International Corporate Finance

Transcription

1 International Corporate Finance Solution Manual Chapter 2: International Flow of Funds Effects of Tariffs Assume a simple world in which the U.S. exports soft drinks and beer to France and imports wine from France. If the U.S. imposes large tariffs on the French wine, explain the likely impact on the values of the U.S. beverage firms, U.S. wine producers, the French beverage firms, and the French wine producers. A N S W E R : T h e U. S. w i n e p r o d u c e r s b e n e f i t f r o m t h e U. S. t a r i f f s, w h i l e t h e F r e n c h w i n e producers are adversely affected. The French government would likely retaliate by imposing tariffs on the U.S. beverage firms, which would adversely affect their value. The French beverage firms would benefit. C u r r e n c y E f f e c t s W h e n S o u t h K o r e a s e x p o r t g r o w t h s t a l l e d, s o m e S o u t h K o r e a n f i r m s suggested that South Korea s primary export problem was the weakness in the Japanese yen. How would you interpret this statement? ANSWER: One of South Korea s primary competitors in exporting is Japan, which produces and exports many of the same types of products to the same countries. When the Japanese yen is weak, some importers switch to Japanese products in place of South Korean products. For this reason, it is often suggested that South Korea s primary export problem i s weakness in the Japanese yen. E x c h a n g e R a t e E f f e c t o n T r a d e B a l a n c e Would the U.S. balance of trade deficit be larger or smaller if the dollar depreciates against all currencies, versus depreciating against some currencies but appreciated against others? Explain. ANSWER: If the dollar weakens against all currencies, the U.S. balance of trade deficit will likely be smaller. Some U.S. importers would have more seriously considered purchasing their g o o d s i n t h e U. S. i f m o s t o r al l c u r r e n c i e s s i m u l t a n e o u s l y s t r e n g t h e n e d a g a i n s t t h e d o l l a r. Conversely, if some currencies weaken against the dollar, the U.S. importers may have simply shifted their importing from one foreign country to another. G o v e r n m e n t R e s t r i c t i o n s How can government restrictions affect international payments among countries? ANSWER: Governments can place tariffs or quotas on imports to restrict imports. They can also place taxes on income from foreign securities, thereby discouraging investors

2 from purchasing foreign securities. If they loosen restrictions, they can encourage international payments among countries. I n f l a t i o n E f f e c t o n T r a d e a. How would a relatively high home inflation rate affect the home country s current account, other things being equal? A N S W E R : A h i g h i n f l at i o n r a t e t en d s t o i n c r e a s e i m p o r t s a n d d e c r e a s e e x p o r t s, t h e r e b y increasing the current account deficit, other things equal. b. Is a negative current account harmful to a country? Discuss. ANSWER: This question is intended to encourage opinions and does not have a perfect solution. A negative current account is thought to reflect lost jobs in a country, which is unfavorable. Yet, the foreign importing reflects strong competition from foreign producers, which may keep prices (inflation) low. B a l a n c e o f P a y m e n t s a. What is the current account generally composed of? ANSWER: The current account balance is composed of (1) the balance of trade, (2) the net amount of payments of interest to foreign investors and from foreign investment, (3) payments from international tourism, and (4) private gifts and grants. b. What is the capital account generally composed of? ANSWER: The capital account is composed of all capital investments made between countries, including both direct foreign investment and purchases of securities with maturities exceeding one year. Advance Question: International Investments I n r e c e n t ye a r s, m a n y U. S. - b a s e d M N C s h a v e i n c r e a s ed t h e i r investments in foreign securities, which are not as susceptible to negative shocks in the U.S. market. Also, when MNCs believe that U.S. securities are overvalued, they can pursue non-u.s. securities that are driven by a different market. Moreover, in periods of low U.S. interest rates, U.S. corporations tend to seek investments in foreign securities. In general, the flow of funds into foreign countries tends to decline when U.S. investors anticipate a strong dollar. a. Explain how expectations of a strong dollar can affect the tendency of U.S. investors to invest abroad.

3 ANSWER: A weak dollar would discourage U.S. investors from investing abroad. It can cause the investors to purchase foreign currency (when investing) at a higher exchange rate than the exchange rate at which they would sell the currency (when the investment is liquidated). b. E x p l ai n h o w l o w U. S. i n t e r e s t r a t e s c a n a f f e c t t h e t e n d e n c y o f U. S. - b a s e d M N C s t o i n v e s t abroad. A N S W E R : Lo w U. S. i n t e r e s t r a t es c a n e n c o u r a g e U. S. - b as e d M N C s t o i n v e s t a b r o a d, a s investors seek higher returns on their investment than they can earn in the U.S. c. In general terms, what is the attraction of foreign investments to U.S. investors? ANSWER: The main attraction is potentially higher returns. The international stocks can outperform U.S. stocks, and international bonds can outperform U.S. bonds. However, there is no guarantee that the returns on international investments will be so favorable. Some investors may also pursue international investments to diversify their investment portfolio, which can possibly reduce risk. Exchange Rate Effects on Trade a. Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explain why a weaker dollar could affect the U.S. balance of trade deficit. ANSWER: A stronger dollar makes U.S. exports more expensive to importers and may reduce imports. It makes U.S. imports cheap and may increase U.S. imports. A weaker home currency increases the prices of imports purchased by the home country and reduces the prices paid by foreign businesses for the home country s exports. This should cause a decrease in the home country s demand for imports and an increase in the foreign demand for the home country s exports, and therefore increase the current account. However, this relationship can be distorted by other factors. b. It is sometimes suggested that a floating exchan ge rate will adjust to reduce or eliminate any current account deficit. Explain why this adjustment would occur. ANSWER: A current account deficit reflects a net sale of the home currency in exchange for other currencies. This places downward pressure on that home currency s value. If the currency weakens, it will reduce the home demand for foreign goods (since goods will now be more expensive), and will increase the home export volume (since exports will appear cheaper to foreign countries). c. Why does the exchange rate not always adjust to a current account deficit? ANSWER: In some cases, the home currency will remain strong even though a current account deficit exists, since other factors (such as international capital flows) can offset the forces placed on the currency by the current account.

4 Solution to Continuing Case Problem: Blades, Inc 1. How could a higher level of inflation in Thailand affect Blades (assume U.S. inflation remains constant)? ANSWER: A high level of inflation in Thailand relative to the United States could affect Blades favorably. Generally, if a country s inflation rate increases relative to the countries with which it trades, consumers and corporations within the country will most likely purchase more goods overseas, as local goods become more expensive. Consequently, Blades sales to Thailand may increase. 2. H o w c o u l d c o m p e t i t i o n f r o m f i r m s i n T h a i l a n d a n d f r o m U. S. f i r m s c o n d u c t i n g b u s i n e s s i n Thailand affect Blades? ANSWER: Blades would be favorably affected relative to Thai roller blade manufacturers and relative to other U.S. roller blade manufacturers with operations in Thailand. Both groups of firms will likely be forced to raise their prices if they want to maintain the same profit margin should inflation in Thailand increase. This is especially true if both groups of firms source their supplies directly from Thailand, so that the prices of these supplies are subject to the higher inflation in T h ai l a n d. C o n v e r s e l y, B l a d e s c o s t o f g o o d s s o l d i n c u r r e d i n T h a i l a n d i s r e l at i v el y s m a l l. Consequently, costs will not be subject to the higher level of inflation in Thailand to a great extent and Blades will probably not have to raise its prices to the same extent as Thai roller blade manufacturers or U.S. manufacturers with operations in Thailand. 3. How could a decreasing level of national income in Thailand affect Blades? ANSWER: At first glance, it would appear that a decreasing level of national income in Thailand could hurt Blades financially, as Thai consumers will have less money to spend. Furthermore, this effect may be magnified because Blades manufactures a leisure product, which is probably one of the first products Thai consumers will stop buying. The arrangement Blades has with its primary Thai importer mitigates this effect somewhat, since the latter has committed himself to the purchase of a certain number of Speedos annually. Nevertheless, the importer may not offer tor e n e w t h i s a r r a n g e m e n t i n ex c e s s o f t h e o r i g i n a l t h r e e ye a r s i f t h e T h a i e c o n o m y d o e s n o t improve. 4. How could a continued depreciation of the Thai baht affect Blades? How would it affect Blades relative to U.S. exporters invoicing their roller blades in U.S. dollars? ANSWER: A continued depreciation of the Thai baht would hurt Blades, especially because the firm invoices its roller blades in baht. A continued depreciation of the baht means that the bahtd e n o m i n a t e d r e v e n u e i n T h a i l a n d w i l l c o n v e r t t o f e w e r U. S. d o l l a r s. B l a d e s a l s o h a s s o m e expenses in baht, but this amount is less than the revenue denominated in baht. Although Blades would be hurt by a depreciating baht because its exports are denominated in b a h t, t h e d e m a n d f o r B l a d e s p r o d u c t s m a y i n c r e a s e r e l a t i v e t o t h a t o f i t s U. S. c o m p e t i t o r s exporting to Thailand. This is because most of the U.S. firms exporting roller blades to Thailand invoice their products in U.S. dollars. If the baht depreciates, Thai importers will have to convert more baht to dollars in order to pay for the dollardenominated exports.

5 5. If Blades increases its business in Thailand and experiences serious financial problems, are there a n y i n t e r n a t i o n a l a g e n c i e s t h a t t h e c o m p a n y c o u l d a p p r o a c h f o r l o a n s o r o t h e r f i n a n ci a l assistance? ANSWER: An agency extending direct loans to corporations involved in international trade is the International Financial Corporation (IFC). Besides extending loans, the IFC may also purchase stock in a corporation, thereby becoming part owner. Small Business Dilemma I d e n t i f yi n g F a c t o r s T h a t W i l l A f f ect t h e F o r ei g n D e m a n d a t t h e S p o r t s E x p o r t s Company Identify the factors that affect the current account balance between the U.S. and the U.K. Explain how each factor may possibly affect the British demand for the footballs that are produced by the Sports Exports Company. ANSWER: 1. High inflation in the U.K. could cause a shift in the demand for U.S. products instead of British products. However, at this time there is not a British producer of footballs, so that high British inflation will not cause an increase in the demand for U.S.-produced footballs. 2. High national income in the U.K. could increase the amount of spending by British consumers, and would therefore cause an increase in the demand for footballs produced by the Sports Exports Company. A lower national income in the U.K. would have the opposite effect. 3. Government restrictions could be imposed by the British government on goods (such as the footballs) exported by U.S. firms. However, footballs are not likely to be targeted by the British government as a product that should be subject to restrictions. 4. The exchange rate of the British pound will change over time. However, since the Sports Exports Company is willing to accept pounds when it sells footballs to the distributor, the distributor does not have to convert the pounds into dollars. Therefore, the British demand for footballs is not affected by changes in the value of the pound (unless this causes the Sports Exports Company to change the price it charges for the footballs someday).

6 Chapter 3: International Financial Markets Indirect Exchange Rate If the direct exchange rate of the euro is worth $1.25, what is the indirect rate of the euro? That is, what is the value of a dollar in Euros? ANSWER: 1/1.25 =.8 Euros. Foreign Stock Markets Explain why firms may issue stock in foreign markets. Why might U.S. firms issue more stock in Europe since the conversion to a single currency in 1999? ANSWER: Firms may issue stock in foreign markets when they are concerned that their home market may be unable to absorb the entire issue. In addition, these firms may have foreign currency inflows in the foreign country that can be used to pay dividends on foreign-issued stock. They may also desire to enhance their global image. Since the euro can be used in several countries, firms may need a large amount of Euros if they are expanding across Europe. Foreign Exchange You just came back from Canada, where the Canadian dollar was worth $.70.You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 130 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain. ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange d e s k, t h e c r o s s - r a t e i s $. 6 0 / $ 1 0 = 6. Thu s, t h e C $ w o u l d b e ex c h an g e d f o r p e s o s (computed as 200 6). If you exchange Canadian dollars for pesos with the tourist, you will receive 130 pesos. Forward Contract The Wolf pack Corporation is a U.S. exporter that invoices its exports to the United Kingdom in British pounds. If it expects that the pound will appreciate against the dollar in the future, should it hedge its exports with a forward contract? Explain. ANSWER: The forward contract can hedge future receivables or payables in foreign currencies to insulate the firm against exchange rate risk. Yet, in this case, the Wolf pack Corporation should not hedge because it would benefit from appreciation of the pound when it converts the pounds to dollars.

7 B i d / a s k S p r e a d Compute the bid/ask percentage spread for Mexican peso retail transactions in which the ask rate is $.11 and the bid rate is $.10. ANSWER: [($.11 $.10)/$.11] =.091, or 9.1%. B i d / a s k S p r e a d Utah Bank s bid price for Canadian dollars is $.7938 and its ask price is $.81.What is the bid/ask percentage spread? ANSWER: ($.81 $.7938)/$.81 =.02 or 2% Cross Exchange Rate Assume Poland s currency (the zloty) is worth $.17 and the Japanese yen is worth $.008. What is the cross rate of the zloty with respect to yen? That is, how many yen equal a zloty? ANSWER: $.17/$.008 = zloty = yen Interpreting Exchange Rate Quotations Today you Notice the following exchange rate quotations: a. $1 = 3.00 Argentine Pesos and b. 1 Argentine Pesos = 0.50 Canadian dollars. You need to purchase 100,000 Canadian dollars with US dollars. How many US Dollars will you need for your purchase? Answer: Value of argentine pesos = $0.333 Value of Canadian dollar in Argentine pesos = 2 Value of CAD in $ = $0.666 So you need $ 66,666 to purchase CAD 100,000. International Financial Markets Recently, Wal-Mart established two retail outlets in the city of Shanzen, China, which has a population of 3.7 million. These outlets are massive and contain products purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs in Shanzen, it may remit those earnings back to the United States. Wal -Mart is likely to build additional outlets in Shanzen or in other Chinese cities in the future. a. Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange. ANSWER: The Wal-Mart stores in China need other currencies to buy products from other countries, and must convert the Chinese currency (Yuan) into the other currencies in the spot m a r k e t t o p u r c h as e t h e s e p r o d u ct s. T h e y a l s o c o u l d u s e t h e s p o t m a r k et t o c o n v e r t ex c e s s earnings denominated in Yuan into dollars, which would be remitted to the U.S. parent.

8 b. Explain how Wal-Mart might utilize the international money market when it is establishing other Wal-Mart stores in Asia. ANSWER: Wal-Mart may need to maintain some deposits in the Eurocurrency market that can be used (when needed) to support the growth of Wal-Mart stores in various foreign markets. When some Wal-Mart stores in foreign markets need funds, they borrow from banks in the Eurocurrency market. Thus, the Eurocurrency market serves as a deposit or lending source for Wal-Mart and other MNCs on a short-term basis. c. Explain how Wal-Mart could use the international bond market to finance the establishment of new outlets in foreign markets. ANSWER: Wal-Mart could issue bonds in the Eurobond market to generate funds needed to establish new outlets. The bonds may be denominated in the currency that is needed; then, once the stores are established, some of the cash flows generated by those stores could be used to pay interest on the bonds. Chapter 4: Exchange Rate Determination Question And Applications 1. Impact of September 11. The terrorist attacks on the U.S. on September 11, 2001 were expected to weaken U.S. economic conditions, and reduce U.S. interest rates. How do you think the weaker U.S. economic conditions would affect trade flows? How would this have affected the value of the dollar (holding other factors constant)? How do you think the lower U.S. interest rates would have affected the value of the U.S. dollar (holding other factors constant)? ANSWER: The weak U.S. economy would result in a reduced demand for foreign products, which results in a decline in the demand for foreign currencies, and therefore places downward pressure on currencies relative to the dollar (upward pressure on the dollar s value). The lower U.S. interest rates should reduce the capital flows to the U.S., which place downward pressure on the value of the dollar. 2. Factors Affecting Exchange Rates. What factors affect the future movements in the value of the euro against the dollar? ANSWER: The Euros value could change because of the balance of trade, which reflects more U.S. demand for European goods than the European demand for U.S. goods. The capital flows between the U.S. and Europe will also affect the U.S. demand for Euros and the supply of Euros for sale (to be exchanged for dollars). 3. Impact of Crises. Why do you think most crises in countries (such as the Asian crisis) cause the local currency to weaken abruptly? Is it because of trade or capital flows? ANSWER: Capital flows have a larger influence. In general, crises tend to cause investors to expect that there will be less investment in the country in the future and also cause concern that

9 any existing investments will generate poor returns (because of defaults on loans or reduced valuations of stocks). Thus, as investors liquidate their investments and convert the local currency into other currencies to invest elsewhere, downward pressure is placed on the local currency. 4. Effects of Real Interest Rates. What is the expected relationship between the relative real interest rates of two countries and the exchange rate of their currencies? ANSWER: The higher the real interest rate of a country relative to another country, the stronger will be its home currency, other things equal. 5. Factors Affecting Exchange Rates. If the Asian countries experience a decline in economic growth (and experience a decline in inflation and interest rates as a result), how will their currency values (relative to the U.S. dollar) be affected? ANSWER: A relative decline in Asian economic growth will reduce Asian demand for U.S. products, which places upward pressure on Asian currencies. However, given the change in interest rates, Asian corporations with excess cash may now invest in the U.S. or other countries, thereby increasing the demand for U.S. dollars. Thus, a decline in Asian interest rates will place downward pressure on the value of the Asian currencies. The overall impact depends on the magnitude of the forces just described. 6. Speculative Effects on Exchange Rates. Explain why a public forecast by a respected economist about future interest rates could affect the value of the dollar today. Why do some forecasts by well-respected economists have no impact on today s value of the dollar? ANSWER: Interest rate movements affect exchange rates. Speculators can use anticipated interest rate movements to forecast exchange rate movements. They may decide to purchase securities in particular countries because of their expectations about currency movements, since their yield will be affected by changes in a currencies value. These purchases of securities require an exchange of currencies, which can immediately affect the equilibrium value of exchange rates. If a forecast of interest rates by a respected economist was already anticipated by market participants or is not different from investor s original expectations, an announced forecast does not provide new information. Thus, there would be no reaction by investors to such an announcement, and exchange rates would not be affected. 7. National Income Effects. Analysts commonly attribute the appreciation of a currency to expectations that economic conditions will strengthen. Yet, this chapter suggests that when other factors are held constant, increased national income could increase imports and cause the local currency to weaken. In reality, other factors are not constant. What other factor is likely to be affected by increased economic growth and could place upward pressure on the value of the local currency? ANSWER: Interest rates tend to rise in response to a stronger economy, and higher interest rates can place upward pressure on the local currency (as long as there is not offsetting pressure by higher expected inflation). 8. Trade Restriction Effects on Exchange Rates. Assume that the Japanese government relaxes its controls on imports by Japanese companies. Other things being equal, how should this affect the (a) U.S. demand for Japanese yen, (b) supply of yen for sale, and (c)equilibrium value of the yen?

10 ANSWER: Demand for yen should not be affected, supply of yen for sale should increase, and the value of yen should decrease. 9. Co movements of Exchange Rates. Explain why the value of the British pound against the dollar will not always move in tandem with the value of the euro against the dollar. ANSWER: The Euros value changes in response to the flow of funds between the U.S. and the countries using the euro or their currency. The pounds value changes in response to the flow of funds between the U.S. and the U.K. [Answer is based on intuition, is not directly from the text.] 10. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate than does the Canadian income level. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? ANSWER: Assuming no effect on U.S. interest rates, demand for dollars should increase, supply of dollars for sale may not be affected, and the dollar s value should increase. 11. Factors Affecting Exchange Rates. In the 1990s, Russia was attempting to import more goods but had little to offer other countries in terms of potential exports. In addition, Russians inflation rate was high. Explain the type of pressure that these factors placed on the Russian currency. ANSWER: The large amount of Russian imports and lack of Russian exports placed downward pressure on the Russian currency. The high inflation rate in Russia also placed downward pressure on the Russian currency. 12. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound? ANSWER: Demand for pounds should increase, supply of pounds for sale should decrease, and the pounds value should increase. 13. Trade Deficit Effects on Exchange Rates. Every month, the U.S. trade deficit figures are announced. Foreign exchange traders often react to this announcement and even attempt to forecast the figures before they are announced. a. Why do you think the trade deficit announcement sometimes has such an impact on foreign exchange trading? ANSWER: The trade deficit announcement may provide a reasonable forecast of future trade deficits and therefore has implications about supply and demand conditions in the foreign exchange market. For example, if the trade deficit was larger than anticipated, and is expected to continue, this implies that the U.S. demand for foreign currencies may be larger than initially anticipated. Thus, the dollar would be expected to weaken. Some speculators may take a position in foreign currencies immediately and could cause an immediate decline in the dollar. b. In some periods, foreign exchange traders do not respond to a trade deficit announcement, even when the announced deficit is very large. Offer an explanation for such a lack of response.

11 ANSWER: If the market correctly anticipated the trade deficit figure, then any news contained in the announcement has already been accounted for in the market. The market should only respond to an announcement about the trade deficit if the announcement contains new information. 14. Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high relative to Canadian inflation. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? ANSWER: Demand for Canadian dollars should increase, supply of Canadian dollars for sale should decrease, and the Canadian dollar s value should increase. 15. Interaction of Exchange Rates. Assume that there are substantial capital flows among Canada, the U.S., and Japan. If interest rates in Canada decline to a level below the U.S. interest rate, and inflationary expectations remain unchanged, how could this affect the value of the Canadian dollar against the U.S. dollar? How might this decline in Canada s interest rates possibly affect the value of the Canadian dollar against the Japanese yen? ANSWER: If interest rates in Canada decline, there may be an increase in capital flows from Canada to the U.S. In addition, U.S. investors may attempt to capitalize on higher U.S. interest rates, while U.S. investors reduce their investments in Canada s securities. This places down ward pressure on the Canadian dollar s value. Japanese investors that previously invested in Canada may shift to the U.S. Thus, the reduced flow of funds from Japan would place downward pressure on the Canadian dollar against the Japanese yen. 16. Percentage Depreciation. Assume the spot rate of the British pound is $1.73. The expected spot rate one year from now is assumed to be $1.66. What percentage depreciation does this reflect? ANSWER: ($1.66 $1.73)/$1.73= 4.05% Expected depreciation of 4.05% percent. Advanced Questions: 17. Assessing the Euros potential movements. Yoou reside in the United States and are planning to make a one year investment in Germany during the next year. Since the investment is denominated in Euros, you want to forecast how the Euros value may change against the dollar over the one year period. You expect the Germany will experience an inflation rate of 1% during the next year. While all over European countries will experience an inflation rate of 8% over the next year. You expect the United States will experience an annual inflation rate of 2 % during the next year. You believe that the primary factors that affects any exchange rate is the inflation rate. Based on the information provided in this question, will the euro appreciate, depreciate or stay at about same level against the dollar over the next year?? Answer: The euro should depreciate because most countries in the Eurozone are presumed to have high inflation.

12 18. Speculation. Diamond Bank expects that the Singapore dollar will depreciate against the dollar from its spot rate of $.43 to $.42 in 60 days. The following interbank lending and borrowing rates exist: Lending Rate U.S. dollar Singapore dollar 7.0% 22.0% Borrowing Rate 7.2%24.0% Diamond Bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in dollars for 60 days. Estimate the profits (or losses)that could be earned from this strategy. Should Diamond Bank pursue this strategy? ANSWER: Borrow S$10,000,000 and convert to U.S. $: S$10,000,000 $.43 =$4,300,000. Invest funds for 60 days. The rate earned in the U.S. for 60 days is: 7%(60/360) = 1.17%. Total amount accumulated in 60 days: $4,300,000 ( ) =$4,350,310. Convert U.S. $ back to S$ in 60 days: $4,350,310/$.42 = S$10,357,881. The rate to be paid on loan is:.24 (60/360) =.04. Amount owed on S$ loan is: S$10,000,000(1 +.04) = S$10,400,000. This strategy results in a loss: S$10,357,881 S$10,400,000 =S$42,119. Diamond Bank should not pursue this strategy. 19. Speculation: Diamond bank expects that the Singapore dollar will depreciate against the Us dollar from its spot rate of $.43 to $.42 in 60 days/ the following interbank lending and borrowing rates exist: Currency Lending Rates Borrowing rates US$ 7.0% 7.2% Singapore $ 22.0% 24.0% Diamond bank considers borrowing 10 million Singapore dollars in the interbank market and investing the funds in US$ for 60days. Estimate the profits or losses that could be earned from this strategy. Should diamond bank pursue this strategy??? Answer: Borrowing S$ 10million and convert to US$: S$10Million * $.43= $ 4300,000. Invest funds for 60 days. The rate earned in the US for 60 days is; 7%(60/360)= 1.17%. Total amount accumulated in 60 days: $34300,000*1.0117= s$ The rate to be paid on loan is.24*(60/360) =.04. Amount owed on S$ loan is S$10 million *1.04 = S$ 10400,000. This strategy results in a loss : (S$42119). Diamond bank should not pursue this strategy. 23. Speculation. Blue Demon Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $.15 to $.14 in 10 days. The following interbank lending and borrowing rates exist: U.S. dollar Mexican peso Lending Rate 8.0% 8.5% Borrowing Rate 8.3% 8.7% 41 Assume that Blue Demon Bank has a borrowing capacity of either $10 million or 70 million pesos in the interbank market, depending on which currency it wants to borrow.

13 a. How could Blue Demon Bank attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. ANSWER: Blue Demon Bank can capitalize on its expectations about pesos (MXP) as follows: 1. Borrow MXP70 million 2.Convert the MXP70 million to dollars: MXP70, 000,000 $.15 = $10,500, Lend the dollars through the interbank market at 8.0% annualized over a 10-day period. The amount accumulated in 10 days is: $10,500,000 [1 + (8% 10/360)] = $10,500,000[ ] = $10,523, Repay the peso loan. The repayment amount on the peso loan is: MXP70,000,000 [1 + (8.7% 10/360)] = 70,000,000 [ ]=MXP70,169, Based on the expected spot rate of $.14, the amount of dollars needed to repay the peso loan is: MXP70,169,167 $.14 = $9,823, After repaying the loan, Blue Demon Bank will have a speculative profit (if its forecasted exchange rate is accurate) of:$10,523,333 $9,823,683 = $699,650 b. Assume all the preceding information with this exception: Blue Demon Bank expects the peso to appreciate from its present spot rate of $.15 to $.17 in 30 days. How could it attempt to capitalize on its expectations without using deposited funds? Estimate the profits that could be generated from this strategy. ANSWER: Blue Demon Bank can capitalize on its expectations as follows: 1. Borrow$10 million 2. Convert the $10 million to pesos (MXP): $10,000,000/$.15 =MXP66,666,667 3.Lend the pesos through the interbank market at 8.5% annualized over a 30-dayperiod. The amount accumulated in 30 days is: MXP66,666,667 [1 + (8.5% 30/360)] =66,666,667 [ ] = MXP67,138, Repay the dollar loan. The repayment amount on the dollar loan is: $10,000,000 [1 + (8.3% 30/360)] = $10,000,000 [ ]= $10,069, Convert the pesos to dollars to repay the loan. The amount of dollars to be received in 30 days (based on the expected spot rate of $.17) is: MXP67,138,889$.17 = $11,413, The profits are determined by estimating the dollars available after repaying the loan: $11,413,611 $10,069,170 = $1,344, Aggregate Effects on Exchange Rates. Assume that the United States invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United States. Approximately $10 billion worth of investment transactions occur between these two countries each year. The total dollar value of trade transactions per year is about $8 million. This information is expected to also hold in the future. Because your firm exports goods to Country K, your job as international cash manager requires you to forecast the value of Country Ks currency (the k rank) with respect to the dollar. Explain how each of the following conditions will affect the value of the k rank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the k ranks movement against the dollar. a. U.S. inflation has suddenly increased substantially, while Country Ks inflation remains low. ANSWER: Increased U.S. demand for the k rank. Decreased supply of k ranks for sale. Upward pressure in the k ranks value.

14 b. U.S. interest rates have increased substantially, while Country K s interest rates remain low. Investors of both countries are attracted to high interest rates. ANSWER: Decreased U.S. demand for the k rank. Increased supply of k ranks for sale. Downward pressure on the k ranks value. c. The U.S. income level increased substantially, while Country Ks income level has remained unchanged. ANSWER: Increased U.S. demand for the k rank. Upward pressure on the kranks value. d. The U.S. is expected to impose a small tariff on goods imported from Country K. ANSWER: The tariff will cause a decrease in the United States desire for Country Ks goods, and will therefore reduce the demand for k ranks for sale. Downward pressure on the k ranks value. e. Combine all expected impacts to develop an overall forecast. ANSWER: Twoof the scenarios described above place upward pressure on the value of the krank. However, these scenarios are related to trade, and trade flows are relatively minor between the U.S. and Country K. The interest rate scenario places downward pressure on the k ranks value. Since the interest rates affect capital flows and capital flows dominate trade flows between the U.S. and Country K, the interest rate scenario should overwhelm all other scenarios. Thus, when considering the importance of implications of all scenarios, the krank is expected to depreciate. 27. Factors Affecting Exchange Rates. Mexico tends to have much higher inflation than the United States and also much higher interest rates than the United States. Inflation and interest rates are much more volatile in Mexico than in industrialized countries. The value of the Mexican peso is typically more volatile than the currencies of industrialized countries from a U.S. perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the peso than for currencies of industrialized countries. a. Identify the most obvious economic reason for the persistent depreciation of the peso. ANSWER: The high inflation in Mexico places continual downward pressure on the value of the peso. b. High interest rates are commonly expected to strengthen a country s currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the pesos value has declined against the dollar over most years even though Mexican interest rates are typically much higher than U.S. interest rates. Thus, it appears that the high Mexican interest rates do not attract substantial U.S. investment in Mexico s securities. Why do you think U.S. investors do not try to capitalize on the high interest rates in Mexico? ANSWER: The high interest rates in Mexico result from expectations of high inflation. That is, the real interest rate in Mexico may not be any higher than the U.S. real interest rate. Given the high inflationary expectations, U.S. investors recognize the potential weakness of the peso, which could more than offset the high interest rate(when they convert the pesos back to dollars at the end of the

15 investment period).therefore, the high Mexican interest rates do not encourage U.S. investment in Mexican securities, and do not help to strengthen the value of the peso. c. Why do you think the bid/ask spread is higher for pesos than for currencies of industrialized countries? How does this affect a U.S. firm that does substantial business in Mexico? ANSWER: The bid/ask spread is wider because the banks that provide foreign exchange services are subject to more risk when they maintain currencies such as the peso that could decline abruptly at any time. A wider bid/ask spread adversely affects the U.S. firm that does business in Mexico because it increases the transactions costs associated with conversion of dollars to pesos, or pesos to dollars. Case Problem: Blades, Inc. 1. How are percentage changes in a currency s value measured? Illustrate your answer numerically by assuming a change in the Thai baths value from a value of $0.022 to $ ANSWER: The percentage change in a currency s value is measured as follows: % S St St 1 1 where S denotes the spot rate, and St 1 denotes the spot rate as of the earlier date. A positive percentage change represents appreciation of the foreign currency, while a negative percentage change represents depreciation. In the example provided, the percentage change in the Thai baht would be: % S St St 1 1$0.026 $0.022 $ % That is, the baht would be expected to appreciate by18.18%. 2. What are the basic factors that determine the value of a currency? In equilibrium, what is the relationship between these factors? ANSWER: The basic factors that determine the value of a currency are the supply of the currency for sale and the demand for the currency. A high level of supply of a currency generally decreases the currency s value, while a high level of demand for a currency increases its value. In equilibrium, the supply of the currency equals the demand for the currency. 3. How might the relatively high levels of inflation and interest rates have affected the baths value? (Assume a constant level of U.S. inflation and interest rates.) ANSWER: The baht would be affected both by inflation levels and interest rates in Thailand relative to levels of these variables in the U.S. A high level of inflation tends to result in currency depreciation, as it would increase the Thai demand for U.S. goods, causing an increase in the Thai demand for dollars. Furthermore, a relatively high level of Thai inflation would reduce the U.S. demand for Thai goods, causing an increase in the supply of baht for sale. Conversely, the high level of interest rates in Thailand may cause appreciation of the baht relative to the dollar. A relatively high level of interest rates in Thailand would have rendered investments there more attractive for U.S. investors, causing an increase in the demand for baht. Furthermore, U.S. securities would have been less attractive to Thai investors, causing an increase in the supply of dollars for sale. However, investors might be unwilling to invest in baht-denominated securities if they are concerned about the potential depreciation of the baht that could result from Thailand s inflation.

16 Speculators who are confident that the exchange rate will appreciate, with very little risk of depreciation, may be more willing to buy futures than call options, because they do not need to insure against depreciation. However, speculators who expect appreciation but want to cover against possible depreciation may be willing to buy call options so that their downside risk is limited to what they pay for the call option. 4. How do yiu think the loss of confidence in the Thai bath evidenced by the withdrawal of funs from Thailand, will affect the baths value?? Would blades be affected by the changes in value, given the primary Thai customers commitment?? Answer: In general, depreciation in the foreign currency results when investors liquidate their investments in the foreign currency, increasing the supply of its currency or sale. Blades would probably be affected by the change in value, as the sales are denominated in bath. Thus, the depreciation in the bath would have caused a conversion of the bath revenue in to fewer US $. 5. Assume the Thailand s central bank wishes to prevent a withdrawal of fund from its country in order to prevent further changes in the currency s value. How could it accomplish this objectives using interest rates?? Answer: If Thailand s central bank wishes to prevent further depreciation in the bath s value, it would attempt to increase the level of interest rates in Thailand. In turn, this would increase the demand for Thai by US investors as Thai securities would now seem more attractive. This would place upward pressure on the currency s value. however the high interest rates could educe local borrowing and spending. Small Business Dilemma: 1. Given Jim s Expectations, forecast whether the pound will appreciate or depreciate against the dollar over time??? Answer: The pound should depreciate because the British inflation is expected to be higher the US inflation. This could cause a shift in trade that would place downward pressure on the pounds value. The interest rate movements of both countries are expected to be similar for both countries. Therefore, there should not be any adjustment in the capital flows between the two countries. 2. Given Jim s expectations, will the sports exports company be favorable or unfavorably affected by the future changes in the value of pound?? Answer: The sports export company will be unfavorably affected, because depreciation in the British pound will cause the pound receivable to convert into fewer dollars.

17 1. Selling Currency Call Options. Chapter 5: Currency Derivatives Mike Suerth sold a call option on Canadian dollars for $.01 per unit. The strike price was $.76, and the spot rate at the time the option was exercised was $.82. Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Mike s net profit on the call option? ANSWER: Premium received per unit $0.01, Amount per unit received from selling C$ 0.76, Amount per unit paid when purchasing C$ 0.82, Net profit per unit ($0.05). Net Profit = 50,000 units ($.05) = $.01 = $.76 = $.82 = $.05 = $2, Hedging with Currency Derivatives. A U.S. professional football team plans to play an exhibition game in the United Kingdom next year. Assume that all expenses will be paid by the British government, and that the team will receive a check for 1 million pounds. The team anticipates that the pound will depreciate substantially by the scheduled date of the game. In addition, the National Football League must approve the deal, and approval (or disapproval) will not occur for three months. How can the team hedge its position? What is there to lose by waiting three months to see if the exhibition game is approved before hedging? ANSWER: The team could purchase put options on pounds in order to lock in the amount at which it could convert the 1 million pounds to dollars. The expiration date of the put option should correspond to the date in which the team would receive the 1 million pounds. If the deal is not approved, the team could let the put options expire. If the team waits three months, option prices will have changed by then. If the pound has depreciated over this three-month period, put options with the same exercise price would command higher premiums. Therefore, the team may wish to purchase put options immediately. The team could also consider selling futures contracts on pounds, but it would be obligated to exchange pounds for dollars in the future, even if the deal is not approved. 3. Speculating with Put Currency Options. Alice Duever purchased a put option on British pounds for $.04 per unit. The strike price was $1.80 and the spot rate at the time the pound option was $1.59. Assume there are 31,250 units in a British pound option. What was Alice s net profit on the option? ANSWER: Profit per unit on exercising the option $0.21, Premium paid per unit$0.04, Net profit per unit$0.17. Net profit for one option = 31,250 units $.17 = $.21 = $.04 = $.17 =$5, Speculation with Currency Put Option. Bulldog, Inc has sold Australian Dollar put option at a premium of $0.01 per unit, and exercise price of $.76 per unit. It has forecasted the Australian dollars lowest level over the period of concern as shown in the following table. Determine the net profit or loss per unit to Buildog Inc, if each level occurs and the put options are exercised at that time

18 Net profit or loss to Bulldog inc, if value occurs $.72 $.73 $.74 $.75 $.76 ANSWER: Possible value of Australian Dollar Net profit or loss to Bulldog Inc, if value occurs $.72 -$.03 $.73 -$0.02 $.74 -$0.01 $ $.76 $ Speculating with Currency Call Options. Randy Rudecki purchased a call option on British pounds for $.02 per unit. The strike price was $1.45 and the spot rate at the time the option was exercised was $1.46. Assume there are 31,250 units in a British pound option. What was Randy s net profit on this option? ANSWER: Profit per unit on exercising the option $0.01, Premium paid per unit $0.02, Net profit per unit $0.01. Net profit per option = 31,250 units ($.01) = $.01 = $.02 = $.01 = $ Speculating with currency call option: Bama Corp has British pound call options for speculative purposes. The option premium was $0.06 per unit and the exercise price was $1.58. Bama will purchase the pounds on the day the options the options are exercised ( if the options are exercised) in order to fulfill its obligation. In the following table, fill in the net profit or loss to Barma corp, if the listed spot rate exists at the time the purchaser of the call options considers exercising them.

19 Answer: Spot Rate Net profit / loss per unit $ = = = = = = = Speculating with Currency Put Options: Auburn Co has purchased Canadian dollar put options for speculative purposes. Each option was purchased for a premium of $0.02 per unit; with an exercise price of $0.86 per unit. Auburn Co will purchase the Canadian dollar just before it exercises the options (If it is feasible to exercise the options). It plans to wait until the expiration date before deciding whether to exercise the options. In the following table, fill in the net profit or loss per unit to Auburn Co based on the listed possible spot rates of the Canadian dollar on the expiration date. Answer: Spot Net loss of gain per unit Rate $ = = = = = = Solution to Continuing Case Problem: Blades, Inc. 1. If Blades uses call options to hedge its yen payables, should it use the call option with the exercise price of $ or the call option with the exercise price of $ ? Describe the tradeoff. ANSWER: The table shows how the option choices have changed for Blades. If it wants to ensure paying no more than 5 percent above the spot rate, the option with the exercise price of $ should be considered, although the premium on that option now has increased to be worth 2 percent of the exercise price (more expensive). The option premium is higher than what the firm normally prefers to pay. The firm could pay a lower premium by purchasing the alternative option with an exercise price of $ , but that exercise price is 10 percent above the existing spot rate. This alternative option does not achieve the firm s desire to ensure paying no more than 5 percent above the existing spot rate. So if the firm is to continue to use options, it must accept either paying a higher premium than it would prefer, or a higher exercise price that limits the