) = 8.60%

b) How did this affect its capital budget? The lower cost of equity more than offset the lower debt ratio. The WACC was reduced to 8.60% from 10.44%. This created a better hurdle rate for capital investments. Furthermore, access to international portfolio investors improved Novo’s marginal cost of capital. Both results increased the number of capital projects that could be undertaken by Novo.

Problem# 11.5: Novo’s cost of equity in 2004.

Assumptions ValuesInternational risk free rate of interest, krf 4.00%International stock market return, km 8.00%Novo’s beta after internationalization 0.80

What was Novo’s cost of equity now?

ke = krf + (km – krf)β = 7.20%

This is a further drop in the cost of equity due to reduction in market expectations & much of the world and lower the interest rates.

Problem# 11.6: Novo’s WACC in 2004.

Assumptions ValuesNovo’s new cost of debt, kd 6.0%Novo’s cost of equity, ke 7.2%Novo’s debt to capital ratio, D/V 50.0%Novo’s equity to capital ratio, E/V 50.0%Novo’s effective tax rate, t 40.0%


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a) What was Novo’s weighted average cost of capital? WACC = (D/V × kd (1 – t)) + (E/V × ke) = 5.40% b) How did this affect its capital budget? Novo’s lower WACC in early 2004,

compared to post-July 1981, was mainly due to lower overall interest rates and required rates of return. Theoretically, Novo’s lower WACC should lead to even more acceptable capital projects. However, the dismal economic outlook worldwide in early 2004 discouraged firms from investing in capital projects even though they pass the new lower hurdle rate.

Problem# 11.7: HangSung before equity issue abroad.

Assumptions ValuesKorean risk free rate of interest, krf 10.00%Korean stock market return, km 14.00%HangSung’s beta 1.00

What was Novo’s cost of equity now? ke = krf + (km – krf)β = 14.00%

Problem# 11.8: HangSung’s WACC before equity issue abroad.

Assumptions ValuesHangSung’s cost of debt, kd 12.0%HangSung’s cost of equity, ke 14.0%HangSung’s debt to capital ratio, D/V 80.0%HangSung’s equity to capital ratio, E/V 20.0%HangSung’s effective tax rate, t 30.0%

What was HangSung’s WACC?

WACC = (D/V × kd (1 – t)) + (E/V × ke) = 9.52%

Problem# 11.9: HangSung after equity issue abroad.

Assumptions ValuesInternational risk free rate of interest, krf 4.00%International stock market return, km 8.00%HangSung’s beta 0.70


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What was Novo’s cost of equity now? ke = krf + (km – krf)β = 6.80%

The cost of equity dropped significantly from 14% to 6.8% after the equity issue abroad. This demonstrates one of the advantages for a firm to internationalize its cost and availability of capital. Problem# 11.10: HangSung’s WACC after equity issue abroad.

Assumptions ValuesHangSung’s cost of debt, kd 6.0%HangSung’s cost of equity, ke 6.8%HangSung’s debt to capital ratio, D/V 60.0%HangSung’s equity to capital ratio, E/V 40.0%HangSung’s effective tax rate, t 30.0%

a). What was HangSung’s WACC?WACC = (D/V × kd (1 – t)) + (E/V × ke) = 5.24%

b) How did this affect its capital budget? HangSung’s WACC was lowered from 9.52% before its equity issue abroad to 5.24% aftewards. This should lead to more acceptable capital projects. The equity issue abroad should also increase HangSung’s liquidity, thereby leading to a less-steeply increasing marginal cost of capital and still more acceptable capital projects.


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Annexure of Currencies Used in Solution Manual

S. No. Country Currency Symbol 1 USA Dollar $2 Australia Australian Dollar A$3 Hong Kong Hong Kong Dollar HK$4 Canada Canadian Dollar C$ 5 Brazil Reais R$ 6 Uruguay Peso Uruguayo $U7 Afghanistan Rupees / Dollar $8 Pakistan Rupees Rs. Or PKR9 India Rupees Rs. 10 Indonesia Rupaya Rs. 11 Malyshia Malaysian Ringget RM 12 Switzerland Swiss franc SF 13 Europeon Union Euro €14 Iran Riyal / Toman R15 Thailand Bhat ฿ 16 China Yoan / Renminbi Y17 Russia Ruble R 18 Germany Deutsche Mark DM 19 Jurden Jordanian Diner JD 20 Iraq Iraqi Diner ID21 Kuwit Kuwaiti Diner KD 22 Dubai Dirham D 23 Saudi Arabia Riyal SRI 24 Mexican Mexican peso Ps 25 Japan Yen ¥26 UK Pound Sterling £27 Egypt Egyptian Pound £E28 Italy Lira Lit 30 Turkey Lira TL


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Formula 1# Direct Quotation Formula for Percentage Change……… 4Formula 2# Indirect Quotation Formula for Percentage Change……. 4Formula 3# Direct Quotation for Premium/Discount (annum)………. 4Formula 4# Indirect Quotation for Premium/Discount (annum)…….. 4Formula 5# Profit Formula……………………………………………… 4Formula 6# Derived Formula for Direct Quotation for S1…………… 4 Formula 7# Derived Formula for Direct Quotation for S2 …………… 4Formula 8# Derived Formula for Indirect Quotation for S1…………. 4Formula 9# Derived Formula for Indirect Quotation for S2 …………. 4Formula 10# Sale Price in Jordanian Dinner (JD) Formula…………… 5Formula 11# Jordanian Import Duty Formula………………………….. 5Formula 12# Total Cost, in Jordanian Diner (JD) Formula……........... 5Formula 13# Jordanian Resale Fees Formula ………………………… 5Formula 14# Resale Price to Iraq in JD Formula……………………… 5Formula 15# Price Paid in Iraqi Diner Formula………………………… 5 Formula 16# Price Paid in US Dollar……………………………………. 5

Formula 17# Current Account Balances Formula……………………… 6Formula 18# Financial Account Balances Formula………………….… 6 Formula 19# Basic Balances Formula………………………………….. 6

Formula 20# Overall Balances Formula…..…………………………….. 6 Formula 21# Mid Rates Formula…………………………………………. 7

Formula 22# Spread & Percent Spread or Margin Formula………….. 7Formula 23# Outright Forward Bid Rate Formula……………………… 7Formula 24# Outright Forward Ask Rate Formula……………………… 7Formula 25# Cross Rate Formula……………………………………….. 7Formula 26# Arbitrage Profit Formula………………………………….. 7Formula 27# Arbitrage Loss Formula …………………………………. 7


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Formula 28# Value of Maturity Formula for Long Position…………… 8Formula 29# Value of Maturity Formula for Short Position………….. 8 Formula 30# Total Value of Call Premium Formula …………………. 8Formula 31# Spot Rate Sensitivity (delta) Formula…………………… 8 Formula 32# Forward Rate Sensitivity (delta) Formula………………. 8 Formula 33# Time to Maturity (theta) Formula………………………... 8Formula 34# 3-month Option Price Formula for theta……..…………….. 8Formula 35# Sensitivity to Volatility (lambda) Formula………………….. 8 Formula 36# Daily Volatility Formula………………………………………. 8 Formula 37# Sensitivity to Changing $ Interest Rate Formula………….. 8Formula 38# Sensitivity to Changing Foreign Interest Rate Formula…… 8Formula 39# Buyer of Call Option: P/L, BEP & Gross Profit Formula….. 9Formula 40# Buyer of Put Option: P/L, BEP & Gross Profit Formula…… 9Formula 41# Writer of Call Option: P/L, BEP & Gross Profit Formula…... 9 Formula 42# Writer of Put Option: P/L, BEP & Gross Profit Formula…… 9 Formula 43# Law of One Price Formula for Swiss France……………….. 10 Formula 44# Law of One Price Formula for U.S. Dollars ………………… 10 Formula 45# Law of One Price & PPP Formula of SF/$ and $/SF………. 10 Formula 46# Law of One Price & Exchange rate pass-through SF/$....... 10 Formula 47# Law of One Price & Exchange rate pass-through $/SF....... 10 Formula 48# Assuming 70% Exchange rate pass-through………………. 10Formula 49# Assuming 100% Exchange rate pass-through……………… 10 Formula 50# Price Elasticity of Demand Formula…………………………. 10

Formula 51# Local Currency Under/Over Valuation formula for $/SF…… 10Formula 52# Local Currency Under/Over Valuation formula for SF/$....... 10 Formula 53# Real/Nominal Effective Exchange Rate Index’s for $............ 10 Formula 54# Fisher Effect Formula in terms of US $ and SF……………… 11 Formula 55# International Fisher Effect Formula#1 ……………………….. 11 Formula 56# International Fisher Effect Formula#2…………………………. 11 Formula 57# Forward Rate Formula#1(n=90) ………………………………. 11 Formula 58# Forward Rate Formula#2(n=360) …………………………….. 11 Formula 59# Interest Rate Parity (IRP) Formula#1…………………………. 11 Formula 60# Interest Rate Parity (IRP) Formula#2 ………………………. 11 Formula 61# Purchasing Power Parity (PPP) Formula (Equilibrium)……… 11 Formula 62# Effective or Implied Cost Formula……………………………… 11Formula 63# Covered/Uncovered Interest Arbitrage Profit Formula………. 11 Formula 64# Covered/Uncovered Interest Arbitrage Loss Formula………. 11 Formula 65# Misery Index Formula…………………………………………... 12Formula 66# Forward Rate Formula for Misery Indexes……………………. 12 Formula 67# Forecasting of Forward Rate Formula for Real Interest Rates.. 12 Formula 68# Implied Interest Rates Formula..……………………………….. 12


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Formula 69# Mean Formula……………………………………………..…….. 12 Formula 70# Lower Class Boundaries Formula………………………………. 12 Formula 71# Upper Class Boundaries Formula………………………………. 12Formula 72# Net Exposure Formula ………………………………………….. 13Formula 73# Net Exposure Alternate Formula ………………………………. 13 Formula 74# Life Span of Transaction Exposure Formula………………….. 13Formula 75# Bank Loan ( Principal) Formula……………………………….. 13 Formula 76# Liabilities and Net Worth Formula…………………………….. 13 Formula 77# Forward Proceeds Formula………………………………….... 13 Formula 78# 3-months 90 days Investment Rate (r) Formula……………… 13

Formula 79# Annual Investment Rate (r) Formula………………………….. 13 Formula 80# Breakeven Investment Rate (r) Formula……………………… 13 Formula 81# SF Needed Today Formula……………………………………. 14

Formula 82# Total Cost of Money Market Hedge Formula………………… 14 Formula 83# Total Cost of Call Option Hedge Formula……………………. 14

Formula 84# FX Gain/Loss Formula……………………………………….… 14Formula 85# Total Sales Formula……………………………………………. 14 Formula 86# Total Repayment in US $ Formula……………………………. 14 Formula 87# Ford’s Payments in US $ (Risk-sharing Agreement)……….. 14Formula 88# Ford’s Cost in US $ Formula………………………………….. 14 Formula 89# Ford’s Savings in US $ Formula……………………………… 14 Formula 90# Cost of Equity Formula (CAPM)……………………………… 14

Formula 91# Weighted Average Cost of Capital (WACC) Formula……… 14 Formula 92# Total Percentage Cost of Capital Formula…………………... 14Formula 93# After-tax Cost of Debt in SF Formula……………………….. 14


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72783538 Multinational Business Finance Solution Manual 12th Edition by Etiman Stone Hill Moffitt...

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Transcript of 72783538 Multinational Business Finance Solution Manual 12th Edition by Etiman Stone Hill Moffitt...