当前位置:首页 >> 管理学 >>

国际财务管理习题解答


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.

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.

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.

9. Emphasizing the importance of voluntary compliance, as opposed to enforcement, in the aftermath of corporate scandals, e.g., Enron and WorldCom, U.S. President George W. Bush stated that while tougher laws might help, “ultimately, the ethics of American business depends on the conscience of America?s business leaders.” Describe your view on this statement.

Answer: There can be different answers to this question. If business leaders always behave with a high ethical standard, many of the corporate scandals we have seen lately might not have happened. Since we cannot fully depend on the ethical behavior on the part of business leaders, the society should protect itself by adopting the rules/regulations and governance structure that would induce business leaders to behave in the interest of the society at large.

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

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.

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.

INPUT/OUTPUT WITHOUT TRADE _______________________________________________________________________

Country X Y Total

________________________________________________________________________ I. Units of Input (000,000) _______________________ Food Textiles 70 40 ______________________________ 60 30

________________________________________________________________________ II. Output per Unit of Input (lbs or yards) ______________________ ______________________________ Food Textiles 17 5 5 2

________________________________________________________________________ III. Total Output (lbs or yards) (000,000) ______________________ ______________________________ Food Textiles 200 1,190 60 300 260 1,490

________________________________________________________________________ IV. Consumption (lbs or yards) (000,000) _____________________ ______________________________ Food 1,190 300 1,490

Textiles

200

60

260

________________________________________________________________________

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.

INPUT/OUTPUT WITH FREE TRADE __________________________________________________________________________

Country X Y Total

__________________________________________________________________________ I. Units of Input (000,000) _______________________ Food Textiles 90 20 ________________________________ 0 90

__________________________________________________________________________ II. Output per Unit of Input (lbs or yards) ______________________ ________________________________ Food Textiles 17 5 5 2

__________________________________________________________________________ III. Total Output (lbs or yards) (000,000) _____________________ ________________________________ Food Textiles 100 1,530 180 0 280 1,530

__________________________________________________________________________ IV. Consumption (lbs or yards) (000,000) _____________________ ________________________________ Food 1,200 330 1,530

Textiles

210

70

280

__________________________________________________________________________

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 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.

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.

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.

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.

CHAPTER 3 BALANCE OF PAYMENTS SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

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, B OP 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 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.

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 do wn 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.

Answer: _________________________________________________________________ Transactions Debit _________________________________________________________________ Credit

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.

Answer: A summary of the Japanese Balance of Payments for 1998 (in $ billion) Credits Current Account (1) Exports (1.1) Merchandise (1.2) Services (1.3) Factor income 646.03 374.04 62.41 209.58 Debits

(2) Imports (2.1) Merchandise (2.2) Services (3.3) Factor income

-516.50 -251.66 -111.83 -153.01

(3) Unilateral transfer

5.53

-14.37

Balance on current account [(1) + (2) + (3)]

120.69

Capital Account (4) Direct investment (5) Portfolio investment (5.1) Equity securities (5.2) Debt securities (6) Other investment 3.27 73.70 16.11 57.59 39.51 -24.62 -113.73 -14.00 -99.73 -109.35

Balance on financial account [(4) + (5) + (6)] (7) Statistical discrepancies 4.36

-131.22

Overall balance Official Reserve Account 6.17

-6.17

Source: IMF, International Financial Statistics Yearbook, 1999. Note: Capital account in the above table corresponds with the ?Financial account? in IMF?s balance of payment statistics. IMF?s Capital account? is included in ?Other investment? in the above table.

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.

CHAPTER 4

THE MARKET FOR FOREIGN EXCHANGE

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

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 costeffective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs. 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.

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.

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.

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. 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.

PROBLEMS 3. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in forward points. Spot One-Month Three-Month Six-Month Solution: One-Month Three-Month Six-Month 01-06 17-27 57-72 1.3431-1.3436 1.3432-1.3442 1.3448-1.3463 1.3488-1.3508

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

Solution: Spot One-Month Three-Month Six-Month 20 5 10 15

7. Given the following information, what are the DM/S$ currency against currency bid-ask quotations? Bank Quotations Bid Deutsche Marks Singapore Dollar .6784 .6999 American Terms European Terms Ask .6789 .7002 Bid 1.4730 1.4282 Ask 1.4741 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. problem). (Ignore bid-ask spreads for this What

Assume you have $5,000,000 with which to conduct the arbitrage.

happens if you initially sell dollars for Swiss francs? triangular arbitrage?

What DM/SF price will eliminate

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. determine this for himself.) (The student can

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 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.

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 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.

CHAPTER 5

THE MARKET FOR FOREIGN EXCHANGE

SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

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 14 percent of FX trades. The other 86 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 100 to 200

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, mutual funds, pension funds, and hedge funds, 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. 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.

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 euro 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 clients? needs to buy or sell FX 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 appreciate against the U.S. dollar and therefore he is trying to increase his inventory of Canadian dollars by discouraging purchases of U.S. dollars 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? arbitrage opportunity?

What is a condition that will give rise to a triangular

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. 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.

PROBLEMS

1. Using Exhibit 5.4, calculate a cross-rate matrix for the euro, Swiss franc, Japanese yen, and the British pound. Use the most current American term quotes to calculate the

cross-rates so that the triangular matrix resulting is similar to the portion above the diagonal in Exhibit 5.6.

Solution: The cross-rate formula we want to use is: S(j/k) = S($/k)/S($/j). The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.

? Euro Japan (100) Switzerland U.K 138.05

SF 1.5481 1.1214

? .6873 .4979 .4440

$ 1.3112 .9498 .8470 1.9077

2. Using Exhibit 5.4, calculate the one-, three-, and six-month forward cross-exchange rates between the Canadian dollar and the Swiss franc using the most current quotations. State the forward cross-rates in “Canadian” terms.

Solution: The formulas we want to use are: FN(CD/SF) = FN($/SF)/FN($/CD) or FN(CD/SF) = FN(CD/$)/FN(SF/$). We will use the top formula that uses American term forward exchange rates. F1(CD/SF) F3(CD/SF) = .8485/.8037 = 1.0557 = .8517/.8043 = 1.0589

F6(CD/SF) = .8573/.8057 = 1.0640

3. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in forward points. Spot One-Month Three-Month Six-Month Solution: One-Month Three-Month Six-Month 01-06 17-27 57-72 1.3431-1.3436 1.3432-1.3442 1.3448-1.3463 1.3488-1.3508

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

Solution: Spot One-Month Three-Month Six-Month 20 5 10 15

5. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the Canadian dollar versus the U.S. dollar using American term quotations. simplicity, assume each month has 30 days. What is the interpretation of your results? For

Solution: The formula we want to use is: fN,CD f1,CD f3,CD f6,CD = [(FN($/CD) - S($/CD/$)/S($/CD)] x 360/N = [(.8037 - .8037)/.8037] x 360/30 = [(.8043 - .8037)/.8037] x 360/90 = .0000 = .0030

= [(.8057 - .8037)/.8037] x 360/180 = .0050

The pattern of forward premiums indicates that the Canadian dollar is trading at an increasing premium versus the U.S. dollar. That is, it becomes more expensive (in both absolute and percentage terms) to buy a Canadian dollar forward for U.S. dollars the further into the future one contracts.

6. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the U.S. dollar versus the British pound using European term quotations. assume each month has 30 days. What is the interpretation of your results? For simplicity,

Solution: The formula we want to use is: fN,$ f1,$ f3,$ f6,$ = [(FN (? /$) - S(? /$))/S(? /$)] x 360/N = [(.5251 - .5242)/.5242] x 360/30 = [(.5268 - .5242)/.5242] x 360/90 = -.0023 = -.0198

= [(.5290 - .5242)/.5242] x 360/180 = -.0183

The pattern of forward premiums indicates that the British pound is trading at a discount versus the U.S. dollar. That is, it becomes more expensive to buy a U.S. dollar forward for British pounds (in absolute but not percentage terms) the further into the future one contracts.

7. Given the following information, what are the NZD/SGD currency against currency bid-ask quotations? American Terms European Terms Bank Quotations New Zealand dollar Singapore dollar Bid Ask .7265 .6135 Bid Ask .7272 .6140 1.3751 1.6287 1.3765 1.6300

Solution:

Equation 5.12 from the text implies Sb(NZD/SGD) = Sb($/SGD) x Sb(NZD/$) The reciprocal, 1/Sb(NZD/SGD) = Sa(SGD/NZD) = 1.1841.

= .6135 x 1.3765 = .8445.

Analogously, it is implied that Sa(NZD/SGD) = Sa($/SGD) x Sa(NZD/$) = .6140 x 1.3765 = .8452. The reciprocal, 1/Sa(NZD/SGD) = Sb(SGD/NZD) = 1.1832. Thus, the NZD/SGD bid-ask spread is NZD0.8445-NZD0.8452 and the SGD/NZD spread is

SGD1.1832-SGD1.1841.

8.

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

terminal, you notice that Dresdner Bank is quoting 0.7627/$1.00 and Credit Suisse is

offering SF1.1806/$1.00. You learn that UBS is making a direct market between the Swiss franc and the euro, with a current /SF quote of .6395. 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 /SF price will eliminate triangular arbitrage?

Solution:

To make a triangular arbitrage profit the Deutsche Bank trader would sell This trade would yield 3,813,500=

$5,000,000 to Dresdner Bank at 0.7627/$1.00.

$5,000,000 x .7627. The Deutsche Bank trader would then sell the euros for Swiss francs to Union Bank of Switzerland at a price of 0.6395/SF1.00, yielding SF5,963,253 = 3,813,500/.6395. The Deutsche Bank trader will resell the Swiss francs to Credit Suisse for $5,051,036 = SF5,963,253/1.1806, yielding a triangular arbitrage profit of $51,036. If the Deutsche Bank trader initially sold $5,000,000 for Swiss francs, instead of euros, the trade would yield SF5,903,000 = $5,000,000 x 1.1806. The Swiss francs would in turn be traded for euros to UBS for 3,774,969= SF5,903,000 x .6395. The euros would be resold to Dresdner Bank for $4,949,481 = 3,774,969/.7627, or a loss of $50,519. Thus, it is necessary to conduct the triangular arbitrage in the correct order. The S(/SF) cross exchange rate should be .7627/1.1806 = .6460. equilibrium rate at which a triangular arbitrage profit will not exist. determine this for himself.) This is an

(The student can

A profit results from the triangular arbitrage when dollars are

first sold for euros because Swiss francs are purchased for euros at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss francs are purchased for only 0.6395/SF1.00 instead of the no-arbitrage rate of 0.6460/SF1.00. Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs are sold for euros at too low a rate, resulting in too few euros. That is, each Swiss franc is sold for

0.6395/SF1.00 instead of the higher no-arbitrage rate of 0.6460/SF1.00.

9.

The current spot exchange rate is $1.95/? and the three-month forward rate is $1.90/? .

Based on your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/?in three months. Assume that you would like to buy or sell ? 1,000,000.

a.

What actions do you need to take to speculate in the forward market? What is the

expected dollar profit from speculation?

b.

What would be your speculative profit in dollar terms if the spot exchange rate actually

turns out to be $1.86/? .

Solution: a. If you believe the spot exchange rate will be $1.92/? in three months, you should buy

? 1,000,000 forward for $1.90/? . Your expected profit will be: $20,000 = ? 1,000,000 x ($1.92 -$1.90). b. If the spot exchange rate actually turns out to be $1.86/?in three months, your loss from

the long position will be: -$40,000 = ? 1,000,000 x ($1.86 -$1.90).

10. Omni Advisors, an international pension fund manager, plans to sell equities denominated in Swiss Francs (CHF) and purchase an equivalent amount of equities denominated in South African Rands (ZAR). Omni will realize net proceeds of 3 million CHF at the end of 30 days and wants to eliminate the risk that the ZAR will appreciate relative to the CHF during this 30-day period. The following exhibit shows current exchange rates between the ZAR, CHF, and the U.S. dollar (USD).

Currency Exchange Rates ZAR/USD ZAR/USD CHF/USD CHF/USD Maturity Bid Spot 6.2681 Ask 6.2789 Bid 1.5282 Ask 1.5343

30-day 90-day

6.2538 6.2104

6.2641 6.2200

1.5226 1.5058

1.5285 1.5115

a.

Describe the currency transaction that Omni should undertake to eliminate currency risk over the 30-day period.

b.

Calculate the following: ? The CHF/ZAR cross-currency rate Omni would use in valuing the Swiss equity portfolio. ? The current value of Omni?s Swiss equity portfolio in ZAR. ? The annualized forward premium or discount at which the ZAR is trading versus the CHF.

CFA Guideline Answer:

a.

To eliminate the currency risk arising from the possibility that ZAR will appreciate against the CHF over the next 30-day period, Omni should sell 30-day forward CHF against 30-day forward ZAR delivery (sell 30-day forward CHF against USD and buy 30-day forward ZAR against USD).

b.

The calculations are as follows:

? currencies

Using the currency cross rates of two forward foreign currencies and three (CHF, ZAR, USD), the exchange would be as follows: --30 day forward CHF are sold for USD. Dollars are bought at the

forward selling because going from currency into

price of CHF1.5285 = $1 (done at ask side dollars) Dollars are

--30 day forward ZAR are purchased for USD. simultaneously sold to

purchase ZAR at the rate of 6.2538 = $1 (done

at the bid side because going from

dollars into currency)

--For every 1.5285 CHF held, 6.2538 ZAR are received; thus the cross currency rate is 1.5285 CHF/6.2538 ZAR = 0.244411398.

? million CHF 12,274,386.65 ZAR. ? CHF requires

At the time of execution of the forward contracts, the value of the 3 equity portfolio would be 3,000,000 CHF/0.244411398 =

To calculate the annualized premium or discount of the ZAR against the comparison of the spot selling exchange rate to the ZAR.

forward selling price of CHF for

Spot rate = 1.5343 CHF/6.2681 ZAR = 0.244779120 30 day forward ask rate 1.5285 CHF/6.2538 ZAR = 0.244411398 The premium/discount formula is: [(forward rate – spot rate) / spot rate] x (360 / # day contract) = [(0.244411398 – 0.24477912) / 0.24477912] x (360 / 30) = -1.8027126 % = -1.80% discount ZAR to CHF

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. Its 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 euros. Shrewsbury?s controller, Elton Peters, is concerned with whether the pound will appreciate versus the euro over the next three months, thus eliminating all or most of the profit when the euro 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 /? is 1.4537, thus the invoice amount should be 465,184. Mr. Peters also learns that the three -month forward rates for the pound and the euro versus the U.S. dollar are $1.8990/? 1.00 and $1.3154/1.00, respectively. The banker offers to set up a forward hedge for selling the euro receivable for pound sterling based on the /? forward cross-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 8. The case is consistent with the discussion that accompanies Exhibit 5.9 of the text. Professor of Finance, Banikanta Mishra, of Xavier Institute of Management – Bhubaneswar, India contributed to this solution.

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 465,184/?256,000 = 1.8171/1.00 before all profit was eliminated. This seems rather unlikely. Nevertheless, a ten percent appreciation of the pound (1.4537 x 1.10) to 1.5991/?1.00 would only yield a profit of ?34,904 (= 465,184/1.5991 - ? 256,000). Shrewsbury can hedge the exposure by selling the euros forward for British pounds at F3(/?) = 1.3154 = 1.4437. F3($/?) ? F3($/) = 1.8990 ÷

At this forward exchange rate, Shrewsbury can “lock-in” a price of

?322,217 (= 465,184/1.4437) for the sale. The forward exchange rate indicates that the euro is trading at a premium to the British pound in the forward market. Thus, the forward hedge allows Shrewsbury to lock-in a greater amount (? 2,217) than if the euro receivable was converted into pounds at the current spot

If the euro was trading at a forward discount, Shrewsbury would end up locking-in an amount less than ? 320,000. Whether that would lead to a loss for the company would depend upon the extent of the discount and the amount of profit built into the price of ? 320,000. Only if the forward exchange rate is even with the spot rate will Shrewsbury receive exactly ? 320,000.

Obviously, Shrewsbury could ensure that it receives exactly ? 320,000 at the end of three-month accounts receivable period if it could invoice in ? . That, however, is not acceptable to the French wholesaler. When invoicing in euros, Shrewsbury could establish the euro invoice amount by use of the forward exchange rate instead of the current spot rate.

The invoice amount in that case would be 461,984 = ?320,000 x 1.4437. Shrewsbury can now lock-in a receipt of ? 320,000 if it simultaneously hedges its euro exposure by selling 461,984 at the forward rate of 1.4437. That is, ?320,000 = 461,984/1.4437.

CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

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+1?It]. 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.

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.

*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.

10. CFA question: 1997, Level 3. A. Explain the following three concepts of purchasing power parity (PPP): a. The law of one price. b. Absolute PPP. c. Relative PPP.

B. Evaluate the usefulness of relative PPP in predicting movements in foreign exchange rates on: a. Short-term basis (for example, three months)

b. Long-term basis (for example, six years)

Answer: A. a. The law of one price (LOP) refers to the international arbitrage condition for the standard consumption basket. LOP requires that the consumption basket should be selling for the same price in a given currency across countries. A. b. Absolute PPP holds that the price level in a country is equal to the price level in another country times the exchange rate between the two countries. A. c. Relative PPP holds that the rate of exchange rate change between a pair of countries

is about equal to the difference in inflation rates of the two countries. B. a. PPP is not useful for predicting exchange rates on the short-term basis mainly

because international commodity arbitrage is a time-consuming process. B. b. PPP is useful for predicting exchange rates on the long-term basis.

PROBLEMS

1. Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months. The six-month interest rate is 8 percent per annum in the United States and 6 percent per annum in Germany. Currently, the spot exchange rate is 1.01 per dollar and the six-month forward exchange rate is 0.99 per dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return?

The market conditions are summarized as follows: I$ = 4%; i = 3.5%; S = 1.01/$; F = 0.99/$. If $100,000,000 is invested in the U.S., the maturity value in six months will be $104,000,000 = $100,000,000 (1 + .04). Alternatively, $100,000,000 can be converted into euros and invested at the German interest rate, with the euro maturity value sold forward. In this case the dollar maturity value will be $105,590,909 = ($100,000,000 x 1.01)(1 + .035)(1/0.99) Clearly, it is better to invest $100,000,000 in Germany with exchange risk hedging.

2. While you were visiting London, you purchased a Jaguar for ? 35,000, payable in three months. You have enough cash at your bank in New York City, which pays 0.35% interest per month, compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/?and the three-month forward exchange rate is $1.40/? . In London, the money market interest rate is 2.0% for a three-month investment. There are two alternative ways of paying for your Jaguar. (a) Keep the funds at your bank in the U.S. and buy ? 35,000 forward. (b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity value becomes equal to ? 35,000. Evaluate each payment method. Which method would you prefer? Why?

Solution: The problem situation is summarized as follows: A/P = ? 35,000 payable in three 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. 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: I? = 1.45%

S = $1.5/? ; F = $1.52/? ; I$ = 2.0%; 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 0.80/$ and the three-month forward exchange rate is 0.7813/$. The three-month interest rate is 5.6 percent per annum in the United States and 5.40 percent per annum in France. Assume that you can borrow up to $1,000,000 or 800,000. a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize profit in terms of U.S. dollars. Also determine the size of your arbitrage profit. b. Assume that you want to realize profit in terms of euros. Show the covered arbitrage process and determine the arbitrage profit in euros.

Solution: a. (1+ i $) = 1.014 < (F/S) (1+ i ) = 1.053. Thus, one has to borrow dollars and invest in euros to make arbitrage profit. 1. Borrow $1,000,000 and repay $1,014,000 in three months. 2. Sell $1,000,000 spot for 1,060,000. 3. Invest 1,060,000 at the euro interest rate of 1.35 % for three months and receive 1,074,310 at maturity. 4. Sell 1,074,310 forward for $1,053,245. Arbitrage profit = $1,053,245 - $1,014,000 = $39,245. b. Follow the first three steps above. But the last step, involving exchange risk hedging, will be different. 5. Buy $1,014,000 forward for 1,034,280. Arbitrage profit = 1,074,310 - 1,034,280 = 40,030

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%.

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$2.29/$

CHAPTER 7 FUTURES AND OPTIONS ON FOREIGN EXCHANGE SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

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 most efficiently, two types of economic agents are needed: hedgers and speculators. Explain.

Answer: Two types of market participants are necessary for the efficient 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, 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. St ? E the option is trading at-the-money. out-of-the-money.

If

If St < E (E < St) the call (put) option is trading

7. List the arguments (variables) of which an 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, r$, T and ?.

When all 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 r$, 5. the larger (smaller) r$ is relative to ri, and 6. the greater is ?.

When r$ 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 r$ 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 r$. 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.

PROBLEMS

1. Assume today?s settlement price on a CME EUR futures contract is $1.3140/EUR. You have a short position in one contract. Your performance bond account currently has a balance of $1,700. The next three days? settlement prices are $1.3126, $1.3133, and $1.3049. Calculate the changes in the performance bond account from daily marking-to-market and the balance of the performance bond account after the third day.

Solution:

$1,700 + [($1.3140 - $1.3126) + ($1.3126 - $1.3133)

+ ($1.3133 - $1.3049)] x EUR125,000 = $2,837.50, where EUR125,000 is the contractual size of one EUR contract.

2. Do problem 1 again assuming you have a long position in the futures contract.

Solution:

$1,700 + [($1.3126 - $1.3140) + ($1.3133 - $1.3126) + ($1.3049 - $1.3133)] x

EUR125,000 = $562.50, where EUR125,000 is the contractual size of one EUR contract. With only $562.50 in your performance bond account, you would experience a margin call requesting that additional funds be added to your performance bond account to bring the balance back up to the initial performance bond level.

3. Using the quotations in Exhibit 7.3, calculate the face value of the open interest in the June 2005 Swiss franc futures contract.

Solution:

2,101 contracts x SF125,000 = SF262,625,000.

where SF125,000 is the contractual size of one SF contract.

4.

Using the quotations in Exhibit 7.3, note that the June 2005 Mexican peso futures

contract has a price of $0.08845. You believe the spot price in June will be $0.09500. 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. the size of your profit (loss) if the futures price is indeed an unbiased spot price and this price materializes?

What is

predictor of the future

Solution:

If you expect the Mexican peso to rise from $0.08845 to $0.09500, you would

take a long position in futures since the futures price of $0.08845 is less than your expected spot price. Your anticipated profit from a long position in three contracts is: 3 x ($0.09500 -

$0.08845) x MP500,000 = $9,825.00, 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 the futures price of $0.08845/MP. If this spot price materializes, you will not have any profits or losses from your short position in three futures contracts: 3 x ($0.08845 $0.08845) x MP500,000 = 0.

5. Do problem 4 again assuming you believe the June 2005 spot price will be $0.08500.

Solution:

If you expect the Mexican peso to depreciate from $0.08845 to $0.07500, you

would take a short position in futures since the futures price of $0.08845 is greater than your expected spot price. Your anticipated profit from a short position in three contracts is: 3 x ($0.08845 $0.07500) x MP500,000 = $20,175.00. 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.

George Johnson is considering a possible six-month $100 million LIBOR-based,

floating-rate bank loan to fund a project at terms shown in the table below. Johnson fears a possible rise in the LIBOR rate by December and wants to use the December Eurodollar futures contract to hedge this risk. The contract expires December 20, 1999, has a US$ 1

million contract size, and a discount yield of 7.3 percent.

Johnson will ignore the cash flow implications of marking to market, initial margin requirements, and any timing mismatch between exchange-traded futures contract cash flows and the interest payments due in March.

Loan Terms September 20, 1999 20, 2000 ? Borrow $100 million at back principal September 20 LIBOR + 200 interest basis points (bps) ? September 20 LIBOR = 7% ? Pay interest for first three months ? Roll loan over at December 20 LIBOR + 200 bps ? plus Pay December 20, 1999 March

Loan initiated ? ? 9/20/99

First loan payment (9%) and futures contract expires ? ? 12/20/99

Second payment and principal ? ? 3/20/00

a. Formulate Johnson?s September 20 floating-to-fixed-rate strategy using the Eurodollar future contracts discussed in the text above. Show that this strategy would result in a

fixed-rate loan, assuming an increase in the LIBOR rate to 7.8 percent by December 20, which remains at 7.8 percent through March 20. Show all calculations.

Johnson is considering a 12-month loan as an alternative. This approach will result in two additional uncertain cash flows, as follows:

Loan Fourth payment initiated and principal ? ? 9/20/99

First payment (9%)

Second payment

Third payment

? ? 12/20/99

? ? 3/20/00

? ? 6/20/00

? ? 9/20/00

b. Describe the strip hedge that Johnson could use and explain how it hedges the 12-month loan (specify number of contracts). No calculations are needed.

CFA Guideline Answer a. The basis point value (BPV) of a Eurodollar futures contract can be found by substituting the contract specifications into the following money market relationship: BPV yield) = ($1 million) x (90 / 360) x (.0001) = $25 The number of contract, N, can be found by: N = (BPV spot) / (BPV futures) = ($2,500) / ($25) = 100 OR N = (value of spot position) / (face value of each futures contract) = ($100 million) / ($1 million) = 100 OR N = (value of spot position) / (value of futures position) = ($100,000,000) / ($981,750) where value of futures position = $1,000,000 x [1 – (0.073 / 4)]
FUT

= Change in Value = (face value) x (days to maturity / 360) x (change in

? 102 contracts

Therefore on September 20, Johnson would sell 100 (or 102) December Eurodollar futures contracts at the 7.3 percent yield. The implied LIBOR rate in December is 7.3 percent as indicated by the December Eurofutures discount yield of 7.3 percent. Thus a borrowing rate of 9.3 percent (7.3 percent + 200 basis points) can be locked in if the hedge is correctly implemented.

A rise in the rate to 7.8 percent represents a 50 basis point (bp) increase over the implied LIBOR rate. position is: = ($25 per basis point per contract) x 50 bp x 100 contracts = $125,000. However, the cash flow on the floating rate liability is: = -0.098 x ($100,000,000 / 4) = - $2,450,000. Combining the cash flow from the hedge with the cash flow from the loan results in a net outflow of $2,325,000, which translates into an annual rate of 9.3 percent: = ($2,325,000 x 4) / $100,000,000 = 0.093 This is precisely the implied borrowing rate that Johnson locked in on September 20. Regardless of the LIBOR rate on December 20, the net cash outflow will be $2,325,000, which translates into an annualized rate of 9.3 percent. Consequently, the floating rate liability has been converted to a fixed rate liability in the sense that the interest rate uncertainty associated with the March 20 payment (using the December 20 contract) has been removed as of September 20. For a 50 basis point increase in LIBOR, the cash flow on the short futures

b. In a strip hedge, Johnson would sell 100 December futures (for the March payment), 100 March futures (for the June payment), and 100 June futures (for the September payment). The objective is to hedge each interest rate payment separately using the appropriate number of contracts. The problem is the same as in Part A except here three cash flows are subject

to rising rates and a strip of futures is used to hedge this interest rate risk. This problem is simplified somewhat because the cash flow mismatch between the futures and the loan payment is ignored. Therefore, in order to hedge each cash flow, Johnson simply sells 100 contracts for each payment. The strip hedge transforms the floating rate loan into a strip of fixed rate payments. As was done in Part A, the fixed rates are found by adding 200 basis

points to the implied forward LIBOR rate indicated by the discount yield of the three different Eurodollar futures contracts. The fixed payments will be equal when the LIBOR term structure is flat for the first year.

7. Jacob Bower has a liability that: ? has a principal balance of $100 million on June 30, 1998, ? accrues interest quarterly starting on June 30, 1998, ? pays interest quarterly, ? has a one-year term to maturity, and ? calculates interest due based on 90-day LIBOR (the London Interbank Offered Rate). Bower wishes to hedge his remaining interest payments against changes in interest rates. Bower has correctly calculated that he needs to sell (short) 300 Eurodollar futures contracts to accomplish the hedge. following table. He is considering the alternative hedging strategies outlined in the

Initial Position (6/30/98) in 90-Day LIBOR Eurodollar Contracts Strategy A (contracts) Strategy B (contracts) 300 0 0 100 100 100

Contract Month September 1998 December 1998 March 1999

a.

Explain why strategy B is a more effective hedge than strategy A when the yield curve

undergoes an instantaneous nonparallel shift.

b. Discuss an interest rate scenario in which strategy A would be superior to strategy B.

CFA Guideline Answer

a. Strategy B?s Superiority Strategy B is a strip hedge that is constructed by selling (shorting) 100 futures contracts maturing in each of the next three quarters. With the strip hedge in place, each quarter of the coming year is hedged against shifts in interest rates for that quarter. The reason Strategy B will be a more effective hedge than Strategy A for Jacob Bower is that Strategy B is likely to work well whether a parallel shift or a nonparallel shift occurs over the one-year term of Bower?s liability. That is, regardless of what happens to the term structure, Strategy B structures the futures hedge so that the rates reflected by the Eurodollar futures cash price match the applicable rates for the underlying liability-the 90day LIBOR-based rate on Bower?s liability. The same is not true for Strategy A. Because Jacob Bower?s liability carries a floating interest rate that resets quarterly, he needs a strategy that provides a series of three-month hedges. Strategy A will need to be restructured when the three-month

September contract expires. In particular, if the yield curve twists upward (futures yields rise more for distant expirations than for near expirations), Strategy A will produce inferior hedge results.

b. Scenario in Which Strategy A is Superior Strategy A is a stack hedge strategy that initially involves selling (shorting) 300 September contracts. Strategy A is rarely better than Strategy B as a hedging or risk-reduction strategy. Only from the perspective of favorable cash flows is Strategy A better than Strategy B. Such cash flows occur only in certain interest rate scenarios. For example Strategy A will work as well as Strategy B for Bower?s liability if interest rates (instantaneously) change in parallel fashion. Another interest rate scenario where Strategy A outperforms Strategy B is one in which the yield curve rises but with a twist so that futures yields rise more for near

expirations than for distant expirations. Upon expiration of the September contract, Bower will have to roll out his hedge by selling 200 December contracts to hedge the remaining interest payments. This action will have the effect that the cash flow from Strategy A will be larger than the cash flow from Strategy B because the appreciation on the 300 short September futures contracts will be larger than the cumulative appreciation in the 300 contracts shorted in Strategy B (i.e., 100 September, 100 December, and 100 March). Consequently, the cash flow from Strategy A will more than offset the increase in the interest payment on the liability, whereas the cash flow from Strategy B will exactly offset the increase in the interest payment on the liability.

8. Use the quotations in Exhibit 7.7 to calculate the intrinsic value and the time value of the 97 September Japanese yen American call and put options.

Solution:

Premium - Intrinsic Value = Time Value

97 Sep Call 2.08 - Max[95.80 – 97.00 = - 1.20, 0] = 2.08 cents per 100 yen 97 Sep Put 2.47 - Max[97.00 – 95.80 = 1.20, 0] = 1.27 cents per 100 yen

9. 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 ? percent.

Solution: Note to Instructor: A complete solution to this problem relies on the boundary expressions presented in footnote 3 of the text of Chapter 7.

Ca ? Max[(70 - 68), (69.50 - 68)/(1.0175), 0] ? Max[ 2, 1.47, 0] = 2 cents

10. Do problem 9 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

11. Use the European option-pricing models developed in the chapter to value the call of problem 9 and the put of problem 10. 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

12. Use the binomial option-pricing model developed in the chapter to value the call of problem 9. 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?- 68. If the Swiss franc depreciates it would not be

rational to exercise the option; its value would be CdT = 0.

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.

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. Graph the call option cash flow schedule. 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 break even.

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 He will only lose the option premium.

worthless.

4. ST = E + C = 96 + 1.35 = 97.35 cents per 100 yen.

CHAPTER 8 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 company can be said to have an ?insurance? policy on its receivable. Explain in what sense this is so.

Answer:

Your company in this case knows in advance that it will receive a certain

minimum dollar amount no matter what might happen to the $/ exchange rate. Furthermore, if the German mark appreciates, your company will benefit from the rising euro.

6. Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. How would you explain this 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.

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.

PROBLEMS

1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced 10 million payable in six months. Currently, the six-month forward exchange rate is $1.10/ and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/ in six months. (a) What is the expected gain/loss from the forward hedging? (b) If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? Why or why not? (c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case? or why not? Why

Solution: (a) Expected gain($)

= 10,000,000(1.10 – 1.05) = 10,000,000(.05) = $500,000.

(b) I would recommend hedging because Cray Research can increase the expected dollar receipt by $500,000 and also eliminate the exchange risk. (c) Since I eliminate risk without sacrificing dollar receipt, I still would recommend hedging.

2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ? 250 million payable in three months. Currently, the spot exchange rate is ? 105/$ and the three-month forward rate is ? 100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen account payable. (a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation. (b) Conduct the cash flow analysis of the money market hedge.

Solution: (a). Let?s first compute the PV of ?250 million, 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. (b) ___________________________________________________________________ Transaction CF0 CF1

____________________________________________________________________ 1. Buy yens spot with dollars 2. Invest in Japan 3. Pay yens Net cash flow - $2,340,002.34 -$2,340,002.34 ? 245,700,245.70 -? 245,700,245.70 ? 250,000,000 -? 250,000,000

____________________________________________________________________

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 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.

$ Cost

$3,453.75 $3,150

Options hedge Forward hedge

$253.75 0 0.579 0.64 (strike price)

$/SF

4. Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. Air France will be billed 20 million which is payable in one year. The current spot exchange rate is $1.05/ and the one-year forward rate is $1.10/. The annual interest rate is 6.0% in the U.S. and 5.0% in France. Boeing is concerned with the volatile exchange rate between the dollar and the euro and would like to hedge exchange exposure. (a) It is considering two hedging alternatives: sell the euro proceeds from the sale forward or borrow euros from the Credit Lyonnaise against the euro receivable. Which alternative would you recommend? Why? (b) Other things being equal, at what forward exchange rate would Boeing be indifferent between the two hedging methods?

Solution: (a) In the case of forward hedge, the future dollar proceeds will be (20,000,000)(1.10) = $22,000,000. In the case of money market hedge (MMH), the firm has to first borrow the PV of its euro receivable, i.e., 20,000,000/1.05 =19,047,619. Then the

firm should exchange this euro amount into dollars at the current spot rate to receive:

(19,047,619)($1.05/) = $20,000,000, which can be invested at the dollar interest rate for one year to yield: $20,000,000(1.06) = $21,200,000. Clearly, the firm can receive $800,000 more by using forward hedging. (b) According to IRP, F = S(1+i$)/(1+iF). Thus the “indifferent” forward rate will be: F = 1.05(1.06)/1.05 = $1.06/.

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. (c) When the option hedge is used, PCC will spend “at most” $4,125,000. On the other hand, when the forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This means that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent between forward and options hedges.

7. Airbus sold an aircraft, A400, to Delta Airlines, a U.S. company, and billed $30 million payable in six months. Airbus is concerned with the euro proceeds from international sales and would like to control exchange risk. The current spot exchange rate is $1.05/ and six-month forward exchange rate is $1.10/ at the moment. Airbus can buy a six -month put option on U.S. dollars with a strike price of 0.95/$ for a premium of 0.02 per U.S. dollar. Currently, six-month interest rate is 2.5% in the euro zone and 3.0% in the U.S. a. Compute the guaranteed euro proceeds from the American sale if Airbus decides to hedge using a forward contract.

b. If Airbus decides to hedge using money market instruments, what action does Airbus need to take? What would be the guaranteed euro proceeds from the American sale in this case? c. If Airbus decides to hedge using put options on U.S. dollars, what would be the ?expected? euro proceeds from the American sale? Assume that Airbus regards the current forward exchange rate as an unbiased predictor of the future spot exchange rate. d. At what future spot exchange rate do you think Airbus will be indifferent between the option and money market hedge?

Solution: a. Airbus will sell $30 million forward for 27,272,727 = ($30,000,000) / ($1.10/). b. Airbus will borrow the present value of the dollar receivable, i.e., $29,126,214 = $30,000,000/1.03, and then sell the dollar proceeds spot for euros: 27,739,251. This is the euro amount that Airbus is going to keep. c. Since the expected future spot rate is less than the strike price of the put option, i.e., 0.9091< 0.95, Airbus expects to exercise the option and receive 28,500,000 = ($30,000,000)(0.95/$). This is gross proceeds. Airbus spent 600,000 (=0.02x30,000,000) upfront for the option and its future cost is equal to 615,000 = 600,000 x 1.025. Thus the net euro proceeds from the American sale is 27,885,000, which is the difference between the gross proceeds and the option costs. d. At the indifferent future spot rate, the following will hold: 28,432,732 = ST (30,000,000) - 615,000. Solving for ST , we obtain the “indifference” future spot exchange rate, i.e., 0.9683/$, or $1.0327/. Note that 28,432,732 is the future value of the proceeds under money market hedging: 28,432,732 = (27,739,251) (1.025).

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.

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.

Buy/Sell Options DM/$ Spot Put Payoff “Put” Profits Call Payoff “Call” Profits Net Profit

1.60 1.61 1.62 1.63 1.64 1.65 1.66 1.67 1.68 1.69 1.70 1.71 1.72 1.73 1.74 1.75

(1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846)

0 0 0 0 0 60,606,061 60,240,964 59,880,240 59,523,810 59,171,598 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529

1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846

60,716,454 60,716,454 60,716,454 60,716,454 60,716,454 0 0 0 0 0 0 0 0 0 0 0

60,716,454 60,716,454 60,716,454 60,716,454 60,716,454 60,606,061 60,240,964 59,880,240 59,523,810 59,171,598 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529

1.76 1.77 1.78 1.79 1.80 1.81 1.82 1.83 1.84 1.85

(1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846) (1,742,846)

58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529

1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846 1,742,846

0 0 0 0 0 0 0 0 0 0

58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529 58,823,529

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

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 0.60 0.61 0.62 0.63 0.64 0.65 0.66 0.67 0.68 0.69 0.70 0.71 0.72 0.73 0.74 0.75 0.76 0.77 0.78 0.79 0.80 0.81 0.82 0.83 0.84 0.85 Put Payoff (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) (75,332) “Put” Principal 72,000,000 72,000,000 72,000,000 72,000,000 72,000,000 72,000,000 72,000,000 72,000,000 72,000,000 72,000,000 72,000,000 72,000,000 72,000,000 73,000,000 74,000,000 75,000,000 76,000,000 77,000,000 78,000,000 79,000,000 80,000,000 0 0 0 0 0 Call Payoff 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 75,573 “Call” Principal 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 80,250,000 80,250,000 80,250,000 80,250,000 80,250,000 Net Profit 72,000,241 72,000,241 72,000,241 72,000,241 72,000,241 72,000,241 72,000,241 72,000,241 72,000,241 72,000,241 72,000,241 72,000,241 72,000,241 73,000,241 74,000,241 75,000,241 76,000,241 77,000,241 78,000,241 79,000,241 80,000,241 80,250,241 80,250,241 80,250,241 80,250,241 80,250,241

4. The German company is bidding on a contract which they cannot be certain of winning. Thus, the need to execute a currency transaction is similarly uncertain, and using a forward or futures as a hedge is inappropriate, because it would force them to perform even if they do not win the contract.

Using a sterling put option as a hedge for this transaction makes the most sense. For a premium of:

12 million STG x 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.

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 ? /$ 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)($0.0001275/? ) 3) Floor rate = Exercise – Premium 128.1499? /$ = 128.15? /$ - $1,524,000/12,000,000,000? 4) The payoff changes depending on the level of the ? /$ rate. The following table summarizes the payoffs. An equilibrium is reached when the spot rate equals the floor rate.

AMC Profitability Yen/$ S pot 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 Put Payoff (1,524,990) (1,524,990) (1,524,990) (1,524,990) (1,524,990) (1,524,990) (1,524,990) (847,829) (109,640) 617,104 1,332,668 2,037,307 2,731,269 3,414,796 4,088,122 4,751,431 5,405,066 6,049,118 6,683,839 7,308,425 7,926,075 8,533,977 9,133,318 9,724,276 10,307,027 10,881,740 Sales 100,000,000 99,173,664 98,360,656 97,560,976 96,774,194 96,000,000 95,238,095 94,488,189 93,750,000 93,023,256 92,307,692 91,603,053 90,909,091 90,225,664 89,552,239 88,888,889 88,235,294 87,591,241 86,966,522 86,330,936 85,714,286 85,106,383 84,507,042 83,916,084 83,333,333 82,758,621 Net Profit 98,475,010 97,648,564 96,835,666 86,035,986 95,249,204 94,475,010 93,713,105 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360 93,640,360

146 147 148 149 150

11,448,579 12,007,707 12,569,279 13,103,448 13,640,360

82,191,781 81,632,653 81,081,081 80,536,913 80,000,000

93,640,360 93,640,360 93,640,360 93,640,360 93,640,360

The parent has a DM payable, and Lira receivable. It has several ways to cover its exposure; forwards, options, or swaps.

The forward would be acceptable for the DM loan, because it has a known quantity and maturity, but the Lira exposure would retain some of its uncertainty because these factors are not assured.

The parent could buy DM calls and Lira puts. This would allow them to take advantage of favorable 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.

CHAPTER 11 INTERNATIONAL BANKING SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS

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 features that distinguish international banks from domestic 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. International banks frequently provide consulting services and advice to their clients in the areas of foreign 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 clients to conduct business worldwide through his local bank or its contacts.

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 ba nk?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 Edge Act banks are not prohibited from

services provided by U.S. commercial banks.

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 Why?

deposit-loan rate spread in the domestic U.S. banking system?

Answer:

Competition has driven the deposit-loan spread in the domestic U.S. banking

system to about the same level as in the Eurodollar market. That is, in the Eurodollar market the deposit rate is about the same as the deposit rate for dollars in the U.S. banking system. Similarly the lending rates are about the same. In theory, the Eurodollar market can operate

at a lower cost than the U.S. banking system because it is not subject to mandatory reserve requirements on deposits or deposit insurance on foreign currency deposits.

4. What is the difference between the Euronote 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. 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. trillion! The international debt crisis had oil as its source. In the early 1970s, 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 At the height of the crisis, Third World countries owed $1.2

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 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 first 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 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.

7. What are the approaches available to an internationally active bank for valuing its credit risk under Basel II.

Answer: For valuing credit risk, banks may choose among the standardized approach, the internal rating-based (IRB) approach, and the securitization approach. The standardized approach provides for risk-weighting assets from five categories based on external credit agencies assessments of the credit risk inherent in the asset. The IRB approach allows banks that have received supervisory approval to rely on their own internal estimates of risk in determining the capital requirement for a given exposure. The key variables the bank must estimate to value credit risk under this approach are the probability of default and the loss given default for each asset. The securitization approach provides for determining the

securitized value of a cash flow stream and then risk-weighting the value according to the standardized approach or (if the bank has received supervisory approval) by applying the IRB approach to determine the capital requirement.

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 ? 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 six” $3,000,000 FRA for a three -month period beginning three months from today and ending six 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 six-month Eurodollar deposit. The agreement rate with the buyer is 5.5 percent. There are actually 92 days in the three-month FRA 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 who--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 92/360]/[1 + (.04875 x 92/360)] = $3,000,000 x [-.001597/(1.012458)] = $4,732.05.

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 92/360]/[1 + (.06125 x 92/360)] = $3,000,000 x [.001597/(1.015653)] = $4,717.16.

4.

A “three-against-nine” FRA has an agreement rate of 4.75 percent.

You believe

six-month LIBOR in three months will be 5.125 percent. You decide to take a speculative position in a FRA with a $1,000,000 notional value. There are 183 days in the FRA period. Determine whether you should buy or sell the FRA and what your expected profit will be if your forecast is correct about the six-month LIBOR rate.

Solution:

Since the agreement rate is less than your forecast, you should buy a FRA.

If

your forecast is correct your expected profit will be:

$1,000,000 x [(.05125-.0475) x 183/360]/[1 + (.05125 x 183/360)] = $1,000,000 x [.001906/(1.026052)] = $1,857.61.

5.

Recall the FRA problem presented as Example 11.2.

Show how the bank can

alternatively use a position in Eurodollar futures contracts (Chapter 7) 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 that the bank can take a position in Eurodollar futures contracts that mature in three months and 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.

6. The Fisher effect (Chapter 6) 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 one-year Eurocurrency interest rates presented in Exhibit 11.3, order the currencies from the eight countries from highest to lowest in terms of the size of the inflation premium embedded in the nominal interest rates for March 3, 2005.

Solution:

According to the Fisher effect, the one-year Eurocurrency interest rates suggest

that the inflation premiums for the countries representing the eight currencies ordered from highest to lowest are: British sterling, U.S. dollar, Canadian dollar, Danish krone, Euro,

Singapore dollar, Swiss franc, and Japanese yen.

7. An internationally active bank has a $500 million portfolio of investments and bank credits. $100 million are claims on sovereigns with a AAA credit rating, $100 million are

claims on corporates with a AAA credit rating, $100 million are claims on sovereigns with a single A credit rating, $100 million are claims on corporates with a single A credit rating, and $100 million are claim on corporates with a single B credit rating. What is the minimum level of capital according to Basel II the bank must maintain using the standardized approach for valuing credit risk? amount of bank capital. Be sure to show both the value of the risk-weighted assets and the

Solution: The standardized approach provides for risk-weighting assets from five categories

based on external credit agencies assessments of the credit risk inherent in the asset. For example, AAA claims on sovereigns have a risk-weighting of zero percent, AAA claims on corporates and single A claims on sovereigns have a risk-weighting of 20 percent, single A claims on corporates and BBB claims on sovereigns have a risk-weighting of 50 percent, whereas corporate claims below BB- have a risk-weighting of 150 percent. Therefore, the value of the risk weighted assets = ($100 million x 0.0) + ($100 million x .20) + ($100 million x .20) + ($100 million x .50) + ($100 million x 1.50) = $240 million. The minimum capital requirement on risk weighted assets is 8 percent according to Basel II. Therefore $19.2 million (= $240 million x .08) of capital is required at the minimum.

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 expenditures 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 United States for sale. two reasons. Nevertheless, an assembly plant in Latin America is attractive for at least First, labor costs are expected to be half what Detroit Motors would have to Since the assembly plant will be a new facility

pay in the United States to union workers.

for a newly designed vehicle, Detroit Motors expects minimal resistance 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?

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 $81,250,000 (= $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. $65,000,000 x .7025). Based on the above analysis, Detroit Motors should consider approaching Mexico about The cost in dollars will be $45,662,500 (=

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

APPENDIX 11A QUESTION

1. 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.


相关文章:
国际财务管理精选习题及答案
国际财务管理精选习题答案_经济学_高等教育_教育专区 暂无评价|0人阅读|0次下载|举报文档 国际财务管理精选习题答案_经济学_高等教育_教育专区。精选习题答案...
国际财务管理课后习题答案chapter 8
国际财务管理课后习题答案chapter 8_管理学_高等教育_教育专区。《国际财务管理》课后习题答案 CHAPTER 8 MANAGEMENT OF TRANSACTION EXPOSURE SUGGESTED ANSWERS AND ...
2015年10月份自考00208国际财务管理真题及答案_图文
2015年10月份自考00208国际财务管理真题及答案_自考_成人教育_教育专区。2015年10...管理费 D. 代理费 二、多项选择题(本大题共 10 小题;每小题 2 分。共...
国际财务管理课后习题答案(第六章)
国际财务管理课后习题答案(第六章)_理学_高等教育_教育专区。CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUEST...
国际财务管理课后习题答案
国际财务管理课后习题答案_管理学_高等教育_教育专区 暂无评价|0人阅读|0次下载|举报文档 国际财务管理课后习题答案_管理学_高等教育_教育专区。CHAPTER 1 ...
国际财务管理课后习题答案chapter 10
国际财务管理课后习题答案chapter 10_理学_高等教育_教育专区。CHAPTER 10 MANAGEMENT OF TRANSLATION EXPOSURE SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER ...
《国际财务管理》章后练习题及答案
国际财务管理》章后练习题答案_管理学_高等教育_教育专区。《国际财务管理》章后练习题答案第一章【题 1—1】某跨国公司 A,2006 年 11 月兼并某亏损国...
国际财务管理课后习题答案chapter 6
国际财务管理课后习题答案chapter 6_管理学_高等教育_教育专区。《国际财务管理》课后习题答案 CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPS SUGGESTED ANSWERS AND ...
国际财务管理课后习题答案chapter 9
国际财务管理课后习题答案chapter 9_管理学_高等教育_教育专区。CHAPTER 9 MANAGEMENT OF ECONOMIC EXPOSURE SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER ...
国际财务管理课后习题答案chapter 3
国际财务管理课后习题答案chapter 3_管理学_高等教育_教育专区。《国际财务管理》课后习题答案 CHAPTER 3 BALANCE OF PAYMENTS SUGGESTED ANSWERS AND SOLUTIONS TO ...
更多相关标签: