Overall Solutions

SUGGESTED ANSWERS AND SOLUTIONS TO

END-OF-CHAPTER QUESTIONS AND PROBLEMS

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TABLE OF CONTENTS

Chapter

1. Globalization and the Multinational Firm Suggested Answers to End-of-Chapter Questions 3

2. International Monetary System Suggested Answers and Solutions to End-of-Chapter Questions

and Problems 12

3. Balance of Payments Suggested Answers and Solutions to End-of-Chapter Questions and

Problems 17

4. The Market for Foreign Exchange Suggested Answers and Solutions to End-of-Chapter Questions

and Problems 23

5. International Parity Relationships Suggested Answers and Solutions to End-of-Chapter Questions

and Problems 33

6. International Banking Suggested Answers and Solutions to End-of-Chapter Questions and

Problems 40

7. International Bond Markets Suggested Answers and Solutions to End-of-Chapter Questions and

Problems 50

8. International Equity Markets Suggested Answers and Solutions to End-of-Chapter Questions and

Problems 56

9. Futures and Options on Foreign Exchange Suggested Answers and Solutions to End-of-Chapter

Questions and Problems 62

10. Currency and Interest Rate Swaps Suggested Answers and Solutions to End-of-Chapter Questions

and Problems 70

11. International Portfolio Investments Suggested Answers and Solutions to End-of-Chapter


12. Management of Economic Exposure Suggested Answers and Solutions to End-of-Chapter


13. Management of Transaction Exposure Suggested Answers and Solutions to End-of-Chapter


14. Management of Translation Exposure Suggested Answers and Solutions to End-of-Chapter


15. Foreign Direct Investment Suggested Answers and Solutions to End-of-Chapter Questions and

Problems 125

16. International Capital Structure and the Cost of Capital Suggested Answers and Solutions to End-

of-Chapter Questions and Problems 131

17. International Capital Budgeting Suggested Answers and Solutions to End-of-Chapter Questions

and Problems 135

18. Multinational Cash Management Suggested Answers and Solutions to End-of-Chapter Questions

and Problems 150

19. Trade Financing Suggested Answers and Solutions to End-of-Chapter Questions and Problems

161

20. International Tax Environment Suggested Answers and Solutions to End-of-Chapter Questions

and Problems 166

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CHAPTER 1 GLOBALIZATION AND THE MULTINATIONAL FIRM

SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS

QUESTIONS

1. Why is it important to study international financial management?

Answer: We are now living in a world where all the major economic functions, i.e., consumption,

production, and investment, are highly globalized. It is thus essential for financial managers to fully

understand vital international dimensions of financial management. This global shift is in marked

contrast to a situation that existed when the authors of this book were learning finance some twenty

years ago. At that time, most professors customarily (and safely, to some extent) ignored international

aspects of finance. This mode of operation has become untenable since then.

2. How is international financial management different from domestic financial management?

Answer: There are three major dimensions that set apart international finance from domestic finance.

They are:

1. foreign exchange and political risks,

2. market imperfections, and

3. expanded opportunity set.

3. Discuss the three major trends that have prevailed in international business during the last two

decades.

Answer: The 1980s brought a rapid integration of international capital and financial markets. Impetus

for globalized financial markets initially came from the governments of major countries that had

begun to deregulate their foreign exchange and capital markets. The economic integration and

globalization that began in the eighties is picking up speed in the 1990s via privatization. Privatization

is the process by which a country divests itself of the ownership and operation of a business venture by

turning it over to the free market system. Lastly, trade liberalization and economic integration

continued to proceed at both the regional and global levels.

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4. How is a country’s economic well-being enhanced through free international trade in goods and

services?

Answer: According to David Ricardo, with free international trade, it is mutually beneficial for two

countries to each specialize in the production of the goods that it can produce relatively most

efficiently and then trade those goods. By doing so, the two countries can increase their combined

production, which allows both countries to consume more of both goods. This argument remains valid

even if a country can produce both goods more efficiently than the other country. International trade

is not a ‘zero-sum’ game in which one country benefits at the expense of another country. Rather,

international trade could be an ‘increasing-sum’ game at which all players become winners.

5. What considerations might limit the extent to which the theory of comparative advantage is

realistic?

Answer: The theory of comparative advantage was originally advanced by the nineteenth century

economist David Ricardo as an explanation for why nations trade with one another. The theory claims

that economic well-being is enhanced if each country’s citizens produce what they have a comparative

advantage in producing relative to the citizens of other countries, and then trade products. Underlying

the theory are the assumptions of free trade between nations and that the factors of production (land,

buildings, labor, technology, and capital) are relatively immobile. To the extent that these

assumptions do not hold, the theory of comparative advantage will not realistically describe

international trade.

6. What are multinational corporations (MNCs) and what economic roles do they play?

Answer: A multinational corporation (MNC) can be defined as a business firm incorporated in one

country that has production and sales operations in several other countries. Indeed, some MNCs have

operations in dozens of different countries. MNCs obtain financing from major money centers around

the world in many different currencies to finance their operations. Global operations force the

treasurer’s office to establish international banking relationships, to place short-term funds in several

currency denominations, and to effectively manage foreign exchange risk.

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7. Mr. Ross Perot, a former Presidential candidate of the Reform Party, which is a third political party

in the United States, had strongly objected to the creation of the North American Trade Agreement

(NAFTA), which nonetheless was inaugurated in 1994, for the fear of losing American jobs to Mexico

where it is much cheaper to hire workers. What are the merits and demerits of Mr. Perot’s position on

NAFTA? Considering the recent economic developments in North America, how would you assess

Mr. Perot’s position on NAFTA?

Answer: Since the inception of NAFTA, many American companies indeed have invested heavily in

Mexico, sometimes relocating production from the United States to Mexico. Although this might have

temporarily caused unemployment of some American workers, they were eventually rehired by other

industries often for higher wages. Currently, the unemployment rate in the U.S. is quite low by

historical standard. At the same time, Mexico has been experiencing a major economic boom. It seems

clear that both Mexico and the U.S. have benefited from NAFTA. Mr. Perot’s concern appears to have

been ill founded.

8. In 1995, a working group of French chief executive officers was set up by the Confederation of

French Industry (CNPF) and the French Association of Private Companies (AFEP) to study the French

corporate governance structure. The group reported the following, among other things “The board of

directors should not simply aim at maximizing share values as in the U.K. and the U.S. Rather, its goal

should be to serve the company, whose interests should be clearly distinguished from those of its

shareholders, employees, creditors, suppliers and clients but still equated with their general common

interest, which is to safeguard the prosperity and continuity of the company”. Evaluate the above

recommendation of the working group.

Answer: The recommendations of the French working group clearly show that shareholder wealth

maximization is not a universally accepted goal of corporate management, especially outside the

United States and possibly a few other Anglo-Saxon countries including the United Kingdom and

Canada. To some extent, this may reflect the fact that share ownership is not wide spread in most other

countries. In France, about 15% of households own shares.

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9. Suppose you are interested in investing in shares of Nokia Corporation of Finland, which is a world

leader in wireless communication. But before you make investment decision, you would like to learn

about the company. Visit the website of CNN Financial network (www.cnnfn.com) and collect

information about Nokia, including the recent stock price history and analysts’ views of the company.

Discuss what you learn about the company. Also discuss how the instantaneous access to information

via internet would affect the nature and workings of financial markets.

Answer: As students might have learned from visiting the website, information is readily available

even for foreign companies like Nokia. Ready access to international information helps integrate

financial markets, dismantling barriers to international investment and financing. Integration, however,

may help a financial shock in one market to be transmitted to other markets.

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MINI CASE: NIKE’S DECISION

Nike, a U.S.-based company with a globally recognized brand name, manufactures athletic

shoes in such Asian developing countries as China, Indonesia, and Vietnam using subcontractors, and

sells the products in the U.S. and foreign markets. The company has no production facilities in the

United States. In each of those Asian countries where Nike has production facilities, the rates of

unemployment and underemployment are quite high. The wage rate is very low in those countries by

the U.S. standard; hourly wage rate in the manufacturing sector is less than one dollar in each of those

countries, which is compared with about $18 in the U.S. In addition, workers in those countries often

are operating in poor and unhealthy environments and their rights are not well protected.

Understandably, Asian host countries are eager to attract foreign investments like Nike’s to develop

their economies and raise the living standards of their citizens. Recently, however, Nike came under a

world-wide criticism for its practice of hiring workers for such a low pay, “next to nothing” in the

words of critics, and condoning poor working conditions in host countries.

Evaluate and discuss various ‘ethical’ as well as economic ramifications of Nike’s decision to

invest in those Asian countries.

Suggested Solution to Nike’s Decision

Obviously, Nike’s investments in such Asian countries as China, Indonesia, and Vietnam were

motivated to take advantage of low labor costs in those countries. While Nike was criticized for the

poor working conditions for its workers, the company has recognized the problem and has

substantially improved the working environments recently. Although Nike’s workers get paid very

low wages by the Western standard, they probably are making substantially more than their local

compatriots who are either under- or unemployed. While Nike’s detractors may have valid points, one

should not ignore the fact that the company is making contributions to the economic welfare of those

Asian countries by creating job opportunities.

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CHAPTER 1A THEORY OF COMPARATIVE ADVANTAGE

SUGGESTED SOLUTIONS TO APPENDIX PROBLEMS

PROBLEMS

1. Country C can produce seven pounds of food or four yards of textiles per unit of input. Compute

the opportunity cost of producing food instead of textiles. Similarly, compute the opportunity cost of

producing textiles instead of food.

Solution: The opportunity cost of producing food instead of textiles is one yard of textiles per 7/4 =

1.75 pounds of food. A pound of food has an opportunity cost of 4/7 = .57 yards of textiles.

2. Consider the no-trade input/output situation presented in the following table for Countries X and Y.

Assuming that free trade is allowed, develop a scenario that will benefit the citizens of both countries.

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INPUT/OUTPUT WITHOUT TRADE

_______________________________________________________________________

Country

X Y Total

________________________________________________________________________

I. Units of Input

(000,000)

_______________________ ______________________________

Food 70 60

Textiles 40 30

________________________________________________________________________

II. Output per Unit of Input

(lbs or yards)

______________________ ______________________________

Food 17 5

Textiles 5 2

________________________________________________________________________

III. Total Output

(lbs or yards)

(000,000)

______________________ ______________________________

Food 1,190 300 1,490

Textiles 200 60 260

________________________________________________________________________

IV. Consumption

(lbs or yards)

(000,000)

_____________________ ______________________________

Food 1,190 300 1,490

Textiles 200 60 260

________________________________________________________________________

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Solution:

Examination of the no-trade input/output table indicates that Country X has an absolute

advantage in the production of food and textiles. Country X can “trade off” one unit of production

needed to produce 17 pounds of food for five yards of textiles. Thus, a yard of textiles has an

opportunity cost of 17/5 = 3.40 pounds of food, or a pound of food has an opportunity cost of 5/17

= .29 yards of textiles. Analogously, Country Y has an opportunity cost of 5/2 = 2.50 pounds of food

per yard of textiles, or 2/5 = .40 yards of textiles per pound of food. In terms of opportunity cost, it is

clear that Country X is relatively more efficient in producing food and Country Y is relatively more

efficient in producing textiles. Thus, Country X (Y) has a comparative advantage in producing food

(textile) is comparison to Country Y (X).

When there are no restrictions or impediments to free trade the economic-well being of the

citizens of both countries is enhanced through trade. Suppose that Country X shifts 20,000,000 units

from the production of textiles to the production of food where it has a comparative advantage and that

Country Y shifts 60,000,000 units from the production of food to the production of textiles where it

has a comparative advantage. Total output will now be (90,000,000 x 17 =) 1,530,000,000 pounds of

food and [(20,000,000 x 5 =100,000,000) + (90,000,000 x 2 =180,000,000) =] 280,000,000 yards of

textiles. Further suppose that Country X and Country Y agree on a price of 3.00 pounds of food for

one yard of textiles, and that Country X sells Country Y 330,000,000 pounds of food for 110,000,000

yards of textiles. Under free trade, the following table shows that the citizens of Country X (Y) have

increased their consumption of food by 10,000,000 (30,000,000) pounds and textiles by 10,000,000

(10,000,000) yards.

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INPUT/OUTPUT WITH FREE TRADE

__________________________________________________________________________

Country

X Y Total

__________________________________________________________________________

I. Units of Input

(000,000)

_______________________ ________________________________

Food 90 0

Textiles 20 90

__________________________________________________________________________

II. Output per Unit of Input

(lbs or yards)

______________________ ________________________________

Food 17 5

Textiles 5 2

__________________________________________________________________________

III. Total Output

(lbs or yards)

(000,000)

_____________________ ________________________________

Food 1,530 0 1,530

Textiles 100 180 280

__________________________________________________________________________

IV. Consumption

(lbs or yards)

(000,000)

_____________________ ________________________________

Food 1,200 330 1,530

Textiles 210 70 280

__________________________________________________________________________

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CHAPTER 2 INTERNATIONAL MONETARY SYSTEM

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER

QUESTIONS AND PROBLEMS

QUESTIONS

1. Explain Gresham’s Law.

Answer: Gresham’s law refers to the phenomenon that bad (abundant) money drives good (scarce)

money out of circulation. This kind of phenomenon was often observed under the bimetallic standard

under which both gold and silver were used as means of payments, with the exchange rate between the

two metals fixed.

2. Explain the mechanism which restores the balance of payments equilibrium when it is disturbed

under the gold standard.

Answer: The adjustment mechanism under the gold standard is referred to as the price-specie-flow

mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium

will be corrected by a counter-flow of gold. Suppose that the U.S. imports more from the U.K. than it

exports to the latter. Under the classical gold standard, gold, which is the only means of international

payments, will flow from the U.S. to the U.K. As a result, the U.S. (U.K.) will experience a decrease

(increase) in money supply. This means that the price level will tend to fall in the U.S. and rise in the

U.K. Consequently, the U.S. products become more competitive in the export market, while U.K.

products become less competitive. This change will improve U.S. balance of payments and at the same

time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium.

3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to

gold at 12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be two

francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take

advantage of this situation? What would be the effect of shipping costs?

Answer: Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds directly in

the foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of

gold for 12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only

costs you 12 francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the

pound. Of course, you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign

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exchange market. The arbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not

exist. If it costs more than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit.

4. Discuss the advantages and disadvantages of the gold standard.

Answer: The advantages of the gold standard include: (I) since the supply of gold is restricted,

countries cannot have high inflation; (2) any BOP disequilibrium can be corrected automatically

through cross-border flows of gold. On the other hand, the main disadvantages of the gold standard

are: (I) the world economy can be subject to deflationary pressure due to restricted supply of gold; (ii)

the gold standard itself has no mechanism to enforce the rules of the game, and, as a result, countries

may pursue economic policies (like de-monetization of gold) that are incompatible with the gold

standard.

5. What were the main objectives of the Bretton Woods system?

Answer: The main objectives of the Bretton Woods system are to achieve exchange rate stability and

promote international trade and development.

6. One can say that the Bretton Woods system was programmed to an eventual demise. Comment on

this proposition.

Answer: The answer to this question is related to the Triffin paradox. Under the gold-exchange

system, the reserve-currency country should run BOP deficits to supply reserves to the world

economy, but if the deficits are large and persistent, they can lead to a crisis of confidence in the

reserve currency itself, eventually causing the downfall of the system.

7. Explain how the special drawing rights (SDR) is constructed. Also, discuss the circumstances under

which the SDR was created.

Answer: SDR was created by the IMF in 1970 as a new reserve asset, partially to alleviate the

pressure on the U.S. dollar as the key reserve currency. The SDR is a basket currency comprised of

five major currencies, i.e., U.S. dollar, German mark, Japanese yen, French franc, and British pound.

Currently, the dollar receives a 40% weight, mark 21%, yen 17%, franc 11%, and pound 11%. The

weights for different currencies tend to change over time, reflecting the relative importance of each

currency in international trade and finance.

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8. Explain the arrangements and workings of the European Monetary System (EMS).

Answer: EMS was launched in 1979 in order to (I) establish a zone of monetary stability in Europe,

(ii) coordinate exchange rate policies against the non-EMS currencies, and (iii) pave the way for the

eventual European monetary union. The main instruments of EMS are the European Currency Unit

(ECU) and the Exchange Rate Mechanism (ERM). Like SDR, the ECU is a basket currency

constructed as a weighted average of currencies of EU member countries. The ECU works as the

accounting unit of EMS and plays an important role in the workings of the ERM. The ERM is the

procedure by which EMS member countries manage their exchange rates. The ERM is based on a

parity grid system, with parity grids first computed by defining the par values of EMS currencies in

terms of the ECU. If a country’s ECU market exchange rate diverges from the central rate by as much

as the maximum allowable deviation, the country has to adjust its policies to maintain its par values

relative to other currencies.

9. There are arguments for and against the alternative exchange rate regimes.

a. List the advantages of the flexible exchange rate regime.

b. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed

exchange rate regime.

c. Rebut the above criticism from the viewpoint of the proponents of the flexible exchange rate

regime.

Answer: a. The advantages of the flexible exchange rate system include: (I) automatic achievement of

balance of payments equilibrium and (ii) maintenance of national policy autonomy.

b. If exchange rates are fluctuating randomly, that may discourage international trade and encourage

market segmentation. This, in turn, may lead to suboptimal allocation of resources.

c. Economic agents can hedge exchange risk by means of forward contracts and other techniques.

They don’t have to bear it if they choose not to. In addition, under a fixed exchange rate regime,

governments often restrict international trade in order to maintain the exchange rate. This is a self-

defeating measure. What’s good about the fixed exchange rate if international trade need to be

restricted?

10. In an integrated world financial market, a financial crisis in a country can be quickly transmitted

to other countries, causing a global crisis. What kind of measures would you propose to prevent the

recurrence of a Asia-type crisis.

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Answer: First, there should be a multinational safety net to safeguard the world financial system from

the Asia-type crisis. Second, international institutions like IMF and the World Bank should monitor

problematic countries more closely and provide timely advice to those countries. Countries should be

required to fully disclose economic and financial information so that devaluation surprises can be

prevented. Third, countries should depend more on domestic savings and long-term foreign

investments, rather than short-term portfolio capital. There can be other suggestions.

11. Discuss the criteria for a ‘good’ international monetary system.

Answer: A good international monetary system should provide (I) sufficient liquidity to the world

economy, (ii) smooth adjustments to BOP disequilibrium as it arises, and (iii) safeguard against the

crisis of confidence in the system.

12. Once capital markets are integrated, it is difficult for a country to maintain a fixed exchange rate.

Explain why this may be so.

Answer: Once capital markets are integrated internationally, vast amounts of money may flow in and

out of a country in a short time period. This will make it very difficult for the country to maintain a

fixed exchange rate.

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MINI CASE: WILL THE UNITED KINGDOM JOIN THE EURO CLUB?

When the euro was introduced in January 1999, the United Kingdom was conspicuously absent

from the list of European countries adopting the common currency. Although the current Labor

government led by Prime Minister Tony Blair appears to be in favor of joining the euro club, it is not

clear at the moment if that will actually happen. The opposition Tory party is not in favor of adopting

the euro and thus giving up monetary sovereignty of the country. The public opinion is also divided on

the issue.

Whether the United Kingdom will eventually join the euro club is a matter of considerable

importance for the future of European Union as well as that of the United Kingdom. The joining of the

United Kingdom with its sophisticated finance industry will most certainly help propel the euro into a

global currency status rivaling the U.S. dollar. The United Kingdom on its part will firmly join the

process of economic and political unionization of Europe, abandoning its traditional balancing role.

Investigate the political, economic and historical situations surrounding the British participation

in the European economic and monetary integration and write your own assessment of the prospect of

British joining the euro club. In dong so, assess from the British perspective, among other things, (1)

potential benefits and costs of adopting the euro, (2) economic and political constraints facing the

country, and (3) the potential impact of British adoption of the euro on the international financial

system, including the role of the U.S. dollar.

Suggested Solution to Will the United Kingdom Join the Euro Club?

Whether the U.K. will join the euro club will be a political as much as economic decision.

Recently, the U.K. economy was converging with those of euro-zone countries. Economic conditions

in terms of government budgets, interest rates, and inflation rate are becoming similar to those in euro-

zone countries. On an economic ground, this convergence is creating a condition that is conducive to

U.K.’s joining the euro club. As recently pointed out by Wim Duisenberg, the President of the

European Central Bank, British opposition to joining the euro club is more “psycho-political” than

justified on economic grounds. Since many political leaders in France and Germany consider adoption

of the euro as a step toward the European political union, the U.K. is likely to join the euro-zone if it is

prepared to join the European political union as well. Once the U.K. joins the euro-zone, the euro will

no doubt become a global currency at the expense of the U.S. dollar.

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CHAPTER 3 BALANCE OF PAYMENTS



QUESTIONS

1. Define the balance of payments.

Answer: The balance of payments (BOP) can be defined as the statistical record of a country’s

international transactions over a certain period of time presented in the form of double-entry

bookkeeping.

2. Why would it be useful to examine a country’s balance of payments data?

Answer: It would be useful to examine a country’s BOP for at least two reasons. First, BOP provides

detailed information about the supply and demand of the country’s currency. Second, BOP data can be

used to evaluate the performance of the country in international economic competition. For example, if

a country is experiencing perennial BOP deficits, it may signal that the country’s industries lack

competitiveness.

3. The United States has experienced continuous current account deficits since the early 1980s. What

do you think are the main causes for the deficits? What would be the consequences of continuous U.S.

current account deficits?

Answer: The current account deficits of U.S. may have reflected a few reasons such as (I) a

historically high real interest rate in the U.S., which is due to ballooning federal budget deficits, that

kept the dollar strong, and (ii) weak competitiveness of the U.S. industries.

4. In contrast to the U.S., Japan has realized continuous current account surpluses. What could be the

main causes for these surpluses? Is it desirable to have continuous current account surpluses?

Answer: Japan’s continuous current account surpluses may have reflected a weak yen and high

competitiveness of Japanese industries. Massive capital exports by Japan prevented yen from

appreciating more than it did. At the same time, foreigners’ exports to Japan were hampered by closed

nature of Japanese markets. Continuous current account surpluses disrupt free trade by promoting

protectionist sentiment in the deficit country. It is not desirable especially when it is brought about by

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the mercantilist policies.

5. Comment on the following statement: “Since the U.S. imports more than it exports, it is necessary

for the U.S. to import capital from foreign countries to finance its current account deficits.”

Answer: The statement presupposes that the U.S. current account deficit causes its capital account

surplus. In reality, the causality may be running in the opposite direction: U.S. capital account surplus

may cause the country’s current account deficit. Suppose foreigners find the U.S. a great place to

invest and send their capital to the U.S., resulting in U.S. capital account surplus. This capital inflow

will strengthen the dollar, hurting the U.S. export and encouraging imports from foreign countries,

causing current account deficits.

6. Explain how a country can run an overall balance of payments deficit or surplus.

Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve

transactions. For example, an overall BOP deficit can be supported by drawing down the central

bank’s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central

bank’s reserve holdings.

7. Explain official reserve assets and its major components.

Answer: Official reserve assets are those financial assets that can be used as international means of

payments. Currently, official reserve assets comprise: (I) gold, (ii) foreign exchanges, (iii) special

drawing rights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges are by far the most

important official reserves.

8. Explain how to compute the overall balance and discuss its significance.

Answer: The overall BOP is determined by computing the cumulative balance of payments including

the current account, capital account, and the statistical discrepancies. The overall BOP is significant

because it indicates a country’s international payment gap that must be financed by the government’s

official reserve transactions.

9. Since the early 1980s, foreign portfolio investors have purchased a significant portion of U.S.

treasury bond issues. Discuss the short-term and long-term effects of foreigners’ portfolio investment

on the U.S. balance of payments.

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Answer: As foreigners purchase U.S. Treasury bonds, U.S. BOP will improve in the short run. But in the

long run, U.S. BOP may deteriorate because the U.S. should pay interests and principals to foreigners. If

foreign funds are used productively and contributes to the competitiveness of U.S. industries, however, U.S.

BOP may improve in the long run.

10. Describe the balance of payments identity and discuss its implications under the fixed and flexible

exchange rate regimes.

Answer: The balance of payments identity holds that the combined balance on the current and capital

accounts should be equal in size, but opposite in sign, to the change in the official reserves: BCA +

BKA = -BRA. Under the pure flexible exchange rate regime, central banks do not engage in official

reserve transactions. Thus, the overall balance must balance, i.e., BCA = -BKA. Under the fixed

exchange rate regime, however, a country can have an overall BOP surplus or deficit as the central

bank will accommodate it via official reserve transactions.

11. Exhibit 3.3 indicates that in 1991, the U.S. had a current account deficit and at the same time a

capital account deficit. Explain how this can happen?

Answer: In 1991, the U.S. experienced an overall BOP deficit, which must have been accommodated

by the Federal Reserve’s official reserve action, i.e., drawing down its reserve holdings.

12. Explain how each of the following transactions will be classified and recorded in the debit and

credit of the U.S. balance of payments:

(1) A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank account

kept in New York City.

(2) A U.S. citizen consumes a meal at a restaurant in Paris and pays with her American Express card.

(3) A Indian immigrant living in Los Angeles sends a check drawn on his L.A. bank account as a gift

to his parents living in Bombay.

(4) A U.S. computer programmer is hired by a British company for consulting and gets paid from the

U.S. bank account maintained by the British company.

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Answer:

_________________________________________________________________

Transactions Credit Debit

_________________________________________________________________

Japanese purchase of U.S. T bonds

Japanese payment using NYC account

U.S. citizen having a meal in Paris

Paying the meal with American Express

Gift to parents in Bombay

Receipts of the check by parents (goodwill)

Export of programming service

British payment out its account in U.S.

_________________________________________________________________

13. Construct the balance of payment table for Japan for the year of 1998 which is comparable in

format to Exhibit 3.1, and interpret the numerical data. You may consult International Financial

Statistics published by IMF or research for useful websites for the data yourself.

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Answer:

A summary of the Japanese Balance of Payments for 1998 (in $ billion)

Credits Debits

Current Account

(1) Exports 646.03

(1.1) Merchandise 374.04

(1.2) Services 62.41

(1.3) Factor income 209.58

(2) Imports -516.50

(2.1) Merchandise -251.66

(2.2) Services -111.83

(3.3) Factor income -153.01

(3) Unilateral transfer 5.53 -14.37

Balance on current account 120.69

[(1) + (2) + (3)]

Capital Account

(4) Direct investment 3.27 -24.62

(5) Portfolio investment 73.70 -113.73

(5.1) Equity securities 16.11 -14.00

(5.2) Debt securities 57.59 -99.73

(6) Other investment 39.51 -109.35

Balance on financial account -131.22

[(4) + (5) + (6)]

(7) Statistical discrepancies 4.36

Overall balance -6.17

Official Reserve Account 6.17

Source: IMF, International Financial Statistics Yearbook, 1999.

Note: Capital account in the above table corresponds the ‘Financial account’ in IMF’s balance of payment statistics. IMF’s

Capital account’ is included in ‘Other investment’ in the above table.

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MINI CASE: MEXICO’S BALANCE OF PAYMENTS PROBLEM

Recently, Mexico experienced large-scale trade deficits, depletion of foreign reserve holdings

and a major currency devaluation in December 1994, followed by the decision to freely float the peso.

These events also brought about a severe recession and higher unemployment in Mexico. Since the

devaluation, however, the trade balance has improved.

Investigate the Mexican experiences in detail and write a report on the subject. In the report, you

may:

(a) document the trend in Mexico’s key economic indicators, such as the balance of payments, the

exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12.;

(b) investigate the causes of Mexico’s balance of payments difficulties prior to the peso devaluation;

(c) discuss what policy actions might have prevented or mitigated the balance of payments problem

and the subsequent collapse of the peso; and

(d) derive lessons from the Mexican experience that may be useful for other developing countries.

In your report, you may identify and address any other relevant issues concerning Mexico’s balance of

payment problem.

Suggested Solution to Mexico’s Balance-of-Payments Problem

To solve this case, it is useful to review Chapter 2, especially the section on the Mexican peso

crisis. Despite the fact that Mexico had experienced continuous trade deficits until December 1994, the

country’s currency was not allowed to depreciate for political reasons. The Mexican government did

not want the peso devaluation before the Presidential election held in 1994. If the Mexican peso had

been allowed to gradually depreciate against the major currencies, the peso crisis could have been

prevented.

The key lessons that can be derived from the peso crisis are: First, Mexico depended too much on

short-term foreign portfolio capital (which is easily reversible) for its economic growth. The country

perhaps should have saved more domestically and depended more on long-term foreign capital. This

can be a valuable lesson for many developing countries. Second, the lack of reliable economic

information was another contributing factor to the peso crisis. The Salinas administration was reluctant

to fully disclose the true state of the Mexican economy. If investors had known that Mexico was

experiencing serious trade deficits and rapid depletion of foreign exchange reserves, the peso might

have been gradually depreciating, rather than suddenly collapsed as it did. The transparent disclosure

of economic data can help prevent the peso-type crisis. Third, it is important to safeguard the world

financial system from the peso-type crisis. To this end, a multinational safety net needs to be in place

to contain the peso-type crisis in the early stage.

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CHAPTER 4 THE MARKET FOR FOREIGN EXCHANGE



QUESTIONS

1. Give a full definition of the market for foreign exchange.

Answer: Broadly defined, the foreign exchange (FX) market encompasses the conversion of purchasing

power from one currency into another, bank deposits of foreign currency, the extension of credit

denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and

futures contracts.

2. What is the difference between the retail or client market and the wholesale or interbank market for

foreign exchange?

Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the

wholesale or interbank market and the other tier is the retail or client market. International banks

provide the core of the FX market. They stand willing to buy or sell foreign currency for their own

account. These international banks serve their retail clients, corporations or individuals, in conducting

foreign commerce or making international investment in financial assets that requires foreign

exchange. Retail transactions account for only about 16 percent of FX trades. The other 84 percent is

interbank trades between international banks, or non-bank dealers large enough to transact in the

interbank market.

3. Who are the market participants in the foreign exchange market?

Answer: The market participants that comprise the FX market can be categorized into five groups:

international banks, bank customers, non-bank dealers, FX brokers, and central banks. International

banks provide the core of the FX market. Approximately 700 banks worldwide make a market in

foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These

international banks serve their retail clients, the bank customers, in conducting foreign commerce or

making international investment in financial assets that requires foreign exchange. Non-bank dealers

are large non-bank financial institutions, such as investment banks, whose size and frequency of trades

make it cost- effective to establish their own dealing rooms to trade directly in the interbank market

for their foreign exchange needs.

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Most interbank trades are speculative or arbitrage transactions where market participants attempt

to correctly judge the future direction of price movements in one currency versus another or attempt to

profit from temporary price discrepancies in currencies between competing dealers.

FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position

themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency

quote to many other dealers.

Central banks sometimes intervene in the foreign exchange market in an attempt to influence the

price of its currency against that of a major trading partner, or a country that it “fixes” or “pegs” its

currency against. Intervention is the process of using foreign currency reserves to buy one’s own

currency in order to decrease its supply and thus increase its value in the foreign exchange market, or

alternatively, selling one’s own currency for foreign currency in order to increase its supply and lower

its price.

4. How are foreign exchange transactions between international banks settled?

Answer: The interbank market is a network of correspondent banking relationships, with large

commercial banks maintaining demand deposit accounts with one another, called correspondent bank

accounts. The correspondent bank account network allows for the efficient functioning of the foreign

exchange market. As an example of how the network of correspondent bank accounts facilities

international foreign exchange transactions, consider a U.S. importer desiring to purchase

merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his bank and

inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the bank will

debit the U.S. importer’s account for the purchase of the Dutch guilders. The bank will instruct its

correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount

of guilders and to credit the Dutch exporter’s bank account. The importer’s bank will then debit its

books to offset the debit of U.S. importer’s account, reflecting the decrease in its correspondent bank

account balance.

5. What is meant by a currency trading at a discount or at a premium in the forward market?

Answer: The forward market involves contracting today for the future purchase or sale of foreign

exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium)

or lower (at a discount) than the spot price.

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6. Why does most interbank currency trading worldwide involve the U.S. dollar?

Answer: Trading in currencies worldwide is against a common currency that has international appeal.

That currency has been the U.S. dollar since the end of World War II. However, the deutsche mark

and Japanese yen have started to be used much more as international currencies in recent years. More

importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a

market against all other currencies.

7. Banks find it necessary to accommodate their client’s needs to buy or sell foreign exchange

forward, in many instances for hedging purposes. How can the bank eliminate the currency exposure

it has created for itself by accommodating a client’s forward transaction?

Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a

forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange

against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To

illustrate, suppose a bank customer wants to buy dollars three months forward against British pound

sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange

rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will

lend the dollars for three months until they are needed to deliver against the dollars it has sold forward.

The British pounds received will be used to liquidate the sterling loan.

8. A CD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the

market is trading at CD1.3436-CD1.3441. What is implied about the trader’s beliefs by his prices?

Answer: The trader must think the Canadian dollar is going to depreciate against the U.S. dollar and

therefore he is trying to reduce his inventory of Canadian dollars by discouraging purchases of CD by

standing willing to buy $ at only CD1.3435/$1.00 and offering to sell from inventory at the slightly

lower than market price of CD1.3440/$1.00.

*9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage

opportunity?

Answer: Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency,

then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an

arbitrage profit via trading from the second to the third currency when the direct exchange between the

two is not in alignment with the cross exchange rate.

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Most, but not all, currency transactions go through the dollar. Certain banks specialize in making

a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate

spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar

market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular

arbitrage profit is possible.

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PROBLEMS

1. Using Exhibit 4.4, calculate a cross-rate matrix for the French franc, German mark, Japanese yen,

and the British pound. Use the most current European term quotes to calculate the cross-rates so that

the triangular matrix result is similar to the portion above the diagonal in Exhibit 4.6.

Solution: The cross-rate formula we want to use is:

S(k/j) = S(k/$)/S(j/$).

The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.

Dollar Pound Yen D-Mark

France 6.4071 10.0488 .05250 3.3538

Germany 1.9104 2.9964 .01565

Japan 122.05 191.42

U.K 0.6376

2. Using Exhibit 4.4, calculate the 30-, 90-, and 180-day forward cross exchange rates between the

German mark and the Swiss franc using the most current quotations. State the forward cross-rates in

“German” terms.

Solution: The formulas we want to use are:

FN(DM/SF) = FN($/SF)/FN($/DM)

or

FN(DM/SF) = FN(SF/$)/FN(DM/$).

We will use the top formula that uses American term forward exchange rates.

F30(DM/SF) = .6408/.5246 = 1.2215

F90(DM/SF) = .6453/.5270 = 1.2245

F180(DM/SF) = .6518/.5307 = 1.2282

3. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in

forward points.

Spot 1.3431-1.3436

One-Month 1.3432-1.3442

Three-Month 1.3448-1.3463

Six-Month 1.3488-1.3508

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Solution:

One-Month 01-06

Three-Month 17-27

Six-Month 57-72

4. Using the spot and outright forward quotes in problem 3, determine the corresponding bid-ask

spreads in points.

Solution:

Spot 5

One-Month 10

Three-Month 15

Six-Month 20

5. Using Exhibit 4.4, calculate the 30-, 90-, and 180-day forward premium or discount for the

Canadian dollar in European terms.

Solution: The formula we want to use is:

fN,$vCD = [(FN(CD/$) - S(CD/$))/S(CD/$)] x 360/N

f30,$vCD = [(1.4709 - 1.4715)/1.4715] x 360/30 = -.0049

f90,$vCD = [(1.4694 - 1.4715)/1.4715] x 360/90 = -.0057

f180,$vCD = [(1.4676 - 1.4715)/1.4715] x 360/180 = -.0053

6. Using Exhibit 4.4, calculate the 30-, 90-, and 180-day forward premium or discount for the British

pound in American terms using the most current quotations.

Solution: The formula we want to use is:

fN,£v$ = [(FN($/£) - S($/£))/S($/£] x 360/N

f30,£v$ = [(1.5685 - 1.5683)/1.5683] x 360/30 = .0015

f90,£v$ = [(1.5694 - 1.5683)/1.5683] x 360/90 = .0028

f180,£v$ = [(1.5714 - 1.5683)/1.5683] x 360/180 = .0040

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7. Given the following information, what are the DM/S$ currency against currency bid-ask

quotations?

Bank Quotations American Terms European Terms

Bid Ask Bid Ask

Deutsche Marks .6784 .6789 1.4730 1.4741

Singapore Dollar .6999 .7002 1.4282 1.4288

Solution: Equation 4.12 from the text implies S(DM/S$b) = S($/S$b) x S(DM/$b) = .6999 x 1.4730 =

1.0310. The reciprocal, 1/S(DM/S$b) = S(S$/DMa) = .9699. Analogously, it is implied that S(DM/S$a)

= S($/S$a) x S(DM/$a) = .7002 x 1.4741 = 1.0322. The reciprocal, 1/S(DM/S$a) = S(S$/DMb) = .9688.

Thus, the DM/S$ bid-ask spread is DM1.0310-DM1.0322 and the S$/DM spread is S$0.9688-

S$0.9699.

8. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal,

you notice that Dresdner Bank is quoting DM1.6230/$1.00 and Credit Suisse is offering

SF1.4260/$1.00. You learn that UBS is making a direct market between the Swiss franc and the mark,

with a current DM/SF quote of 1.1250. Show how you can make a triangular arbitrage profit by

trading at these prices. (Ignore bid-ask spreads for this problem). Assume you have $5,000,000 with

which to conduct the arbitrage. What happens if you initially sell dollars for Swiss francs? What

DM/SF price will eliminate triangular arbitrage?

Solution: To make a triangular arbitrage profit the Deutsche Bank trader would sell $5,000,000 to

Dresdner Bank at DM1.6230/$1.00. This trade would yield DM8,115,000 = $5,000,000 x 1.6230.

The Deutsche Bank trader would then sell the deutsche marks for Swiss francs to Union Bank of

Switzerland at a price of DM1.1250/SF1.00, yielding SF7,213,333 = DM8,115,000/1.1250. The

Dresdner trader will resell the Swiss francs to Credit Suisse for $5,058,438 =SF7,213,333/1.4260,

yielding a triangular arbitrage profit of $58,438.

If the Deutsche Bank trader initially sold $5,000,000 for Swiss francs, instead of deutsche marks,

the trade would yield SF7,130,000 = $5,000,000 x 1.4260. The Swiss francs would in turn be traded

for deutsche marks to UBS for DM8,021,250 = SF7,130,000 x 1.1250. The marks would be resold to

Dresdner Bank for $4,942,237 =DM8,021,250/1.6230, or a loss of $57,763. Thus, it is necessary to

conduct the triangular arbitrage in the correct order.

The S(DM/SF) cross exchange rate should be 1.6230/1.4260 = 1.1381. This is an equilibrium

rate at which a triangular arbitrage profit will not exist. (The student can determine this for himself.)

A profit results from the triangular arbitrage when dollars are first sold for marks, because Swiss

francs are purchased for marks at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss

IM-29

francs are purchased for only DM1.1250/SF1.00 instead of the no-arbitrage rate of DM1.1381/SF1.00.

Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs

are sold for marks at too low a rate, resulting in too few marks, i.e. each Swiss franc is sold for DM

1.1250/SF1.00 instead of the higher no-arbitrage rate of DM1.1381/SF1.00.

IM-30

MINI CASE: SHREWSBURY HERBAL PRODUCTS, LTD.

Shrewsbury Herbal Products, located in central England, close to the Welsh border, is an old-line

producer of herbal teas, seasonings, and medicines. Their products are marketed all over the United

Kingdom and in many parts of continental Europe as well.

Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign customers

in order to guard against adverse exchange rate changes. Nevertheless, it has just received an order

from a large wholesaler in central France for £320,000 of its products, conditional upon delivery being

made in three months’ time and the order invoiced in French francs.

Shrewsbury’s controller, Elton Peters, is concerned with whether the pound will appreciate

versus the franc over the next three months, thus eliminating all or most of the profit when the French

franc receivable is paid. He thinks this is an unlikely possibility, but he decides to contact the firm’s

banker for suggestions about hedging the exchange rate exposure.

Mr. Peters learns from the banker that the current spot exchange rate is FF/£ is FF7.8709, thus the

invoice amount should be FF2,518,688. Mr. Peters also learns that the 90-day forward rates for the

pound and the French franc versus the U.S. dollar are $1.5458/£1.00 and FF5.0826/$1.00,

respectively. The banker offers to set up a forward hedge for selling the franc receivable for pound

sterling based on the FF/£ cross forward exchange rate implicit in the forward rates against the dollar.

What would you do if you were Mr. Peters?

Suggested Solution to Shrewsbury Herbal Products, Ltd.

Note to Instructor: This elementary case provides an intuitive look at hedging exchange rate

exposure. Students should not have difficulty with it even though hedging will not be formally

discussed until Chapter 13. The case is consistent with the discussion that accompanies Exhibit 4.5 of

the text.

Suppose Shrewsbury sells at a twenty percent markup. Thus the cost to the firm of the £320,000 order

is £256,000. Thus, the pound could appreciate to FF2,518,688/£256,000 = FF9.8386/£1.00 before all

profit was eliminated. This seems rather unlikely. Nevertheless, a ten percent appreciation of the

pound (FF7.8709 x 1.10) to FF8.6580/£1.00 would only yield a profit of £34,909 (=

FF2,518,688/8.6580 - £256,000). Shrewsbury can hedge the exposure by selling the French francs

forward for British pounds at F1/4(FF/£) = F1/4($/£) x F1/4(FF/$) = 1.5458 x 5.0826 = 7.8567. At this

forward exchange rate, Shrewsbury can “lock-in” a price of £320,578 (= FF2,518,688/7.8567) for the

sale. The forward exchange rate indicates that the French franc is trading at a premium to the British

IM-31

pound for forward purchase, thus the forward hedge allows Shrewsbury to lock-in a greater amount

(£578) for the sale than if payment was made up front.

IM-32

CHAPTER 5 INTERNATIONAL PARITY RELATIONSHIPS



QUESTIONS

1. Give a full definition of arbitrage.

Answer: Arbitrage can be defined as the act of simultaneously buying and selling the same or

equivalent assets or commodities for the purpose of making certain, guaranteed profits.

2. Discuss the implications of the interest rate parity for the exchange rate determination.

Answer: Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot

rate, IRP can be written as:

S = [(1 + I£)/(1 + I$)]E[St+1It].

The exchange rate is thus determined by the relative interest rates, and the expected future spot rate,

conditional on all the available information, It, as of the present time. One thus can say that

expectation is self-fulfilling. Since the information set will be continuously updated as news hit the

market, the exchange rate will exhibit a highly dynamic, random behavior.

3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the

future spot exchange rate.

Answer: The forward exchange rate will be an unbiased predictor of the future spot rate if (I) the risk

premium is insignificant and (ii) foreign exchange markets are informationally efficient.

4. Explain the purchasing power parity, both the absolute and relative versions. What causes the

deviations from the purchasing power parity?

Answer: The absolute version of purchasing power parity (PPP):

S = P$/P£.

The relative version is:

e = $ - £.

PPP can be violated if there are barriers to international trade or if people in different countries have

different consumption taste. PPP is the law of one price applied to a standard consumption basket.

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5. Discuss the implications of the deviations from the purchasing power parity for countries’

competitive positions in the world market.

Answer: If exchange rate changes satisfy PPP, competitive positions of countries will remain

unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative

competitiveness of countries. If a country’s currency appreciates (depreciates) by more than is

warranted by PPP, that will hurt (strengthen) the country’s competitive position in the world market.

6. Explain and derive the international Fisher effect.

Answer: The international Fisher effect can be obtained by combining the Fisher effect and the

relative version of PPP in its expectational form. Specifically, the Fisher effect holds that

E($) = I$ - $,

E(£) = I£ - £.

Assuming that the real interest rate is the same between the two countries, i.e., $ = £, and substituting

the above results into the PPP, i.e., E(e) = E($)- E(£), we obtain the international Fisher effect: E(e)

= I$ - I£.

7. Researchers found that it is very difficult to forecast the future exchange rates more accurately than

the forward exchange rate or the current spot exchange rate. How would you interpret this finding?

Answer: This implies that exchange markets are informationally efficient. Thus, unless one has

private information that is not yet reflected in the current market rates, it would be difficult to beat the

market.

8. Explain the random walk model for exchange rate forecasting. Can it be consistent with the

technical analysis?

Answer: The random walk model predicts that the current exchange rate will be the best predictor of

the future exchange rate. An implication of the model is that past history of the exchange rate is of no

value in predicting future exchange rate. The model thus is inconsistent with the technical analysis

which tries to utilize past history in predicting the future exchange rate.

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*9. Derive and explain the monetary approach to exchange rate determination.

Answer: The monetary approach is associated with the Chicago School of Economics. It is based on

two tenets: purchasing power parity and the quantity theory of money. Combing these two theories

allows for stating, say, the $/£ spot exchange rate as:

S($/£) = (M$/M£)(V$/V£)(y£/y$),

where M denotes the money supply, V the velocity of money, and y the national aggregate output. The

theory holds that what matters in exchange rate determination are:

1. The relative money supply,

2. The relative velocities of monies, and

3. The relative national outputs.

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PROBLEMS

1. Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for six months.

The six-month interest rate is 8% per annum in the U.S. and 6% per annum in Germany. Currently, the

spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate is DM1.56 per

dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to

maximize the return?

Solution: The market conditions are summarized as follows:

I$ = 4%; iDM = 3%; S = DM1.60/$; F = DM1.56/$.

If $1,000,000 is invested in the U.S., the maturity value in six months will be

$1,040,000 = $1,000,000 (1 + .04).

Alternatively, $1,000,000 can be converted into DM and invested at the German interest rate, with the

DM maturity value sold forward. In this case the dollar maturity value will be

$1,056,410 = ($1,000,000 x 1.60)(1 + .03)(1/1.56)

Clearly, it is better to invest $1,000,000 in Germany with exchange risk hedging.

2. While you were visiting London, you purchased a Jaguar for £35,000, payable in three months.

You have enough cash at your bank in New York City, which pays 0.35% interest per month,

compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£ and the three-

month forward exchange rate is $1.40/£. In London, the money market interest rate is 2.0% for a

three-month investment. There are two alternative ways of paying for your Jaguar.

(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.

(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that

the maturity value becomes equal to £35,000.

Evaluate each payment method. Which method would you prefer? Why?

Solution: The problem situation is summarized as follows:

A/P = £35,000 payable in three months

iNY = 0.35%/month, compounding monthly

iLD = 2.0% for three months

S = $1.45/£; F = $1.40/£.

Option a:

When you buy £35,000 forward, you will need $49,000 in three months to fulfill the forward

contract. The present value of $49,000 is computed as follows:

$49,000/(1.0035)3 = $48,489.

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Thus, the cost of Jaguar as of today is $48,489.

Option b:

The present value of £35,000 is £34,314 = £35,000/(1.02). To buy £34,314 today, it will cost

$49,755 = 34,314x1.45. Thus the cost of Jaguar as of today is $49,755.

You should definitely choose to use “option a”, and save $1,266, which is the difference between

$49,755 and $48489.

3. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£.

The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume

that you can borrow as much as $1,500,000 or £1,000,000.

a. Determine whether the interest rate parity is currently holding.

b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps

and determine the arbitrage profit.

c. Explain how the IRP will be restored as a result of covered arbitrage activities.

Solution: Let’s summarize the given data first:

S = $1.5/£; F = $1.52/£; I$ = 2.0%; I£ = 1.45%

Credit = $1,500,000 or £1,000,000.

a. (1+I$) = 1.02

(1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280

Thus, IRP is not holding exactly.

b. (1) Borrow $1,500,000; repayment will be $1,530,000.

(2) Buy £1,000,000 spot using $1,500,000.

(3) Invest £1,000,000 at the pound interest rate of 1.45%;

maturity value will be £1,014,500.

(4) Sell £1,014,500 forward for $1,542,040

Arbitrage profit will be $12,040

c. Following the arbitrage transactions described above,

The dollar interest rate will rise;

The pound interest rate will fall;

The spot exchange rate will rise;

The forward exchange rate will fall.

These adjustments will continue until IRP holds.

4. Suppose that the current spot exchange rate is FF6.25/$ and the three-month forward exchange rate

is FF6.28/$. The three-month interest rate is 5.6% per annum in the U.S. and 8.8% per annum in

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France. Assume that you can borrow up to $1,000,000 or FF6,250,000.

a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize

profit in terms of U.S. dollars. Also determine the magnitude of arbitrage profit.

b. Assume that you want to realize profit in terms of French francs. Show the covered arbitrage

process and determine the arbitrage profit in French francs.

Solution: The market data is summarized as follows:

S = FF6.25/$ = $0.16/FF;

F = FF6.28/$ = $0.1592/FF;

I$ = 1.40%; iFF = 2.20%

(1+I$) = 1.014 < (1+iFF)(F/S) = (1.022)(.1592/.16) = 1.0169

a. (1) Borrow $1,000,000; repayment will be $1,014,000.

(2) Buy FF6,250,000 spot for $1,000,000.

(3) Invest in France; maturity value will be FF6,387,500.

(4) Sell FF6,387,500 forward for $1,017,118.

Arbitrage profit will be $3,118 = $1,017,118 - $1,014,000.

b. (1) Borrow $1,000,000; repayment will be $1,014,000.

(2) Buy FF6,250,000 spot for $1,000,000.

(3) Invest in France; maturity value will be FF6,387,500.

(4) Buy $1,014,000 forward for FF6,367,920.

Arbitrage profit will be FF19,580 = FF6,387,500-FF6,367,920.

Note that only step (4) is different.

5. In the issue of October 23, 1999, the Economist reports that the interest rate per annum is 5.93% in

the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based

on the reported interest rates, how would you predict the change of the exchange rate between the U.S.

dollar and the Turkish lira?

Solution: A high Turkish interest rate must reflect a high expected inflation in Turkey. According to

international Fisher effect (IFE), we have

E(e) = i$ - iLira

= 5.93% - 70.0% = -64.07%

The Turkish lira thus is expected to depreciate against the U.S. dollar by about 64%.

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6. As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is R$1.95/$.

The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6% and

20.0%, respectively. How would you forecast the exchange rate to be at around November 1, 2000?

Solution: Since the inflation rate is quite high in Brazil, we may use the purchasing power parity to

forecast the exchange rate.

E(e) = E($) - E(R$)

= 2.6% - 20.0%

= -17.4%

E(ST) = So(1 + E(e))

= (R$1.95/$) (1 + 0.174)

= R$2.29/$

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CHAPTER 6 INTERNATIONAL BANKING



QUESTIONS

1. Briefly discuss some of the services that international banks provide their customers and the market

place.

Answer: International banks can be characterized by the types of services they provide that

distinguish them from domestic banks. Foremost, international banks facilitate the imports and

exports of their clients by arranging trade financing. Additionally, they serve their clients by

arranging for foreign exchange necessary to conduct cross-border transactions and make foreign

investments and by assisting in hedging exchange rate risk in foreign currency receivables and

payables through forward and options contracts. Since international banks have established trading

facilities, they generally trade foreign exchange products for their own account.

Two major distinguishing features between domestic banks and international banks are the types of

deposits they accept and the loans and investments they make. Large international banks both borrow

and lend in the Eurocurrency market. Moreover, depending upon the regulations of the country in which

it operates and its organizational type, an international bank may participate in the underwriting of

Eurobonds and foreign bonds. In the United States, only investment banks and the investment banking

operations of bank holding companies are allowed to participate in the underwriting of international

bonds.

International banks frequently provide consulting services and advice to their clients in the areas

of exchange hedging strategies, interest rate and currency swap financing, and international cash

management services. Not all international banks provide all services. Banks that do provide a

majority of these services are known as universal banks or full service banks.

2. Briefly discuss the various types of international banking offices.

Answer: The services and operations which an international bank undertakes is a function of the

regulatory environment in which the bank operates and the type of banking facility established.

A correspondent bank relationship is established when two banks maintain a correspondent bank

account with one another. The correspondent banking system provides a means for a bank’s MNC

client to conduct business worldwide through his local bank or its contacts.

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A representative office is a small service facility staffed by parent bank personnel that is designed

to assist MNC clients of the parent bank in its dealings with the bank’s correspondents. It is a way for

the parent bank to provide its MNC clients with a level of service greater than that provided through

merely a correspondent relationship.

A foreign branch bank operates like a local bank, but legally it is a part of the parent bank. As

such, a branch bank is subject to the banking regulations of its home country and the country in which

it operates. The primary reason a parent bank would establish a foreign branch is that it can provide a

much fuller range of services for its MNC customers through a branch office than it can through a

representative office.

A subsidiary bank is a locally incorporated bank that is either wholly owned or owned in major

part by a foreign subsidiary. An affiliate bank is one that is only partially owned, but not controlled by

its foreign parent. Both subsidiary and affiliate banks operate under the banking laws of the country in

which they are incorporated. U.S. parent banks find subsidiary and affiliate banking structures

desirable because they are allowed to engage in security underwriting.

Edge Act banks are federally chartered subsidiaries of U.S. banks which are physically located in

the United States that are allowed to engage in a full range of international banking activities. A 1919

amendment to Section 25 of the Federal Reserve Act created Edge Act banks. The purpose of the

amendment was to allow U.S. banks to be competitive with the services foreign banks could supply

their customers. Federal Reserve Regulation K allows Edge Act banks to accept foreign deposits,

extend trade credit, finance foreign projects abroad, trade foreign currencies, and engage in investment

banking activities with U.S. citizens involving foreign securities. As such, Edge Act banks do not

compete directly with the services provided by U.S. commercial banks. Edge Act banks are not

prohibited from owning equity in business corporations as are domestic commercial banks. Thus, it is

through the Edge Act that U.S. parent banks own foreign banking subsidiaries and have ownership

positions in foreign banking affiliates.

An offshore banking center is a country whose banking system is organized to permit external

accounts beyond the normal economic activity of the country. Offshore banks operate as branches or

subsidiaries of the parent bank. The primary activities of offshore banks are to seek deposits and grant

loans in currencies other than the currency of the host government.

In 1981, the Federal Reserve authorized the establishment of International Banking Facilities

(IBF). An IBF is a separate set of asset and liability accounts that are segregated on the parent bank’s

books; it is not a unique physical or legal entity. IBFs operate as foreign banks in the U.S. IBFs were

established largely as a result of the success of offshore banking. The Federal Reserve desired to

return a large share of the deposit and loan business of U.S. branches and subsidiaries to the U.S.

3. How does the deposit-loan rate spread in the Eurodollar market compare with the deposit-loan rate

spread in the domestic U.S. banking system? Why?

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Answer: The deposit-loan spread in the Eurodollar market is narrower than in the domestic U.S.

banking system. That is, in the Eurodollar market the deposit rate is greater than the deposit rate of

dollars in the U.S. banking system and the lending rate is less. The Eurodollar market can operate at a

lower cost than can the U.S. banking system because it is not subject to Federal Reserve Bank reserve

requirements on deposits or FDIC deposit insurance.

4. What is the difference between the Euronote market, the Euro-medium-term-note market, and the

Eurocommercial paper market?

Answer: Euronotes are short-term notes underwritten by a group of international investment or

commercial banks called a “facility.” A client-borrower makes an agreement with a facility to issue

Euronotes in its own name for a period of time, generally three to 10 years. Euronotes are sold at a

discount from face value, and pay back the full face value at maturity. Euronotes typically have

maturities of from three to six months. Euro-medium-term notes (Euro MTNs) are typically fixed-rate

notes issued by a corporation with maturities ranging from less than a year to about 10 years. Like

fixed-rate bonds, Euro-MTNs have a fixed maturity and pay coupon interest at periodic dates. Unlike

a bond issue, in which the entire issue is brought to market at once, permission is received for a Euro-

MTN issue which is then partially sold on a continuous basis through an issuance facility that allows

the borrower to obtain funds only as needed on a flexible basis. Eurocommercial paper is an

unsecured short-term promissory note issued by a corporation or a bank and placed directly with the

investment public through a dealer. Like Euronotes, Eurocommercial paper is sold at a discount from

face value. Maturities typically range from one to six months.

5. Briefly discuss the cause and the solution(s) to the international bank crisis involving less

developed countries.

Answer: The international debt crisis began on August 20, 1982 when Mexico asked more than 100

U.S. and foreign banks to forgive its $68 billion in loans. Soon Brazil, Argentina and more than 20

other developing countries announced similar problems in making the debt service on their bank loans.

At the height of the crisis, Third World countries owed $1.2 trillion!

The international debt crisis had oil as its source. In the early 1970’s, the Organization of

Petroleum Exporting Countries (OPEC) became the dominant supplier of oil worldwide. Throughout

this time period, OPEC raised oil prices dramatically and amassed a tremendous supply of U.S.

dollars, which was the currency generally demanded as payment from the oil importing countries.

OPEC deposited billions in Eurodollar deposits; by 1976 the deposits amounted to nearly $100

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billion. Eurobanks were faced with a huge problem of lending these funds in order to generate interest

income to pay the interest on the deposits. Third World countries were only too eager to assist the

equally eager Eurobankers in accepting Eurodollar loans that could be used for economic development

and for payment of oil imports. The high oil prices were accompanied by high interest rates, high

inflation, and high unemployment during the 1979-1981 period. Soon, thereafter, oil prices collapsed

and the crisis was on.

Today, most debtor nations and creditor banks would agree that the international debt crisis is

effectively over. U.S. Treasury Secretary Nicholas F. Brady of the Bush Administration is largely

credited with designing a strategy in the spring of 1989 to resolve the problem. Three important

factors were necessary to move from the debt management stage, employed over the years 1982-1988

to keep the crisis in check, to debt resolution. First, banks had to realize that the face value of the debt

would never be repaid on schedule. Second, it was necessary to extend the debt maturities and to use

market instruments to collateralize the debt. Third, the LDCs needed to open their markets to private

investment if economic development was to occur. Debt-for-equity swaps helped pave the way for an

increase in private investment in the LDCs. However, monetary and fiscal reforms in the developing

countries and the recent privatization trend of state owned industry were also important factors.

Treasury Secretary Brady’s solution was to offer creditor banks one of three alternatives: (1)

convert their loans to marketable bonds with a face value equal to 65 percent of the original loan

amount; (2) convert the loans into collateralized bonds with a reduced interest rate of 6.5 percent; or,

(3) lend additional funds to allow the debtor nations to get on their feet. The second alternative called

for an extension the debt maturities by 25 to 30 years and the purchase by the debtor nation of zero-

coupon U.S. Treasury bonds with a corresponding maturity to guarantee the bonds and make them

marketable. These bonds have come to be called Brady bonds.

6. What warning did David Hume, the 18th-century Scottish philosopher-economist, give about

lending to sovereign governments?

Answer: (From the February 21, 1989 article “LDC Lenders Should Have Listened To David Hume”

by Thomas M. Humphrey in The Wall Street Journal.)

Hume thought no good could result from borrowing:

If the abuses of treasures [held by the state] be dangerous by engaging the state in rash

enterprise in confidence of its riches; the abuses of mortgaging are more certain and inevitable:

poverty, impotence, and subjection to foreign powers.

Nations, presuming they can find the necessary lenders, are tempted to borrow without limit and

to squander the funds on unproductive projects:

It is very tempting to a minister to employ such an expedient as enables him to make a great

IM-43

figure during his administration without over burthening the people with taxes or exciting any

immediate clamorous against himself. The practice, therefore, of contracting debt will almost

infallibly be abused in every government. It would scarcely be more imprudent to give a prodigal son

a credit in every banker’s shop in London than to empower a statesman to draw bills in this manner

upon posterity.

Eventually, however, interest must be paid and the burden of debt service charges will fall

heavily on the poor:

The taxes which are levied to pay the interest of these debts are . . . an oppression on the poorer

sort.

Those same taxes “hurt commerce and discourage industry” and thus inhibit economic

development and condemn the borrowing nation to continuing poverty. The debt burden will also

pauperize the prosperous merchant and landowning classes that constitute the main bulwark of

political freedom and stability. With the pauperization of the middle class:

No expedient at all remains for resisting tyranny: Elections are swayed by bribery and

corruption alone: And the middle power between king and people being totally removed, a grievous

despotism must infallibly prevail. The landholders [and merchants] despised for their oppressions,

will be utterly unable to make any opposition to it.

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PROBLEMS

1. Grecian Tile Manufacturing of Athens, Georgia borrows $1,500,000 at LIBOR plus a lending

margin of 1.25 percent per annum on a six-month rollover basis from a London bank. If six-month

LIBOR is 4 ½ percent over the first six-month interval and 5 3/8 percent over the second six-month

interval, how much will Grecian Tile pay in interest over the first year of its Eurodollar loan?

Solution: $1,500,000 x (.045 + .0125)/2 + $1,500,000 x (.05375 + .0125)/2

= $43,125 + $49,687.50 = $92,812.50.

2. A bank sells a “three against nine” $3,000,000 FRA for a six-month period beginning three months

from today and ending nine months from today. The purpose of the FRA is to cover the interest rate

risk caused by the maturity mismatch from having made a three-month Eurodollar loan and having

accepted a nine-month Eurodollar deposit. The agreement rate with the buyer is 5.5 percent. There

are actually 183 days in the six-month period. Assume that three months from today the settlement

rate is 4 7/8 percent. Determine how much the FRA is worth and who pays whom--the buyer pays the

seller or the seller pays the buyer.

Solution: Since the settlement rate is less than the agreement rate, the buyer pays the seller the

absolute value of the FRA. The absolute value of the FRA is:

$3,000,000 x [(.04875-.055) x 183/360]/[1 + (.04875 x 183/360)]

= $3,000,000 x [-.003177/(1.024781)]

= $9,300.52.

3. Assume the settlement rate in problem 2 is 6 1/8 percent. What is the solution now?

Solution: Since the settlement rate is greater than the agreement rate, the seller pays the buyer the

absolute value of the FRA. The absolute value of the FRA is:

$3,000,000 x [(.06125-.055) x 183/360]/[1 + (.06125 x 183/360)]

= $3,000,000 x [.006250/(1.031135)]

= $18,183.85.

4. The Fisher effect (Chapter 5) suggests that nominal interest rates differ between countries because

of differences in the respective rates of inflation. According to the Fisher effect and your examination

of the long-term and short-term Eurocurrency interest rates presented in Exhibit 6.4, order the five

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countries from highest to lowest in terms of the size of the inflation premium imbedded in the nominal

interest rates for 1998.

Solution: According to the Fisher effect, both the short-term and the long-term interest rates suggest

that the inflation premiums for the four countries (or zone) ordered from highest to lowest are: Great

Britain, the United States, the Euro-zone, and Japan.

5. A bank has a $500 million portfolio of investments and bank credits. The daily standard deviation

of return on this portfolio is .666 percent. Capital adequacy standards require the bank to maintain

capital equal to its VAR calculated over a ten-day holding period. What is the capital charge for the

bank?

Solution: VAR = $500 million x .00666 x 2.236 x 10 = $24.49 million.

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MINI CASE: DETROIT MOTORS’ LATIN AMERICAN EXPANSION

It is September 1990 and Detroit Motors of Detroit, Michigan is considering establishing an

assembly plant in Latin America for a new utility vehicle it has just designed. The cost of the capital

expenditure has been estimated at $65,000,000. There is not much of a sales market in Latin

America, and virtually all output would be exported to the U.S. for sale. Nevertheless, an assembly

plant in Latin America is attractive for at least two reasons. First, labor costs are expected to be half

what Detroit Motors would have to pay in the U.S. to union workers. Since the assembly plant will be

a new facility for a newly designed vehicle, Detroit Motors does not expect any hassle from its U.S.

union in establishing the plant in Latin America. Secondly, the chief financial officer (CFO) of

Detroit Motors believes that a debt-for-equity swap can be arranged with at least one of the Latin

American countries that has not been able to meet its debt service on its sovereign debt with some of

the major U.S. banks.

The September 10, 1990 issue of Barron’s indicated the following prices (cents on the dollar) on

Latin American bank debt:

Brazil 21.75

Mexico 43.12

Argentina 14.25

Venezuela 46.25

Chile 70.25

The CFO is not comfortable with the level of political risk in Brazil and Argentina, and has decided to

eliminate them from consideration. After some preliminary discussions with the central banks of

Mexico, Venezuela, and Chile, the CFO has learned that all three countries would be interested in

hearing a detailed presentation about the type of facility Detroit Motors would construct, how long it

would take, the number of locals that would be employed, and the number of units that would be

manufactured per year. Since it is time consuming to prepare and make these presentations, the CFO

would like to approach the most attractive candidate first. He has learned that the central bank of

Mexico will redeem its debt at 80 percent of face value in a debt-for-equity swap, Venezuela at 75

percent, and Chile 100 percent. As a first step, the CFO decides an analysis based purely on financial

considerations is necessary to determine which country looks like the most viable candidate. You are

asked to assist in the analysis. What do you advise?

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Suggested Solution for Detroit Motors’ Latin American Expansion

Regardless in which LDC Detroit Motors establishes the new facility, it will need $65,000,000 in

the local currency of the country to build the plant. The analysis involves a comparison of the dollar

cost of enough LDC debt from a creditor bank to provide $65,000,000 in local currency upon

redemption with the LDC central bank.

If Detroit Motors builds in Mexico, it will need to purchase $81,250,00 (= $65,000,000/.80) in

Mexican sovereign debt in order to have $65,000,000 in pesos after redemption with the Mexican

central bank. The cost in dollars will be $35,035,000 (= $81,250,000 x .4312).

If Detroit Motors builds in Venezuela, it will need to purchase $86,666,667 (= $65,000,000/.75)

in Venezuelan sovereign debt in order to have $65,000,000 in bolivars after redemption with the

Venezuelan central bank. The cost in dollars will be $40,083,333 (= $86,666,667 x .4625).

If Detroit Motors builds in Chile, it will need to purchase $65,000,000 (= $65,000,000/1.00) in

Chilean sovereign debt in order to have $65,000,000 in pesos after redemption with the Chilean

central bank. The cost in dollars will be $45,662,500 (= $65,000,000 x .7025).

Based on the above analysis, Detroit Motors should consider approaching Mexico about the

possibility of a debt-for-equity swap to build an assembly facility in Mexico. Of course, there are

many other factors, such as tax rates, shipping costs, labor costs that need also to be considered.

Assuming all else is equal, however, Mexico appears to be the most attractive candidate.

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APPENDIX 6A QUESTION

1. Verbally explain how Eurocurrency is created.

Answer: The core of the international money market is the Eurocurrency market. A Eurocurrency is a

time deposit of money in an international bank located in a country different from the country that

issues the currency. For example, Eurodollars are deposits of U.S. dollars in banks located outside of

the United States. As an illustration, assume a U.S. Importer purchases $100 of merchandise from a

German Exporter and pays for the purchase by drawing a $100 check on his U.S. checking account

(demand deposit). If the funds are not needed for the operation of the business, the German Exporter

can deposit the $100 in a time deposit in a bank outside the U.S. and receive a greater rate of interest

than if the funds were put in a U.S. time deposit. Assume the German Exporter deposits the funds in a

London Eurobank. The London Eurobank credits the German Exporter with a $100 time deposit and

deposits the $100 into its correspondent bank account (demand deposit) with the U.S. Bank (banking

system) to hold as reserves. Two points are noteworthy. First, the entire $100 remains on deposit in the

U.s. Bank. Second, the $100 time deposit of the German Exporter in the London Eurobank represents

the creation of Eurodollars. This deposit exists in addition to the dollars deposited in the U.S. Hence,

no dollars have flowed out of the U.S. banking system in the creation of Eurodollars.

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CHAPTER 7 INTERNATIONAL BOND MARKETS



QUESTIONS

1. Describe the differences between foreign bonds and Eurobonds. Also discuss why Eurobonds

make up the lions share of the international bond market.

Answer: The two segments of the international bond market are: foreign bonds and Eurobonds. A

foreign bond issue is one offered by a foreign borrower to investors in a national capital market and

denominated in that nation’s currency. A Eurobond issue is one denominated in a particular currency,

but sold to investors in national capital markets other than the country which issues the denominating

currency.

Eurobonds make up over 80 percent of the international bond market. The two major reasons for

this stem from the fact that the U.S. dollar is the currency most frequently sought in international bond

financing. First, Eurodollar bonds can be brought to market more quickly than Yankee bonds because

they are not offered to U.S. investors and thus do not have to meet the strict SEC registration

requirements. Second, Eurobonds are typically bearer bonds that provide anonymity to the owner and

thus allow a means for evading taxes on the interest received. Because of this feature, investors are

generally willing to accept a lower yield on Eurodollar bonds in comparison to registered Yankee bonds

of comparable terms, where ownership is recorded. For borrowers the lower yield means a lower cost of

debt service.

2. Briefly define each of the major types of international bond market instruments, noting their

distinguishing characteristics.

Answer: The major types of international bond instruments and their distinguishing characteristics are

as follows:

Straight fixed-rate bond issues have a designated maturity date at which the principal of the

bond issue is promised to be repaid. During the life of the bond, fixed coupon payments that are some

percentage rate of the face value are paid as interest to the bondholders. This is the major international

bond type. Straight fixed-rate Eurobonds are typically bearer bonds and pay coupon interest annually.

Floating-rate notes (FRNs) are typically medium-term bonds with their coupon payments

indexed to some reference rate. Common reference rates are either three-month or six-month U.S.

dollar LIBOR. Coupon payments on FRNs are usually quarterly or semi-annual, and in a accord with

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the reference rate.

A convertible bond issue allows the investor to exchange the bond for a pre-determined number

of equity shares of the issuer. The floor value of a convertible bond is its straight fixed-rate bond

value. Convertibles usually sell at a premium above the larger of their straight debt value and their

conversion value. Additionally, investors are usually willing to accept a lower coupon rate of interest

than the comparable straight fixed coupon bond rate because they find the call feature attractive.

Bonds with equity warrants can be viewed as a straight fixed-rate bond with the addition of a call

option (or warrant) feature. The warrant entitles the bondholder to purchase a certain number of

equity shares in the issuer at a pre-stated price over a pre-determined period of time.

Zero coupon bonds are sold at a discount from face value and do not pay any coupon interest

over their life. At maturity the investor receives the full face value. Another form of zero coupon

bonds are stripped bonds. A stripped bond is a zero coupon bond that results from stripping the

coupons and principal from a coupon bond. The result is a series of zero coupon bonds represented by

the individual coupon and principal payments.

A dual currency bond is a straight fixed-rate bond which is issued in one currency and pays

coupon interest in that same currency. At maturity, the principal is repaid in a second currency.

Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount

of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for

some appreciation in the exchange rate of the stronger currency. From the investor’s perspective, a

dual currency bond includes a long-term forward contract.

Composite currency bonds are denominated in a currency basket, such as SDRs or ECUs,

instead of a single currency. They are frequently called currency cocktail bonds. They are typically

straight fixed-rate bonds. The currency composite is a portfolio of currencies: when some currencies

are depreciating others may be appreciating, thus yielding lower variability overall.

3. Why do most international bonds have high Moody’s or Standard & Poor’s credit ratings?

Answer: Moody’s Investors Service and Standard & Poor’s provide credit ratings on most

international bond issues. It has been noted that a disproportionate share of international bonds have

high credit ratings. The evidence suggests that a logical reason for this is that the Eurobond market is

only accessible to firms that have good credit ratings to begin with.

4. What factors does Standard & Poor’s analyze in determining the credit rating it assigns a sovereign

government?

Answer: In rating a sovereign government, S&P’s analysis centers around an examination of the

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degree of political risk and economic risk. In assessing political risk, S & P examines the stability of

the political system, the social environment, and international relations with other the countries.

Factors examined in assessing economic risk include the sovereign’s external financial position,

balance of payments flexibility, economic structure and growth, management of the economy, and

economic prospects. The rating assigned a sovereign is particularly important because it usually

represents the ceiling for ratings S&P will assign an obligation of an entity domiciled within that

country.

5. Discuss the process of bringing a new international bond issue to market.

Answer: A borrower desiring to raise funds by issuing Eurobonds to the investing public will contact

an investment banker and ask it to serve as lead manager of an underwriting syndicate that will bring

the bonds to market. The lead manager will usually invite other banks to form a managing group to

help negotiate terms with the borrower, ascertain market conditions, and manage the issuance. The

managing group, along with other banks, will serve as underwriters for the issue, i.e., they will commit

their own capital to buy the issue from the borrower at a discount from the issue price. Most of the

underwriters, along with other banks, will be part of a selling group that sells the bonds to the

investing public. The various members of the underwriting syndicate receive a portion of the spread

(usually in the range of 2 to 2.5 percent of the issue size), depending upon the number and type of

functions they perform. The lead manager receives the full spread, and a bank serving as only a

member of the selling group receives a smaller portion.

6. You are an investment banker advising a Eurobank about a new international bond offering it is

considering. The proceeds are to be used to fund Eurodollar loans to bank clients. What type of bond

instrument would you recommend that the bank consider issuing? Why?

Answer: Since the Eurobank desires to use the bond proceeds to finance Eurodollar loans, which are

floating-rate loans, the investment banker should recommend that the bank issue FRNs, which are a

variable rate instrument. Thus there will a correspondence between the interest rate the bank pays for

funds and the interest rate it receives from its loans. For example, if the bank frequently makes term

loans at indexed to 3-month LIBOR, it might want to issue FRNs, also, indexed to 3-month LIBOR.

7. What should a borrower consider before issuing dual currency bonds? What should an investor

consider before investing in dual currency bonds?

Answer: A dual currency bond is a straight fixed-rate bond which is issued in one currency and pays

coupon interest in that same currency. At maturity, the principal is repaid in a second currency.

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Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount

of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for

some appreciation in the exchange rate of the stronger currency. From the investor’s perspective, a

dual currency bond includes a long-term forward contract. If the second currency appreciates over the

life of the bond, the principal repayment will be worth more than a return of principal in the issuing

currency. However, if the payoff currency depreciates, the investor will suffer an exchange rate loss.

Dual currency bonds are attractive to MNCs seeking financing in order to establish or expand

operations in the country issuing the payoff currency. During the early years, the coupon payments

can be made by the parent firm in the issuing currency. At maturity, the MNC anticipates the principal

to be repaid from profits earned by the subsidiary. The MNC may suffer an exchange rate loss if the

subsidiary is unable to repay the principal and the payoff currency has appreciated relative to the

issuing currency. Consequently, both the borrower and the investor are exposed to exchange rate

uncertainty from a dual currency bond.

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PROBLEMS:

1. You firm has just issued five year floating-rate notes indexed to six-month U.S. dollar LIBOR plus

1/4%. What is the amount of first coupon payment your firm will pay per U.S. $1,000 of face value, if

six-month LIBOR is currently 7.2%?

Solution: 0.5 x (.072 + .0025) x $1,000 = $37.25.

2. The discussion of zero-coupon bonds in the text gave an example of two zero-coupon bonds issued

by Commerzbank. The DM300,000,000 issue due in 1995 sold at 50 percent of face value and the

DM300,000,000 due in 2000 sold at 33 1/3 percent of face value; both were issued in 1985. Calculate

the implied yield-to-maturity of each of these two zero-coupon bond issues.

Solution: The bonds due in 1995 sold at 50% percent of face value. Since they were issued in 1985,

they had a ten year maturity. Assuming a DM1,000 par value, their yield-to-maturity is:

(DM1,000/DM500)1/10 - 1 = .07177 or 7.177% per annum.

The bonds due in year 2000 sold at 33 1/3%. They have a 15 year maturity. Their yield-to-

maturity is: (DM1,000/DM333.33)1/15 - 1 =.07599 or 7.599% per annum.

3. Consider 8.5 percent Swiss franc/U.S. dollar dual currency bonds that pay $666.67 at maturity per

SF1,000 of par value. What is the implicit SF/$ exchange rate at maturity? Will the investor be better

or worse off at maturity if the actual SF/$ exchange rate is SF1.35/$1.00?

Solution: Implicitly, the dual currency bonds call for the exchange of SF1,000 of face value for

$666.67. Therefore, the implicit exchange rate built into the dual currency bond issue is

SF1,000/$666.67, or SF1.50/$1.00. If the exchange rate at maturity is SF1.35/$1.00, SF1,000 would

buy $740.74 = SF1,000/SF1.35. Thus, the dual currency bond investor is worse off with $666.67

because the dollar is at a depreciated level in comparison to the implicit exchange rate of

SF1.50/$1.00.

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MINI CASE: SARA LEE CORP.’S EUROBONDS

The International Finance in Practice boxed reading in the chapter discussed a three-year $100

million Eurobond issue by Sara Lee Corporation. The article also mentions other bond issues recently

placed by various foreign divisions of Sara Lee. What thoughts do you have about Sara Lee’s debt

financing strategy?

Suggested Solution to Sara Lee Corp.’s Eurobonds

Sara Lee is the ideal candidate to issue Eurobonds. The company has worldwide name

recognition, and it has an excellent credit rating that allows it to place new bond issues easily. By

issuing dollar denominated Eurobonds to Swiss investors, Sara Lee can bring new issues to market

much more quickly than if it sold domestic dollar denominated bonds. Moreover, the Eurodollar

bonds likely sell at a lower yield than comparable domestic bonds.

Additionally, it appears as if Sara Lee is raising funds in a variety of foreign currencies. Sara Lee

most likely has large cash inflows in these same currencies that can be used to meet the debt service

obligations on these bond issues. Thus Sara Lee is finding a use for some of its foreign currency

receipts and does not have to be concerned with the exchange rate uncertainty of these part of its

foreign cash inflows.

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CHAPTER 8 INTERNATIONAL EQUITY MARKETS



QUESTIONS

1. Get a current copy of The Wall Street Journal and find the Dow Jones Global Indexes listing in

Section C of the newspaper. Examine the 12-month changes in U.S. dollars for the various national

and regional indices. How do the changes from your table compare with the 12-month changes from

the sample provided in the textbook as Exhibit 8.8? Are they all of similar size? Are the same

national indexes positive and negative in both listings? Discuss your findings.

Answer: This question is designed to provide an intuitive understanding of the benefits from

international diversification of equity portfolios. It is very unlikely that the student will find many, if

any, national market indexes that have 12- month returns that are even close to the same level as in

Exhibit 8.8. Over different time periods, different market forces will affect each national market in

unique ways and the exchange rates will be different. Some markets that previously yielded a positive

return will now show a negative return, and vice versa. Similarly, some markets that had yielded a

large positive (negative) return may now show only a small positive (negative) return.

2. As an investor, what factors would you consider before investing in the emerging stock market of a

developing country?

Answer: An investor in emerging market stocks needs to be concerned with the depth of the market

and the market’s liquidity. Depth of the market refers to the opportunities to invest in the country.

One measure of the depth of the market is the concentration ratio of a country’s stock market. The

concentration ratio frequently is calculated to show the market value of the ten largest stock traded as

a fraction of the total market capitalization of all equities traded. The lower the concentration ratio,

the less deep is the market. That is, most value is concentrated in only a few companies. While this

does not necessarily imply that the largest stocks in the emerging market are not good investments, it

does, however, suggest that there are few opportunities for investment in that country and that proper

diversification within the country may be difficult. In terms of liquidity, an investor would be wise to

examine the market turnover ratio of the country’s stock market. High market turnover suggests that

the market is liquid, or that there are opportunities for purchasing or selling the stock quickly at close

to the current market price. This is important because liquidity means you can get in or out of a stock

position quickly without spending more than you intended on purchase or receiving less than you

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expected on sale.

3. Compare and contrast the various types of secondary market trading structures.

Answer: There are two basic types of secondary market trading structures: dealer and agency. In a

dealer market, the dealer serves as market maker for the security, holding an inventory of the security.

The dealer buys at his bid price and sells at his asked price from this inventory. All public trades go

through the dealer. In an agency market, public trades go through the agent who matches it with

another public trade. Both dealer and agency markets can be continuous trade markets, but non-

continuous markets tend to be only agency markets. Over-the-counter trading, specialist markets, and

automated markets are types of continuous market trading systems. Call markets and crowd trading

are each types of non-continuous trading market systems. Continuous trading systems are desirable

for actively traded issues, whereas call markets and crowd trading offer advantages for smaller

markets with many thinly traded issues because they mitigate the possibility of sparse order flow over

short time periods.

4. Discuss any benefits you can think of for a company to (a) cross-list its equity shares on more than

one national exchange, and, (b) to source new equity capital from foreign investors as well as domestic

investors.

Answer: A MNC that has a product market presence or manufacturing facilities in several countries

may cross-list its shares on the exchanges of these same countries because there is typically investor

demand for the shares of companies that are known within a country. Additionally, a company may

cross-list its shares on foreign exchanges to broaden its investor base and therefore to increase the

demand for the its stock. An increase in demand will generally increase the stock price and improve

the its market liquidity. A broader investor base may also mitigate the possibility of a hostile

takeover. Additional, cross-listing a company’s shares establishes name recognition and thus

facilitates sourcing new equity capital in these foreign capital markets.

5. Why might it be easier for an investor desiring to diversify his portfolio internationally to buy

depository receipts rather than the actual shares of the company?

Answer: A depository receipt can be purchased on the investor’s domestic exchange. It represents a

package of the underlying foreign security that is priced in the investor’s local currency and in a

trading range that is typical for the investor’s marketplace. The investor can purchase a depository

receipt directly from his domestic broker, rather than having to deal with an overseas broker and the

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necessity of obtaining foreign funds to make the foreign stock purchase. Additionally, dividends are

received in the local currency rather than in foreign funds that would need to be converted into the

local currency.

6. Why do you think the empirical studies about factors affecting equity returns basically showed that

domestic factors were more important than international factors, and, secondly, that industrial

membership of a firm was of little importance in forecasting the international correlation structure of a

set of international stocks?

Answer: While national security markets have become more integrated in recent years, there is still a

tremendous amount of segmentation that brings about the benefit to be derived from international

diversification of financial assets. Monetary and fiscal policies differ among countries because of

different economic circumstances. The economic policies of a country directly affect the securities

traded in the country, and they will behave differently than securities traded in another country with

other economic policies being implemented. Hence, it is not surprising that domestic factors are found

to be more important than international factors in affecting security returns. Similarly, industrial

activity within a country is also affected by the economic policies of the country; thus firms in the

same industry group, but from different countries, will not necessarily behave the same in all

countries, nor should we expect the securities issued by these firms to behave alike.

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PROBLEMS

1. On the Milan bourse, Fiat stock closed at EUR31.90 per share on Friday, September 10, 1999. Fiat

trades as and ADR on the NYSE. One underlying Fiat share equals one ADR. On September 10, the

$/EUR spot exchange rate was $1.0367/EUR1.00. At this exchange rate, what is the no-arbitrage U.S.

dollar price of one ADR?

Solution: The no-arbitrage ADR U.S. dollar price is: EUR31.90 x $1.0367 = $33.07.

2. If Fiat ADRs were trading at $35 when the underlying shares were trading in Milan at EUR31.90,

what could you do to earn a trading profit? Use the information in problem 1, above, to help you and

assume that transaction costs are negligible.

Solution: As the solution to problem 1 shows, the no-arbitrage ADR U.S. dollar price is $33.07. If

Fiat ADRs were trading at $35, a wise investor would sell short the relatively overvalued ADRs and

use the proceeds to buy the relatively undervalued Fiat shares on the Milan exchange. The profit

would be $35 - $33.07 = $1.93 per ADR.

IM-59

MINI CASE: SAN PICO’S NEW STOCK EXCHANGE

San Pico is a rapidly growing Latin American developing country. The country is blessed with

miles of scenic beaches that have attracted tourists by the thousands to in recent years to new resort

hotels financed by joint ventures of San Pico businessmen and moneymen from the Middle East,

Japan, and the U.S. Additionally, San Pico has good natural harbors that are conducive for receiving

imported merchandise and exporting merchandise produced in San Pico and other surrounding

countries that lack access to the sea. Because of these advantages, many new businesses are being

started in San Pico.

Presently, stock is traded in a cramped building in La Cobijio, the nation’s capital. Admittedly,

the San Pico Stock Exchange system is rather archaic. Twice a day an official of the exchange will

call out the name of each of the 43 companies whose stock trade on the exchange. Brokers wanting to

buy or sell shares for their clients will then attempt to make a trade with one another. This crowd

trading system has worked well for over one hundred years, but the government desires to replace it

with a new modern system that will allow greater and more frequent opportunities for trading in each

company, and will allow for trading the shares of the many new start-up companies that are expected

to trade in the secondary market. Additionally, the government administration is rapidly privatizing

many state-owned businesses in an attempt to foster their efficiency, obtain foreign exchange from the

sale, and convert the country to a more capitalist economy. The government believes that it could

conduct this privatization faster and perhaps at more attractive prices if it had a modern stock

exchange facility where the shares of the newly privatized companies will eventually trade.

You are an expert in the operation of secondary stock markets and have been retained as a

consultant to the San Pico Stock Exchange to offer your expertise in modernizing the stock market.

What would you advise?

Suggested Solution to San Pico’s New Stock Exchange

Most new and renovated stock exchanges are being established these days as either a partially or

fully automated trading system. A fully automated system is especially beneficial for a small to

medium size country in which there is only moderate trading in most issues. Such a system that

deserves special note is the continuous National Integrated Market system of New Zealand. This

system is fully computerized and does not require a physical structure. Essentially, all buyers and

sellers of a stock enter through their broker into the computer system the number of shares they desire

to buy or sell and their required transaction price. The system is updated constantly as new purchase

or sale orders are entered into the system. The computer constantly searches for a match between

buyer and seller, and when one is found a transaction takes place. This type of system would likely

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serve San Pico’s needs very well. There is existing technology to implement, the bugs have been

worked out in other countries, and it would satisfy all the demands of the San Pico government and

easily accommodate growth in market activity.

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CHAPTER 9 FUTURES AND OPTIONS ON FOREIGN EXCHANGE



QUESTIONS

1. Explain the basic differences between the operation of a currency forward market and a futures

market.

Answer: The forward market is an OTC market where the forward contract for purchase or sale of

foreign currency is tailor-made between the client and its international bank. No money changes

hands until the maturity date of the contract when delivery and receipt are typically made. A futures

contract is an exchange-traded instrument with standardized features specifying contract size and

delivery date. Futures contracts are marked-to-market daily to reflect changes in the settlement price.

Delivery is seldom made in a futures market. Rather a reversing trade is made to close out a long or

short position.

2. In order for a derivatives market to function two types of economic agents are needed: hedgers and

speculators. Explain.

Answer: Two types of market participants are necessary for the operation of a derivatives market:

speculators and hedgers. A speculator attempts to profit from a change in the futures price. To do

this, the speculator will take a long or short position in a futures contract depending upon his

expectations of future price movement. A hedger, on-the-other-hand, desires to avoid price variation

by locking in a purchase price of the underlying asset through a long position in a futures contract or a

sales price through a short position. In effect, the hedger passes off the risk of price variation to the

speculator who is better able, or at least more willing, to bear this risk.

3. Why are most futures positions closed out through a reversing trade rather than held to delivery?

Answer: In forward markets, approximately 90 percent of all contracts that are initially established result

in the short making delivery to the long of the asset underlying the contract. This is natural because the

terms of forward contracts are tailor made between the long and short. By contrast, only about one percent

of currency futures contracts result in delivery. While futures contracts are useful for speculation and

hedging, their standardized delivery dates make them unlikely to correspond to the actual future dates when

foreign exchange transactions will occur. Thus, they are generally closed out in a reversing trade. In fact,

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the commission that buyers and sellers pay to transact in the futures market is a single amount that covers

the round-trip transactions of initiating and closing out the position.

4. How can the FX futures market be used for price discovery?

Answer: To the extent that FX forward prices are an unbiased predictor of future spot exchange rates,

the market anticipates whether one currency will appreciate or depreciate versus another. Because FX

futures contracts trade in an expiration cycle, different contracts expire at different periodic dates into

the future. The pattern of the prices of these contracts provides information as to the market’s current

belief about the relative future value of one currency versus another at the scheduled expiration dates

of the contracts. One will generally see a steadily appreciating or depreciating pattern; however, it

may be mixed at times. Thus, the futures market is useful for price discovery, i.e., obtaining the

market’s forecast of the spot exchange rate at different future dates.

5. What is the major difference in the obligation of one with a long position in a futures (or forward)

contract in comparison to an options contract?

Answer: A futures (or forward) contract is a vehicle for buying or selling a stated amount of foreign

exchange at a stated price per unit at a specified time in the future. If the long holds the contract to the

delivery date, he pays the effective contractual futures (or forward) price, regardless of whether it is an

advantageous price in comparison to the spot price at the delivery date. By contrast, an option is a

contract giving the long the right to buy or sell a given quantity of an asset at a specified price at some

time in the future, but not enforcing any obligation on him if the spot price is more favorable than the

exercise price. Because the option owner does not have to exercise the option if it is to his

disadvantage, the option has a price, or premium, whereas no price is paid at inception to enter into a

futures (or forward) contract.

6. What is meant by the terminology that an option is in-, at-, or out-of-the-money?

Answer: A call (put) option with St > E (E > St) is referred to as trading in-the-money. If St E the

option is trading at-the-money. If St < E (E < St) the call (put) option is trading out-of-the-money.

7. List the arguments (variables) of which a FX call or put option model price is a function. How

does the call and put premium change with respect to a change in the arguments?

Answer: Both call and put options are functions of only six variables: St, E, ri, rus, T and . When all

IM-63

else remains the same, the price of a European FX call (put) option will increase:

1. the larger (smaller) is S,

2. the smaller (larger) is E,

3. the smaller (larger) is ri,

4. the larger (smaller) is rus,

5. the larger (smaller) rus is relative to ri, and

6. the greater is .

When rus and ri are not too much different in size, a European FX call and put will increase in price

when the option term-to-maturity increases. However, when rus is very much larger than ri, a

European FX call will increase in price, but the put premium will decrease, when the option term-to-

maturity increases. The opposite is true when ri is very much greater than rus. For American FX

options the analysis is less complicated. Since a longer term American option can be exercised on any

date that a shorter term option can be exercised, or a some later date, it follows that the all else

remaining the same, the longer term American option will sell at a price at least as large as the shorter

term option.

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PROBLEMS

1. Assume today’s settlement price on a CME DM futures contract is $0.6080/DM. You have a short

position in one contract. Your margin account currently has a balance of $1,700. The next three days’

settlement prices are $0.6066, $0.6073, and $0.5989. Calculate the changes in the margin account

from daily marking-to-market and the balance of the margin account after the third day.

Solution: $1,700 + [($0.6080 - $0.6066) + ($0.6066 - $0.6073)

+ ($0.6073 - $0.5989)] x DM125,000 = $2,837.50,

where DM125,000 is the contractual size of one DM contract.

2. Do problem 1 over again assuming you have a long position in the futures contract.

Solution: $1,700 + [($0.6066 - $0.6080) + ($0.6073 - $0.6066) + ($0.5989 - $0.6073)] x DM125,000

= $562.50,

where DM125,000 is the contractual size of one DM contract.

With only $562.50 in your margin account, you would experience a margin call requesting that

additional cash be added to the margin account to bring it back up to the initial margin level.

3. Using the quotations in Exhibit 9.3, calculate the face value of the open interest in the December

1999 Swiss franc futures contract.

Solution: 172 contracts x SF125,000 = SF21,500,000.

where SF125,000 is the contractual size of one SF contract.

4. Using the quotation in Exhibit 9.3, note that the March 2000 Mexican peso futures contract has a

price of $0.11695. You believe the spot price in March will be $0.09550. What speculative position

would you enter into to attempt to profit from your beliefs? Calculate your anticipated profits

assuming you take a position in three contracts. What is the size of your profit (loss) if the futures

price is indeed an unbiased predictor of the future spot price and this price materializes?

Solution: If you expect the Mexican peso to rise from $0.09550 to $0.11000, you would take a long

position in futures since the futures price of $0.09550 is less than your expected spot price.

Your anticipated profit from a long position in three contracts is: 3 x ($0.11000 - $0.09550) x

MP500,000 = $21,750.00, where MP500,000 is the contractual size of one MP contract.

If the futures price is an unbiased predictor of the expected spot price, the expected spot price is

IM-65

the futures price of $0.09550/MP. If this spot price materializes, you will not have any profits or

losses from your short position in three futures contracts: 3 x ($0.09550 - $0. 09550) x MP500,000 =

0.

5. Do problem 4 over again assuming you believe the March 2000 spot price will be $0.08500.

Solution: If you expect the Mexican peso to depreciate from $0.09550 to $0.08500, you would take a

short position in futures since the futures price of $0. 09550 is greater than your expected spot price.

Your anticipated profit from a short position in three contracts is: 3 x ($0.09550 - $0.08500) x

MP500,000 = $15,750.00.

If the futures price is an unbiased predictor of the future spot price and this price materializes,

you will not profit or lose from your long futures position.

6. Recall the forward rate agreement (FRA) example in Chapter 6. Show how the bank can

alternatively use a position in Eurodollar futures contracts to hedge the interest rate risk created by the

maturity mismatch it has with the $3,000,000 six-month Eurodollar deposit and rollover Eurocredit

position indexed to three-month LIBOR. Assume the bank can take a position in Eurodollar futures

contracts maturing in three months’ time that have a futures price of 94.00.

Solution: To hedge the interest rate risk created by the maturity mismatch, the bank would need to

buy (go long) three Eurodollar futures contracts. If on the last day of trading, three-month LIBOR is 5

1/8%, the bank will earn a profit of $6,562.50 from its futures position. This is calculated as:

[94.875 - 94.00] x 100 bp x $25 x 3 contracts = $6,562.50.

Note that this sum differs slightly from the $6,550.59 profit that the bank will earn from the FRA for

two reasons. First, the Eurodollar futures contract assumes an arbitrary 90 days in a three-month

period, whereas the FRA recognizes that the actual number of days in the specific three-month period

is 91 days. Second, the Eurodollar futures contract pays off in future value terms, or as of the end of

the three-month period, whereas the FRA pays off in present value terms, or as of the beginning of the

three-month period.

7. Use the quotations in Exhibit 9.6 to calculate the intrinsic value and the time value of the 80 ½

September Japanese yen American put options.

Solution: Premium - Intrinsic Value = Time Value

80 ½ Sep Put .60 - [80.5 – 82.64 = - 2.14] = 2.74 cents per 100 yen

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8. Assume spot Swiss franc is $0.7000 and the six-month forward rate is $0.6950. What is the

minimum price that a six-month American call option with a striking price of $0.6800 should sell for

in a rational market? Assume the annualized six-month Eurodollar rate is 3 ½ percent.

Solution:

Note to Instructor: A complete solution to this problem relies on the boundary expressions presented

in endnote 2 of the text of Chapter 9.

Ca Max[(70 - 68), (69.50 - 68)/(1.0175), 0]

Max[ 2, 1.47, 0] = 2 cents

9. Do problem 8 over again assuming an American put option instead of a call option.

Solution: Pa Max[(68 - 70), (68 - 69.50)/(1.0175), 0]

Max[ -2, -1.47, 0] = 0 cents

10. Use the European option pricing models developed in the chapter to value the call of problem 8

and the put of problem 9. Assume the annualized volatility of the Swiss franc is 14.2 percent. This

problem can be solved using the FXOPM.xls spreadsheet.

Solution:

d1 = [ln(69.50/68) + .5(.142)2(.50)]/(.142).50 = .2675

d2 = d1 - .142.50 = .2765 - .1004 = .1671

N(d1) = .6055

N(d2) = .5664

N(-d1) = .3945

N(-d2) = .4336

Ce = [69.50(.6055) - 68(.5664)]e-(.035)(.50) = 3.51 cents

Pe = [68(.4336) - 69.50(.3945)]e-(.035)(.50) = 2.03 cents

11. Use the binomial option-pricing model developed in the chapter to value the call of problem 8. The volatility of the Swiss franc is 14.2 percent.

Solution: The spot rate at T will be either 77.39¢ = 70.00¢(1.1056) or 63.32¢ = 70.00¢(.9045), where u = e.142.50 = 1.1056 and d = 1/u = .9045. At the exercise price of E = 68, the option will only be exercised at time T if the Swiss franc appreciates; its exercise value would be CuT = 9.39¢ = 77.39¢ - 69. If the Swiss franc depreciates it would not be rational to exercise the option; its value would be CdT = 0.

IM-67

The hedge ratio is h = (9.39 – 0)/(77.39 – 63.32) = .6674.

Thus, the call premium is:

C0 = Max{[69.50(.6674) – 68((70/68)(.6674 – 1) +1)]/(1.0175), 70 – 68}

= Max[1.64, 2] = 2 cents per SF.

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MINI CASE: THE OPTIONS SPECULATOR

A speculator is considering the purchase of five three-month Japanese yen call options with a

striking price of 96 cents per 100 yen. The premium is 1.35 cents per 100 yen. The spot price is 95.28

cents per 100 yen and the 90-Day forward rate is 95.71 cents. The speculator believes the yen will

appreciate to $1.00 per 100 yen over the next three months. As the speculator’s assistant, you have

been asked to prepare the following:

1. Diagram the call option.

2. Determine the speculator’s profit if the yen appreciates to $1.00/100 yen.

3. Determine the speculator’s profit if the yen only appreciates to the forward rate.

4. Determine the future spot price at which the speculator will only breakeven.

Suggested Solution to the Options Speculator:

1. +

-

2. (5 x ¥6,250,000) x [(100 - 96) - 1.35]/10000 = $8,281.25.

3. Since the option expires out-of-the-money, the speculator will let the option expire worthless. He

will only lose the option premium.

4. ST = E + C = 96 + 1.35 = 97.35 cents per 100 yen.

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CHAPTER 10 CURRENCY AND INTEREST RATE SWAPS



QUESTIONS

1. Describe the difference between a swap broker and a swap dealer.

Answer: A swap broker arranges a swap between two counterparties for a fee without taking a risk

position in the swap. A swap dealer is a market maker of swaps and assumes a risk position in

matching opposite sides of a swap and in assuring that each

counterparty fulfills its contractual obligation to the other.

2. What is the necessary condition for a fixed-for-floating interest rate swap to be possible?

Answer: For a fixed-for-floating interest rate swap to be possible it is necessary for a quality spread

differential to exist. In general, the default-risk premium of the fixed-rate debt will be larger than the

default-risk premium of the floating-rate debt.

3. Describe the difference between a parallel loan and a back-to-back loan.

Answer: A parallel loan involves four parties. One MNC borrows and re-lends to another’s

subsidiary and vice versa. A back-to-back loan involves only two parties. One MNC borrows and re-

lends directly to another.

4. Discuss the basic motivations for a counterparty to enter into a currency swap.

Answer: One basic reason for a counterparty to enter into a currency swap is to exploit the

comparative advantage of the other in obtaining debt financing at a lower interest rate than could be

obtained on its own. A second basic reason is to lock in long-term exchange rates in the repayment of

debt service obligations denominated in a foreign currency.

5. How does the theory of comparative advantage relate to the currency swap market?

Answer: Name recognition is extremely important in the international bond market. Without it, even

a creditworthy corporation will find itself paying a higher interest rate for foreign denominated funds

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than a local borrower of equivalent creditworthiness. Consequently, two firms of equivalent

creditworthiness can each exploit their, respective, name recognition by borrowing in their local

capital market at a favorable rate and then re-lending at the same rate to the other.

6. Discuss the risks confronting an interest rate and currency swap dealer.

Answer: An interest rate and currency swap dealer confronts many different types of risk. Interest

rate risk refers to interest rates changing unfavorably before the swap dealer can lay off with an

opposing counterparty the unplaced side of a swap entered into with another counterparty. Basis risk

refers to the floating rates of two counterparties being pegged to two different indices. In this

situation, since the indexes are not perfectly positively correlated, the swap bank may not always

receive enough floating rate funds from one counterparty to pass through to satisfy the other side,

while still covering its desired spread, or avoiding a loss. Exchange-rate risk refers to the risk the

swap bank faces from fluctuating exchange rates during the time it takes the bank to lay off a swap it

undertakes on an opposing counterparty before exchange rates change. Additionally, the dealer

confronts credit risk from one counterparty defaulting and its having to fulfill the defaulting party’s

obligation to the other counterparty. Mismatch risk refers to the difficulty of the dealer finding an

exact opposite match for a swap it has agreed to take. Sovereign risk refers to a country imposing

exchange restrictions on a currency involved in a swap making it costly, or impossible, for a

counterparty to honor its swap obligations to the dealer. In this event, provisions exist for the early

termination of a swap, which means a loss of revenue to the swap bank.

7. Briefly discuss some variants of the basic interest rate and currency swaps diagramed in the

chapter.

Answer: Instead of the basic fixed-for-floating interest rate swap, there are also zero-coupon-for-

floating rate swaps where the fixed rate payer makes only one zero-coupon payment at maturity on the

notional value. There are also floating-for-floating rate swaps where each side is tied to a different

floating rate index or a different frequency of the same index. Currency swaps need not be fixed-for-

fixed; fixed-for-floating and floating-for-floating rate currency swaps are frequently arranged.

Moreover, both currency and interest rate swaps can be amortizing as well as non-amortizing.

8. If the cost advantage of interest rate swaps would likely be arbitraged away in competitive markets,

what other explanations exist to explain the rapid development of the interest rate swap market?

Answer: All types of debt instruments are not always available to all borrowers. Interest rate swaps

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can assist in market completeness. That is, a borrower may use a swap to get out of one type of

financing and to obtain a more desirable type of credit that is more suitable for its asset maturity

structure.

9. Assume you are the swap bank in the Eli Lilly swap discussed in the chapter. Develop an example

of how you might lay off the swap to an opposing counterparty.

Answer: The swap bank may try to lay off the swap on a Japanese MNC that has issued yen

denominated debt to finance a capital expenditure of a U.S. subsidiary. The subsidiary is earning U.S.

dollar revenues which are to be used to service the yen debt. A currency swap would allow the

Japanese MNC to avoid the foreign exchange risk of an appreciating yen; the swap could serve as a

ready means for disposing of dollars and receiving yen to service the debt.

10. Discuss the motivational difference in the currency swap presented as Example 10.5 and the Eli

Lilly and Company swap discussed in the chapter.

Answer: The currency swap presented as Example 10.5 can be classified as a liability swap. The

motivation of a counterparty to enter into a liability swap is to obtain the cost-saving advantage of the

other counterparty. Each has a comparative advantage in raising funds in a particular currency. When

the proceeds are swapped and each counterparty pays the other’s debt service, a cost-savings is

obtained. The Eli Lilly currency swap was motivated by Lilly’s desire to find a use for its yen cash

inflows. What it desired to do was to convert yen cash flow into U.S. dollar cash flow at a stable

exchange rate. The swap allowed Lilly to do this. Currency swaps that transform cash flows are

referred to as asset swaps.

*11. Assume a currency swap in which two counterparties of comparable credit risk each borrow at

the best rate available, yet the nominal rate of one counterparty is higher than the other. After the

initial principal exchange, is the counterparty that is required to make interest payments at the higher

nominal rate at a financial disadvantage to the other in the swap agreement? Explain your thinking.

Answer: Superficially, it may appear that the counterparty paying the higher nominal rate is at a

disadvantage since it has borrowed at a lower rate. However, if the forward rate is an unbiased

predictor of the expected spot rate and if IRP holds, then the currency with the higher nominal rate is

expected to depreciate versus the other. In this case, the counterparty making the interest payments at

the higher nominal rate is in effect making interest payments at the lower interest rate because the

payment currency is depreciating in value versus the borrowing currency.

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PROBLEMS

1. Develop a different arrangement of interest payments among the counterparties and the swap bank

in Example 10.1 that still leaves each counterparty with an all-in cost 1/2 percent below each’s best

rate and the swap bank with a 1/4 percent inflow.

Solution: Company B could pay a fixed-rate of 10.75 percent to the swap bank, which would pass

through 10.50 percent to Bank A. Bank A could pay LIBOR, which the swap bank would pass in its

entirety through to Company B. In fact, generic plain vanilla interest rate swaps, such as this one, are

quoted by swap banks against LIBOR flat. The swap bank would pay U.S. dollar LIBOR flat in return

for receiving dollar payments at 10.75 percent or the bank would make dollar payments at 10.50

percent in return for receiving U.S. dollar LIBOR flat. Hence, the bank is charging a fixed-rate spread

of .50 percent for the swap.

2. Alpha and Beta Companies can borrow at the following rates.

Alpha Beta

Moody’s credit rating Aa Baa

Fixed-rate borrowing cost 10.5% 12.0%

Floating-rate borrowing cost LIBOR LIBOR + 1%

a. Calculate the Quality Spread Differential (QSD).

b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their

borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt.

Solution:

a. The QSD = (12.0% - 10.5%) minus (LIBOR + 1% - LIBOR) = .5%.

b. Alpha needs to issue fixed-rate debt at 10.5% and Beta needs to issue floating rate-debt at LIBOR +

1%. Alpha needs to pay LIBOR to Beta. Beta needs to pay 10.75% to Alpha. If this is done, Alpha’s

floating-rate all-in-cost is: 10.5% + LIBOR - 10.75% = LIBOR - .25%, a .25% savings over issuing

floating-rate debt on its own. Beta’s fixed-rate all-in-cost is: LIBOR+ 1% + 10.75% - LIBOR =

11.75%, a .25% savings over issuing fixed-rate debt.

3. Company A is a AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue FRNs

at six-month LIBOR + 1/8 percent or at the six-month Treasury-bill rate + ½ percent. Given its asset

structure, LIBOR is the preferred index. Company B is an A-rated firm that also desires to issue five-

year FRNs. It finds that it can issue at six-month LIBOR + 5/8 percent or at the six-month Treasury-

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bill rate + 1 5/8 percent. Given its asset structure, the six-month Treasury-bill rate is the preferred

index. Assume a notional principal of $15,000,000. Determine the QSD and set up a floating-for-

floating rate swap where the swap bank receives 1/8 percent and the two counterparties share the

remaining savings equally.

Solution: The quality spread differential is [(T-bill + 1 3/8 percent) minus (T-bill + 4/8 percent) =] 9/8

percent minus [(LIBOR + 5/8 percent) minus (LIBOR + 1/8 percent) =] 4/8 percent, which equals 5/8

percent. If the swap bank receives 1/8 percent, each counterparty is to save 2/8 percent. Company B

would issue LIBOR indexed FRNs. Company A would issue Treasury-bill indexed notes. Semi-

annual payments will be made by both counterparties to the swap bank. On an annualized basis,

Company B will remit to the swap bank the T-bill rate + 11/8 percent and pay LIBOR + 5/8 percent on

its FRNs. It will receive LIBOR + 5/8 percent from the swap bank. This arrangement results in an

all-in cost of the T-bill rate + 11/8 percent, which is a rate 1/4 percent below the T-bill indexed FRNs

Company B could issue on its own. Company A will remit LIBOR + 5/8 percent to the swap bank and

pay the T-bill rate + 4/8 percent on its FRNs. It will receive the T-bill rate +10/8 percent from the

swap bank. This arrangement results in an all-in cost of LIBOR - 1/8 percent for Company A, which

is 1/4 percent less than the LIBOR indexed FRNs it could issue on its own. The arrangements with the

two counterparties net the swap bank 1/8 percent per annum, received semi-annually.

4. Suppose Morgan Guaranty, Ltd. is quoting swap rates as follows: 7.75 - 8.10 percent annually

against six-month dollar LIBOR for dollars and 11.25 - 11.65 percent annually against six-month

dollar LIBOR for British pound sterling. At what rates will Morgan Guaranty enter into a $/£

currency swap?

Solution: Morgan Guaranty will pay annual fixed-rate dollar payments of 7.75 percent against

receiving six-month dollar LIBOR flat, or it will receive fixed-rate annual dollar payments at 8.10

percent against paying six-month dollar LIBOR flat. Morgan Guaranty will make annual fixed-rate £

payments at 11.25 percent against receiving six-month dollar LIBOR flat, or it will receive annual

fixed-rate £ payments at 11.65 percent against paying six-month dollar LIBOR flat. Thus, Morgan

Guaranty will enter into a currency swap in which it would pay annual fixed-rate dollar payments of

7.75 percent in return for receiving semi-annual fixed-rate £ payments at 11.65 percent, or it will

receive annual fixed-rate dollar payments at 8.10 percent against paying annual fixed-rate £ payments

at 11.25 percent.

*5. A corporation enters into a five-year interest rate swap with a swap bank in which it agrees to pay

the swap bank a fixed-rate of 9.75 percent annually on a notional amount of DM15,000,000 and

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receive LIBOR – ½ percent. As of the second reset date, determine the price of the swap from the

corporation’s viewpoint, assuming that the fixed-rate at which it can borrow has increased to 10.25

percent.

Solution: On the reset date, the present value of the future floating-rate payments the corporation will

receive from the swap bank based on the notional value will be DM15,000,000. The present value of

a hypothetical bond issue of DM15,000,000 with three remaining 9.75 percent coupon payments at the

new fixed-rate of 10.25 percent is DM14,814,304. This sum represents the present value of the

remaining payments the swap bank will receive from the corporation. Thus, the swap bank should be

willing to buy and the corporation should be willing to sell the swap for DM15,000,000 -

DM14,814,304 = DM185,696.

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MINI CASE: THE CENTRALIA CORPORATION’S CURRENCY SWAP

The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has

decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture

microwave ovens for sale to the European Union market. The plant is expected to cost

Ptas620,000,000, and to take about one year to complete. The plant is to be financed over its

economic life of eight years. The borrowing capacity created by this capital expenditure is

$1,700,000; the remainder of the plant will be equity financed. Centralia is not well known in the

Spanish or international bond market; consequently, it would have to pay 14 percent per annum to

borrow pesetas, whereas the normal borrowing rate in the Spanish capital market for well-known firms

of equivalent risk is 12.5 percent. Centralia could borrow in the U.S. at a rate of 8 percent.

Study Questions

1. Suppose a Spanish MNC has a mirror image situation and needs $1,700,000 to finance a capital

expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed-rate in the U.S.

for dollars, whereas it can borrow pesetas at 12.5 percent. The exchange rate has been forecast to be

Ptas145.44/$1.00 in one year. Set up a currency swap that will be beneficial for each counterparty.

*2. Suppose that one year after the inception of the currency swap between Centralia and the Spanish

MNC, the U.S. dollar fixed-rate has fallen from 8 to 6 percent and the Spanish capital market fixed-

rate for pesetas has fallen from 12.5 to 11 percent. In both dollars and pesetas, determine the market

value of the swap if the exchange rate is Ptas152.30/$1.00.

Suggested Solution to The Centralia Corporation’s Currency Swap

1. The Spanish MNC should issue Ptas247,250,000 of 12.5 percent fixed rate debt and Centralia

should issue $1,700,000 of fixed-rate 8 percent debt, since each counterparty has a relative

comparative advantage in their home market. They will exchange principal sums in one year. The

contractual exchange rate for the initial exchange is Ptas247,250,000/$1,700,000, or Ptas145.44/$1.00.

Annually the counterparties will swap debt service: the Spanish MNC will pay Centralia $136,000

(=$1,700,000 x .08) and Centralia will pay the Spanish MNC Ptas30,906,250 (=Ptas247,250,000

x .125). The contractual exchange rate of the first seven annual debt service exchanges is

Ptas30,906,250/$136,000, or Ptas227.25/$1.00. At retirement, Centralia and the Spanish MNC will

re-exchange the principal sums and the final debt service payments. The contractual exchange rate of

the final currency exchange is Ptas278,156,250/$1,836,000 = (Ptas247,250,000 +

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Ptas30,906,250)/($1,700,000 + $136,000), or Ptas151.50/$1.00.

*2. The market value of the dollar debt is the present value of a seven-year annuity of $136,000 and a

lump sum of $1,700,000 discounted at 6 percent. This present value is $1,889,801.

Similarly, the market value of the peseta debt is the present value of a seven-year annuity of

Ptas30,906,250 and a lump sum of Ptas247,250,000 discounted at 11 percent. This present value is

Ptas264,726,358.

The dollar value of the swap is $1,889,801 - Ptas264,726,358/152.30 = $151,611.

The peseta value of the swap is Ptas264,726,358 - (152.30)$1,889,801 =-Ptas23,090,334.

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CHAPTER 11 INTERNATIONAL PORTFOLIO INVESTMENTS



QUESTIONS

1. What factors are responsible for the recent surge in international portfolio investment (IPI)?

Answer: The recent surge in international portfolio investments reflects the globalization of financial

markets. Specifically, many countries have liberalized and deregulated their capital and foreign

exchange markets in recent years. In addition, commercial and investment banks have facilitated

international investments by introducing such products as American Depository Receipts (ADRs) and

country funds. Also, recent advancements in computer and telecommunication technologies led to a

major reduction in transaction and information costs associated with international investments. In

addition, investors might have become more aware of the potential gains from international

investments.

2. Security returns are found to be less correlated across countries than within a country. Why can this

be?

Answer: Security returns are less correlated probably because countries are different from each other

in terms of industry structure, resource endowments, macroeconomic policies, and have non-

synchronous business cycles. Securities from a same country are subject to the same business cycle

and macroeconomic policies, thus causing high correlations among their returns.

3. Explain the concept of the world beta of a security.

Answer: The world beta measures the sensitivity of returns to a security to returns to the world market

portfolio. It is a measure of the systematic risk of the security in a global setting. Statistically, the

world beta can be defined as:

Cov(Ri, RM)/Var(RM),

where Ri and RM are returns to the I-th security and the world market portfolio, respectively.

4. Explain the concept of the Sharpe performance measure.

Answer: The Sharpe performance measure (SHP) is a risk-adjusted performance measure. It is

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defined as the mean excess return to a portfolio above the risk-free rate divided by the portfolio’s

standard deviation.

5. Explain how exchange rate fluctuations affect the return from a foreign market measured in dollar

terms. Discuss the empirical evidence on the effect of exchange rate uncertainty on the risk of foreign

investment.

Answer: It is useful to refer to Equations 11.4 and 11.5 of the text. Exchange rate fluctuations mostly

contribute to the risk of foreign investment through its own volatility as well as its covariance with the

local market returns. The covariance tends to be positive in most of the cases, implying that exchange

rate changes tend to add to exchange risk, rather than offset it. Exchange risk is found to be much

more significant in bond investments than in stock investments.

6. Would exchange rate changes always increase the risk of foreign investment? Discuss the condition

under which exchange rate changes may actually reduce the risk of foreign investment.

Answer: Exchange rate changes need not always increase the risk of foreign investment. When the

covariance between exchange rate changes and the local market returns is sufficiently negative to

offset the positive variance of exchange rate changes, exchange rate volatility can actually reduce the

risk of foreign investment.

7. Evaluate a home country’s multinational corporations as a tool for international diversification.

Answer: Despite the fact that MNCs have operations worldwide, their stock prices behave very much

like purely domestic firms. This is puzzling yet undeniable. As a result, MNCs are a poor substitute for

direct foreign portfolio investments.

8. Discuss the advantages and disadvantages of closed-end country funds (CECFs) relative to the

American Depository Receipts (ADRs) as a means of international diversification.

Answer: CECFs can be used to diversify into exotic markets that are otherwise difficult to access such

as India and Turkey. Being a portfolio, CECFs also provide instant diversification. ADRs do not

provide instant diversification; investors should form portfolios themselves. In addition, there are

relatively few ADRs from emerging markets. The main disadvantage of CECFs is that their share

prices behave somewhat like the host country’s share prices, reducing the potential diversification

benefits.

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9. Why do you think closed-end country funds often trade at a premium or discount?

Answer: CECFs trade at a premium or discount because capital markets of the home and host

countries are segmented, preventing cross-border arbitrage. If cross-border arbitrage is possible,

CECFs should be trading near their net asset values.

10. Why do investors invest the lion’s share of their funds in domestic securities?

Answer: Investors invest heavily in their domestic securities because there are significant barriers to

investing overseas. The barriers may include excessive transaction costs, information costs for foreign

securities, legal and institutional restrictions, extra taxes, exchange risk and political risk associated

with overseas investments, etc.

11. What are the advantages of investing via international mutual funds?

Answer: The advantages of investing via international mutual funds include: (1) save

transaction/information costs, (2) circumvent legal/institutional barriers, and (3) benefit from the

expertise of professional fund managers.

12. Discuss how the advent of the euro would affect international diversification strategies.

Answer: As the euro-zone will have the same monetary and exchange-rate policies, the correlations

among euro-zone markets are likely to go up. This will reduce diversification benefits. However, to

the extent that the adoption of euro strengthens the European economy, investors may benefit from

enhanced returns.

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PROBLEMS

1. Suppose you are a euro-based investor who just sold Microsoft shares that you had bought six

months ago. You had invested 10,000 euros to buy Microsoft shares for $120 per share; the exchange

rate was $1.15 per euro. You sold the stock for $135 per share and converted the dollar proceeds into

euro at the exchange rate of $1.06 per euro. First, determine the profit from this investment in euro

terms. Second, compute the rate of return on your investment in euro terms. How much of the return is

due to the exchange rate movement?

Solution: It is useful first to compute the rate of return in euro terms:

This indicates that this euro-based investor benefited from an appreciation of dollar against the euro,

as well as from an appreciation of the dollar value of Microsoft shares. The profit in euro terms is

about C2,100, and the rate of return is about 21% in euro terms, of which 8.5% is due to the exchange

rate movement.

2. Mr. James K. Silber, an avid international investor, just sold a share of Rhone-Poulenc, a French

firm, for FF50. The share was bought for FF42 a year ago. The exchange rate is FF5.80 per U.S. dollar

now and was FF6.65 per dollar a year ago. Mr. Silber received FF4 as a cash dividend immediately

before the share was sold. Compute the rate of return on this investment in terms of U.S. dollars.

Solution: Mr. Silber must have paid $6.32 (=42/6.65) for a share of Rhone-Poulenc a year ago. When

the share was liquidated, he must have received $9.31 (=54/5.8). Therefore, the rate of return in dollar

terms is:

R($) = [(9.31-6.32)/6.32]x100 = 47.31%.

3. In the above problem, suppose that Mr. Silber sold FF42, his principal investment amount, forward

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C

at the forward exchange rate of FF6.15 per dollar. How would this affect the dollar rate of return on

this French stock investment? In hindsight, should Mr. Silber have sold the French franc amount

forward or not? Why or why not?

Solution: When FF42 is sold forward, the investor’s profit is reduced:

Profit($) = 42 (1/6.15 - 1/5.80)

= 42 ($.1626 - $.1724)

= -$.41

Thus, the total return of investment is:

R($) = [(9.31-6.32-.41)/6.32]x100 = 40.82%.

Due to hedging, the return became lower. By hindsight, Mr. Silber should not have entered into the

forward contract.

4. Japan Life Insurance Company invested $10,000,000 in pure-discount U.S. bonds in May 1995

when the exchange rate was 80 yen per dollar. The company liquidated the investment one year later

for $10,650,000. The exchange rate turned out to be 110 yen per dollar at the time of liquidation. What

rate of return did Japan Life realize on this investment in yen terms?

Solution: Japan Life Insurance Company spent ¥800,000,000 to buy $10,000,000 that was invested in

U.S. bonds. The liquidation value of this investment is ¥1,171,500,000, which is obtained from

multiplying $10,650,000 by ¥110/$. The rate of return in terms of yen is:

[(¥1,171,500,000 - ¥800,000,000)/ ¥800,000,000]x100 = 46.44%.

5. At the start of 1996, the annual interest rate was 6 percent in the United States and 2.8 percent in

Japan. The exchange rate was 95 yen per dollar at the time. Mr. Jorus, who is the manager of a

Bermuda-based hedge fund, thought that the substantial interest advantage associated with investing in

the United States relative to investing in Japan was not likely to be offset by the decline of the dollar

against the yen. He thus concluded that it might be a good idea to borrow in Japan and invest in the

United States. At the start of 1996, in fact, he borrowed ¥1,000 million for one year and invested in the

United States. At the end of 1996, the exchange rate became 105 yen per dollar. How much profit did

Mr. Jorus make in dollar terms?

Solution: Let us first compute the maturity value of U.S. investment:

(¥1,000,000,000/95)(1.06) = $11,157,895.

The dollar amount necessary to pay off yen loan is:

(¥1,000,000,000)(1.028)/105 = $9,790,476.

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The dollar profit = $11,157,895 - $9,790,476 = $1,367,419.

Mr. Jorus was able to realize a large dollar profit because the interest rate was higher in the U.S. than

in Japan and the dollar actually appreciated against yen. This is an example of uncovered interest

arbitrage.

6. From Exhibit 11.3 we obtain the following data in dollar terms:

Stock market Return (mean) Risk (SD)

United States 1.33% per month 4.56%

United Kingdom 1.52% per month 6.47%

The correlation coefficient between the two markets is 0.57. Suppose that you invest equally, i.e., 50%

each, in the two markets. Determine the expected return and standard deviation risk of the resulting

international portfolio.

Solution: The expected return of the equally weighted portfolio is:

E(Rp) = (.5)(1.33%) + (.5)(1.52%) = 1.43%

The variance of the portfolio is:

Var(Rp) = (.5)2(4.56)2 + (.5)2(6.47)2 +2(.5)2(4.56)(6.47)(.57)

= 5.20 +10.47 + 8.41 = 24.08

The standard deviation of the portfolio is thus 4.91%.

7. Suppose you are interested in investing in the stock markets of 7 countries--i.e., Canada, France,

Germany, Japan, Switzerland, the United Kingdom, and the United States--the same 7 countries that

appear in Exhibit 11.9. Specifically, you would like to solve for the optimal (tangency) portfolio

comprising the above 7 stock markets. In solving the optimal portfolio, use the input data (i.e.

correlation coefficients, means, and standard deviations) provided in Exhibit 11.4. The risk-free

interest rate is assumed to be 0.5% per month and you can take a short position in any stock market.

What are the optimal weights for each of the 7 stock markets? This problem can be solved using

MPTSolver.xls spreadsheet.

Solution: Using the data in Exhibit 11.4, the covariance matrix is computed and is given below.

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CN FR GM JP SW UK US

CN 33.99 15.53 12.97 11.08 14.01 21.88 18.61

FR 15.53 49.14 31.18 21.52 25.88 24.49 14.38

GM 12.97 31.18 45.43 17.74 28.44 21.37 11.37

JP 11.08 21.52 17.74 53.44 16.28 19.86 8.00

SW 14.01 25.88 28.44 16.28 34.34 19.72 12.83

UK 21.88 24.49 21.37 19.86 19.72 41.86 16.82

US 18.61 14.38 11.37 8.00 12.83 16.82 20.79

The optimal weights computed are -0.7457 for Canada, 0.0453 for France, 0.0237 for Germany,

0.2435 for Japan, -0.0474 for Switzerland, 0.3168 for U.K., and 1.1638 for U.S., respectively.

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MINI CASE: SOLVING FOR THE OPTIMAL INTERNATIONAL PORTFOLIO

Suppose you are a financial advisor and your client, who is currently investing only in the

U.S. stock market, is considering diversifying into the U.K. stock market. At the moment, there are

neither particular barriers nor restrictions on investing in the U.K. stock market. Your client would like

to know what kind of benefits can be expected from doing so. Using the data provided in the above

problem (i.e., problem 12), solve the following problems:

(a) Graphically illustrate various combinations of portfolio risk and return that can be generated by

investing in the U.S. and U.K. stock markets with different proportions. Two extreme proportions are

(I) investing 100% in the U.S. with no position in the U.K. market, and (ii) investing 100% in the

U.K. market with no position in the U.S. market.

(b) Solve for the ‘optimal’ international portfolio comprised of the U.S. and U.K. markets. Assume

that the monthly risk-free interest rate is 0.5% and that investors can take a short (negative) position in

either market.

(c) What is the extra return that U.S. investors can expect to capture at the ‘U.S.-equivalent’ risk

level? Also trace out the efficient set. [The Appendix 11.B provides an example.]

Suggested Solution to the Optimal International Portfolio:

Let U.S. be market 1 and U.K. be market 2. The parameter values are: ¯1 = 1.33%, ¯2 = 1.52%, 1 =

4.56%, 2 = 6.47%, Rf = 0.5%.

Accordingly, 12 = 12 (correlation coefficient) = (4.56)(6.47)(0.57) = 16.82, 12 = 20.79, 2

2 =41.86.

(a) E(Rp) = 1.33w1 + 1.52w2

The variance of the portfolio is:

Var(Rp) = 20.79w12 + 41.86w2

2 + 33.63w1w2

Some possible portfolios are:

w1 w2 E(Rp) Var(Rp)

1.00 0.00 1.33 20.79

0.75 0.25 1.38 20.62

0.50 0.50 1.43 24.07

0.25 0.75 1.47 31.15

0.00 1.00 1.52 41.86

(b) The optimal weights are w1 = 0.71 and w2 = 0.29.

(c) ¯I = Rf + US

Here, = Slope of efficient set = (¯OIP - Rf )/ OIP

¯OIP = (0.71)(1.33) + (0.29)(1.52) = 1.39%

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OIP2 = (0.71)2(20.79) + (0.29)2(16.82) + (0.71)(0.29)(33.63) = 18.79

OIP = 4.33%

Therefore, ¯I = 0.5 + ((1.39-0.5)/4.33)(4.56) = 1.97%

Extra return = 1.97-1.33 = 0.64%

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CHAPTER 12 MANAGEMENT OF ECONOMIC EXPOSURE



QUESTIONS

1. How would you define economic exposure to exchange risk?

Answer: Economic exposure can be defined as the possibility that the firm’s cash flows and thus its

market value may be affected by the unexpected exchange rate changes.

2. Explain the following statement: “Exposure is the regression coefficient”.

Answer: Exposure to currency risk can be appropriately measured by the sensitivity of the firm’s

future cash flows and the market value to random changes in exchange rates. Statistically, this

sensitivity can be estimated by the regression coefficient. Thus, exposure can be said to be the

regression coefficient.

3. Suppose that your company has an equity position in a French firm. Discuss the condition under

which the dollar/franc exchange rate uncertainty does not constitute exchange exposure for your

company.

Answer: Mere changes in exchange rates do not necessarily constitute currency exposure. If the

French franc value of the equity moves in the opposite direction as much as the dollar value of the

franc changes, then the dollar value of the equity position will be insensitive to exchange rate

movements. As a result, your company will not be exposed to currency risk.

4. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating

cash flow.

Answer: The competitive effect: exchange rate changes may affect operating cash flows by altering

the firm’s competitive position.

The conversion effect: A given operating cash flows in terms of a foreign currency will be converted

into higher or lower dollar (home currency)amounts as the exchange rate changes.

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5. Discuss the determinants of operating exposure.

Answer: The main determinants of a firm’s operating exposure are (1) the structure of the markets in

which the firm sources its inputs, such as labor and materials, and sells its products, and (2) the firm’s

ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and

sourcing.

6. Discuss the implications of purchasing power parity for operating exposure.

Answer: If the exchange rate changes are matched by the inflation rate differential between countries,

firms’ competitive positions will not be altered by exchange rate changes. Firms are not subject to

operating exposure.

7. General Motors exports cars to Spain but the strong dollar against the peseta hurts sales of GM cars

in Spain. In the Spanish market, GM faces competition from the Italian and French car makers, such as

Fiat and Renault, whose currencies remain stable relative to the peseta. What kind of measures would

you recommend so that GM can maintain its market share in Spain.

Answer: Possible measures that GM can take include: (1) diversify the market; try to market the cars

not just in Spain and other European countries but also in, say, Asia; (2) locate production facilities in

Spain and source inputs locally; (3) locate production facilities, say, in Mexico where production costs

are low and export to Spain from Mexico.

8. What are the advantages and disadvantages of financial hedging of the firm’s operating exposure

vis-a-vis operational hedges (such as relocating manufacturing site)?

Answer: Financial hedging can be implemented quickly with relatively low costs, but it is difficult to

hedge against long-term, real exposure with financial contracts. On the other hand, operational hedges

are costly, time-consuming, and not easily reversible.

9. Discuss the advantages and disadvantages of maintaining multiple manufacturing sites as a hedge

against exchange rate exposure.

Answer: To establish multiple manufacturing sites can be effective in managing exchange risk

exposure, but it can be costly because the firm may not be able to take advantage of the economy of

scale.

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10. Evaluate the following statement: “A firm can reduce its currency exposure by diversifying

across different business lines”.

Answer: Conglomerate expansion may be too costly as a means of hedging exchange risk exposure.

Investment in a different line of business must be made based on its own merit.

11. The exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure.

Explain why this may be the case.

Answer: A firm can have a natural hedging position due to, for example, diversified markets, flexible

sourcing capabilities, etc. In addition, to the extent that the PPP holds, nominal exchange rate changes

do not influence firms’ competitive positions. Under these circumstances, firms do not need to worry

about exchange risk exposure.

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PROBLEMS

1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year.

As a U.S. resident, we are concerned with the dollar value of the land. Assume that, if the British

economy booms in the future, the land will be worth £2,000 and one British pound will be worth

$1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500,

but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom

with a 60% probability and a slow-down with a 40% probability.

(a) Estimate your exposure b to the exchange risk.

(b) Compute the variance of the dollar value of your property that is attributable to the exchange rate

uncertainty.

(c) Discuss how you can hedge your exchange risk exposure and also examine the consequences of

hedging.

Solution: (a) Let us compute the necessary parameter values:

E(P) = (.6)(2800)+(.4)(2250) = 1680+900 = $2,580

E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44

Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2

= .00096+.00144 = .0024.

Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)

= -5.28-7.92 = -13.20

b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.

You have a negative exposure! As the pound gets stronger(weaker) against the dollar, the dollar

value of your British holding goes down(up).

(b) b2Var(S) = (-5500)2(.0024) =72,600($)2

(c) Buy £5,500 forward. By doing so, you can eliminate the volatility of the dollar value of your

British asset that is due to the exchange rate volatility.

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2. A U.S. firm holds an asset in France and faces the following scenario:

State 1 State 2 State 3 State 4

Probability 25% 25% 25% 25%

Spot rate $.30/FF $.25/FF $.20/FF $.18/FF

P* FF1500 FF1400 FF1300 FF1200

P $450 $350 $260 $216

In the above table, P* is the French franc price of the asset held by the U.S. firm and P is the dollar

price of the asset.

(a) Compute the exchange exposure faced by the U.S. firm.

(b) What is the variance of the dollar price of this asset if the U.S. firm remains unhedged against this

exposure.

(c) In case the U.S. firm hedges against this exposure using the forward contract, what is the

variance of the dollar value of the hedged position?

Solution: (a)

E(P) = .25(.30+.25+.20+.18) = $.2325

E(P) = .25(450+350+260+216) = $319

Var(S) = .25[(.30-.2325)2+(.25-.2325)2+(.2-.2325)2+(.18-.2325)2]

= .0022

Cov(P,S) = .25[(450-319)(.30-.2325)+(350-319)(.25-.2325)

(260-319)(.20-.2325)+(216-319)(.18-.2325)]

= 4.18

b = Cov(P,S)/Var(S) = 4.18/.0022 = FF1,900.

(b) Var(P) = .25[(450-319)2+(350-319)2+(260-319)2+(216-319)2]

= 8,053($)2.

(c) Var(P) - b2Var(S) = 8053-(1900)2(.0022) = 111($)2.

This means that most of the volatility of the dollar value of the French asset can be removed by

hedging exchange risk.

IM-91

MINI CASE: ECONOMIC EXPOSURE OF ALBION COMPUTERS PLC

Consider Case 3 of Albion Computers PLC discussed in the chapter. Now, assume that the

pound is expected to depreciate to $1.50 from the current level of $1.60 per pound. This implies that

the pound cost of the imported part, i.e., Intel’s microprocessors, is £341 (=$512/$1.50). Other

variables, such as the unit sales volume and the U.K. inflation rate, remain the same as in Case 3.

(a) Compute the projected annual cash flow in dollars.

(b) Compute the projected operating gains/losses over the four-year horizon as the discounted present

value of change in cash flows, which is due to the pound depreciation, from the benchmark case

presented in Exhibit 12.4.

(c) What actions, if any, can Albion take to mitigate the projected operating losses due to the pound

depreciation?

Suggested Solution to Economic Exposure of Albion Computers PLC

a) The projected annual cash flow can be computed as follows:

______________________________________________________

Sales (40,000 units at £1,080/unit) £43,200,000

Variable costs (40,000 units at £697/unit) £27,880,000

Fixed overhead costs 4,000,000

Depreciation allowances 1,000,000

Net profit before tax £15,315,000

Income tax (50%) 7,657,500

Profit after tax 7,657,500

Add back depreciation 1,000,000

Operating cash flow in pounds £8,657,500

Operating cash flow in dollars $12,986,250

______________________________________________________

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b) ______________________________________________________

Benchmark Current

Variables Case Case

______________________________________________________

Exchange rate ($/£) 1.60 1.50

Unit variable cost (£) 650 697

Unit sales price (£) 1,000 1,080

Sales volume (units) 50,000 40,000

Annual cash flow (£) 7,250,000 8,657,500

Annual cash flow ($) 11,600,000 12,986,250

Four-year present value ($) 33,118,000 37,076,946

Operating gains/losses ($) 3,958,946

______________________________________________________

c) In this case, Albion actually can expect to realize exchange gains, rather than losses. This is mainly

due to the fact that while the selling price appreciates by 8% in the U.K. market, the variable cost of

imported input increased by about 6.25%. Albion may choose not to do anything.

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CHAPTER 13 MANAGEMENT OF TRANSACTION EXPOSURE

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND

PROBLEMS

QUESTIONS

1. How would you define transaction exposure? How is it different from economic exposure?

Answer: Transaction exposure is the sensitivity of realized domestic currency values of the firm’s

contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates.

Unlike economic exposure, transaction exposure is well-defined and short-term.

2. Discuss and compare hedging transaction exposure using the forward contract vs. money market

instruments. When do the alternative hedging approaches produce the same result?

Answer: Hedging transaction exposure by a forward contract is achieved by selling or buying foreign

currency receivables or payables forward. On the other hand, money market hedge is achieved by

borrowing or lending the present value of foreign currency receivables or payables, thereby creating

offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are

equivalent.

3. Discuss and compare the costs of hedging via the forward contract and the options contract.

Answer: There is no up-front cost of hedging by forward contracts. In the case of options hedging,

however, hedgers should pay the premiums for the contracts up-front. The cost of forward hedging,

however, may be realized ex post when the hedger regrets his/her hedging decision.

4. What are the advantages of a currency options contract as a hedging tool compared with the forward

contract?

Answer: The main advantage of using options contracts for hedging is that the hedger can decide

whether to exercise options upon observing the realized future exchange rate. Options thus provide a

hedge against ex post regret that forward hedger might have to suffer. Hedgers can only eliminate the

downside risk while retaining the upside potential.

5. Suppose your company has purchased a put option on the German mark to manage exchange

exposure associated with an account receivable denominated in that currency. In this case, your

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company can be said to have an ‘insurance’ policy on its receivable. Explain in what sense this is so.

Answer: Your company in this case knows in advance that it will receive a certain minimum dollar

amount no matter what might happen to the $/DM exchange rate. Furthermore, if the German mark

appreciates, your company will benefit from the rising mark.

6. Recent surveys of corporate exchange risk management practices indicate that many U.S. firms

simply do not hedge. How would you explain this result?

Answer: There can be many possible reasons for this. First, many firms may feel that they are not

really exposed to exchange risk due to product diversification, diversified markets for their products,

etc. Second, firms may be using self-insurance against exchange risk. Third, firms may feel that

shareholders can diversify exchange risk themselves, rendering corporate risk management

unnecessary.

7. Should a firm hedge? Why or why not?

Answer: In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to

their value by hedging if markets are imperfect. First, if management knows about the firm’s exposure

better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to

hedge at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable

because it reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce

tax obligations by hedging which stabilizes corporate earnings.

8. Using an example, discuss the possible effect of hedging on a firm’s tax obligations.

Answer: One can use an example similar to the one presented in the chapter.

9. Explain contingent exposure and discuss the advantages of using currency options to manage this

type of currency exposure.

Answer: Companies may encounter a situation where they may or may not face currency exposure. In

this situation, companies need options, not obligations, to buy or sell a given amount of foreign

exchange they may or may not receive or have to pay. If companies either hedge using forward

contracts or do not hedge at all, they may face definite currency exposure.

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10. Explain cross-hedging and discuss the factors determining its effectiveness.

Answer: Cross-hedging involves hedging a position in one asset by taking a position in another asset.

The effectiveness of cross-hedging would depend on the strength and stability of the relationship

between the two assets.

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PROBLEMS

1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced

DM 10 million payable in six months. Currently, the six-month forward exchange rate is $1.50/DM and

the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.43 in six

months.

(a) What is the expected gain/loss from the forward hedging?

(b) If you were the financial manager of Cray Research, would you recommend hedging this DM

receivable? Why or why not?

(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the

forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not?

Solution: (a) Expected gain($) = 10,000,000(1/1.50-1/1.43)

= 10,000,000(.6667-.6993)

= -$326,000.

(b) There is no easy answer here. Hedging is expected to reduce the dollar receipt by $326,000. If I

were willing to sacrifice $326,000 or more to eliminate exchange risk, I would hedge. Otherwise, I

would not. It depends on the degree of my risk aversion.

(c) Since I eliminate risk without sacrificing dollar receipt, I would be more likely to hedge.

2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million

payable in three months. Currently, the spot exchange rate is ¥105/$ and the three-month forward rate is

¥100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per

annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen

account payable.

(a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen

obligation.

(b) Conduct the cash flow analysis of the money market hedge.

Solution: (a). Let’s first compute the PV of ¥250 million, i.e.,

250m/1.0175 = ¥245,700,245.7

So if the above yen amount is invested today at the Japanese interest rate for three months, the

maturity value will be exactly equal to ¥25 million which is the amount of payable.

To buy the above yen amount today, it will cost:

$2,340,002.34 = ¥250,000,000/105.

The dollar cost of meeting this yen obligation is $2,340,002.34 as of today.

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(b) ___________________________________________________________________

Transaction CF0 CF1

____________________________________________________________________

1. Buy yens spot -$2,340,002.34

with dollars ¥245,700,245.70

2. Invest in Japan - ¥245,700,245.70 ¥250,000,000

3. Pay yens - ¥250,000,000

Net cash flow - $2,340,002.34

____________________________________________________________________

3. You plan to visit Geneva, Switzerland in three months to attend an international business

conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during

your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is

$0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the

premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the

forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent

per annum in Switzerland.

(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on

SF.

(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a

forward contract.

(c) At what future spot exchange rate will you be indifferent between the forward and option market

hedges?

(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate

under both the options and forward market hedges.

Solution: (a) Total option premium = (.05)(5000) = $250. In three months, $250 is worth $253.75 =

$250(1.015). At the expected future spot rate of $0.63/SF, which is less than the exercise price, you

don’t expect to exercise options. Rather, you expect to buy Swiss franc at $0.63/SF. Since you are

going to buy SF5,000, you expect to spend $3,150 (=.63x5,000). Thus, the total expected cost of

buying SF5,000 will be the sum of $3,150 and $253.75, i.e., $3,403.75.

(b) $3,150 = (.63)(5,000).

(c) $3,150 = 5,000x + 253.75, where x represents the break-even future spot rate. Solving for x, we

obtain x = $0.57925/SF. Note that at the break-even future spot rate, options will not be exercised.

(d) If the Swiss franc appreciates beyond $0.64/SF, which is the exercise price of call option, you will

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exercise the option and buy SF5,000 for $3,200. The total cost of buying SF5,000 will be $3,453.75 =

$3,200 + $253.75.

This is the maximum you will pay.

4. McDonnell Douglas just signed a contract to sell a DC 10 aircraft to Air France. Air France will be

billed FF50 million which is payable in one year. The current spot exchange rate is $0.20/FF and the

one-year forward rate is $0.19/FF. The annual interest rate is 6.0% in the U.S. and 9.5% in France.

McDonnell Douglas is concerned with the volatile exchange rate between the dollar and the franc and

would like to hedge exchange exposure.

(a) It is considering two hedging alternatives: sell the franc proceeds from the sale forward or borrow

francs from the Credit Lyonnaise against the franc receivable. Which alternative would you

recommend? Why?

(b) Other things being equal, at what forward exchange rate would McDonnell Douglas be indifferent

between the two hedging methods?

Solution: (a) In the case of forward hedge, the future dollar proceeds will be (50,000,000)(0.19) =

$9,500,000.

In the case of money market hedge (MMH), the firm has to first borrow the PV of its franc receivable,

i.e.,

50,000,000/1.095 =FF45,662,100. Then the firm should exchange this franc amount into dollars at the

current spot rate to receive: (FF45,662,100)(0.20) = $9,132,420, which can be invested at the dollar

interest rate for one year to yield:

$9,132,420(1.06) = $9,680,365.

Clearly, the firm can receive $180,365 more by using MMH.

(b) According to IRP, F = S(1+i$)/(1+iF). Thus the “indifferent” forward rate will be:

F = 0.20(1.06)/1.095 = $0.1936/FF.

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$ Cost

Options hedge

Forward hedge

$3,453.75

$3,150

0 0.579 0.64(strike price)

$/SF$253.75

5. Suppose that Baltimore Machinery sold a drilling machine to a Swiss firm and gave the Swiss

client a choice of paying either $10,000 or SF 15,000 in three months.

(a) In the above example, Baltimore Machinery effectively gave the Swiss client a free option to buy

up to $10,000 dollars using Swiss franc. What is the ‘implied’ exercise exchange rate?

(b) If the spot exchange rate turns out to be $0.62/SF, which currency do you think the Swiss client

will choose to use for payment? What is the value of this free option for the Swiss client?

(c) What is the best way for Baltimore Machinery to deal with the exchange exposure?

Solution: (a) The implied exercise (price) rate is: 10,000/15,000 = $0.6667/SF.

(b) If the Swiss client chooses to pay $10,000, it will cost SF16,129 (=10,000/.62). Since the Swiss

client has an option to pay SF15,000, it will choose to do so. The value of this option is obviously

SF1,129 (=SF16,129-SF15,000).

(c) Baltimore Machinery faces a contingent exposure in the sense that it may or may not receive

SF15,000 in the future. The firm thus can hedge this exposure by buying a put option on SF15,000.

6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes

Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and

the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the

U.S. PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a

premium of .014 cents per yen.

(a) Compute the future dollar costs of meeting this obligation using the money market hedge and the

forward hedges.

(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the

expected future dollar cost of meeting this obligation when the option hedge is used.

(c) At what future spot rate do you think PCC may be indifferent between the option and forward

hedge?

Solution: (a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In

the case of money market hedge, the future dollar cost will be: 500,000,000(1.08)/(1.05)(124)

= $4,147,465.

(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000(1.08)

= $75,600.

At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC

will exercise its call option and buy ¥500,000,000 for $4,050,000 (=500,000,000x.0081).

The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.

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(c) When the option hedge is used, PCC will spend “at most” $4,125,000. On the other hand, when the

forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This means

that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent

between forward and options hedges.

IM-101

Suggested solution for Mini Case: Chase Options, Inc.

[See Chapter 13 for the case text]

Chase Options, Inc.

Hedging Foreign Currency Exposure Through Currency Options

Harvey A. Poniachek

I. Case Summary

This case reviews the foreign exchange options market and hedging. It presents various international

transactions that require currency options hedging strategies by the corporations involved. Seven

transactions under a variety of circumstances are introduced that require hedging by currency options.

The transactions involve hedging of dividend remittances, portfolio investment exposure, and strategic

economic competitiveness. Market quotations are provided for options (and options hedging ratios),

forwards, and interest rates for various maturities.

II. Case Objective.

The case introduces the student to the principles of currency options market and hedging strategies.

The transactions are of various types that often confront companies that are involved in extensive

international business or multinational corporations. The case induces students to acquire hands-on

experience in addressing specific exposure and hedging concerns, including how to apply various

market quotations, which hedging strategy is most suitable, and how to address exposure in foreign

currency through cross hedging policies.

III. Proposed Assignment Solution

1. The company expects DM100 million in repatriated profits, and does not want the DM/$ exchange

rate at which they convert those profits to rise above 1.70. They can hedge this exposure using DM put

options with a strike price of 1.70. If the spot rate rises above 1.70, they can exercise the option, while

if that rate falls they can enjoy additional profits from favorable exchange rate movements.

To purchase the options would require an up-front premium of:

DM 100,000,000 x 0.0164 = DM 1,640,000.

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With a strike price of 1.70 DM/$, this would assure the U.S. company of receiving at least:

DM 100,000,000 – DM 1,640,000 x (1 + 0.085106 x 272/360)

= DM 98,254,544/1.70 DM/$ = $57,796,791

by exercising the option if the DM depreciated. Note that the proceeds from the repatriated profits are

reduced by the premium paid, which is further adjusted by the interest foregone on this amount.

However, if the DM were to appreciate relative to the dollar, the company would allow the option to

expire, and enjoy greater dollar proceeds from this increase.

Should forward contracts be used to hedge this exposure, the proceeds received would be:

DM100,000,000/1.6725 DM/$ = $59,790,732,

regardless of the movement of the DM/$ exchange rate. While this amount is almost $2 million more

than that realized using option hedges above, there is no flexibility regarding the exercise date; if this

date differs from that at which the repatriate profits are available, the company may be exposed to

additional further current exposure. Further, there is no opportunity to enjoy any appreciation in the

DM.

If the company were to buy DM puts as above, and sell an equivalent amount in calls with strike price

1.647, the premium paid would be exactly offset by the premium received. This would assure that the

exchange rate realized would fall between 1.647 and 1.700. If the rate rises above 1.700, the company

will exercise its put option, and if it fell below 1.647, the other party would use its call; for any rate in

between, both options would expire worthless. The proceeds realized would then fall between:

DM 100,00,000/1.647 DM/$ = $60,716,454

and

DM 100,000,000/1.700 DM/$ = $58,823,529.

This would allow the company some upside potential, while guaranteeing proceeds at least $1 million

greater than the minimum for simply buying a put as above.

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Buy/Sell Options

DM/$

Spot Put Payoff

“Put”

Profits Call Payoff

“Call”

Profits Net Profit

1.60 (1,742,846) 0 1,742,846 60,716,454 60,716,454

1.61 (1,742,846) 0 1,742,846 60,716,454 60,716,454

1.62 (1,742,846) 0 1,742,846 60,716,454 60,716,454

1.63 (1,742,846) 0 1,742,846 60,716,454 60,716,454

1.64 (1,742,846) 0 1,742,846 60,716,454 60,716,454

1.65 (1,742,846) 60,606,061 1,742,846 0 60,606,061

1.66 (1,742,846) 60,240,964 1,742,846 0 60,240,964

1.67 (1,742,846) 59,880,240 1,742,846 0 59,880,240

1.68 (1,742,846) 59,523,810 1,742,846 0 59,523,810

1.69 (1,742,846) 59,171,598 1,742,846 0 59,171,598

1.70 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.71 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.72 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.73 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.74 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.75 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.76 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.77 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.78 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.79 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.80 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.81 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.82 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.83 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.84 (1,742,846) 58,823,529 1,742,846 0 58,823,529

1.85 (1,742,846) 58,823,529 1,742,846 0 58,823,529

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Since the firm believes that there is a good chance that the pound sterling will weaken, locking them

into a forward contract would not be appropriate, because they would lose the opportunity to profit

from this weakening. Their hedge strategy should follow for an upside potential to match their

viewpoint. Therefore, they should purchase sterling call options, paying a premium of:

5,000,000 STG x 0.0176 = 88,000 STG.

If the dollar strengthens against the pound, the firm allows the option to expire, and buys sterling in

the spot market at a cheaper price than they would have paid for a forward contract; otherwise, the

sterling calls protect against unfavorable depreciation of the dollar.

Because the fund manager is uncertain when he will sell the bonds, he requires a hedge which will

allow flexibility as to the exercise date. Thus, options are the best instrument for him to use. He can

buy A$ puts to lock in a floor of 0.72 A$/$. Since he is willing to forego any further currency

appreciation, he can sell A$ calls with a strike price of 0.8025 A$/$ to defray the cost of his hedge (in

fact he earns a net premium of A$ 100,000,000 x (0.007234 – 0.007211) = A$ 2,300), while knowing

that he can’t receive less than 0.72 A$/$ when redeeming his investment, and can benefit from a small

appreciation of the A$.

Example #3:

Problem: Hedge principal denominated in A$ into US$. Forgo upside potential to buy floor protection.

I. Hedge by writing calls and buying puts

1) Write calls for $/A$ @ 0.8025

Buy puts for $/A$ @ 0.72

# contracts needed = Principal in A$/Contract size

100,000,000A$/100,000 A$ = 100

2) Revenue from sale of calls = (# contracts)(size of contract)(premium)

$75,573 = (100)(100,000 A$)(.007234 $/A$)(1 + .0825 195/360)

3) Total cost of puts = (# contracts)(size of contract)(premium)

$75,332 = (100)(100,000 A$)(.007211 $/A$)(1 + .0825 195/360)

4) Put payoff

If spot falls below 0.72, fund manager will exercise put

If spot rises above 0.72, fund manager will let put expire

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5) Call payoff

If spot rises above .8025, call will be exercised

If spot falls below .8025, call will expire

6) Net payoff

See following Table for net payoff

Australian Dollar Bond Hedge

Strike

Price Put Payoff

“Put”

Principal Call Payoff

“Call”

Principal Net Profit

0.60 (75,332) 72,000,000 75,573 0 72,000,241

0.61 (75,332) 72,000,000 75,573 0 72,000,241

0.62 (75,332) 72,000,000 75,573 0 72,000,241

0.63 (75,332) 72,000,000 75,573 0 72,000,241

0.64 (75,332) 72,000,000 75,573 0 72,000,241

0.65 (75,332) 72,000,000 75,573 0 72,000,241

0.66 (75,332) 72,000,000 75,573 0 72,000,241

0.67 (75,332) 72,000,000 75,573 0 72,000,241

0.68 (75,332) 72,000,000 75,573 0 72,000,241

0.69 (75,332) 72,000,000 75,573 0 72,000,241

0.70 (75,332) 72,000,000 75,573 0 72,000,241

0.71 (75,332) 72,000,000 75,573 0 72,000,241

0.72 (75,332) 72,000,000 75,573 0 72,000,241

0.73 (75,332) 73,000,000 75,573 0 73,000,241

0.74 (75,332) 74,000,000 75,573 0 74,000,241

0.75 (75,332) 75,000,000 75,573 0 75,000,241

0.76 (75,332) 76,000,000 75,573 0 76,000,241

0.77 (75,332) 77,000,000 75,573 0 77,000,241

0.78 (75,332) 78,000,000 75,573 0 78,000,241

0.79 (75,332) 79,000,000 75,573 0 79,000,241

0.80 (75,332) 80,000,000 75,573 0 80,000,241

0.81 (75,332) 0 75,573 80,250,000 80,250,241

0.82 (75,332) 0 75,573 80,250,000 80,250,241

0.83 (75,332) 0 75,573 80,250,000 80,250,241

0.84 (75,332) 0 75,573 80,250,000 80,250,241

0.85 (75,332) 0 75,573 80,250,000 80,250,241

4. The German company is bidding on a contract which they cannot be certain of winning. Thus, the

need to execute a currency transaction is similarly uncertain, and using a forward or futures as a hedge

is inappropriate, because it would force them to perform even if they do not win the contract.

Using a sterling put option as a hedge for this transaction makes the most sense. For a premium of:

IM-106

12 million STG x 0.0161 = 193,200 STG,

they can assure themselves that adverse movements in the pound sterling exchange rate will not

diminish the profitability of the project (and hence the feasibility of their bid), while at the same time

allowing the potential for gains from sterling appreciation.

5. Since AMC in concerned about the adverse effects that a strengthening of the dollar would have on

its business, we need to create a situation in which it will profit from such an appreciation. Purchasing

a yen put or a dollar call will achieve this objective. The data in Exhibit 1, row 7 represent a 10

percent appreciation of the dollar (128.15 strike vs. 116.5 forward rate) and can be used to hedge

against a similar appreciation of the dollar.

For every million yen of hedging, the cost would be:

Yen 100,000,000 x 0.000127 = 127 Yen.

To determine the breakeven point, we need to compute the value of this option if the dollar

appreciated 10 percent (spot rose to 128.15), and subtract from it the premium we paid. This profit

would be compared with the profit earned on five to 10 percent of AMC’s sales (which would be lost

as a result of the dollar appreciation). The number of options to be purchased which would equalize

these two quantities would represent the breakeven point.

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Example #5:

Hedge the economic cost of the depreciating Yen to AMC.

If we assume that AMC sales fall in direct proportion to depreciation in the yen (i.e., a 10 percent

decline in yen and 10 percent decline in sales), then we can hedge the full value of AMC’s sales. I

have assumed $100 million in sales.

1) Buy yen puts

# contracts needed = Expected Sales *Current Y/$ Rate / Contract size

9600 = ($100,000,000)(120¥/$) / $1,250,000¥

2) Total Cost = (# contracts)(contract size)(premium)

$1,524,000 = (9600)(1,250,000)(.0001275/¥)

3) Floor rate = Exercise – Premium

128.1499¥/$ = 128.15¥/$ - $1,524,000/12,000,000,000¥

4) The payoff changes depending on the level of the Y/$ rate. The following table summarizes the

payoffs. An equilibrium is reached when the spot rate equals the floor rate.

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AMC Profitability

Yen/$

Spot Put Payoff Sales Net Profit

120 (1,524,990) 100,000,000 98,475,010

121 (1,524,990) 99,173,664 97,648,564

122 (1,524,990) 98,360,656 96,835,666

123 (1,524,990) 97,560,976 86,035,986

124 (1,524,990) 96,774,194 95,249,204

125 (1,524,990) 96,000,000 94,475,010

126 (1,524,990) 95,238,095 93,713,105

127 (847,829) 94,488,189 93,640,360

128 (109,640) 93,750,000 93,640,360

129 617,104 93,023,256 93,640,360

130 1,332,668 92,307,692 93,640,360

131 2,037,307 91,603,053 93,640,360

132 2,731,269 90,909,091 93,640,360

133 3,414,796 90,225,664 93,640,360

134 4,088,122 89,552,239 93,640,360

135 4,751,431 88,888,889 93,640,360

136 5,405,066 88,235,294 93,640,360

137 6,049,118 87,591,241 93,640,360

138 6,683,839 86,966,522 93,640,360

139 7,308,425 86,330,936 93,640,360

140 7,926,075 85,714,286 93,640,360

141 8,533,977 85,106,383 93,640,360

142 9,133,318 84,507,042 93,640,360

143 9,724,276 83,916,084 93,640,360

144 10,307,027 83,333,333 93,640,360

145 10,881,740 82,758,621 93,640,360

146 11,448,579 82,191,781 93,640,360

147 12,007,707 81,632,653 93,640,360

148 12,569,279 81,081,081 93,640,360

149 13,103,448 80,536,913 93,640,360

150 13,640,360 80,000,000 93,640,360

The parent has a DM payable, and Lira receivable. It has several ways to cover its exposure;

forwards, options, or swaps.

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The forward would be acceptable for the DM loan, because it has a known quantity and maturity, but

the Lira exposure would retain some of its uncertainty because these factors are not assured.

The parent could buy DM calls and Lira puts. This would allow them to take advantage of favorable

currency fluctuations, but would require paying for two premiums.

Finally, they could swap their Lira receivable into DM. This would leave a net DM exposure which

would probably be smaller than the amount of the loan, which they could hedge using forwards or

options, depending upon their risk outlook.

The company has Lira receivables, and is concerned about possible depreciation versus the dollar.

Because of the high costs of Lira options, they instead buy DM puts, making the assumption that

movement in the DM and Lira exchange rates versus the dollar correlate well.

A hedge of lira using DM options will depend on the relationship between lira FX rates and DM

options. This relationship could be determined using a regression of historical data.

The hedged risk as a percent of the open risk can be estimated as:

Square Root ( var(error)/(b2var(lira FX rate) ) * 100

The “cost” of the risk of the DM hedge would have to be compared with the cost of the expensive

lira options.

Whichever hedge is “cheaper” (i.e., lower cost for same risk or lower risk for same cost) should be

selected. This hedge must be closely monitored, however, to make sure that this relationship holds

true. If it does not, this “basis risk” can cause the ratio of DM versus Lira to change, so that the

appropriate amount of cross-hedge is different. If that amount is not then adjusted, a net currency

exposure could result, leaving the company open to additional currency losses.

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CHAPTER 14 MANAGEMENT OF TRANSLATION EXPOSURE



QUESTIONS

1. Explain the difference in the translation process between the monetary/nonmonetary method and

the temporal method.

Answer: Under the monetary/nonmonetary method, all monetary balance sheet accounts of a foreign

subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at

the historical rate exchange rate in effect when the account was first recorded. Under the temporal

method, monetary accounts are translated at the current exchange rate. Other balance sheet accounts

are also translated at the current rate, if they are carried on the books at current value. If they are

carried at historical value, they are translated at the rate in effect on the date the item was put on the

books. Since fixed assets and inventory are usually carried at historical costs, the temporal method

and the monetary/nonmonetary method will typically provide the same translation.

2. How are translation gains and losses handled differently according to the current rate method in

comparison to the other three methods, that is, the current/noncurrent method, the

monetary/nonmonetary method, and the temporal method?

Answer: Under the current rate method, translation gains and losses are handled only as an adjustment

to net worth through an equity account named the “cumulative translation adjustment” account.

Nothing passes through the income statement. The other three translation methods pass foreign

exchange gains or losses through the income statement before they enter on to the balance sheet

through the accumulated retained earnings account.

3. Identify some instances under FASB 52 that a foreign entity’s functional currency would be the

same as the parent firm’s currency.

Answer: Three examples under FASB 52, where the foreign entity’s functional currency will be the

same as the parent firm’s currency, are: i) the foreign entity’s cash flows directly affect the parent’s

cash flows and are readily available for remittance to the parent firm; ii) the sales prices for the foreign

entity’s products are responsive on a short-term basis to exchange rate changes, where sales prices are

determined through worldwide competition; and, iii) the sales market is primarily located in the

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parent’s country or sales contracts are denominated in the parent’s currency.

4. Describe the remeasurement and translation process under FASB 52 of translating into the

reporting currency the books of a wholly owned affiliate that keeps its books in the local currency of

the country in which it operates, which is different than its functional currency.

Answer: For a foreign entity that keeps its books in its local currency, which is different from its

functional currency, the translation process according to FASB 52 is to: first, remeasure the financial

reports from the local currency into the functional currency using the temporal method of translation,

and second, translate from the functional currency into the reporting currency using the current rate

method of translation.

5. It is, generally, not possible to completely eliminate both translation exposure and transaction

exposure. In some cases, the elimination of one exposure will also eliminate the other. But in other

cases, the elimination of one exposure actually creates the other. Discuss which exposure might be

viewed as the most important to effectively manage, if a conflict between controlling both arises.

Also, discuss and critique the common methods for controlling translation exposure.

Answer: Since it is, generally, not possible to completely eliminate both transaction and translation

exposure, we recommend that transaction exposure be given first priority since it involves real cash

flows. The translation process, on-the-other hand, has no direct effect on reporting currency cash

flows, and will only have a realizable effect on net investment upon the sale or liquidation of the

assets.

There are two common methods for controlling translation exposure: a balance sheet hedge and

a derivatives hedge. The balance sheet hedge involves equating the amount of exposed assets in an

exposure currency with the exposed liabilities in that currency, so the net exposure is zero. Thus when

an exposure currency exchange rate changes versus the reporting currency, the change in assets will

offset the change in liabilities. To create a balance sheet hedge, once transaction exposure has been

controlled, often means creating new transaction exposure. This is not wise since real cash flow losses

can result. A derivatives hedge is not really a hedge, but rather a speculative position, since the size of

the “hedge” is based on the future expected spot rate of exchange for the exposure currency with the

reporting currency. If the actual spot rate differs from the expected rate, the “hedge” may result in the

loss of real cash flows.

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PROBLEMS

1. Assume that FASB 8 is still in effect instead of FASB 52. Construct a translation exposure report

for Centralia Corporation and its affiliates that is the counterpart to Exhibit 14.7 in the text. Centralia

and its affiliates carry inventory and fixed assets on the books at historical values.

Solution: The following table provides a translation exposure report for Centralia Corporation and its

affiliates under FASB 8, which is essentially the temporal method of translation. The difference

between the new report and Exhibit 14.7 is that nonmonetary accounts such as inventory and fixed

assets are translated at the historical exchange rate if they are carried at historical costs. Thus, these

accounts will not change values when exchange rates change and they do not create translation

exposure.

Examination of the table indicates that under FASB 8 there is negative net exposure for the

Mexican peso and the Spanish peseta, whereas under FASB 52 the net exposure for these currencies is

positive. There is no change in net exposure for the Canadian dollar and the French franc.

Consequently, if the Spanish peseta depreciates against the dollar from Ptas140.00/$1.00 to

Ptas150.00/$1.00, as the text example assumed, exposed assets will now fall in value by a smaller

amount than exposed liabilities, instead of vice versa. The associated reporting currency imbalance

will be $239,333, calculated as follows:

Reporting Currency Imbalance=

- Ptas502,600,000

Ptas150 / $1.00 -

- Ptas502,600,000

Ptas140 / $1.00 = $239,333.

IM-113

Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and Spanish

Affiliates,

December 31, 1997 (in 000 currency units)

Canadian

Dollar

Mexican

Peso

Spanish

Peseta

French

Franc

Assets

Cash CD200 PS 1,800 Ptas 105,000 FF 0

Accounts receivable 0 2,700 133,000 0

Inventory 0 0 0 0

Net fixed assets 0 0 0 0

Exposed assets CD200 PS 4,500 Ptas 238,000 FF 0

Liabilities

Accounts payable CD 0 Ps 2,100 Ptas 173,600 FF 0

Notes payable 0 5,100 119,000 1,400

Long-term debt 0 8,100 448,000 0

Exposed liabilities CD 0 Ps15,300 Ptas 740,600 FF1,400

Net exposure CD200 (Ps10,800) (Ptas502,600) (FF1,400)

2. Assume that FASB 8 is still in effect instead of FASB 52. Construct a consolidated balance sheet

for Centralia Corporation and its affiliates after a depreciation of the Spanish peseta from

Ptas140.00/$1.00 to Ptas150.00/$1.00 that is the counterpart to Exhibit 14.8 in the text. Centralia and

its affiliates carry inventory and fixed assets on the books at historical values.

Solution: This problem is the sequel to Problem 1. The solution to Problem 1 showed that if the

Spanish peseta depreciated there would be a reporting currency imbalance of $239,333. Under FASB

8 this is carried through the income statement as a foreign exchange gain to the retained earnings on

the balance sheet. The following table shows that consolidated retained earnings increased to

$4,190,000 from $3,950,000 in Exhibit 14.8. This is an increase of $240,000, which is the same as the

reporting currency imbalance after accounting for rounding error.

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Consolidated Balance Sheet under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates,December 31, 1997 (in $000): Post-Exchange Rate Change.

Centralia Corp.

(parent)

Mexican

Affiliate

Spanish

Affiliate

Consolidated

Balance Sheet

Assets

Cash $ 950a $ 600 $ 700 $ 2,250

Accounts receivable 1,450b 900 887 3,237

Inventory 3,000 1,500 1,500 6,000

Investment in Mexican affiliate -c - - -

Investment in Spanish affiliate -d - - -

Net fixed assets 9,000 4,600 4,000 17,600

Total assets $29,087

Liabilities and Net Worth

Accounts payable $1,800 $ 700b $1,157 $ 3,657

Notes payable 2,200 1,700 1,043e 4,943

Long-term debt 7,110 2,700 2,987 12,797

Common stock 3,500 -c -d 3,500

Retained earnings 4,190 -c -d 4,190

Total liabilities and net worth $29,087

aThis includes CD200,000 the parent firm has in a Canadian bank, carried as $150,000. CD200,000/(CD1.3333/$1.00) = $150,000.b$1,750,000 - $300,000 (= Ps900,000/(Ps3.00/$1.00)) intracompany loan = $1,450,000.c,dInvestment in affiliates cancels with the net worth of the affiliates in the consolidation.eThe Spanish affiliate owes a French bank FF1,400,000 (x Ptas26.79/FF1.00 = Ptas37,506,000). This is carried on the books,after the exchange rate change, as part of Ptas156,506,000 = Ptas37,506,000 + Ptas119,000,000.Ptas156,506,000/(Ptas150/$1.00) = $1,043,373.

IM-115

3. In Example 14.2, a forward contract was used to establish a derivatives “hedge” to protect Centralia

from a translation loss if the peseta depreciated from Ptas140/$1.00 to Ptas150/$1.00. Assume that an

over-the-counter call option on the dollar with a striking price of Ptas145 can be purchased for

Ptas1.50. Show how the potential translation loss can be “hedged” with an option contract.

Solution: As in example 14.2, if the potential translation loss is $110,667, the equivalent amount in

functional currency that needs to be hedged is Ptas481,400,00. If in fact the peseta does depreciate to

Ptas150/$1.00, Ptas481,400,000 can be purchased in the spot market for $3,209,333. At a striking

price of Ptas145/$1.00, the Ptas481,400,000 can be used to purchase $3,320,000, yielding a gross

profit of $110,667. At the initial exchange rate of Ptas140/$1.00, the call option cost ($3,320,000 x

Ptas1.50)/Ptas140 = $35,571. Thus, at an exchange rate of Ptas150/$1.00, the call option will

effectively hedge $110,667 - $35,571 = $75,096 of the potential translation loss. At terminal

exchange rates of Ptas145/$1.00 to Ptas150/$1.00, the call option hedge will be less effective. An

option contract does not have to be exercised if doing so is disadvantageous to the option owner. The

call will not be exercised at exchange rates of less than Ptas145/$1.00, in which case the “hedge” will

lose the $35,571 cost of the option.

IM-116

MINI CASE: SUNDANCE SPORTING GOODS, INC.

Sundance Sporting Goods, Inc. is a U.S. manufacturer of high-quality sporting goods--principally golf,

tennis and other racquet equipment, and also lawn sports, such as croquet and badminton-- with

administrative offices and manufacturing facilities in Chicago, Illinois. Sundance has two wholly

owned manufacturing affiliates, one in Mexico and the other in Canada. The Mexican affiliate is

located in Mexico City and services all of Latin America. The Canadian affiliate is in Toronto and

serves only Canada. Each affiliate keeps its books in its local currency, which is also the functional

currency for the affiliate. The current exchange rates are: $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 =

W800. The nonconsolidated balance sheets for Sundance and its two affiliates appear in the

accompanying table.

Nonconsolidated Balance Sheet for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates,December 31, 1997 (in 000 currency units)

Sundance, Inc.(parent)

MexicanAffiliate

CanadianAffiliate

Assets

Cash $ 1,500 Ps 1,420 CD 1,200

Accounts receivable 2,500a 2,800e 1,500f

Inventory 5,000 6,200 2,500

Investment in Mexican affiliate 2,400b - -

Investment in Canadian affiliate 3,600c - -

Net fixed assets 12,000 11,200 5,600

Total assets $27,000 Ps21,620 CD10,800


Accounts payable $ 3,000 Ps 2,500a CD 1,700

Notes payable 4,000d 4,200 2,300

Long-term debt 9,000 7,000 2,300

Common stock 5,000 4,500b 2,900c

Retained earnings 6,000 3,420 b 1,600 c

Total liabilities and net worth $27,000 Ps21,620 CD10,800

aThe parent firm is owed Ps1,320,000 by the Mexican affiliate. This sum is included in the parent’s accounts receivable as $400,000, translated at Ps3.30/$1.00. The remainder of the parent’s (Mexican affiliate’s) accounts receivable (payable) are denominated in dollars (pesos).bThe Mexican affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $2,400,000. This represents the sum of the common stock (Ps4,500,000) and retained earnings (Ps3,420,000) on the Mexican affiliate’s books, translated at Ps3.30/$1.00.cThe Canadian affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $3,600,000. This represents the sum of

IM-117

the common stock (CD2,900,000) and the retained earnings (CD1,600,000) on the Canadian affiliate’s books, translated at CD1.25/$1.00.dThe parent firm has outstanding notes payable of ¥126,000,000 due a Japanese bank. This sum is carried on the parent firm’s books as $1,200,000, translated at ¥105/$1.00. Other notes payable are denominated in U.S. dollars. eThe Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This sum is carried on the Mexican affiliate’s books as Ps396,000, translated at A1.00/Ps3.30. Other accounts receivable are denominated in Mexican pesos.

fThe Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This sum is carried on the Canadian affiliate’s books as CD300,000, translated at W800/CD1.25. Other accounts receivable are denominated in Canadian dollars.

You joined the International Treasury division of Sundance six months ago after spending the last

two years receiving your MBA degree. The corporate Treasurer has asked you to prepare a report

analyzing all aspects of the translation exposure faced by Sundance as a MNC. She has also asked

you to address in your analysis the relationship between the firm’s translation exposure and its

transaction exposure. After performing a forecast of future spot rates of exchange, you decide that you

must do the following before any sensible report can be written.

a. Using the current exchange rates and the nonconsolidated balance sheets for Sundance and its

affiliates, prepare a consolidated balance sheet for the MNC according to FASB 52.

b. i. Prepare a translation exposure report for Sundance Sporting Goods, Inc., and its two affiliates.

b. ii. Using the translation exposure report you have prepared, determine if any reporting currency

imbalance will result from the change in exposure currency exchange rates. Your forecast is that

exchange rates will change from $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800 to $1.00 =

CD1.30 = Ps3.30 = A1.03 = ¥105 = W800.

c. Prepare a second consolidated balance sheet for the MNC using the exchange rates you expect in

the future. Determine how any reporting currency imbalance will affect the new consolidated balance

sheet for the MNC.

d. i. Prepare a transaction exposure report for Sundance and its affiliates. Determine if any

transaction exposures are also translation exposures.

d. ii. Investigate what Sundance and its affiliates can do to control its transactions and translation

exposure. Determine if any of the translation exposure should be hedged.

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Suggested Solution to Sundance Sporting Goods, Inc.

Note to Instructor: It is not necessary to assign the entire case problem. Parts a. and b.i. can be used

as self-contained problems, respectively, on basic balance sheet consolidation and the preparation of a

translation exposure report.

a. Below is the consolidated balance sheet for the MNC prepared according to the current rate method

prescribed by FASB 52. Note that the balance sheet balances. That is, Total Assets and Total

Liabilities and Net Worth equal one another. Thus, the assumption is that the current exchange rates

are the same as when the affiliates were established. This assumption is relaxed in part c.

Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates,

December 31, 1997 (in $000): Pre-Exchange Rate Change


MexicanAffiliate

CanadianAffiliate

ConsolidatedBalance Sheet

Assets

Cash $ 1,500 $ 430 $ 960 $ 2,890

Accounts receivable 2,100a 849e 1,200f 4,149

Inventory 5,000 1,879 2,000 8,879

Investment in Mexican affiliate -b - - -

Investment in Canadian affiliate -c - - -

Net fixed assets 12,000 3,394 4,480 19,874



Accounts payable $ 3,000 $ 358a $1,360 $ 4,718

Notes payable 4,000d 1,273 1,840 7,113

Long-term debt 9,000 2,121 1,840 12,961

Common stock 5,000 -b -c 5,000

Retained earnings 6,000 -b -c 6,000

Total liabilities and net worth $35,792a$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.

b,cThe investment in the affiliates cancels with the net worth of the affiliates in the consolidation.

dThe parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)).

eThe Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate’s books as Ps396,000 (= A120,000 x Ps3.30/A1.00).

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fThe Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This is carried on the Canadian affiliate’s books as CD300,000 (= W192,000,000/(W800/CD1.25)).

b. i. Below is presented the translation exposure report for the Sundance MNC. Note, from the report

that there is net positive exposure in the Mexican peso, Canadian dollar, Argentine austral and Korean

won. If any of these exposure currencies appreciates (depreciates) against the U.S. dollar, exposed

assets denominated in these currencies will increase (fall) in translated value by a greater amount than

the exposed liabilities denominated in these currencies. There is negative net exposure in the Japanese

yen. If the yen appreciates (depreciates) against the U.S. dollar, exposed assets denominated in the

yen will increase (fall) in translated value by smaller amount than the exposed liabilities denominated

in the yen.

Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian

Affiliates, December 31, 1997 (in 000 currency units)

JapaneseYen

MexicanPeso

Canadian Dollar

Argentine Austral

KoreanWon

Assets

Cash ¥ 0 Ps 1,420 CD 1,200 A 0 W 0

Accounts receivable 0 2,404 1,200 120 192,000

Inventory 0 6,200 2,500 0 0

Fixed assets 0 11,200 5,600 0 0

Exposed assets ¥ 0 Ps21,224 CD10,500 A120 W192,000

Liabilities

Accounts payable ¥ 0 Ps 1,180 CD 1,700 A 0 W 0

Notes payable 126,000 4,200 2,300 0 0

Long-term debt ¥ 0 7,000 2,300 0 0

Exposed liabilities ¥126,000 Ps12,380 CD 6,300 A 0 W 0

Net exposure (¥126,000) Ps 8,844 CD 4,200 A120 W192,000

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b. ii. The problem assumes that Canadian dollar depreciates from CD1.25/$1.00 to CD1.30/$1.00 and

that the Argentine austral depreciates from A1.00/$1.00 to A1.03/$1.00. To determine the reporting

currency imbalance in translated value caused by these exchange rate changes, we can use the

following formula:

Net Exposure Currency i

S (i / reporting) -

Net Exposure Currency i

S (i / reporting)new old = Reporting Currency Imbalance.

From the translation exposure report we can determine that the depreciation in the Canadian dollar

will cause a

CD4,200,000

CD1.30 / $1.00 -

CD4,200,000

CD1.25 / $1.00 = - $129,231

reporting currency imbalance.

Similarly, the depreciation in the Argentine austral will cause a

A120,000

A1.03 / $1.00 -

A120,000

A1.00 / $1.00 = - $3,495

reporting currency imbalance.

In total, the depreciation of the Canadian dollar and the Argentine austral will cause a reporting

currency imbalance in translated value equal to -$129,231 -$3,495= -$132,726.

c. The new consolidated balance sheet for Sundance MNC after the depreciation of the Canadian

dollar and the Argentine austral is presented below. Note that in order for the new consolidated

balance sheet to balance after the exchange rate change, it is necessary to have a cumulative

translation adjustment account balance of -$133 thousand, which is the amount of the reporting

currency imbalance determined in part b. ii (rounded to the nearest thousand).

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Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates,

December 31, 1997 (in $000): Post-Exchange Rate Change


MexicanAffiliate

CanadianAffiliate

ConsolidatedBalance Sheet

Assets

Cash $ 1,500 $ 430 $ 923 $ 2,853

Accounts receivable 2,100 845e 1,163f 4,108

Inventory 5,000 1,879 1,923 8,802

Investment in Mexican affiliate -b - - -

Investment in Canadian affiliate -c - - -

Net fixed assets 12,000 3,394 4,308 19,702



Accounts payable $3,000 $ 358a $1,308 $ 4,666

Notes payable 4,000b 1,273 1,769 7,042

Long-term debt 9,000 2,121 1,769 12,890

Common stock 5,000 -b -c 5,000

Retained earnings 6,000 -b -c 6,000

CTA - - - (133)

Total liabilities and net worth $35,465

a$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.b,cThe investment in the affiliates cancels with the net worth of the affiliates in the consolidation.dThe parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)). eThe Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate’s books as Ps384,466 (= A120,000 x Ps3.30/A1.03).fThe Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This is carried on the Canadian affiliate’s books as CD312,000 (=W192,000,000/(W800/CD1.30)).

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d. i. The transaction exposure report for Sundance, Inc. and its two affiliates is presented below. The

report indicates that the Ps1,320,000 accounts receivable due from the Mexican affiliate is not also a

translation exposure because this is netted out in the consolidation. However, the ¥126,000,000 notes

payable of the parent is also a translation exposure. Additionally, the A120,000 accounts receivable of

the Mexican affiliate and the W192,000,000 accounts receivable of the Canadian affiliate are both

translation exposures.

Transaction Exposure Report for Sundance Sporting Goods, Inc. and

its Mexican and Canadian Affiliates, December 31, 1997

Affiliate Amount Account

Translation

Exposure

Parent Ps1,320,000 Accounts

Receivable

No

Parent ¥126,000,000 Notes Payable Yes

Mexican A120,000 Accounts

Receivable

Yes

Canadian W192,000,000 Accounts

Receivable

Yes

d. ii. Since transaction exposure may potentially result real cash flow losses while translation

exposure does not have an immediate direct effect on operating cash flows, we will first address the

transaction exposure that confronts Sundance and its affiliates. The analysis assumes the depreciation

in the Canadian dollar and the Argentine austral have already taken place.

The parent firm can pay off the ¥126,000,000 loan from the Japanese bank using funds from the cash

account and money from accounts receivable that it will collect. Additionally, the parent firm can

collect the accounts receivable of Ps1,320,000 from its Mexican affiliate that is carried on the books as

$400,000. In turn, the Mexican affiliate can collect the A120,000 accounts receivable from the

Argentine importer, valued at Ps384,466 after the depreciation in the austral, to guard against further

depreciation and to use to pay off the peso liability to the parent. The Canadian affiliate can eliminate

its transaction exposure by collecting the W192,000,000 accounts receivable as soon as possible,

which is currently valued at CD300,000.

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The elimination of these transaction exposures will affect the translation exposure of Sundance

MNC. A revised translation exposure report follows.

Revised Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and

Canadian Affiliates,

December 31, 1997 (in 000 currency units)

Japanese

Yen

Mexican

Peso

Canadian

Dollar

Argentine

Austral

Korean

Won

Assets

Cash ¥ 0 Ps 484 CD 1,500 A 0 W 0

Accounts receivable 0 2,404 1,200 0 0

Inventory 0 6,200 2,500 0 0

Fixed assets 0 11,200 5,600 0 0

Exposed assets ¥ 0 Ps20,288 CD10,800 A 0 W 0

Liabilities

Accounts payable ¥ 0 Ps 1,180 CD1,700 A 0 W 0

Notes payable 0 4,200 2,300 0 0

Long-term debt 0 7,000 2,300 0 0

Exposed liabilities ¥ 0 Ps12,380 CD6,300 A 0 W 0

Net exposure ¥ 0 Ps 7,908 CD4,500 A 0 W 0

Note from the revised translation exposure report that the elimination of the transaction exposure

will also eliminate the translation exposure in the Japanese yen, Argentine austral and the Korean won.

Moreover, the net translation exposure in the Mexican peso has been reduced. But the net translation

exposure in the Canadian dollar has increased as a result of the Canadian affiliate’s collection of the

won receivable.

The remaining translation exposure can be hedged using a balance sheet hedge or a derivatives

hedge. Use of a balance sheet hedge is likely to create new transaction exposure, however. Use of a

derivatives hedge is actually speculative, and not a real hedge, since the size of the “hedge” is based

on one’s expectation as to the future spot exchange rate. An incorrect estimate will result in the

“hedge” losing money for the MNC.

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CHAPTER 15 FOREIGN DIRECT INVESTMENT



QUESTIONS

1. Recently, many foreign firms from both developed and developing countries acquired high-tech

U.S. firms. What might have motivated these firms to acquire U.S. firms?

Answer: Many foreign firms might have been motivated to gain access to technical know-how

residing in U.S. firms and at the same time monopolize its use. Refer to the reverse-internalization

hypothesis discussed in the text.

2. Japanese MNCs, such as Toyota, Toshiba, Matsushita, etc., made extensive investments in the

Southeast Asian countries like Thailand, Malaysia and Indonesia. In your opinion, what forces are

driving Japanese investments in the region?

Answer: Most likely, these Japanese MNCs have invested heavily in Southeast Asia in order to take

advantage of under priced labor services and cheaper land and other factors of production. Refer to the

life-cycle theory of FDI.

3. Since the NAFTA was established, many Asian firms especially those from Japan and Korea made

extensive investments in Mexico. Why do you think these Asian firms decided to build production

facilities in Mexico?

Answer: Asian firms might have been motivated to gain access to NAFTA of which Mexico is a

member and circumvent the external trade barriers maintained by NAFTA.

4. How would you explain the fact that China emerged as the second most important recipient of FDI

after the United States in recent years?

Answer: China attracted a great deal of FDI recently because foreign firms want to (I) take advantage

of inexpensive labor and resources, and also (ii) gain access to the Chinese market that is often not

accessible otherwise.

5. Explain the internalization theory of FDI. What are the strength and weakness of the theory?

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Answer: According to the internalization theory, firms that have intangible assets with a public good

property tend to undertake FDI to take advantage of the assets on a large scale and, at the same time,

prevent misappropriation of returns from the assets that may occur during arm’s length transactions in

foreign countries. The theory can be effective in explaining green field investments, but not in

explaining mergers and acquisitions.

6. Explain Vernon’s product life-cycle theory of FDI. What are the strength and weakness of the

theory?

Answer: According to the product life-cycle theory, firms undertake FDI at a particular stage in the life-

cycle of the products that they initially introduced. When a new product is introduced, the firm chooses to

keep production at home, close to customers. But when the product become mature and foreign demands

develop, the firm may be induced to start production in foreign countries, especially in low-cost countries,

to serve the local markets as well as to export the product back to the home country. As can be inferred

from the boxed reading on Singer in the text, the product life-cycle theory can explain historical

development of FDI quite well. In recent years, however, the international system of production has

become too complicated to be explained neatly by the life-cycle theory. For example, new products are

often introduced simultaneously in many countries and production facilities may be located in many

countries at the same time.

7. Why do you think the host country tends to resist cross-border acquisitions, rather than green field

investments?

Answer: The host country tends to view green field investments as creating new production facilities

and new job opportunities. In contrast, cross-border acquisitions can be viewed as foreign takeover of

existing domestic firms, without creating new job opportunities.

8. How would you incorporate political risk into the capital budgeting process of foreign investment

projects?

Answer: One approach is to adjust the cost of capital upward to reflect political risk and discount the

expected future cash flows at a higher rate. Alternatively, one can subtract insurance premium for

political risk from the expected future cash flows and use the usual cost of capital which is applied to

domestic capital budgeting.

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9. Explain and compare forward vs. backward internalization.

Answer: Forward internalization occurs when MNCs with intangible assets make FDI in order to

utilize the assets on a larger scale and at the same time internalize any possible externalities generated

by the assets. Backward internalization, on the other hand, occurs when MNCs acquire foreign firms

in order to gain access to the intangible assets residing in the foreign firms and at the same time

internalize any externalities generated by the assets.

10. What can be the reason for the negative synergistic gains for British acquisitions of U.S. firms?

Answer: Negative synergies for British acquisitions of U.S. firms may reflect that British managers

might have been motivated to invest in U.S. firms in order to pursue their own interests, such as

building corporate empire, rather than shareholders’ interests. Negative synergies can be viewed as

agency costs.

11. Define country risk. How is it different from political risk?

Answer: Country risk is a broader measure of risk than political risk, as the former encompasses

political risk, credit risk, and other economic performances.

12. What are the advantages and disadvantages of FDI as opposed to a licensing agreement with a

foreign partner?

Answer: The main advantage of FDI over licensing agreement with a foreign partner is that it

provides protection against possible interlopers. The main disadvantage of FDI is that it is costly and

time consuming to establish foreign presence in this manner and FDI is probably more vulnerable to

political risk.

13. What operational and financial measures can a MNC take in order to minimize the political risk

associated with a foreign investment project?

Answer: First, MNCs should explicitly incorporate political risk in the capital budgeting process and

adjust the project’s NPV accordingly. Second, MNCs can form joint-ventures with local partners or

form a consortium with other MNCs to reduce risk. Third, MNCs can purchase insurance against

political risk from OPIC, Lloyd’s, etc.

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14. Study the experience of Enron in India, and discuss what we can learn from it for the management

of political risk.

Answer: This question can be used as a mini-case or mini-project. Students can utilize various

business/financial publications, such as Wall Street Journal, Financial Times, and Business week, to study the

issue.

15. Discuss the different ways political events in a host country may affect local operations of an

MNC.

Answer: The answer can be organized based on the three types of political risk: Namely, transfer risk,

operational risk, and control risk. Transfer risk arises from the uncertainty about cross-border flows of

capital, payments, know-how, etc. Operational risk arises from the uncertainty about the host

country’s policies affecting the local operations of MNCs. Control risk arises from the uncertainty

about the host country’s policy regarding ownership and control of local operations of MNCs.

16. What factors would you consider in evaluating the political risk associated with making FDI in a

foreign country.

Answer: Factors to be considered include: (1) the host country’s political and government system; (2)

track record of political parties and their relative strength; (3) the degree of integration into the world

system; (4) the host country’s ethnic and religious stability; (5) regional security; and (6) key economic

indicators.

17. Mini Project: Suppose you are hired as a political consultant by Coca-Cola, which is considering

investing in the bottling facilities in four countries: Mexico, Argentina, China, and Russia. Pick a

country out of the four and analyze the political risk associated with investing there. Prepare a final

report to Coca-Cola using a similar format as Exhibit 15.10.

Answer: This is an open-ended question. Students can collect basic economic data for the country of

their choice from such sources as International Financial Statistics, various publications of the World

Bank, Economist, Financial Times, etc.

Both China and Russia are shedding their socialist economic system and are in the process of

establishing market economies. Often, the “rules of the game” are not clearly stipulated for foreign

investors like Coca-Cola. Corruption is a major problem in both countries. In addition, the property

rights, tangible or intangible, and the tax codes are not well established, adding to the risk of doing

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business in these countries.

In contrast, Argentina and Mexico, which used to be inward-looking and highly protectionist

countries, have made significant progress in liberalizing their economies. In the case of Mexico,

joining NAFTA will no doubt accelerate this liberalization process. As we have seen during the 1994-

5 peso crisis, however, gross mismanagement of the economy can negatively affect foreign investors

in Mexico. Also, there is substantial uncertainty about the long-term viability of the current political

system in Mexico. Argentina, on the other hand, appears to be the most safe among the four countries.

The country has successfully made the transition from the protectionist to the open economy and is

well positioned to become a second Chile, a well publicized success story.

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Suggest Answers for Mini Case: Enron in India

[See Chapter 15 for the case text.]

Questions for Discussion:

1) Foreign Direct Investment

a) What are the particular challenges faced by foreign companies investing in India?

Suggested Answer: among the most difficult challenges that foreign investors face in India are the

lack of infra-structure like road and port facilities, an inefficient and massive bureaucracy, and

restrictions on international trade and financing.

b) Are there financially more efficient ways to achieve the same objective without undertaking FDI?

Suggested Answer: Joint-venture with a credible local partner who is more familiar with Indian local

situations could have been an alternative mode for entry to the Indian market.

2) Political Risk

a) What were the various elements of political risk faced by Enron in India?

Suggested Answer: Like in many developing countries, there is a general lack of commitment to

legal contracts. In addition, in India, decision making authorities are diffused among different

government offices, causing confusion and uncertainty.

b) What could Enron have done differently to avoid this political risk in order to safeguard its FDI?

Suggested Answer: Enron could have done a more accurate analysis of political risk and considered

the possibility of election victory of the nationalist party. In addition, Enron could have purchased an

insurance policy against this political risk from Overseas Private Investment Corporation or other

insurers. Further, involving a local partner could have dampened the nationalistic sentiment in India.

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CHAPTER 16 INTERNATIONAL CAPITAL STRUCTURE AND THE COST OF CAPITAL



QUESTIONS

1. Suppose that your firm is operating in a segmented capital market. What actions would you

recommend to mitigate the negative effects?

Answer: The best solution for this problem is to cross-list your firm’s stock in overseas markets like

London and New York that are not segmented. But you should be aware of the associated costs such

as the cost of adjusting financial statements, fees charged by the listing exchanges, etc.

2. Explain why and how a firm’s cost of capital may decrease when the firm’s stock is cross-listed on

foreign stock exchanges.

Answer: If a stock becomes internationally tradable upon overseas listing, the required return on the

stock is likely to go down because the stock will be priced according to the international systematic

risk rather than the local systematic risk. It is well known that for a typical stock, the international

systematic risk is lower than the local systematic risk.

3. Explain the pricing spill-over effect.

Answer: Suppose a firm operating in a segmented capital market (like China, for example) decides to

cross-list its stock in New York or London. Upon cross-border listing, the firm’s stock will be priced

internationally. In addition, the pricing of remaining purely domestic stocks (other Chinese stocks)

will be affected in such a way that these stocks will be priced partially internationally and partially

domestically. The degree of international pricing depends on the correlations between these purely

domestic stocks and internationally traded stocks.

4. In what sense do firms with nontradable assets get a free-ride from firms whose securities are

internationally tradable?

Answer: Due to the spillover effect, firms with nontradable securities can benefit in terms of higher

security prices and lower cost of capital, without incurring any costs associated with making the

securities internationally tradable. This is an example of free-ride.

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5. Define and discuss indirect world systematic risk.

Answer: The indirect world systematic risk can be defined as the covariance between a nontradable

asset and the world market portfolio that is induced by tradable assets. In the presence of

internationally tradable assets, nontradable assets will be priced partly by the indirect world systematic

risk and partly by the pure domestic systematic risk.

6. Discuss how the cost of capital is determined in segmented vs. integrated capital markets.

Answer: In segmented capital markets, the cost of capital will be determined essentially by the

securities’ domestic systematic risks. In integrated capital markets, on the other hand, the cost of

capital will be determined by the securities’ world systematic risk, regardless of nationality.

7. Suppose there exists a nontradable asset with a perfect positive correlation with a portfolio T of

tradable assets. How will the nontradable asset be priced?

Answer: The nontradable asset with a perfect positive correlation with portfolio T (for tradable) will

be priced as if it were tradable by itself. In a word, it will be priced solely according to its world

systematic risk.

8. Discuss what factors motivated Novo Industries to seek U.S. listing of its stock. What lessons can

be derived from Novo’s experiences?

Answer: Novo, a rapidly growing company, was domiciled in a small and segmented Danish market.

This restricted the firm’s ability to raise capital at a competitive rate. As discussed in the text, Novo

solved this problem by listing its stock in London and New York stock exchanges. This move enabled

Novo to gain access to large capital sources and lower its cost of capital.

9. Discuss foreign equity ownership restrictions. Why do you think countries impose these

restrictions?

Answer: Many countries restrict the maximum fractional ownership of local firms by foreigners.

Mostly, these restrictions are imposed to ensure domestic control of local firms.

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10. Explain the pricing-to-market phenomenon.

Answer: The pricing-to-market (PTM) refers to the phenomenon that the same securities are priced

differently for different investors. A well-known example of PTM is provided by Nestle. Up until

1988 November, foreigners were only allowed to hold Nestle bearer shares; only Swiss residents were

allowed to hold registered shares. As indicated in Exhibit 16.11 in the text, bearer shares were trading

for about twice the price of registered shares.

11. Explain how the premium and discount are determined when assets are priced-to-market. When

would the law of one price prevail in international capital markets even if foreign equity ownership

restrictions are imposed?

Answer: The premium and discount are determined by (I) the severity of restrictions imposed on

foreigners and (ii) foreigners’ ability to mitigate the effect of these restrictions using their own

domestic securities. In a special case where foreigners can exactly replicate the securities under

restriction, then PTM will cease to apply.

12. Under what conditions will the foreign subsidiary’s financial structure become relevant?

Answer: The subsidiary’s own financial structure will become relevant when the parent firm is not

responsible for the financial obligations of the subsidiary.

13. Under what conditions would you recommend that the foreign subsidiary conform to the local

norm of financial structure?

Answer: It may make sense for the subsidiary to confirm to the local norm if the parent is not

responsible for the subsidiary’s debt and the subsidiary has to depend on local financial markets for

raising capital.

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PROBLEMS

Answer problems 1-3 based on the stock market data given by the following table.

Correlation Coefficients

Telmex Mexico World SD(%) (%)

Telmex 1.00 .90 0.60 18 ?

Mexico 1.00 0.75 15 14

World 1.00 10 12

The above table provides the correlations among Telmex, a telephone/communication company

located in Mexico, the Mexico stock market index, and the world market index, together with the

standard deviations (SD) of returns and the expected returns ( ). The risk-free rate is 5%.

1. Compute the domestic country beta of Telmex as well as its world beta. What do these betas

measure?

2. Suppose the Mexican stock market is segmented from the rest of the world. Using the CAPM

paradigm, estimate the equity cost of capital of Telmex.

3. Suppose now that Telmex has made its shares tradable internationally via cross-listing on NYSE.

Again using the CAPM paradigm, estimate Telmex’s equity cost of capital. Discuss the possible

effects of international pricing of Telmex shares on the share prices and the firm’s investment

decisions.

Solutions.

1. The domestic beta, , and the world beta, , of Telmex can be computed as follows:

Both the domestic and world beta turn out to be the same. As the market moves by 1%, Telmex stock

return will move by 1.08%

2.

3.

As the equity cost of capital decreases from 14.72% to 12.56%, Telmex will experience an increase in

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its share price. In addition, Telmex will be able to undertake more investment projects profitably.

CHAPTER 17 INTERNATIONAL CAPITAL BUDGETING



QUESTIONS

1. Why is capital budgeting analysis so important to the firm?

Answer: The fundamental goal of the financial manager is to maximize shareholder wealth. Capital

investments with positive NPV or APV contribute to shareholder wealth. Additionally, capital

investments generally represent large expenditures relative to the value of the entire firm. These

investments determine how efficiently and expensively the firm will produce its product.

Consequently, capital expenditures determine the long-run competitive position of the firm in the

product marketplace.

2. What is the intuition behind the NPV capital budgeting framework?

Answer: The NPV framework is a discounted cash flow technique. The methodology compares the

present value of all cash inflows associated with the proposed project versus the present value of all

project outflows. If inflows are enough to cover all operating costs and financing costs, the project

adds wealth to shareholders.

3. Discuss what is meant by the incremental cash flows of a capital project.

Answer: Incremental cash flows are denoted by the change in total firm cash inflows and cash

outflows that can be traced directly to the project under analysis.

4. Discuss the nature of the equation sequence in the chapter of going from equation 17.2a to 17.2f.

Answer: The equation sequence is a presentation of incremental annual cash flows associated with a

capital expenditure. Equation 17.2a presents the most detailed expression for calculating these cash

flows; it is composed of three terms. Equation 17.2b shows that these three terms are: i) incremental

net profit associated with the project; ii) incremental depreciation allowance; and, iii) incremental

after-tax interest expense associated with the borrowing capacity created by the project. Note, the

incremental “net profit” is not accounting profit but rather net cash actually available for shareholders.

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Equation 17.2c cancels out the after-tax interest term in 17.2a, yielding a simpler formula. Equation

17.2d shows that the first term in 17.2c is generally called after-tax net operating income. Equation

17.2e yields yet a computationally simpler formula by combining the depreciation terms of 17.2c.

Equation 17.2f shows that the first term in 17.2e is generally referred to as after-tax operating cash

flow.

5. What makes the APV capital budgeting framework useful for analyzing foreign capital

expenditures?

Answer: The APV framework is a value-additivity technique. Because international projects

frequently have cash flows not encountered in domestic projects, the APV technique easily allows the

analyst to add terms to the model that represent the special cash flows.

6. Relate the concept of lost sales to the definition of incremental cash flow.

Answer: When a new capital project is under taken it may compete with an existing project(s),

causing the old project(s) to experience a loss in sales revenue. From an incremental cash flow

standpoint, the new project’s incremental revenue is the total sales revenue associated with the new

project minus the lost sales revenue from the old project(s).

7. What problems can enter into the capital budgeting analysis if project debt is evaluated instead of

the borrowing capacity created by the project?

Answer: If project debt is greater (less) than the borrowing capacity created by the capital project, and

tax shields on the actual new debt are used in the analysis, the APV will be overstated (understated)

making the project unjustly appear more (less) attractive than it actually is.

8. What is the nature of a concessionary loan and how is it handled in the APV model?

Answer: A concessionary loan is a loan offered by a governmental body at below the normal market

rate of interest as an enticement for a firm to make a capital investment that will economically benefit

the lender. The benefit to the MNC is the difference between the face value of the concessionary loan

converted into the home currency and the present value of the similarly converted concessionary loan

payments discounted at the MNC’s normal domestic borrowing rate. The loan payments will yield a

present value less than the face amount of the concessionary loan when they are discounted at the

higher normal rate. This difference represents a subsidy the host country is willing to extend to the

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MNC if the investment is made. The benefit to the MNC of the concessionary loan is handled in the

APV model via a separate term.

9. What is the intuition of discounting the various cash flows in the APV model at specific discount

rates?

Answer: The APV model is a value-additivity technique where total value is determined by the sum

of the present values of the individual cash inflows and outflows. Each cash flow will not necessarily

have the same amount of risk associated with it. To account for risk differences in the analysis, each

cash flow is discounted at a rate commensurate with the inherent riskiness of the cash flow.

10. In the Modigliani-Miller equation, why is the market value of the levered firm greater than the

market value of an equivalent unlevered firm?

Answer: The levered firm has a greater market value because less money is taken from the firm by the

government in taxes due to tax-deductible interest payments. Thus, there is more cash left for investor

groups than when the firm is financed with all-equity funds.

11. Discuss the difference between performing the capital budgeting analysis from the parent firm’s

perspective as opposed to the project perspective.

Answer: The goal of the financial manager of the parent firm is to maximize its shareholders’ wealth.

A capital project of a subsidiary of the parent may have a positive NPV (or APV) from the

subsidiary’s perspective yet have a negative NPV (or APV) from the parent’s perspective if certain

cash flows cannot be repatriated to the parent because of remittance restrictions by the host country, or

if the home currency is expected to appreciate substantially over the life of the project, yielding

unattractive cash flows when converted into the home currency of the parent. Additionally, a higher

tax rate in the home country may cause the project to be unprofitable from the parent’s perspective.

Any of these reasons could result in the project being unattractive to the parent and the parent’s

stockholders.

12. Define the concept of a real option. Discuss some of the various real options a firm can be

confronted with when investing in real projects.

Answer: A positive APV project is accepted under the assumption that all future operating decisions

will be optimal. The firm’s management does not know at the inception date of a project what future

decisions it will be confronted with because all information concerning the project has not yet been

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learned. Consequently, the firm’s management has alternative paths, or options, that it can take as

new information is discovered. The application of options pricing theory to the evaluation of

investment options in real projects is known as real options.

The firm is confronted with many possible real options over the life of a capital asset. For

example, the firm may have a timing option as when to make the investment; it may have a growth

option to increase the scale of the investment; it may have a suspension option to temporarily cease

production; and, it may have an abandonment option to quit the investment early.

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PROBLEMS

1. The Alpha Company plans to establish a subsidiary in Greece to manufacture and sell fashion

wristwatches. Alpha has total assets of $70 million, of which $45 million is equity financed. The

remainder is financed with debt. Alpha considered its current capital structure optimal. The

construction cost of the Greek facility in drachmas is estimated at Dr2,400,000,000, of which

Dr1,800,000,000 is to be financed at a below-market borrowing rate arranged by the Greek

government. Alpha wonders what amount of debt it should use in calculating the tax shields on

interest payments in its capital budgeting analysis. Can you offer assistance?

Solution: The Alpha Company has an optimal debt ratio of $25 million debt/$70 million assets = .357

or 35.7%. The project debt ratio is Dr1,800/Dr2,400 = .75 or 75%. Alpha will overstate the tax shield

on interest payments if it uses the 75% figure because the proposed project will only increase

borrowing capacity by Dr856,800,000 (=Dr2,400,000,000 x .357).

2. The current spot exchange rate is Dr240/$1.00. Long-run inflation in Greece is estimated at 8

percent annually and 4.5 percent in the United States. If PPP is expected to hold between the two

countries, what spot exchange should one forecast five years into the future?

Solution: Dr240(1 + .08)5/(1 + .045)5 = Dr283/$1.00.

3. The Beta Corporation has an optimal debt ratio of 40 percent. Its cost of equity capital is 12 percent

and its before-tax borrowing rate is 8 percent. Given a marginal tax rate of 35 percent, calculate (a)

the weighted-average cost of capital and, (b) the cost of equity for an equivalent all-equity financed

firm.

Solution:

(a) K = (1 - .40).12 + (.40).08(1 - .35)

= .0928 or 9.28%

(b) A weighted-average cost of capital of 9.28% for a levered firm implies:

K =.0928 = Ku (1-(.35)(.40)). Solving for Ku yields .1079 or 10.79%.

4. Suppose in the illustrated mini case in the chapter that the APV for Centralia had been -$60,000.

How large would the after tax terminal value of the project need to be before the APV would be

positive and Centralia would accept the project?

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Solution: Centralia should not go ahead with its plans to build a manufacturing plant in the Spain

unless the terminal value is likely to be large enough to yield a positive APV. The terminal value of

the project must be $299,010 in order for the APV to equal zero. This is calculated as follows. Set

STTVT/(1+Kud)T = $60,000. This implies

TVT = ($60,000/ST)(1+Kud)T

= ($60,000/.005266)(1.11)8

= Ptas26,257,551.

5. With regards to the Centralia illustrated mini case in the chapter, how would the APV change if:

a. The forecast of d and/or f are incorrect?

Answer: A larger or smaller d will not have any effect because a change will

affect the numerator and denominator of each APV term in an offsetting manner.

A larger (smaller) f, however, will decrease (increase) the project APV because

the foreign currency received will buy less (more) parent country currency upon

repatriation.

b. Deprecation cash flows are discounted at Kud instead of id?

Answer: The APV would be less favorable because Kud is a larger discount rate

than id.

c. The host country did not provide the concessionary loan?

Answer: The APV would be less favorable because the project would have to

cover a higher finance charge, i.e., there would be no benefit received from

below market financing.

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MINI CASE ONE: DORCHESTER, LTD.

Dorchester Ltd. is an old-line confectioner specializing in high-quality chocolates. Through its

facilities in the United Kingdom, Dorchester manufactures candies that it sells throughout Western

Europe and North America (United States and Canada). With its current manufacturing facilities,

Dorchester has been unable to supply the U.S. market with more than 225,000 pounds of candy per

year. This supply has allowed its sales affiliate, located in Boston, to be able to penetrate the U.S.

market no farther west than St. Louis and only as far south as Atlanta. Dorchester believes that a

separate manufacturing facility located in the United States would allow it to supply the entire U.S.

market and Canada (which presently accounts for 65,000 pounds per year). Dorchester currently

estimates initial demand in the North American market at 390,000 pounds, with growth at a 5 percent

annual rate. A separate manufacturing facility would, obviously, free up the amount currently shipped

to the United States and Canada. But Dorchester believes that this is only a short-run problem. They

believe the economic development taking place in Eastern Europe will allow it to sell there the full

amount presently shipped to North America within a period of five years.

Dorchester presently realizes £3.00 per pound on its North American exports. Once the U.S.

manufacturing facility is operating, Dorchester expects that it will be able to initially price its product

at $7.70 per pound. This price would represent an operating profit of $4.40 per pound. Both sales

price and operating costs are expected to keep track with the U.S. price level; U.S. inflation is forecast

at a rate of 3 percent for the next several years. In the U.K., long-run inflation is expected to be in the

4 to 5 percent range, depending on which economic service one follows. The current spot exchange

rate is $1.50/£1.00. Dorchester explicitly believes in PPP as the best means to forecast future

exchange rates.

The manufacturing facility is expected to cost $7,000,000. Dorchester plans to finance this amount

by a combination of equity capital and debt. The plant will increase Dorchester’s borrowing capacity

by £2,000,000, and it plans only to borrow that amount. The local community in which Dorchester

has decided to build will provide $1,500,000 of debt financing for a period of seven years at 7.75

percent. The principal is to be repaid in equal installments over the life of the loan. At this point,

Dorchester is uncertain whether to raise the remaining debt it desires through a domestic bond issue or

a Eurodollar bond issue. It believes it can borrow pounds sterling at 10.75 percent per annum and

dollars at 9.5 percent. Dorchester estimates its all-equity cost of capital to be 15 percent.

The U.S. Internal Revenue Service will allow Dorchester to depreciate the new facility over a seven

year period. After that time the confectionery equipment, which accounts for the bulk of the

investment, is expected to have substantial market value.

Dorchester does not expect to receive any special tax concessions. Further, because the corporate

tax rates in the two countries are the same--35 percent in the U.K. and in the U.S.--transfer pricing

IM-141

strategies are ruled out.

Should Dorchester build the new manufacturing plant in the United States?

Suggested Solution to Dorchester Ltd.

Summary of Key Information

The current exchange rate in European terms is So(£/$) = 1/1.50 = .6667.

The initial cost of the project in British pounds is SoCo = £0.6667($7,000,000) =

£4,666,900.

The U.K. inflation rate is estimated at 4.5% per annum, or the mid-point of the 4%-5% range. The

U.S. inflation rate is forecast at 3% per annum. Under the simplifying assumption that PPP holds tS

= .6667(1.045)t/(1.03)t.

The before-tax nominal contribution margin per unit at t=1 is $4.40(1.03)t-1.

It is assumed that Dorchester will be able to sell one-fifth of the 290,000 pounds of candy it presently

sells to North America in Eastern Europe the first year the new manufacturing facility is in operation;

two-fifths the second year; etc.; and all 290,000 pounds beginning the fifth year.

The contribution margin on lost sales per pound in year t equals £3.00(1.045)t.

Terminal value will initially be assumed to equal zero.

Straight line depreciation over the seven year economic life of the project is assumed: Dt =

$1,000,000 = $7,000,000/7 years.

The marginal tax rate, , is the U.K. (or U.S.) rate of 35%.

Dorchester will borrow $1,500,000 at the concessionary loan rate of 7.75% per annum. Optimally,

Dorchester should borrow the remaining funds it needs, £1,000,000, in pounds sterling because

according to the Fisher equation, the real rate is less for borrowing pounds sterling than it is for

borrowing dollars:

5.98% or .0598 = (1.1075)/(1.045) - 1.0 versus

6.31% or .0631 = (1.095)/(1.03) - 1.0.

Kud = 15%.

IM-142

Calculation of the Present Value of the After-Tax Operating Cash Flows

Year (t) tS Quantity

tS x Quantity

x $4.40

x (1.03)t-1

Quantity

Lost

Sales

Quantity

Lost Sales

x £3.00

x (1.045)t

t tS OCF

(a)

£

(b)

£

(a + b)

£ £

1 .6764 390,000 1,160,702 (232,000) (696,000) 464,702 262,658

2 .6863 409,500 1,273,673 (174,000) (545,490) 728,183 357,897

3 .6963 429,975 1,397,548 (116,000) (380,025) 1,017,523 434,875

4 .7064 451,474 1,533,373 (58,000) (198,563) 1,334,810 496,068

5 .7167 474,048 1,682,524 0 0 1,682,524 543,733

6 .7271 497,750 1,846,053 0 0 1,846,053 518,765

7 .7377 522,638 2,025,613 0 0 2,025,613 494,977

3,108,972

IM-143

Calculation of the Present Value of the Depreciation Tax Shields

Year (t)

tS Dt

) i+(D S

td

tt

1

$ £

1 .6764 1,000,000 213,761

2 .6863 1,000,000 195,837

3 .6963 1,000,000 179,404

4 .7064 1,000,000 164,340

5 .7167 1,000,000 150,552

6 .7271 1,000,000 137,911

7 .7377 1,000,000 126,340

1,168,146

IM-144

Calculation of the Present Value of the Concessionary Loan Payments

Year(t)

tS

(a)

PrincipalPayment

(b)

$

It

(c)

$

t tS LP

(a) x (b + c)

£

t t

dt

S LP

(1+i )

£

1 .6764 214,286 116,250 330,536 201,873

2 .6863 214,286 99,643 313,929 175,654

3 .6963 214,286 83,036 297,321 152,402

4 .7064 214,286 66,429 280,714 131,808

5 .7167 214,286 49,821 264,107 113,605

6 .7271 214,286 33,214 247,500 97,523

7 .7377 214,286 16,607 230,893 83,346

1,500,000 956,211

Calculation of the Present Value of the Benefit from the Concessionary Loan

)i+(

LPS - CLS td

ttT

1=too

1 =£0.6667 x $1,500,000 - £956,211 = £43,839

IM-145

Calculation of the Present Value of the Interest Tax Shields

from the $1,500,000 Concessionary Loan

Year (t)

tS

(a)

It

(b)

$

t tS I

(a x b x )

£

t t

dt

S I

(1+i )

£

1 .6764 116,250 27,521 24,850

2 .6863 99,643 23,935 19,514

3 .6963 83,036 20,236 14,897

4 .7064 66,429 16,424 10,917

5 .7167 49,821 12,497 7,501

6 .7271 33,214 8,452 4,581

7 .7377 16,607 4,288 2,098

84,357

IM-146

Calculation of the Present Value of the Interest Tax Shields

from the £1,000,000 Bond Issue

Year (t)

OutstandingLoan

Balance

PrincipalPayment

InterestPayment )i+(

It

d

t

1

£ £ £ £

1 1,000,000 0 107,500 33,973

2 1,000,000 0 107,500 30,675

3 1,000,000 0 107,500 27,698

4 1,000,000 0 107,500 25,009

5 1,000,000 0 107,500 22,582

6 1,000,000 0 107,500 20,390

7 1,000,000 1,000,000 107,500 18,411

178,738

IM-147

Without considering the terminal value of the project, the APV of the project is negative:

APV = £3,108,972 + 1,168,146 + 43,839 + 84,357 + 178,738 - 4,666,900 =

-£82,848).

Dorchester should not go ahead with its plans to build a manufacturing plant in the U.S. unless the

terminal value is likely to be large enough to yield a positive APV. The terminal value of the project

must be $298,736 in order for the APV to equal zero. This is calculated as follows. Set

STTVT/(1+Kud)T = £82,848. This implies

TVT = (£82,848/ST)(1+Kud)T

= (£82,848/.7377)(1.15)7

= $298,736.

Since the terminal value is expected to be substantial, and the initial cost of the project is $7,000,000,

it appears likely that the terminal value will be sufficient to yield a positive APV. Thus, Dorchester

should go ahead with its plans to build a manufacturing plant in the U.S.

IM-148

MINI-CASE: STRIK-IT-RICH GOLD MINING COMPANY

The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so it will

need to purchase land that its geologists believe is rich in gold. Strik-it-Rich’s management believes

that the expansion will allow it to mine and sell an additional 2000 troy ounces of gold per year. The

expansion, including the cost of the land, will cost $500,000. The current price of gold bullion is $275

per ounce and one-year gold futures are trading at $291.50 = $250(1.06). Extraction costs are $225

per ounce. The firm’s cost of capital is 10%. At the current price of gold, the expansion appears

profitable: NPV = ($275 – 225) x 2000/.10 - $500,000 = $500,000. Strik-it-Rich’s management is,

however, concerned with the possibility that large sales of gold reserves by Russia and the United

Kingdom will drive the price of gold down to $240 for the foreseeable future. On-the-other-hand,

management believes there is some possibility that the world will soon return to a gold reserve

international monetary system. In the latter event, the price of gold would increase to at least $310 per

ounce. The course of the future price of gold bullion should become clear within a year. Strik-it-Rich

can postpone the expansion for a year by buying a purchase option on the land for $25,000. What

should Strik-it-Rich’s management do?

Suggested Solution to Strik-it-Rich Gold Mining Company

There is considerable risk in expanding operations at the present time, even though the NPV based on

the current price of gold is a positive $500,000. If the price of gold falls to $240 per ounce, the NPV =

($240 – 225) x 2000/.10 - $500,000 = -$200,000. On-the-other-hand, if the price of gold increases to

$310, the NPV is a very attractive NPV= ($310 – 225) x 2000/.10 - $500,000 = $1,200,000. The

purchase option for $25,000 on the land is a relatively small amount to have the opportunity to

postpone the decision until additional information is learned. Obviously, Strik-it-Rich’s management

will only invest if the NPV is positive. The risk-neutral probability of gold increasing to $310 per

ounce is:

q = (F0 - S0·d)/S0(u – d) = (291.50 – 240)/(310 – 240) = .7357.

Thus, the value of the timing option to postpone the decision one year is:

C = .7357($1,200,000)/(1.06) = $832,868.

Since this amount is substantially in excess of the $25,000 cost of the purchase option on the land,

Strik-it-Rich’s management should definitely take advantage of the timing option it is confronted with

to wait and see what the price of gold is in one year before it makes a decision to expand operations.

IM-149

CHAPTER 18 MULTINATIONAL CASH MANAGEMENT



QUESTIONS

1. Describe the key factors contributing to effective cash management within a firm. Why is the cash

management process more difficult in a MNC?

Answer: An effective cash management system should be based on a cash budget that projects

expected cash inflows and outflows over some planning horizon. It provides for the systematic receipt

and disbursement of cash. It also provides for funds mobilization, where cash shortages are covered

by borrowing at the most favorable rates and surplus funds are invested at the most advantageous

rates. Within a MNC the complexity of the cash management process is compounded because the

firm does business in a variety of currencies, and hence the cost of foreign exchange transactions is an

additional dimension to be managed.

2. Discuss the pros and cons of a MNC having a centralized cash manager handle all investment and

borrowing for all affiliates of the MNC versus each affiliate having a local manager who performs the

cash management activities of the affiliate.

Answer: Under a centralized cash management system, the cash manager will have a global view of

the cash requirements of the MNC. There will be less chance that funds will be mislocated, i.e.,

denominated in the wrong currency. Additionally, under a global view, transaction exposure for the

MNC can be more efficiently managed. Moreover, a centralized system readily allows for investing

excess cash at the most advantageous rates and borrowing to cover cash shortages at the most

favorable rates.

Under a decentralized system, the local cash manager is given more responsibility for managing the

cash needs of the affiliate than under a centralized system. Consequently, the local cash management

position serves as good training for higher level positions within the affiliate or MNC. Also, under a

decentralized system, local bank relationships are better developed since the affiliate conducts more of

its cash management functions at the local level. This may prove important if funds need to be

borrowed locally. But overall, the benefits of a centralized cash management system tend to outweigh

its disadvantages.

3. How might a MNC use transfer pricing strategies? How do import duties affect transfer pricing

IM-150

policies?

Answer: A MNC might use transfer pricing strategies for two basic purposes: income tax liability

reduction or funds repositioning. If the tax rate in the country of the selling affiliate is less than the tax

rate in buying affiliate country, a high markup policy on sales will leave little taxable income in the

buying affiliate country to be taxed at the higher rate. Even if the tax rate in the buying affiliate

country is not more than that in the selling affiliate country, a high markup policy will leave less funds

to be removed from the buying affiliate country. In general, import duties work in the opposite

direction from income taxes. For example, a high markup policy will decrease the income taxes due

in the buying affiliate country, but increase the import duty due in that country. Generally, the income

tax is more important in comparison to the import duty in its after-tax effect on consolidated net

income.

4. What are the various ways the taxing authority of a country might use to determine if a transfer

price is reasonable?

Answer: The U.S. and many other countries require the transfer price to be consistent with arm’s

length pricing, i.e., be a price that an unrelated party would pay for the same good or service. The

taxing authority can arbitrarily set the transfer price if it believes that transfer pricing schemes are

being used to evade taxes or that taxable income is not being clearly reflected. There are three general

methods to establish arm’s length pricing. One method is to use a comparable uncontrolled price at

which the good or service would be priced between unrelated parties. A second method is the resale

price approach; that is, reduce the price at which the good is resold by an amount sufficient to cover

overhead costs and a reasonable profit for the selling affiliate. The third method is the cost-plus

approach, where an appropriate profit is added to the cost of the manufacturing affiliate.

5. Discuss how a MNC might attempt to repatriate blocked funds from a host country?

Answer: There are several methods a parent firm might use to repatriate profits from an affiliate in a

host country that is blocking funds. Some of these measures should be enacted early on as a guard

against future funds blockage. One is to establish a regular dividend policy that the host country

becomes used to and expects. This assumes, however, the host country will let a reasonable amount of

funds be repatriated. If this is not the case, the parent firm might attempt to use a high markup policy

transfer pricing scheme. Since host countries are aware of transfer pricing strategies, a large change in

the transfer price is likely not to go unquestioned by the host country. Thus, the parent firm should

establish early on recognition of, and payment for, specific services that are being provided by the

IM-151

affiliate in addition to payment at an arm’s length price for the physical goods. For example, the

parent firm might charge for a share of worldwide advertising, technical training of employees of the

affiliate, appropriate overhead charges, or a royalty or licensing fee for use of well-recognized brand

names, technology, or patents. The host country might accept these charges as reasonable, whereas a

large transfer price that incorporates all charges into a single price might be questioned as

unreasonably large. Additionally, the parent firm can create exports, by having the affiliate charged in

the blocked currency for goods and services for which the parent would typically pay, or through

direct negotiation appeal to the host country for more reasonable treatment, if it is in an important

industry to the host country.

IM-152

PROBLEMS

1. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A is

25 percent and the marginal income tax rate for Affiliate B is 40 percent. The transfer price per unit is

currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive a formula to

determine how much annual after-tax profits can be increased by selecting the optimal transfer price.

Note To Instructor: The solution to this problem is consistent with the example presented in the text

as Exhibit 18.13.

Solution: Let A and B be the marginal income tax rate for Affiliate A and B. Further let Q denote

quantity, and let P be the current transfer price per unit and P* be the optimal transfer price per unit.

The increase in annual after-tax profit (or the tax savings) can be stated as Q(P - P*)(A - B). For each

unit there is a tax savings of (A - B) on (P - P*). Using the above numbers, there is a tax savings of

(.25 - .40) = .15 for each additional dollar of cost transferred from the low tax affiliate to the high tax

affiliate. Thus, at the maximum there can be a $60 = ($2,000 - 2,400)(.25 - .40) tax savings per unit

from raising the transfer price from $2,000 to $2,400. In total, the tax savings is 5,000 units x $60 =

$300,000.

2. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A is

25 percent and the marginal income tax rate for Affiliate B is 40 percent. Additionally, Affiliate B

pays a tax-deductible tariff of 5 percent on imported merchandise. The transfer price per unit is

currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive (a) a formula to

determine the effective marginal tax rate for Affiliate B and, (b) a formula to determine how much

annual after-tax profits can be increased by selecting the optimal transfer price.

Note to Instructor: The solution to this problem is consistent with the example presented in the text as

Exhibit 18.14.

Solution: This problem extends the work in problem 1, above. When the ad-valorem import tariff is

tax deductible, the effective marginal tax rate paid by Affiliate B is:

(1 + Tariff)B - Tariff = (1 + .05)(.40) - .05 = .37. Hence, for each additional dollar of cost transferred

from the low tax affiliate to the high tax affiliate there is an after-tax savings of: (P - P*)[A + Tariff -

(1 + Tariff) B]. In total, the tax savings is:

Q(P - P*)[A + Tariff - (1 + Tariff) B] = 5,000 x ($2,000 - 2,400)(.25 - .37) = 5,000 x $48 = $240,000.

IM-153

MINI CASE 1: EFFICIENT FUNDS FLOW AT EASTERN TRADING COMPANY

The Eastern Trading Company of Singapore purchases spices in bulk from around the world,

packages them into consumer size quantities and sells them through sales affiliates in Hong Kong, the

United Kingdom and the United States. For a recent month, the following payments matrix of

interaffiliate cash flows, stated in Singapore dollars, was forecasted. Show how Eastern Trading can

use multilateral netting to minimize the foreign exchange transactions necessary to settle interaffiliate

payments. If foreign exchange transactions cost the company .5 percent, what savings result from

netting?

Eastern Trading Company Payments Matrix (S$000)

Disbursements

Receipts Singapore Hong Kong U.K. U.S. Total

Receipts

Singapore -- 40 75 55 170

Hong Kong 8 -- -- 22 30

U.K. 15 -- -- 17 32

U.S. 11 25 9 -- 45

Total disbursements 34 65 84 94 277

IM-154

Suggested Solution to Mini Case 1: Efficient Funds Flow at Eastern Trading Company

Bilateral Netting

IM-155

Singapore Hong Kong

United States

United Kingdom

S$8

S$40

S$75S$15 S$25

S$17

S$22

S$9

S$11

S$55

Singapore Hong Kong

United States

United Kingdom

S$32

S$60 S$3

S$8

S$44

Multilateral Netting

Without netting, S$277,000 of interaffiliate foreign exchange transactions occur among the four

affiliates of Eastern Trading. With multilateral netting, interaffiliate foreign exchange transactions

are reduced to S$136,000, or by S$141,000. The savings are .005 x S$141,000 = S$705 for the

planning period.

IM-156

Singapore Hong Kong

United States

United Kingdom

S$35

S$52

S$49

MINI CASE 2: EASTERN TRADING COMPANY’S OPTIMAL TRANSFER PRICING

STRATEGY

The Eastern Trading Company of Singapore ships prepackaged spices to Hong Kong, the United

Kingdom, and the United States, where they are resold by sales affiliates. Eastern Trading is

becoming concerned with what might happen in Hong Kong now that control has been turned over to

China. Eastern Trading has decided that it should reexamine its transfer pricing policy with its Hong

Kong affiliate as a means of repositioning funds from Hong Kong to Singapore. The following table

shows the present transfer pricing scheme, based on a carton of assorted, prepackaged spices, which is

the typical shipment to the Hong Kong sales affiliate. What do you recommend that Eastern Trading

should do?

Eastern Trading Company Current Transfer PricingPolicy with Hong Kong Sales Affiliate

Singapore Parent

Hong Kong Affiliate

Consolidated Company

Sales revenue S$300 S$500 S$500

Cost of goods sold 200 300 200

Gross profit 100 200 300

Operating expenses 50 50 100

Taxable income 50 150 200

Income taxes (31%/16.5%) 16 25 41

Net income 34 125 159

IM-157

Suggested Solution to Mini Case 2: Eastern Trading Company’s Optimal Transfer Pricing Strategy

Eastern Trading is currently in a good situation. Because the income tax rate in Hong Kong is less

than in Singapore, Eastern Trading’s present low markup transfer price strategy results in larger pre-

tax income in Hong Kong, which is taxed at only a 16.5% rate versus the 31% rate on taxable income

in Singapore. If Eastern Trading is free to repatriate profits from Hong Kong, it defers paying the

additional tax due (31% - 16.5% = 14.5%) in Singapore until the profits are actually repatriated.

Nevertheless, the marginal tax rate on Hong Kong taxable income will eventually be 31% upon

repatriation.

Since Eastern Trading is concerned about 1997, it should attempt to increase its transfer price at the

current time. If successful in being able to change the transfer price, more of the taxable income per

unit will be taxed at the current time in Singapore at 31%. This is better than postponing a change to a

high markup transfer price strategy, which may be more difficult to change later under the communist

Chinese. It is better to have the new transfer price already firmly established. Moreover, given the

current political climate, Eastern Trading might meet with little resistance from the Hong Kong

authorities in changing to a high markup policy, since capital flight in a variety of forms is taking

place. A 25% increase in the transfer price would raise it from S$300 to S$375 per unit. At S$375,

the split would be as follows:

Eastern Trading Company Current Transfer PricingPolicy with Hong Kong Sales Affiliate

Singapore Parent

Hong Kong Affiliate

Consolidated Company

Sales revenue S$375 S$500 S$500

Cost of goods sold 200 375 200

Gross profit 175 125 300

Operating expenses 50 50 100

Taxable income 125 75 200

Income taxes (31%/16.5%) 39 12 51

Net income 86 63 149

IM-158

MINI CASE 3: EASTERN TRADING COMPANY’S NEW M.B.A.

The Eastern Trading Company of Singapore presently follows a decentralized system of cash

management where it and its affiliates each maintains its own transaction and precautionary cash

balances. Eastern Trading believes that it and its affiliates’ cash needs are normally distributed and

independent from one another. It is corporate policy to maintain two and one-half standard deviations

of cash as precautionary holdings. At this level of safety there is a 99.37 percent chance that each

affiliate will have enough cash holdings to cover transactions.

A new MBA hired by the company claims that the investment in precautionary cash balances is

needlessly large and can be reduced substantially if the firm converts to a centralized cash

management system. Use the projected information for the current month, which is presented below,

to determine the amount of cash Eastern Trading needs to hold in precautionary balances under its

current decentralized system and the level of precautionary cash it would need to hold under a

centralized system. Was the new MBA a good hire?

Affiliate Expected Transactions

One StandardDeviation

Singapore S$125,000 S$40,000

Hong Kong 60,000 25,000

United Kingdom 95,000 40,000

United States 70,000 35,000

Suggested Solution to Mini Case 3: Eastern Trading Company’s New M.B.A.

Affiliate Expected Transactions (a)

One Standard Deviation

(b)

Expected Needs plus Precautionary (a +

2.5b)

Singapore S$125,000 S$45,000 S$237,500

Hong Kong 60,000 25,000 122,500

United Kingdom 95,000 40,000 195,000

United States 70,000 35,000 157,500

Total S$350,000S$712,500

IM-159

Eastern Trading is holding S$350,000 to cover expected transactions and S$362,500 as

precautionary balances among the four affiliates. In total, it is holding S$712,500 under its

decentralized cash management system.

If Eastern Trading views its cash needs from a portfolio perspective under a centralized cash

management system, one portfolio standard deviation of cash would be:

$73,993S =

)$35,000(S + )$40,000(S + )$25,000(S + )$45,000(S =

.Dev .Std

Portfolio 2222

Hence, under a centralized system, Eastern Trading would continue to need S$350,000 to cover

expected transactions, but precautionary cash balances could be reduced to $184,983 (= 2.5 x

S$73,993). Thus, the investment in precautionary cash can be reduced by S$177,517 (= S$362,500 -

184,983). The new MBA was a good hire.

IM-160

CHAPTER 19 TRADE FINANCING



QUESTIONS

1. Discuss some of the reasons why international foreign trade is more difficult and risky from the

exporter’s perspective than is domestic trade.

Answer: International trade is more difficult and risky for a firm than is domestic trade. In foreign

trade, the exporter may not be familiar with the buyer, and thus not know if the importer is

creditworthy. If merchandise is exported abroad and the buyer does not pay, it may prove difficult, if

not impossible, for the exporter to have any legal recourse. Additionally, political instability makes it

risky to ship merchandise abroad to certain parts of the world.

2. What three basic documents are necessary to conduct a typical foreign commerce trade? Briefly

discuss the purpose of each.

Answer: The three basic documents necessary to conduct a typical foreign commerce trade are: letter

of credit, time draft, and a bill of lading. A letter of credit (L/C) is a guarantee from the importer’s

bank that it will act on behalf of the importer and pay the exporter for the merchandise if all relevant

documents specified in the L/C are presented according to the terms of L/C. A time draft is a written

order instructing the importer or his agent, the importer’s bank, to pay the amount specified on its face

on a certain date. A bill of lading (B/L) is a document issued by the common carrier specifying that it

has received the goods for shipment; it can serve as title to the goods.

3. How does a time draft become a banker’s acceptance?

Answer: When the goods are shipped by the exporter via common carrier, the exporter’s bank

presents the shipping documents and the time draft to the importer’s bank. After taking title to the

goods via the bill of lading, the importer’s bank accepts the time draft, creating at this point a

banker’s acceptance (B/A). A B/A is a money market instrument for which a secondary market exists.

4. What is a forfaiting transaction?

Answer: Forfaiting is a form of medium-term trade financing used to finance the sale of capital

IM-161

goods. A forfaiting transaction involves the sale by the exporter of promissory notes signed by the

exporter in favor of the importer. The forfait, usually a bank, buys the notes at a discount from face

value. The forfait does not have recourse against the exporter in the event of default by the importer.

The promissory notes typically extend out in a series over a period of three to five years, with a note in

the series maturing every six months.

5. What is the purpose of the Export-Import Bank?

Answer: The Export-Import Bank (Eximbank) of the United States was founded as an independent

government agency to facilitate and finance U.S. export trade. Eximbank’s purpose is to provide

financing in situations where private financial institutions are unable or unwilling because: i) the loan

maturity was too long; ii) the amount of the loan was too large; iii) the loan risk was too great; and,

iv) where the importing firm had difficulty obtaining hard currency for payment. To meet its

objectives, Eximbank provides service through three types of programs: direct loans to foreign

borrowers, loan guarantees, and credit insurance.

6. Do you think that a country’s government should assist private business in the conduct of

international trade through direct loans, loan guarantees, and/or credit insurance?

Answer: When a country’s government offers below-market financing directly to foreign importers,

or offers loan guarantees to domestic banks financing the foreign import, or provides low cost credit

insurance to U.S. exporters to alleviate the commercial and political risk in the sale, it is using

taxpayers’ money to subsidize foreign trade. Consequently, the foreign trade is not paying for itself.

Nevertheless, if most governments of developed countries offer such assistance to their domestic

exporters, it is difficult for one to refuse if the country desires to have its export-oriented industries

remain competitive.

7. Briefly discuss the various types of countertrade.

Answer: Countertrade is an umbrella term used to describe six types of international trade: barter,

clearing arrangement, switch trading, buy-back, counterpurchase, and offset. The first three do not

involve the use of money, whereas the later three do.

Barter is the direct exchange of goods between two parties. While money does not exchange hands

in a barter transaction, it is common to value the goods each party exchanges in an agreed-upon

currency. A clearing arrangement is a form of barter in which the counterparties contract to purchase

a certain amount of goods and services from one another. Both parties set up accounts with each other

IM-162

that are debited whenever one country imports from the other. The clearing arrangement introduces

the concept of credit to barter transactions, and means bilateral trade can take place that does not have

to be immediately settled. A switch trade is the purchase by a third party of one country’s clearing

agreement imbalance for hard currency, which is in turn resold. The second buyer uses the account

balance to purchase goods and services from the original clearing agreement counterparty who had the

account imbalance.

A buy-back transaction involves a technology transfer via the sale of a manufacturing plant. As part

of the transaction, the seller agrees to purchase a certain portion of the plant output once it is

constructed. First, the plant buyer borrows hard currency in the capital market to pay the seller for the

plant. Second, the plant seller agrees to purchase enough of the plant output over a period of time to

enable the buyer to pay back the borrowed funds. A counterpurchase is similar to a buy-back

transaction, but with some notable differences. The major difference between a buy-back and a

counterpurchase transaction is that in the latter, the buyer agrees to purchase unrelated merchandise

that has not been produced on the exported equipment. The seller agrees to purchase goods from a list

drawn up by the importer at prices set by the importer. The list frequently includes items the buyer

may be experiencing difficulty in selling. An offset transaction can be viewed as a counterpurchase

trade agreement involving the aerospace/defense industry.

8. Discuss some of the pros and cons of countertrade from the country’s perspective and the firm’s

perspective.

Answer: Arguments both for and against countertrade transactions can be made. There are both

negative and positive incentives for a country to be in favor of countertrade. Negative incentives are

those that are forced upon a country or corporations whether or not they desire to engage in

countertrade. Negative reasons include: the conservation of cash and hard currency, the improvement

of trade imbalances, and the maintenance of export prices. Positive reasons from both the country and

corporate perspectives include: enhanced economic development, increased employment, technology

transfer, market expansion, increased profitability, less costly sourcing of supply, reduction of surplus

goods from inventory, and the development of marketing expertise.

Those against countertrade transactions claim that such transactions tamper with the fundamental

operation of free markets, and therefore, resources are used inefficiently. Opponents claim that

transaction costs are increased, that multilateral trade is restricted through fostering bilateral trade

agreements, and that, in general, transactions that do not make use of money represent a step

backwards in economic development.

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PROBLEMS

1. Assume the time from acceptance to maturity on a $2,000,000 bankers’ acceptance is 90 days.

Further assume the importing bank’s acceptance commission is 1.25 percent and that the market rate

for 90-day B/As is 7.00 percent. Determine the amount the exporter will receive if he holds the B/A

until maturity and also the amount the exporter will receive if he discounts the B/A with the importer’s

bank.

Solution: The exporter will receive $1,993,750 = $2,000,000 x [1 - (.0125 x 90/360)] if he holds the

B/A to maturity. The acceptance commission is $6,250. The exporter will receive $1,958,750 =

$2,000,000 x [1 - ((.0700 + .0125) x 90/360)] if he discounts the B/A with the importer’s bank.

2. The time from acceptance to maturity on a $1,000,000 banker’s acceptance is 120 days. The

importer’s bank’s acceptance commission is 1.75 percent and the market rate for 120-day B/As is 5.75

percent. What amount will the exporter receive if he holds the B/A until maturity? If he discounts the

B/A with the importer’s bank? Also determine the bond equivalent yield the importer’s bank will

earn from discounting the B/A with the exporter. If the exporter’s opportunity cost of capital is 11

percent, should he discount the B/A or hold it to maturity?

Solution: If the exporter holds the B/A until maturity, he will receive $994,166.67 =

$1,000,000 x [1 - (.0175 x 120/360)]. Thus, the acceptance commission is $5,833.33.

If the exporter discounts the B/A he will receive $975,000 = $1,000,000

x [1 - ((.0575 + .0175) x 120/360)].

The importer’s bank receives a discount rate of interest of 7.5 percent

(= 5.75 + 1.75 percent) on its investment. At maturity it will receive $1,000,000 from the importer.

The bond equivalent yield the importer’s bank earns on its investment is 7.8 percent, or .078 =

($1,000,000/$975,000 - 1) x 365/120.

The exporter pays the acceptance commission regardless of whether he discounts the B/A or holds it

to maturity. The bond equivalent rate the exporter receives from discounting the B/A is 5.98 percent,

or .0598 = ($994,166.67/$975,000 - 1) x 365/120. Since the exporter’s opportunity cost of capital is

11 percent, which is greater than 5.98 percent compounded tri-annually (an effective annual rate of

6.10 percent), he should discount the B/A.

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MINI CASE: AMERICAN MACHINE TOOLS, INC.

American Machine Tools is a Midwestern manufacturer of tool-and-die-making equipment. The

company has had an inquiry from a representative of the Estonian government about the terms of sale

for a $5,000,000 order of machinery. The sales manager spoke with the Estonian representative, but

he is doubtful that the Estonian government will be able to obtain enough hard currency to be able to

make the purchase. While the U.S. economy has been growing, American Machine Tools has not had

a very good year. An additional $5,000,000 in sales would definitely help. If something cannot be

arranged, the firm will likely be forced to lay off some of its skilled work force.

Is there a way that you can think of that American Machine Tools might be able to make the

machinery sale to Estonia?

Suggested Solution to American Tools, Inc.

American Machine Tools needs a manager in charge of countertrade. This manage would be skilled

in negotiating trades for his firm’s machine tools. Since the U.S. economy is fairly strong, there are

two types of countertrades that might work with the Estonian government and help American Machine

Tools consummate the sale: a buy-back transaction or a countertrade.

In a buy-back transaction, the Estonian government would issue debt denominated in a hard currency

to obtain the funds to purchase the equipment from American Machine Tools. It should be able to

obtain hard currency debt financing if it is likely that it can service the debt. American Machine

Tools, in turn, would agree to buy in dollars from the Estonian tool and die manufacturer enough of

the output produced on the machinery to enable it to meet the debt service obligations. A countertrade

works similarly, except that American Machine Tools would agree to purchase enough other goods

produced in Estonia to enable the hard currency debt service obligations to be met. Either of these two

types of countertrade would work if American Machine Tools has the sales ability to market the

Estonia output in the U.S., or elsewhere.

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CHAPTER 20 INTERNATIONAL TAX ENVIRONMENT



QUESTIONS

1. Discuss the twin objectives of taxation. Be sure to define the key words.

Answer: There are two basic objectives of taxation that are necessary to discuss to help frame our

thinking about the international tax environment: tax neutrality and tax equity.

Tax neutrality has its foundations in the principles of economic efficiency and equity. Tax

neutrality is determined by three criteria. Capital-export neutrality is the criterion that an ideal tax

should be effective in raising revenue for the government and not have any negative effects on the

economic decision making process of the taxpayer. That is, a good tax is one that is efficient in

raising tax revenue for the government and does not prevent economic resources from being allocated

to their most appropriate use no matter where in the world the highest rate of return can be earned. A

second neutrality criterion is national neutrality. That is, regardless of where in the world taxable

income is earned it is taxed in the same manner by the taxpayer’s national tax authority. In theory,

national tax neutrality is a commendable objective, as it is based on the principle of equality. The

third neutrality criterion is capital-import neutrality. This criterion implies that the tax burden placed

on the foreign subsidiary of a MNC by the host country should be the same regardless in which

country the MNC is incorporated and the same as that placed on domestic firms.

Tax equity is the principle that all similarly situated taxpayers should participate in the cost of

operating the government according to the same rules. This means that regardless in which country an

affiliate of a MNC earns taxable income, the same tax rate and tax due date apply.

2. Compare and contrast the three basic types of taxation that governments levy within their tax

jurisdiction.

Answer: There are three basic types of taxation that national governments throughout the world use in

generating tax revenue: income tax, withholding tax, and value-added tax. Many countries in the

world obtain a significant portion of their tax revenue from imposing an income tax on personal and

corporate income. An income tax is a direct tax, that is, one that is paid directly by the taxpayer on

whom it is levied. The tax is levied on active income, that is, income that results from production by

the firm or individual or from services that have been provided. A withholding tax is a tax levied on

passive income earned by an individual or corporation of one country within the tax jurisdiction of

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another country. Passive income includes dividends and interest income, and income from royalties,

patents or copyrights paid to the taxpayer. A withholding tax is an indirect tax, that is, a tax borne by

a taxpayer that did not directly generate the income that serves as the source of the passive income.

The tax is withheld from payments the corporation makes to the taxpayer and turned over to the local

tax authority. A value-added tax (VAT) is an indirect national tax charged on the sales price of a

service or consumption good as it moves through the various stages of production and/or service. As

such, a VAT is a sales tax borne by the final consumer.

3. Show how double taxation on a taxpayer may result if all countries were to tax the worldwide

income of their residents and the income earned within their territorial boundaries.

Answer: There are two fundamental types of tax jurisdiction: the worldwide and the territorial. The

worldwide method of declaring a national tax jurisdiction is to tax national residents of the country on

their worldwide income no matter in which country it is earned. The territorial method of declaring a

tax jurisdiction is to tax all income earned within the country by any taxpayer, domestic or foreign.

Hence, regardless of the nationality of a taxpayer, if the income is earned within the territorial

boundary of a country it is taxed by that country.

If a MNC was a resident of a country that taxed worldwide income, the foreign-source income of its

foreign affiliates would be taxed in the parent country. If the host country also taxes the income of the

affiliate earned within its territorial borders, the foreign affiliate would pay taxes on the same income

both in the host country and in the parent country. To avoid this “evil,” some mechanism needs to be

established to prevent double taxation.

4. What methods do taxing authorities use to eliminate or mitigate the evil of double taxation?

Answer: The typical approach to avoiding double taxation is for a nation not to tax foreign-source

income of its national residents. An alternative method, and the one the U.S. follows, is to grant to the

parent firm foreign tax credits against U.S. taxes for taxes paid to foreign tax authorities on foreign-

source income.

5. There is a difference in the tax liability levied on foreign-source income depending upon whether a

foreign branch or subsidiary form of organizational structure is selected for a foreign affiliate. Please

elaborate on this statement.

Answer: A foreign branch is not an independently incorporated firm separate from the parent, it is an

extension of the parent. Consequently, active or passive foreign-source income earned a the branch is

consolidated with the domestic-source income of the parent for determining the U.S. tax liability,

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regardless of whether or not the foreign-source income has been repatriated to the parent. A foreign

subsidiary is an affiliate organization of the MNC that is independently incorporated in the foreign

country, and one in which the U.S. MNC owns at least 10 percent of the voting equity stock. A

foreign subsidiary in which the U.S. MNC owns more than 10 but less than 50 percent of the voting

equity is a minority foreign subsidiary or a uncontrolled foreign corporation. Active and passive

foreign-source income derived from a minority foreign subsidiary is taxed in the U.S. only when

remitted to the U.S. parent firm via a dividend. A foreign subsidiary in which the U.S. MNC owns

more than 50 percent of the voting equity is a controlled foreign corporation. Active foreign-source

income from a controlled foreign corporation is taxed in the U.S. only as remitted to the U.S. parent,

but passive income is taxed in the U.S. as earned, even if it has not been repatriated to the parent.

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PROBLEMS

1. There are three production stages required before a pair of skies produced by Innsbruck Fabrication

retails for S2,300. Fill in the following table to show the value added at each stage in the production

process and the incremental and total VAT. The Austrian VAT rate is 20 percent.

_______________________________________________________________________

Production Selling Value Incremental Stage Price Added VAT_______________________________________________________________________

1 S 450

2 S1,900

3 S2,300

Total VAT _______________________________________________________________________

Solution:

Production Selling Value Incremental Stage Price Added VAT_______________________________________________________________________

1 S 450 S 450 S 90

2 S1,900 S1,450 S290

3 S2,300 S 400 S 80

Total VAT S460_______________________________________________________________________

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MINI CASE: SIGMA CORP.’S LOCATION DECISION

Sigma Corporation of Boston is contemplating establishing an affiliate operation in the

Mediterranean. Two countries under consideration are Spain and Cyprus. Sigma intends to repatriate

all after-tax foreign-source income to the United States. At this point, Sigma is not certain whether it

would be best to establish the affiliate operation as a branch operation or a wholly owned subsidiary of

the parent firm.

In Cyprus, the marginal corporate tax rate is 25 percent. Foreign branch profits are taxed at the same

rate. In Spain, corporate income is taxed at 35 percent, the same rate as in the U.S. Additionally,

foreign branch income in Spain is also taxed at 35 percent. The U.S. withholding tax treaty rates on

dividend income are 5 percent with Cyprus and 10 percent with Spain.

The financial manager of Sigma has asked you to help him determine where to locate the new

affiliate and which organization structure to establish. The location decision will be largely based on

whether the total tax liability would be smallest for a foreign branch or a wholly owned subsidiary in

Cyprus or Spain.

Suggested Solution for Sigma Corp.’s Location Decision

Foreign-source income of a foreign branch of a U.S. MNC in Cyprus would be taxed at a rate of 25

per cent in Cyprus. The after-tax foreign-source income would be grossed-up for U.S. tax purposes,

and income taxes at the rate of 35 percent would be levied in the U.S.. If the Cyprus affiliate was

established as a wholly owned subsidiary, the total (income and withholding) tax liability in Cyprus

would be: [.20 + .05 - (.20 x .05)] = .24, or 24 percent. Additional taxes in the U.S. would be due,

bringing the total tax liability up to the U.S. income tax rate of 35 percent.

Foreign-source income of a foreign branch of a U.S. MNC in Spain would be taxed at a rate of 35

per cent in Spain. Since the Spanish income tax rate and the U.S. income tax rate are both 35 percent,

no additional income taxes would be due in the U.S. on grossed-up foreign-source taxable income. If

the Spanish affiliate was a wholly owned subsidiary, the total (income and withholding) tax liability in

Spain would be: [.35 + .10 - (.35 x .10)] = .415, or 41.5 percent. Since this is greater than the U.S.

income tax rate of 35 percent, no additional taxes would be due in the U.S. If the excess foreign tax

credits (equal to 6.5 percent of foreign-source taxable income) could all be used by carrying them back

two years or forward five years, the total tax liability would be equal to the U.S. income tax rate of 35

percent. If the excess foreign tax credits cannot all be used, as is more typical, the total tax liability

could be as high as 41.5 percent.

Consequently, all else being equal, Sigma Corporation should be indifferent between establishing

either a wholly owned subsidiary or branch in Cyprus and a branch operation in Spain.

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Overall Solutions

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