International Financial Management FINA 4836 Rauli Susmel Spring 2017 First Midterm Exam - Solutions

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1 International Financial Management FINA 4836 Rauli Susmel Spring 2017 First Midterm Exam - Solutions No points will be given by simply writing down formulas, and writing down definitions or irrelevant statements from the book, or saying "yes," will get you zero points. Justify all your answers. If you cannot prove something give some intuition. Good luck. Reminder: this is an open book exam, but no open notes. Time: 1hr 20 minutes. I. Problems (15 points each). 1. Chambers Inc will receive EUR 10,000,000 in 180 days. It considers using (1) a forward hedge, (2) a money market hedge, or (3) no hedge. Chambers develops the following information: * S t = 1.10 USD/EUR * The 180-day forward rate of the euro, F t,180, is equal to USD/EUR * The interest rates, for a 180-day holding period, are as follows: deposit rate: 3% in Germany., and 2% in the U.S. borrowing rate: 4% in Germany, and 3% in the U.S. * Chambers Inc. forecasted the future spot rate in 180 days as follows: Possible Outcomes Probability 1.06 USD/EUR 20% 1.09 USD/ EUR 40% 1.11 USD/EUR 30% 1.17 USD/EUR 10% Carefully describe each strategy and cash flows (if possible, calculate sure amounts and expected values). Which hedging strategy would you recommend to Chambers Inc? Do preferences matter for your strategy recommendation? Justify your answer. 1) Forward hedge (sell EUR forward at F t,180 = USD/EUR). Firm will receive EUR 10 M x (1.095 USD/EUR) = USD M in 180 days. 2) Money market hedge (borrow GBP at 4%, convert to USD, deposit in U.S. at 2%) Firm will borrow EUR 10 M /(1+.04x180/360) = EUR 9,803,922 Firm will convert to USD EUR 9,803,922x 1.1 USD/EUR = USD 10,784,310 (amount to deposit) Firm will receive USD 10,784,310 *(1+.02*180/360) = USD 10,892,160 (dominated by FH) 3) No Hedge (do nothing; just wait) Possible Outcomes Probability Amount to receive 1.06 USD/EUR 20% EUR 10.6 M 1.09 USD/ EUR 40% EUR 10.9 M 1.11 USD/EUR 30% EUR 11.1 M 1.17 USD/EUR 10% EUR 11.7 M E[Amount to receive] = EUR M Recommendation: No Hedge; but preferences matter. A risk averse manager may not like the 60% chance of getting a lower outcome with the NH than with the FH.

2 2. Mr. Pendant is the owner of a liquor store chain in Texas. Mr. Pendant imports beer from England, payments are denominated in GBP. Mr. Pendant is worried about a potential appreciation of the GBP against the USD in June He wants to set up an option hedge. Mr. Pendant s June payables are GBP 300,000. The USD/GBP exchange rate is USD/GBP. A. Calculate Mr Pendant s TE in June. B. Suppose changes in the USD/GBP, e f, follow a Normal distribution with mean zero and standard deviation.15. Derive the VaR(97.5%) for Mr. Pendant s transaction exposure. C. Using the information given in the quote clip, construct: i) at the money (closest in-the-money) June hedge. ii) a collar, with out-of-the-money June options. (Specify strike prices, total premium costs and worst case scenario.) Briefly discuss the advantages and disadvantages of each strategy. (A) TE = GBP 300,000 * USD/GBP = USD 454,530 (B) e f,t [ *.15] = [ ; 0.294] => TE [USD 454,530 * ( ); USD 454,530 * ( )] = [USD 320,898.2; USD 588,161.8] => VaR(97.5%) = USD 588,161.8 (C) ATM (X c = 1.51 USD/GBP; p c = USD /GBP) Total premium paid = GBP 300,000 * USD /GBP = USD 4,920 Worst case scenario = Cap = GBP 300,000 * 1.51 USD/GBP = USD 453,000 Advantage: Low cap. Disadvantage: High cost. Collar: Long X c = 1.54 USD/GBP; p c = USD /GBP Short X p = 1.49 USD/GBP; p p = USD /GBP Net premium = USD /GBP Total premium paid = GBP 300,000 * USD /GBP = USD 960 Worst case scenario = Cap = GBP 300,000 * 1.54 USD/GBP = USD 462,000 Best case scenario = Floor = GBP 300,000 * 1.49 USD/GBP = USD 447,000 Advantage: Low cost. Disadvantage: Limited upside to USD 447,000.

3 3. Assume that the following regression model was applied to historical annual data: e f,t = α + ß INT t + τ INC t + δ TB t + ε t, where e f,t is the percentage change in the USD/MYR exchange rate in period t (MYR= Malaysian Ringgit), INT t is the interest rate differential between Malaysia and the U.S. in period t, INC t is the income growth rate differential between Malaysia and the U.S. in period t, TB t represents the change in the U.S. trade balance and ε t is an error term. Assume that the regression coefficients were estimated as α =.002 ß =.80 τ = -.75 δ =.40 This year the change in the U.S. trade balance, TB t, is forecasted to be 10% and the income growth rate differential, INC t, is forecasted to be 2%. This year INT t is forecasted as follows: INT Probability -2%.10-1%.30 0%.50 4%.10 Now, you have to answer the following questions: (i) Using the above information, what will be your forecast for e f,t? E[e f,t+1 ] = E[INT t+1 ] + (-.75) E[INC t+1 ] +.40 E[TB t+1 ] = *(-.001) -.75* *.10 = (ii) Assume St-1 is equal to 4.30 MYR/USD. Using the regression model, forecast St. E[S,t+1 ] = S t * (1+ E[e f,t+1 ]) = 1/(4.30 MYR/USD) * ( ) = USD/MYR (or MYR/USD) (iii) What is your Random Walk forecast for S t? E[S,t+1 ] = S t =1/(4.30 MYR/USD) = USD/MYR (iv) Suppose S t =.23 USD/MYR. Looking at (ii) and (iii), which forecast has the lowest squared error? (error_model) 2 = ( USD/MYR 0.23 USD/MYR) 2 = e-05 (error_rw) 2 = ( USD/MYR 0.23 USD/MYR) 2 = e-06 <= Lowest!

4 4. Kramerica Company does business in the U.S. and Canada. In attempting to assess its economic exposure, it compiled the following information: Its U.S. sales are somewhat affected by the Canadian dollar's value. It forecasts the U.S. sales based on the following exchange rate scenarios: S t (USD/CAD) Revenue from U.S. (in million) 0.80 USD USD 160 Its CAD revenues on sales to Canada invoiced in CAD are expected to be CAD 200 million. Its anticipated cost of goods sold is estimated at USD 100 million from the purchase of U.S. material and CAD 50 million from the purchase of Canadian materials. Fixed operating expenses are USD 10 million in the U.S. and CAD 20 million in Canada. Variable operating expenses (in USD and CAD) are estimated at 10 percent of total sales. Interest expense is estimated at CAD 10 million on existing CAD loans. It has no USD loans. U.S. income taxes are 30%, while Canadian taxes are 20%. Because of the U.S.-Canada Tax treaty, tax credits are not used. A. Create a forecasted income statement for Kramerica under each of the two exchange rate scenarios. B. Calculate the pseudo-elasticity. C. Interpret this pseudo-elasticity and state if Kramerica behaves like an importer or an exporter. D. Provide two specific measures to reduce the sensitivity of Kramerica s earnings to exchange rate movements, without reducing its volume of business in Canada. (A) Forecasted Income Statement for Kramerica (in millions) 0.80 USD/CAD 0.90 USD/CAD Sales (US + Canada) 370 (= ) 340 (= ) COGS (US + Canada) 140 (=100+40) 145 (=100+45) Gross Profit Op. Expenses Fixed (US + Canada) 26 (=10+16) 28 (=10+18) Variable Total EBIT Interest Expense 8 9 EBT Taxes U.S (=79*.30) 10.2 (=34*.30) Taxes Canada 16.0 (=80*.20) 18.0 (=90*.20) Total EAT (B) pseudo-cf elasticity = (95.8/ )/(.90/.80-1) = (C) A 1% depreciation of the USD against the CAD, Kramerica s CFs are reduced by 1.58%. Kramerica behaves like an importer. (D) - Move expenses to the U.S. - Borrow more in the U.S.

5 II. CASE (25 points) Questions are based on the posted article (January 26, 2017). Briefly answer the following questions: Note: No points will be given by simply writing lines from the article. 1) Drinks group Diageo seems to have economic exposure. Can you provide an estimate of its economic exposure? pseudo-cf elasticity = % change in EBT/e f,t =.16/.16 = 1 GBP, increases CFs by 1%). (=> a 1% depreciation of the 2) Assume Diageo is considering moving production abroad. What are the advantages and disadvantages of this move for Diageo? Advantage: Very efficient long-term hedge to reduce EE. Disadvantage: Very expensive to unwind. 3) FX analysts expect the GBP to continue to depreciate. Would you advise Whirlpool, the U.S. manufacturer of appliances, to hedge its GBP currency receivables? What advice would you give Diageo regarding its foreign currency receivables? Whirlpool: hedge GBP receivables Diageo: Do not hedge GBP receivables. 4) Unilever, like the majority of U.K. multinational companies, derives a majority of its revenue from outside the U.K. Based on the revenue and profits reported in the article, do you think Unilever faces economic exposure? The pre-tax profits went up 3.4% as the GBP depreciated by 16% (pseudo-cf elasticity= ). It seems to point out to a low EE. 5) The stock market did not show a big reaction in response to Unilever s end-of-year results. Given what you learned in class, how would you interpret this reaction? The stock market reaction points out that EE for Unilever is very close to zero.