国际财务管理课后作业答案

《国际财务管理》章后练习题第一章【题1—1】某跨国公司A，2006年11月兼并某亏损国有企业B。

B企业兼并时账面净资产为500万元，2005年亏损100万元（以前年度无亏损），评估确认的价值为550万元。

经双方协商，A 跨国公司可以用以下两种方式兼并B企业。

甲方式：A公司以180万股和10万元人民币购买B企业（A公司股票市价为3元/股）；乙方式：A公司以150万股和100万元人民币购买B企业。

兼并后A公司股票市价3.1元/股。

A公司共有已发行的股票2000万股（面值为1元/股）。

假设兼并后B企业的股东在A公司中所占的股份以后年度不发生变化，兼并后A公司企业每年未弥补亏损前应纳税所得额为900万元，增值后的资产的平均折旧年限为5年，行业平均利润率为10%。

所得税税率为33%。

请计算方式两种发方式的差异。

【题1—1】答案（1）甲方式：B企业不需将转让所得缴纳所得税；B 企业2005年的亏损可以由A公司弥补。

A公司当年应缴所得税=（900-100）×33%=264万元，与合并前相比少缴33万元所得税，但每年必须为增加的股权支付股利。

（2）乙方式：由于支付的非股权额（100万元）大于股权面值的20%（30万元）。

所以，被兼并企业B应就转让所得缴纳所得税。

B企业应缴纳的所得税=（150 ×3 + 100- 500）×33% = 16.5（万元）B企业去年的亏损不能由A公司再弥补。

（3）A公司可按评估后的资产价值入帐,计提折旧,每年可减少所得税(550-500)/5×33%=3.3万元。

【题1—2】东方跨国公司有A、B、C、D四个下属公司，2006年四个公司计税所得额和所在国的所得税税率为：A公司：500万美元 33%B公司：400万美元 33%C公司：300万美元 24%D公司：-300万美元 15%东方公司的计税所得额为-100万美元，其所在地区的所得税税率为15%。

CHAPTER 10 MANAGEMENT OF TRANSLATION EXPOSURESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. Explain the difference in the translation process between the monetary/nonmonetary method and the temporal method.Answer: Under the monetary/nonmonetary method, all monetary balance sheet accounts of a foreign subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at the historical rate exchange rate in effect when the account was first recorded. Under the temporal method, monetary accounts are translated at the current exchange rate. Other balance sheet accounts are also translated at the current rate, if they are carried on the books at current value. If they are carried at historical value, they are translated at the rate in effect on the date the item was put on the books. Since fixed assets and inventory are usually carried at historical costs, the temporal method and the monetary/nonmonetary method will typically provide the same translation.2. How are translation gains and losses handled differently according to the current rate method in comparison to the other three methods, that is, the current/noncurrent method, the monetary/nonmonetary method, and the temporal method?Answer: Under the current rate method, translation gains and losses are handled only as an adjustment to net worth through an equity account named the “cumulative translation adjustment” account. Nothing passes through the income statement. The other three translation methods pass foreign exchange gains or losses through the income statement before they enter on to the balance sheet through the accumulated retained earnings account.3. Identify some instances under FASB 52 when a foreign enti ty’s functional currency would be the same as the parent firm’s currency.Answer: Three examples under FASB 52, where the foreign entity’s functional currency will be the same as the parent firm’s currency, are: i) the foreign entity’s cash flows directly affect the parent’s cash flows and are readily available for remittance to the parent firm; ii) the sales prices for the foreign entity’s products are responsive on a short-term basis to exchange rate changes, where sales prices are determined through wo rldwide competition; and, iii) the sales market is primarily located in the parent’s country or sales contracts are denominated in the parent’s currency.4. Describe the remeasurement and translation process under FASB 52 of a wholly owned affiliate that keeps its books in the local currency of the country in which it operates, which is different than its functional currency.Answer: For a foreign entity that keeps its books in its local currency, which is different from its functional currency, the translation process according to FASB 52 is to: first, remeasure the financial reports from the local currency into the functional currency using the temporal method of translation, and second, translate from the functional currency into the reporting currency using the current rate method of translation.5. It is, generally, not possible to completely eliminate both translation exposure and transaction exposure. In some cases, the elimination of one exposure will also eliminate the other. But in other cases, the elimination of one exposure actually creates the other. Discuss which exposure might be viewed as the most important to effectively manage, if a conflict between controlling both arises. Also, discuss and critique the common methods for controlling translation exposure.Answer: Since it is, generally, not possible to completely eliminate both transaction and translation exposure, we recommend that transaction exposure be given first priority since it involves real cash flows. The translation process, on-the-other hand, has no direct effect on reporting currency cash flows, and will only have a realizable effect on net investment upon the sale or liquidation of the assets.There are two common methods for controlling translation exposure: a balance sheet hedge and a derivatives hedge. The balance sheet hedge involves equating the amount of exposed assets in an exposure currency with the exposed liabilities in that currency, so the net exposure is zero. Thus when an exposure currency exchange rate changes versus the reporting currency, the change in assets will offset the change in liabilities. To create a balance sheet hedge, once transaction exposure has been controlled, often means creating new transaction exposure. This is not wise since real cash flow losses can result. A derivatives hedge is not really a hedge, but rather a speculative position, since the size of the “hedge” is based on the future expected spot rate of exchange for the exposure currency with the reporting currency. If the actual spot rate differs from the expected rate, the “hedge” may result in the loss of real cash flows.PROBLEMS1. Assume that FASB 8 is still in effect instead of FASB 52. Construct a translation exposure report for Centralia Corporation and its affiliates that is the counterpart to Exhibit 10.7 in the text. Centralia and its affiliates carry inventory and fixed assets on the books at historical values.Solution: The following table provides a translation exposure report for Centralia Corporation and its affiliates under FASB 8, which is essentially the temporal method of translation. The difference between the new report and Exhibit 10.7 is that nonmonetary accounts such as inventory and fixed assets are translated at the historical exchange rate if they are carried at historical costs. Thus, these accounts will not change values when exchange rates change and they do not create translation exposure.Examination of the table indicates that under FASB 8 there is negative net exposure for the Mexican peso and the euro, whereas under FASB 52 the net exposure for these currencies is positive. There is no change in net exposure for the Canadian dollar and the Swiss franc. Consequently, if the euro depreciates against the dollar from €1.1000/$1.00 to €1.1786/$1.00, as the text example assumed, exposed assets will now fall in value by a smaller amount than exposed liabilities, instead of vice versa. The associated reporting currency imbalance will be $239,415, calculated as follows:Reporting Currency Imbalance=-€3,949,0000€1.1786/$1.00--€3,949,0000€1.1000/$1.00=$239,415.Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and Spanish Affiliates, December 31, 2005 (in 000 Currency Units)Canadian Dollar MexicanPeso EuroSwissFrancAssetsCash CD200 Ps 6,000 € 825SF 0 Accounts receivable 0 9,000 1,045 0Inventory 0 0 0 0Net fixed assets 0 0 0 0Exposed assets CD200 Ps15,000 € 1,870SF 0LiabilitiesAccounts payable CD 0 Ps 7,000 € 1,364SF 0Notes payable 0 17,000 935 1,400Long-term debt 0 27,000 3,520 0Exposed liabilities CD 0 Ps51,000 € 5,819SF1,400Net exposure CD200 (Ps36,000) (€3,949)(SF1,400)2. Assume that FASB 8 is still in effect instead of FASB 52. Construct a consolidated balance sheet for Centralia Corporation and its affiliates after a depreciation of the euro from €1.1000/$1.00 to €1.1786/$1.00 that is the counterpart to Exhibit 10.8 in the text. Centralia and its affiliates c arry inventory and fixed assets on the books at historical values.Solution: This problem is the sequel to Problem 1. The solution to Problem 1 showed that if the euro depreciated there would be a reporting currency imbalance of $239,415. Under FASB 8 this is carried through the income statement as a foreign exchange gain to the retained earnings on the balance sheet. The following table shows that consolidated retained earnings increased to $4,190,000 from $3,950,000 in Exhibit 10.8. This is an increase of $240,000, which is the same as the reporting currency imbalance after accounting for rounding error.Consolidated Balance Sheet under FASB 8 for Centralia Corporation and its Mexican and Spanisha This includes CD200,000 the parent firm has in a Canadian bank, carried as $150,000. CD200,000/(CD1.3333/$1.00) = $150,000.b$1,750,000 - $300,000 (= Ps3,000,000/(Ps10.00/$1.00)) intracompany loan = $1,450,000.c,d Investment in affiliates cancels with the net worth of the affiliates in the consolidation.e The Spanish affiliate owes a Swiss bank SF375,000 (÷ SF1.2727/€1.00 = €294,649). This is carried on the books,after the exchange rate change, as part of €1,229,649 = €294,649 + €935,000. €1,229,649/(€1.1786/$1.00) = $1,043,313.3. In Example 10.2, a f orward contract was used to establish a derivatives “hedge” to protect Centralia from a translation loss if the euro depreciated from €1.1000/$1.00 to €1.1786/$1.00. Assume that an over-the-counter put option on the euro with a strike price of €1.1393/$1.00 (or $0.8777/€1.00) can be purchased for $0.0088 per euro. Show how the potential translation loss can be “hedged” with an option contract.Solution: As in example 10.2, if the potential translation loss is $110,704, the equivalent amount in functiona l currency that needs to be hedged is €3,782,468. If in fact the euro does depreciate to €1.1786/$1.00 ($0.8485/€1.00), €3,782,468 can be purchased in the spot market for $3,209,289. At a striking price of €1.1393/$1.00, the €3,782,468 can be sold throu gh the put for $3,319,993, yielding a gross profit of $110,704. The put option cost $33,286 (= €3,782,468 x $0.0088). Thus, at an exchange rate of €1.1786/$1.00, the put option will effectively hedge $110,704 - $33,286 = $77,418 of the potential translat ion loss. At terminal exchange rates of €1.1393/$1.00 to €1.1786/$1.00, the put option hedge will be less effective. An option contract does not have to be exercised if doing so is disadvantageous to the option owner. Therefore, the put will not be exer cised at exchange rates of less than €1.1393/$1.00 (more than $0.8777/€1.00), in which case the “hedge” will lose the $33,286 cost of the option.MINI CASE: SUNDANCE SPORTING GOODS, INC.Sundance Sporting Goods, Inc., is a U.S. manufacturer of high-quality sporting goods--principally golf, tennis and other racquet equipment, and also lawn sports, such as croquet and badminton-- with administrative offices and manufacturing facilities in Chicago, Illinois. Sundance has two wholly owned manufacturing affiliates, one in Mexico and the other in Canada. The Mexican affiliate is located in Mexico City and services all of Latin America. The Canadian affiliate is in Toronto and serves only Canada. Each affiliate keeps its books in its local currency, which is also the functional currency for the affiliate. The current exchange rates are: $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800. The nonconsolidated balance sheets for Sundance and its two affiliates appear in the accompanying table.Nonconsolidated Balance Sheet for Sundance Sporting Goods, Inc. and Its Mexican and Canadiana The parent firm is owed Ps1,320,000 by the Mexican affiliate. This sum is included in the parent’s accounts receivable as $400,000, translated at Ps3.30/$1.00. The remainder of the parent’s (Mexican affiliate’s) a ccounts receivable (payable) is denominated in dollars (pesos).b The Mexican affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $2,400,000. This represents the sum of the common stock (Ps4,500,000) and retained earnings (Ps3,420,000) on the Mexican affiliate’s books, translated at Ps3.30/$1.00.c The Canadian affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $3,600,000. This represents the sum of the common stock (CD2,900,000) and the retained earnings (CD1,600,000) on the Canadian affiliate’s books, translated at CD1.25/$1.00.d The parent firm has outstanding notes payable of ¥126,000,000 due a Japanese bank. This sum is carried on th e parent firm’s books as $1,200,000, translated at ¥105/$1.00. Other notes payable are denominated in U.S. dollars.e The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This sum is carried on the Mexican affi liate’s books as Ps396,000, translated at A1.00/Ps3.30. Other accounts receivable are denominated in Mexican pesos.f The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This sum is carried on the Canadian affilia te’s books as CD300,000, translated at W800/CD1.25. Other accounts receivable are denominated in Canadian dollars.You joined the International Treasury division of Sundance six months ago after spending the last two years receiving your MBA degree. The corporate treasurer has asked you to prepare a report analyzing all aspects of the translation exposure faced by Sundance as a MNC. She has also asked you to address in your analysis the relationship between the firm’s translation exposure and its transa ction exposure. After performing a forecast of future spot rates of exchange, you decide that you must do the following before any sensible report can be written.a. Using the current exchange rates and the nonconsolidated balance sheets for Sundance and its affiliates, prepare a consolidated balance sheet for the MNC according to FASB 52.b. i. Prepare a translation exposure report for Sundance Sporting Goods, Inc., and its two affiliates.ii. Using the translation exposure report you have prepared, determine if any reporting currency imbalance will result from a change in exchange rates to which the firm has currency exposure. Your forecast is that exchange rates will change from $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800 to $1.00 = CD1.30 = Ps3.30 = A1.03 = ¥105 = W800.c. Prepare a second consolidated balance sheet for the MNC using the exchange rates you expect in the future. Determine how any reporting currency imbalance will affect the new consolidated balance sheet for the MNC.d. i. Prepare a transaction exposure report for Sundance and its affiliates. Determine if any transaction exposures are also translation exposures.ii. Investigate what Sundance and its affiliates can do to control its transaction and translation exposures. Determine if any of the translation exposure should be hedged.Suggested Solution to Sundance Sporting Goods, Inc.Note to Instructor: It is not necessary to assign the entire case problem. Parts a. and b.i. can be used as self-contained problems, respectively, on basic balance sheet consolidation and the preparation of a translation exposure report.a. Below is the consolidated balance sheet for the MNC prepared according to the current rate method prescribed by FASB 52. Note that the balance sheet balances. That is, Total Assets and Total Liabilities and Net Worth equal one another. Thus, the assumption is that the current exchange rates are the same as when the affiliates were established. This assumption is relaxed in part c.Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates, December 31, 2005: Pre-Exchange Rate Change (in 000 Dollars)Sundance, Inc. Mexican Canadian Consolidateda$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.b,c The investment in the affiliates cancels with the net worth of the affiliates in the consolidation.d The parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)).e The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate’s books as Ps396,000 (= A120,000 x Ps3.30/A1.00).f The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This is carried on the Canadian affiliate’s books as CD300,000 (= W192,000,000/(W800/CD1.25)).b. i. Below is presented the translation exposure report for the Sundance MNC. Note, from the report that there is net positive exposure in the Mexican peso, Canadian dollar, Argentine austral and Korean won. If any of these exposure currencies appreciates (depreciates) against the U.S. dollar, exposed assets denominated in these currencies will increase (fall) in translated value by a greater amount than the exposed liabilities denominated in these currencies. There is negative net exposure in the Japanese yen. If the yen appreciates (depreciates) against the U.S. dollar, exposed assets denominated in the yen will increase (fall) in translated value by smaller amount than the exposed liabilities denominated in the yen.Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates, December 31, 2005 (in 000 Currency Units)b. ii. The problem assumes that Canadian dollar depreciates from CD1.25/$1.00 to CD1.30/$1.00 and that the Argentine austral depreciates from A1.00/$1.00 to A1.03/$1.00. To determine the reporting currency imbalance in translated value caused by these exchange rate changes, we can use the following formula:Net Exposure Currency i S(i/reporting)-Net Exposure Currency i S(i/reporting)new old = Reporting Currency Imbalance.From the translation exposure report we can determine that the depreciation in the Canadian dollar will cause aCD4,200,000 CD1.30/$1.00-CD4,200,000CD1.25/$1.00= -$129,231reporting currency imbalance.Similarly, the depreciation in the Argentine austral will cause aA120,000 A1.03/$1.00-A120,000A1.00/$1.00= -$3,495reporting currency imbalance.In total, the depreciation of the Canadian dollar and the Argentine austral will cause a reporting currency imbalance in translated value equal to -$129,231 -$3,495= -$132,726.c. The new consolidated balance sheet for Sundance MNC after the depreciation of the Canadian dollar and the Argentine austral is presented below. Note that in order for the new consolidated balance sheet to balance after the exchange rate change, it is necessary to have a cumulative translation adjustment account balance of -$133 thousand, which is the amount of the reporting currency imbalance determined in part b. ii (rounded to the nearest thousand).Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates, December 31, 2005: Post-Exchange Rate Change (in 000 Dollars)a$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.b,c The investment in the affiliates cancels with the net worth of the affiliates in the consolidation.d The parent owes a Japanese bank ¥126,000,000. This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)).e The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This is carried on the Mexican affiliate’s books as Ps384,466 (= A120,000 x Ps3.30/A1.03).f The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This is carried on the Canadian affiliate’s books as CD312,000 (=W192,000,000/(W800/CD1.30)).d. i. The transaction exposure report for Sundance, Inc. and its two affiliates is presented below. The report indicates that the Ps1,320,000 accounts receivable due from the Mexican affiliate is not also a translation exposure because this is netted out in the consolidation. However, the ¥126,000,000 notes payable of the parent is also a translation exposure. Additionally, the A120,000 accounts receivable of the Mexican affiliate and the W192,000,000 accounts receivable of the Canadian affiliate are both translation exposures.Transaction Exposure Report for Sundance Sporting Goods, Inc. andits Mexican and Canadian Affiliates, December 31, 2005d. ii. Since transaction exposure may potentially result in real cash flow losses while translation exposure does not have an immediate direct effect on operating cash flows, we will first address the transaction exposure that confronts Sundance and its affiliates. The analysis assumes the depreciation in the Canadian dollar and the Argentine austral have already taken place.The parent firm can pay off the ¥126,000,000 loan from the Japanese bank using funds from the cash account and money from accounts receivable that it will collect. Additionally, the parent firm can collect the accounts receivable of Ps1,320,000 from its Mexican affiliate that is carried on the books as $400,000. In turn, the Mexican affiliate can collect the A120,000 accounts receivable from the Argentine importer, valued at Ps384,466 after the depreciation in the austral, to guard against further depreciation and to use to partially pay off the peso liability to the parent. The Canadian affiliate can eliminate its transaction exposure by collecting the W192,000,000 accounts receivable as soon as possible, which is currently valued at CD312,000.The elimination of these transaction exposures will affect the translation exposure of Sundance MNC. A revised translation exposure report follows.Revised Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian Affiliates, December 31, 2005 (in 000 Currency Units)Note from the revised translation exposure report that the elimination of the transaction exposure will also eliminate the translation exposure in the Japanese yen, Argentine austral and the Korean won. Moreover, the net translation exposure in the Mexican peso has been reduced. But the net translation exposure in the Canadian dollar has increased as a result of the Canadian affiliate’s collection of the won receivable.The remaining translation exposure can be hedged using a balance sheet hedge or a derivatives hedge. Use of a balance sheet hedge is likely to create new transaction exposure, however. Use of a derivatives hedge is actually speculative, and not a real hedge, since the size of the “hedge” is based on one’s expectation as to the future spot exchange rate. An incorrect estimate will result in the “hedge” losing money for the MNC.。

CHAPTER 1GLOBALIZATION AND THE MULTINATIONAL FIRMSUGGESTED ANSWERS TO END—OF-CHAPTER QUESTIONS QUESTIONS1 。

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 。

CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGESUGGESTED ANSWERS AND SOLUTIONS TO END—OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. 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。

CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGESUGGESTED ANSWERS AND SOLUTIONS TO END-OF—CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1。

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。

CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPSSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. 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$)]E[S t+1 I t].The exchange rate is thus determined by the relative interest rates, and the expected future spot rate, conditional on all the available information, I t, as of the present time. One thus can say that expectation is self-fulfilling. Since the information set will be continuously updated as news hit the market, the exchange rate will exhibit a highly dynamic, random behavior.3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate.Answer: The forward exchange rate will be an unbiased predictor of the future spot rate if (I) the risk premium is insignificant and (ii) foreign exchange markets are informationally efficient.4. Explain the purchasing power parity, both the absolute and relative versions. What causes the deviations from the purchasing power parity?Answer: The absolute version of purchasing power parity (PPP):S = P$/P£.The relative version is:e = π$ - π£.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.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, and3. 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 standardconsumption basket. LOP requires that the consumption basket should be selling for the same price ina given currency across countries.A. b. Absolute PPP holds that the price level in a country is equal to the price level in another countrytimes 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 aboutequalto 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 becauseinternational commodity arbitrage is a time-consuming process.B. b. PPP is useful for predicting exchange rates on the long-term basis.PROBLEMS1. 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 monthsi NY = 0.35%/month, compounding monthlyi LD = 2.0% for three monthsS = $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 diff erence between $49,755 and $48489.3. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.a. Determine whether the interest rate parity is currently holding.b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.c. Explain how the IRP will be restored as a result of covered arbitrage activities.Solution: Let’s summarize the given data first:S = $1.5/£; F = $1.52/£; I$ = 2.0%; I£ = 1.45%Credit = $1,500,000 or £1,000,000.a. (1+I$) = 1.02(1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280Thus, 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 $1,542,040Arbitrage profit will be $12,040c. Following the arbitrage transactions described above,The dollar interest rate will rise;The pound interest rate will fall;The spot exchange rate will rise;The forward exchange rate will fall.These adjustments will continue until IRP holds.4. Suppose that the current spot exchange rate is €0.80/$ and the three-month forward exchange rate is €0.7813/$. The three-month interest rate is5.6 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 tomake 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 atmaturity.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 bedifferent.5.Buy $1,014,000 forward for €1,034,280.Arbitrage profit = €1,074,310 - €1,034,280 = €40,0305. In the issue of October 23, 1999, the Economist reports that the interest rate per annum is 5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based on the reported interest rates, how would you predict the change of the exchange rate between the U.S. dollarand the Turkish lira?Solution: A high Turkish interest rate must reflect a high expected inflation in Turkey. According to international Fisher effect (IFE), we haveE(e) = i$ - i Lira= 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(π$) - E(πR$)= 2.6% - 20.0%= -17.4%E(S T) = S o(1 + E(e))= (R$1.95/$) (1 + 0.174)= R$2.29/$7. (CFA question) Omni Advisors, an international pension fund manager, uses the concepts of purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates. Omni gathers the financial information as follows:Base price level 100Current U.S. price level 105Current South African price level 111Base rand spot exchange rate $0.175Current rand spot exchange rate $0.158Expected annual U.S. inflation 7%Expected annual South African inflation 5%Expected U.S. one-year interest rate 10%Expected South African one-year interest rate 8%Calculate the following exchange rates (ZAR and USD refer to the South African and U.S. dollar, respectively).a. The current ZAR spot rate in USD that would have been forecast by PPP.b. Using the IFE, the expected ZAR spot rate in USD one year from now.c. Using PPP, the expected ZAR spot rate in USD four years from now.Solution:a. ZAR spot rate under PPP = [1.05/1.11](0.175) = $0.1655/rand.b. Expected ZAR spot rate = [1.10/1.08] (0.158) = $0.1609/rand.c. Expected ZAR under PPP = [(1.07)4/(1.05)4] (0.158) = $0.1704/rand.8. Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate is €1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot exchange rate.a.Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are aeuro-based investor. Also determine the size of the arbitrage profit.b.Discuss how the interest rate parity may be restored as a result of the abovetransactions.c.Suppose you are a pound-based investor. Show the covered arbitrage process anddetermine the pound profit amount.Solution:a. First, note that (1+i €) = 1.054 is less than (F/S)(1+i €) = (1.60/1.50)(1.052) = 1.1221.You should thus borrow in euros and lend in pounds.1)Borrow €1,000,000 and promise to repay €1,054,000 in one year.2)Buy ₤666,667 spot for €1,000,000.3)Invest ₤666,667 at the pound interest rate of 5.2%; the maturity value will be ₤701,334.4)To hedge exchange risk, sell the maturity value ₤701,334 forward in exchange for €1,122,134.The arbitrage profit will be the difference between €1,122,134 and €1,054,000, i.e., €68,134.b. As a result of the above arbitrage transactions, the euro interest rate will rise, the poundinterest rate will fall. In addition, the spot exchange rate (euros per pound) will rise and the forward rate will fall. These adjustments will continue until the interest rate parity is restored.c. The pound-based investor will carry out the same transactions 1), 2), and 3) in a. But to hedge, he/she will bu y €1,054,000 forward in exchange for ₤658,750. The arbitrage profit will then be ₤42,584 = ₤701,334 - ₤658,750.9. Due to the integrated nature of their capital markets, investors in both the U.S. and U.K. require the same real interest rate, 2.5%, on their lending. There is a consensus in capital markets that the annual inflation rate is likely to be 3.5% in the U.S. and 1.5% in the U.K. for the next three years. The spot exchange rate is currently $1.50/£.pute the nominal interest rate per annum in both the U.S. and U.K., assuming that the Fishereffect holds.b.What is your expected future spot dollar-pound exchange rate in three years from now?c.Can you infer the forward dollar-pound exchange rate for one-year maturity?Solution.a. Nominal ra te in US = (1+ρ) (1+E(π$)) – 1 = (1.025)(1.035) – 1 = 0.0609 or 6.09%.Nominal rate in UK= (1+ρ) (1+E(π₤)) – 1 = (1.025)(1.015) – 1 = 0.0404 or 4.04%.b. E(S T) = [(1.0609)3/(1.0404)3] (1.50) = $1.5904/₤.c. F = [1.0609/1.0404](1.50) = $1.5296/₤.Mini Case: Turkish Lira and the Purchasing Power ParityVeritas Emerging Market Fund specializes in investing in emerging stock markets of the world. Mr. Henry Mobaus, an experienced hand in international investment and your boss, is currently interested in Turkish stock markets. He thinks that Turkey will eventually be invited to negotiate its membership in the European Union. If this happens, it will boost the stock prices in Turkey. But, at the same time, he is quite concerned with the volatile exchange rates of the Turkish currency. He would like to understand what drives the Turkish exchange rates. Since the inflation rate is much higher in Turkey than in the U.S., he thinks that the purchasing power parity may be holding at least to some extent. As a research assistant for him, you were assigned to check this out. In other words, you have to study and prepare a report on the following question: Does the purchasing power parity hold for the Turkish lira-U.S. dollar exchange rate? Among other things, Mr. Mobaus would like you to do the following:Plot the past exchange rate changes against the differential inflation rates betweenTurkey and the U.S. for the last four years.Regress the rate of exchange rate changes on the inflation rate differential to estimatethe intercept and the slope coefficient, and interpret the regression results.Data source: You may download the consumer price index data for the U.S. and Turkey from the following website: /home/0,2987,en_2649_201185_1_1_1_1_1,00.html, “hot file” (Excel format) . You may download the exchange rate data from the website: merce.ubc.ca/xr/data.html.Solution:a. In the current solution, we use the monthly data from January 1999 – December 2002.b. We regress exchange rate changes (e) on the inflation rate differential and estimate theintercept (α ) and slope coefficient (β):3.095) (t 1.472βˆ0.649)- (t 0.011αˆε Inf_US) -Inf_Turkey (βˆαˆ e tt ===-=++=The estimated intercept is insignificantly different from zero, whereas the slope coefficient is positive and significantly different from zero. In fact, the slope coefficient is insignificantly different from unity. [Note that t-statistics for β = 1 is 0.992 = (1.472 – 1)/0.476 where s.e. is 0.476] In other words, we cannot reject the hypothesis that the intercept is zero and the slope coefficient is one. The results are thus supportive of purchasing power parity.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 th e 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 thatE(π$) = I$ - ρ$,E(π£) = I£ - ρ£.Assuming that the real interest rate is the same between the two countries, i.e., ρ$ = ρ£, and substituting the above results into the PPP, i.e., E(e) = E(π$)- E(π£), we obtain the international Fisher effect: E(e) = I$ - 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.。

C H A P T E R8M A N A G E M E N T O F T R A N S A C T I O N E X P O S U R ESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS1. 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.PROBLEMS1. 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 $1.05/€ in six months.(a) What is the expected gain/loss from the forward hedging?(b) If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? Why or why not?(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not?Solution: (a) Expected gain($) = 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 = ￥245,700,245.7So 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 -$2,340,002.34with dollars ￥245,700,245.702. Invest in Japan - ￥245,700,245.70 ￥250,000,0003. Pay yens - ￥250,000,000Net cash flow - $2,340,002.34____________________________________________________________________3. You plan to visit Geneva, Switzerland in three months to attend an international business conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is $0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent per annum in Switzerland.(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on SF.(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a forward contract.(c) At what future spot exchange rate will you be indifferent between the forward and option market hedges?(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate under both the options and forward market hedges.Solution: (a) Total option premium = (.05)(5000) = $250. In three months, $250 is worth $253.75 = $250(1.015). At the expected future spot rate of $0.63/SF, which is less than the exercise price, you don’t e xpect 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.4. Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. AirFrance 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 annualinterest rate is 6.0% in the U.S. and 5.0% in France. Boeing is concerned with thevolatile 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+i F ). T hus 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 $ Cost Options hedge Forward hedge $3,453.75$3,150 0 0.579 0.64(strikeprice)$/SF $253.75option 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.pute the guaranteed euro proceeds from the American sale if Airbus decides tohedge using a forward contract.b.If Airbus decides to hedge using money market instruments, what action doesAirbus 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 betweenthe 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 = S T (30,000,000) - €615,000.Solving for S T, we obtain the “indifference” future spot exchange rate, i.e., €0.9683/$, or $1.0327/€. Note that €28,432,732 is the future value of the proceeds under money market hedging: €28,432,732 = (€27,739,251) (1.025).Suggested solution for Mini Case: Chase Options, Inc.[See Chapter 13 for the case text]Chase Options, Inc.Hedging Foreign Currency Exposure Through Currency OptionsHarvey A. PoniachekI. Case SummaryThis case reviews the foreign exchange options market and hedging. It presents various international transactions that require currency options hedging strategies by the corporations involved. Seven transactions under a variety of circumstances are introduced that require hedging by currency options. The transactions involve hedging of dividend remittances, portfolio investment exposure, and strategic economic competitiveness. Market quotations are provided for options (and options hedging ratios), forwards, and interest rates for various maturities.II. Case Objective.The case introduces the student to the principles of currency options market and hedging strategies. The transactions are of various types that often confront companies that are involved in extensive international business or multinational corporations. The case induces students to acquire hands-on experience in addressing specific exposure and hedging concerns, including how to apply various market quotations, which hedging strategy is most suitable, and how to address exposure in foreign currency through cross hedging policies.III. Proposed Assignment Solution1. The company expects DM100 million in repatriated profits, and does not want the DM/$ 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/$, this would assure the U.S. company of receiving at least:DM 100,000,000 – DM 1,640,000 x (1 + 0.085106 x 272/360)= DM 98,254,544/1.70 DM/$ = $57,796,791by exercising the option if the DM depreciated. Note that the proceeds from the repatriated profits are reduced by the premium paid, which is further adjusted by the interest foregone on this amount.However, if the DM were to appreciate relative to the dollar, the company would allow the option to expire, and enjoy greater dollar proceeds from this increase.Should forward contracts be used to hedge this exposure, the proceeds received would be:DM100,000,000/1.6725 DM/$ = $59,790,732,regardless of the movement of the DM/$ exchange rate. While this amount is almost $2 million more than that realized using option hedges above, there is no flexibility regarding the exercise date; if this date differs from that at which the repatriate profits are available, the company may be exposed to additional further current exposure. Further, there is no opportunity to enjoy any appreciation in the DM.If the company were to buy DM puts as above, and sell an equivalent amount in calls with strike price 1.647, the premium paid would be exactly offset by the premium received. This would assure that the exchange rate realized would fall between 1.647 and 1.700. If the rate rises above 1.700, the company will exercise its put option, and if it fell below 1.647, the other party would use its call; for any rate in between, both options would expire worthless. The proceeds realized would then fall between:DM 100,00,000/1.647 DM/$ = $60,716,454andDM 100,000,000/1.700 DM/$ = $58,823,529.This would allow the company some upside potential, while guaranteeing proceeds at least $1 million greater than the minimum for simply buying a put as above.Buy/Sell OptionsDM/$Spot Put Payoff “Put”ProfitsCallPayoff“Call”Profits Net Profit1.60 (1,742,846) 0 1,742,846 60,716,45460,716,4541.61 (1,742,846) 0 1,742,846 60,716,45460,716,454 1.62 (1,742,846) 0 1,742,846 60,716,45460,716,454 1.63 (1,742,846) 0 1,742,846 60,716,45460,716,4541.64 (1,742,846) 0 1,742,846 60,716,45460,716,454 1.65 (1,742,846) 60,606,0611,742,846 0 60,606,0611.66 (1,742,846) 60,240,9641,742,846 0 60,240,964 1.67 (1,742,846) 59,880,241,742,846 0 59,880,2401.68 (1,742,846) 59,523,811,742,846 0 59,523,810 1.69 (1,742,846) 59,171,5981,742,846 0 59,171,598 1.70 (1,742,846) 58,823,5291,742,846 0 58,823,529 1.71 (1,742,846) 58,823,5291,742,846 0 58,823,5291.72 (1,742,846) 58,823,5291,742,846 0 58,823,529 1.73 (1,742,846) 58,823,5291,742,846 0 58,823,5291.74 (1,742,846) 58,823,5291,742,846 0 58,823,5291.75 (1,742,846) 58,823,521,742,846 0 58,823,52991,742,846 0 58,823,529 1.76 (1,742,846) 58,823,5291,742,846 0 58,823,529 1.77 (1,742,846) 58,823,5291,742,846 0 58,823,529 1.78 (1,742,846) 58,823,5291.79 (1,742,846) 58,823,521,742,846 0 58,823,52991,742,846 0 58,823,529 1.80 (1,742,846) 58,823,5291.81 (1,742,846) 58,823,521,742,846 0 58,823,52991,742,846 0 58,823,529 1.82 (1,742,846) 58,823,5291,742,846 0 58,823,529 1.83 (1,742,846) 58,823,5291.84 (1,742,846) 58,823,521,742,846 0 58,823,52991,742,846 0 58,823,529 1.85 (1,742,846) 58,823,529Since 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 puts1) Write calls for $/A$ @ 0.8025Buy puts for $/A$ @ 0.72# contracts needed = Principal in A$/Contract size100,000,000A$/100,000 A$ = 1002) 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 payoffIf spot falls below 0.72, fund manager will exercise putIf spot rises above 0.72, fund manager will let put expire5) Call payoffIf spot rises above .8025, call will be exercised If spot falls below .8025, call will expire6) Net payoffSee following Table for net payoffAustralian Dollar Bond HedgeStrikePrice Put Payoff “Put”PrincipalCallPayoff“Call”Principal Net Profit0.60 (75,332) 72,000,0075,573 0 72,000,2410.61 (75,332) 72,000,0075,573 0 72,000,2410.62 (75,332) 72,000,0075,573 0 72,000,2410.63 (75,332) 72,000,0075,573 0 72,000,2410.64 (75,332) 72,000,0075,573 0 72,000,2410.65 (75,332) 72,000,0075,573 0 72,000,2410.66 (75,332) 72,000,0075,573 0 72,000,2410.67 (75,332) 72,000,0075,573 0 72,000,2410.68 (75,332) 72,000,0075,573 0 72,000,2410.69 (75,332) 72,000,0075,573 0 72,000,2410.70 (75,332) 72,000,0075,573 0 72,000,2410.71 (75,332) 72,000,0075,573 0 72,000,2410.72 (75,332) 72,000,0075,573 0 72,000,2410.73 (75,332) 73,000,0075,573 0 73,000,2410.74 (75,332) 74,000,0075,573 0 74,000,241 0.75 (75,332) 75,000,0075,573 0 75,000,2410.76 (75,332) 76,000,0075,573 0 76,000,24175,573 0 77,000,241 0.77 (75,332) 77,000,000.78 (75,332) 78,000,0075,573 0 78,000,24175,573 0 79,000,241 0.79 (75,332) 79,000,000.80 (75,332) 80,000,0075,573 0 80,000,24180,250,241 0.81 (75,332) 0 75,573 80,250,000.82 (75,332) 0 75,573 80,250,0080,250,24180,250,241 0.83 (75,332) 0 75,573 80,250,000.84 (75,332) 0 75,573 80,250,0080,250,24180,250,241 0.85 (75,332) 0 75,573 80,250,004. 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. Fora 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 (wh ich 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 size9600 = ($100,000,000)(120￥/$) / ￥1,250,0002) Total Cost = (# contracts)(contract size)(premium)$1,524,000 = (9600)( ￥1,250,000)($0.0001275/￥)3) Floor rate = Exercise – Premium128.1499￥/$ = 128.15￥/$ - $1,524,000/12,000,000,000￥4) The payoff changes depending on the level of the ￥/$ rate. The following tablesummarizes the payoffs. An equilibrium is reached when the spot rate equals the floor rate.AMC ProfitabilityYen/$ Spot Put Payoff Sales Net Profit 120 (1,524,990) 100,000,000 98,475,010 121 (1,524,990) 99,173,664 97,648,564 122 (1,524,990) 98,360,656 96,835,666 123 (1,524,990) 97,560,976 86,035,986 124 (1,524,990) 96,774,194 95,249,204 125 (1,524,990) 96,000,000 94,475,010 126 (1,524,990) 95,238,095 93,713,105 127 (847,829) 94,488,189 93,640,360 128 (109,640) 93,750,000 93,640,360 129 617,104 93,023,256 93,640,360 130 1,332,668 92,307,692 93,640,360 131 2,037,307 91,603,053 93,640,360 132 2,731,269 90,909,091 93,640,360 133 3,414,796 90,225,664 93,640,360 134 4,088,122 89,552,239 93,640,360 135 4,751,431 88,888,889 93,640,360 136 5,405,066 88,235,294 93,640,360 137 6,049,118 87,591,241 93,640,360 138 6,683,839 86,966,522 93,640,360 139 7,308,425 86,330,936 93,640,360 140 7,926,075 85,714,286 93,640,360 141 8,533,977 85,106,383 93,640,360 142 9,133,318 84,507,042 93,640,360 143 9,724,276 83,916,084 93,640,360 144 10,307,027 83,333,333 93,640,360 145 10,881,740 82,758,621 93,640,360 146 11,448,579 82,191,781 93,640,360 147 12,007,707 81,632,653 93,640,360 148 12,569,279 81,081,081 93,640,360 149 13,103,448 80,536,913 93,640,360。

C H A P T E R8M A N A G E M E N T O F T R A N S A C T I O N E X P O S U R ESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS ANDPROBLEMSQUESTIONS1. How would you define transaction exposure How is it different from economic exposureAnswer: 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 resultAnswer: 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 contractAnswer: 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 resultAnswer: 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 notAnswer: 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.PROBLEMS1. 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 $€ and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $€ in six months.(a) What is the expected gain/loss from the forward hedging(b) If you were the financial manager of Cray Research, would you recommend hedging this euro receivable Why or why not(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the forward exchange rate quoted today. Would you recommend hedging in this case Why or why not Solution: (a) Expected gain($) = 10,000,000 –= 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, .,250m/ = ￥245,700,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, = ￥250,000,000/105.The dollar cost of meeting this yen obligation is $2,340, as of today.(b)___________________________________________________________________Transaction CF0 CF1____________________________________________________________________1. Buy yens spot -$2,340,with dollars ￥245,700,2. Invest in Japan - ￥245,700, ￥250,000,0003. Pay yens - ￥250,000,000Net cash flow - $2,340,____________________________________________________________________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 $SF and the three-month forward rate is $SF. You can buy the three-month call option on SF with the exercise rate of $SF for the premium of $ 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 $ = $250. At the expected future spot rate of $SF, which is less than the exercise price, you don’t expect to exercise options. Rather, you expect to buy Swiss franc at $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 $, ., $3,.(b) $3,150 = (.63)(5,000).(c) $3,150 = 5,000x + , where x represents the break-even future spot rate. Solving for x, we obtain x = $SF. Note that at the break-even future spot rate, options will not be exercised.(d) If the Swiss franc appreciates beyond $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, = $3,200 + $.This is the maximum you will pay.4. Boeing just signed a contract to sell a Boeing 737 aircraft to Air France. Air France will be billed €20million which is payable in one year. The current spot exchange rate is $€ and the one -year forward rateis $€. The annual interest rate is % in the U.S. and % 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 methodsSolution: (a) In the case of forward hedge, the future dollar proceeds will be (20,000,000) = $22,000,000. In the case of money market hedge (MMH), the firm has to first borrow the PV of its euro receivable, ., 20,000,000/ =€19,047,619. Then the firm should exchange this euro amount into dollars at the current spot rate to receive: (€19,047,619)($€) = $20,000,000, which can be in vested at the dollar interest rate for one year to yield:$20,000,000 = $21,200,000.Clearly, the firm can receive $800,000 more by using forward hedging.(b) According to IRP, F = S(1+i $)/(1+i F ). Thus the “indifferent” forward rate will be: F = / = $€.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 $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 = $SF .(b) If the Swiss client chooses to pay $10,000, it will cost SF16,129 (=10,000/.62). Since the Swiss client has an option to pay SF15,000, it will choose to do so. The value of this option is obviously SF1,129 (=SF16,129-SF15,000).(c) Baltimore Machinery faces a contingent exposure in the sense that it may or may not receive SF15,000 in the future. The firm thus can hedge this exposure by buying a put option on SF15,000. 6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the .$ Cost Options hedgeForward hedge$3,$3,1500 (strike price)$/SF$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/(124)= $4,147,465.(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000 = $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,.The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.(c) When t he 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 $€ and six-month forward exchange rate is $€ at the moment. Airbus can buy a six-month put option on . dollars with a strike price of €$ for a premium of € per . dollar. Currently, six-month interest rate is % in the euro zone and % in the U.S.pute the guaranteed euro proceeds from the American sale if Airbus decides to hedge using aforward contract.b.If Airbus decides to hedge using money market instruments, what action does Airbus need to takeWhat would be the guaranteed euro proceeds from the American sale in this casec.If Airbus decides to hedge using put options on . dollars, what would be the ‘expected’ europroceeds 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 andmoney market hedgeSolution:a. Airbus will sell $30 million for ward for €27,272,727 = ($30,000,000) / ($€).b. Airbus will borrow the present value of the dollar receivable, ., $29,126,214 = $30,000,000/, and then sell the dollar proceeds spot for euros: €27,739,251. This is the euro amount that Airbus is going to ke ep.c. Since the expected future spot rate is less than the strike price of the put option, ., €< €, Airbus expects to exercise the option and receive €28,500,000 = ($30,000,000)(€$). This is gross proceeds. Airbus spent €600,000 (=,000,000) upfront for the option and its future cost is equal to €615,000 = €600,000 x . Thus the net europroceeds 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 = S T (30,000,000) - €615,000.Solving for S T, we obtain the “indifference” future spot exchange rate, ., €$, or $€. Note that €28,432,732 is the future value of the proceeds under money market hedging:€28,432,732 = (€27,739,251) .Suggested solution for Mini Case: Chase Options, Inc.[See Chapter 13 for the case text]Chase Options, Inc.Hedging Foreign Currency Exposure Through Currency OptionsHarvey A. PoniachekI. Case SummaryThis case reviews the foreign exchange options market and hedging. It presents various international transactions that require currency options hedging strategies by the corporations involved. Seven transactions under a variety of circumstances are introduced that require hedging by currency options. The transactions involve hedging of dividend remittances, portfolio investment exposure, and strategic economic competitiveness. Market quotations are provided for options (and options hedging ratios), forwards, and interest rates for various maturities.II. Case Objective.The case introduces the student to the principles of currency options market and hedging strategies. The transactions are of various types that often confront companies that are involved in extensive international business or multinational corporations. The case induces students to acquire hands-on experience in addressing specific exposure and hedging concerns, including how to apply various market quotations, which hedging strategy is most suitable, and how to address exposure in foreign currency through cross hedging policies.III. Proposed Assignment Solution1. The company expects DM100 million in repatriated profits, and does not want the DM/$ exchange rate at which they convert those profits to rise above . They can hedge this exposure using DM put options with a strike price of . If the spot rate rises above , 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 = DM 1,640,000.With a strike price of DM/$, this would assure the U.S. company of receiving at least:DM 100,000,000 – DM 1,640,000 x (1 + x 272/360)= DM 98,254,544/ DM/$ = $57,796,791by exercising the option if the DM depreciated. Note that the proceeds from the repatriated profits are reduced by the premium paid, which is further adjusted by the interest foregone on this amount. However, if the DM were to appreciate relative to the dollar, the company would allow the option to expire, and enjoy greater dollar proceeds from this increase.Should forward contracts be used to hedge this exposure, the proceeds received would be:DM100,000,000/ DM/$ = $59,790,732,regardless of the movement of the DM/$ exchange rate. While this amount is almost $2 million more than that realized using option hedges above, there is no flexibility regarding the exercise date; if this date differs from that at which the repatriate profits are available, the company may be exposed to additional further current exposure. Further, there is no opportunity to enjoy any appreciation in the DM. If the company were to buy DM puts as above, and sell an equivalent amount in calls with strike price , the premium paid would be exactly offset by the premium received. This would assure that the exchange rate realized would fall between and . If the rate rises above , the company will exercise its put option, and if it fell below , the other party would use its call; for any rate in between, both options would expire worthless. The proceeds realized would then fall between:DM 100,00,000/ DM/$ = $60,716,454andDM 100,000,000/ DM/$ = $58,823,529.This would allow the company some upside potential, while guaranteeing proceeds at least $1 million greater than the minimum for simply buying a put as above.Buy/Sell OptionsDM/$SpotPut Payoff “Put”Profits Call Payoff“Call”Profits Net Profit(1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 0 1,742,846 60,716,454 60,716,454 (1,742,846) 60,606,061 1,742,846 0 60,606,061 (1,742,846) 60,240,964 1,742,846 0 60,240,964 (1,742,846) 59,880,240 1,742,846 0 59,880,240 (1,742,846) 59,523,810 1,742,846 0 59,523,810 (1,742,846) 59,171,598 1,742,846 0 59,171,598 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529(1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529 (1,742,846) 58,823,529 1,742,846 0 58,823,529Since 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 = 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 A$/$. Since he is willing to forego any further currency appreciation, he can sell A$ calls with a strike price of A$/$ to defray the cost of his hedge (in fact he earns a net premium of A$ 100,000,000 x –= A$ 2,300), while knowing that he can’t receive less than 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 puts1) Write calls for $/A$ @Buy puts for $/A$ @# contracts needed = Principal in A$/Contract size100,000,000A$/100,000 A$ = 1002) 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 payoffIf spot falls below , fund manager will exercise putIf spot rises above , fund manager will let put expire5) Call payoffIf spot rises above .8025, call will be exercised If spot falls below .8025, call will expire6) Net payoffSee following Table for net payoff Australian Dollar Bond HedgeStrikePrice Put Payoff “Put”Principal Call Payoff“Call”Principal Net Profit(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 72,000,000 75,573 0 72,000,241(75,332) 73,000,000 75,573 0 73,000,241(75,332) 74,000,000 75,573 0 74,000,241(75,332) 75,000,000 75,573 0 75,000,241(75,332) 76,000,000 75,573 0 76,000,241(75,332) 77,000,000 75,573 0 77,000,241(75,332) 78,000,000 75,573 0 78,000,241(75,332) 79,000,000 75,573 0 79,000,241(75,332) 80,000,000 75,573 0 80,000,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241(75,332) 0 75,573 80,250,000 80,250,241 4. The German company is bidding on a contract which they cannot be certain of winning. Thus, the need to execute a currency transaction is similarly uncertain, and using a forward or futures as a hedge is inappropriate, because it would force them to perform even if they do not win the contract.Using a sterling put option as a hedge for this transaction makes the most sense. For a premium of:12 million STG x = 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 strike vs. 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 = 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 , 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 ., 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 size9600 = ($100,000,000)(120￥/$) / ￥1,250,0002) Total Cost = (# contracts)(contract size)(premium)$1,524,000 = (9600)( ￥1,250,000)($￥)3) Floor rate = Exercise – Premium￥/$ = ￥/$ - $1,524,000/12,000,000,000￥4) The payoff changes depending on the level of the ￥/$ rate. The following table summarizes thepayoffs. An equilibrium is reached when the spot rate equals the floor rate.AMC ProfitabilityYen/$ Spot Put Payoff Sales Net Profit120 (1,524,990) 100,000,000 98,475,010121 (1,524,990) 99,173,664 97,648,564122 (1,524,990) 98,360,656 96,835,666123 (1,524,990) 97,560,976 86,035,986124 (1,524,990) 96,774,194 95,249,204125 (1,524,990) 96,000,000 94,475,010126 (1,524,990) 95,238,095 93,713,105127 (847,829) 94,488,189 93,640,360128 (109,640) 93,750,000 93,640,360129 617,104 93,023,256 93,640,360130 1,332,668 92,307,692 93,640,360131 2,037,307 91,603,053 93,640,360132 2,731,269 90,909,091 93,640,360133 3,414,796 90,225,664 93,640,360134 4,088,122 89,552,239 93,640,360135 4,751,431 88,888,889 93,640,360136 5,405,066 88,235,294 93,640,360137 6,049,118 87,591,241 93,640,360138 6,683,839 86,966,522 93,640,360139 7,308,425 86,330,936 93,640,360140 7,926,075 85,714,286 93,640,360141 8,533,977 85,106,383 93,640,360142 9,133,318 84,507,042 93,640,360143 9,724,276 83,916,084 93,640,360144 10,307,027 83,333,333 93,640,360145 10,881,740 82,758,621 93,640,360146 11,448,579 82,191,781 93,640,360147 12,007,707 81,632,653 93,640,360148 12,569,279 81,081,081 93,640,360149 13,103,448 80,536,913 93,640,360150 13,640,360 80,000,000 93,640,360The 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。

CHAPTER 3 BALANCE OF PAYMENTSSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. 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 reaso ns. First, BOP provides detailed information about the supply and demand of the country’s currency. Second, BOP data can be used to evaluate the performance of the country in international economic competition. For example, if a country is experiencing per ennial 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 protectionistsentiment 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 fin d 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 su pported 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 down its reserve holdings.12. Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments:(1) A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank account kept in New York City.(2) A U.S. citizen consumes a meal at a restaurant in Paris and pays with her American Express card.(3) A Indian immigrant living in Los Angeles sends a check drawn on his L.A. bank account as a gift to his parents living in Bombay.(4) A U.S. computer programmer is hired by a British company for consulting and gets paid from the U.S. bank account maintained by the British company.Answer:_________________________________________________________________Transactions Credit Debit_________________________________________________________________Japanese purchase of U.S. T bonds √Japanese payment using NYC account √U.S. citizen having a meal in Paris √Paying the meal with American Express √Gift to parents in Bombay √Receipts of the check by parents (goodwill) √Export of programming service √British payment out its account in U.S. √_________________________________________________________________13. Construct the balance of payment table for Japan for the year of 1998 which is comparable in format to Exhibit 3.1, and interpret the numerical data. You may consult International Financial Statistics published by IMF or research for useful websites for the data yourself.Answer:A summary of the Japanese Balance of Payments for 1998 (in $ billion)Credits DebitsCurrent Account(1) Exports 646.03(1.1) Merchandise 374.04(1.2) Services 62.41(1.3) Factor income 209.58(2) Imports -516.50(2.1) Merchandise -251.66(2.2) Services -111.83(3.3) Factor income -153.01(3) Unilateral transfer 5.53 -14.37Balance on current account 120.69[(1) + (2) + (3)]Capital Account(4) Direct investment 3.27 -24.62(5) Portfolio investment 73.70 -113.73(5.1) Equity securities 16.11 -14.00(5.2) Debt securities 57.59 -99.73(6) Other investment 39.51 -109.35Balance on financial account -131.22[(4) + (5) + (6)](7) Statistical discrepancies 4.36Overall balance -6.17Official Reserve Account 6.17Source: 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 PROBLEMRecently, 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 tr end 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 ProblemTo 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 5 THE MARKET FOR FOREIGN EXCHANGESUGGESTED ANSWERS AND SOLUTIONS TO END—OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. 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。

国际财务管理课后习题答案chapter3***** 3 ***** OF *****S*****ED ***** AND *****NS TO END-OF-**********NS AND *****S*****NS1. Define the balance of payments.Answer: The balance of payments (BOP) can be defined as the statistical record of a country?s international transactions over a certain period of time presented in the form of double-entry bookkeeping.2. Why would it be useful to examine a country?s balance of payments data?Answer: It would be useful to examine a country?s BOP for at least two reasons. First, BOP provides detailed information about the supply and demand of the country?s currency. Second, BOP data can be used to evaluate the performance of the country in international economic competition. For example, if a country is experiencing perennial BOP deficits, it may signal that the country?s industries lack competitiveness.3. The United States has experienced continuous current account deficits since the early 1980s. What do you think are the main causes for the deficits? What would be the consequences of continuous U.S. current account deficits?Answer: The current account deficits of U.S. may have reflected a few reasons such as (I) a historically high real interest rate in the U.S., which is due to ballooning federal budget deficits, that kept the dollar strong, and (ii) weak competitiveness of the U.S. industries.4. In contrast to the U.S., Japan has realized continuous current account surpluses. What could be the main causes for these surpluses? Is it desirable to have continuous current account surpluses?Answer: Japan?s continuous current account surpluses may have reflected a weak yen and high competitiveness of Japanese industries. Massive capital exports by Japan prevented yen from appreciating more than it did. At the same time, foreigners? exports to Japan were hampered by closed nature of Japanese markets. Continuous current account surpluses disrupt free trade by promoting protectionist IM-1sentiment 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 byadding 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.IM-29. 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 beequal in size, but opposite in sign, to the change in the official reserves: BCA + BKA = -BRA. Under the pure flexible exchange rate regime, central banks do not engage in official reserve transactions. Thus, the overall balance must balance, i.e., BCA = -BKA. Under the fixed exchange rate regime, however, a country can have an overall BOP surplus or deficit as the central bank will accommodate it via official reserve transactions.11. Exhibit 3.3 indicates that in 1991, the U.S. had a current account deficit and at the same time a capital account deficit. Explain how this can happen?Answer: In 1991, the U.S. experienced an overall BOP deficit, which must have been accommodated by the Federal Reserve?s official reserve action, i.e., drawing down its reserve holdings.12. Explain how each of the following transactions will be classified and recorded in the debit and credit of the U.S. balance of payments:(1) A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank account kept in New York City.(2) A U.S. citizen consumes a meal at a restaurant in Paris and pays with her American Express card. (3) A Indian immigrant living in Los Angeles sends a check drawn on his L.A. bank account as a gift to his parents living in Bombay.IM-3(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:_________________________________________________________________ TransactionsJapanese purchase of U.S. T bonds? ? ? ???? ?Credit Debit_________________________________________________________________ Japanese payment using NYC accountU.S. citizen having a meal in Paris Paying the meal with American ExpressGift to parents in Bombay Receipts of the check by parents (goodwill)Export of programming serviceBritish 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.IM-4Answer:A summary of the Japanese Balance of Payments for 1998 (in $ billion)Current Account (1) Exports(2) Imports(3) Unilateral transferCapital Account (4) Direct investment (5) Portfolio investmentBalance on financial account [(4) + (5) + (6)]Overall balance (5.1) Equity securities (5.2) Debt securities Balance on current account [(1) + (2) + (3)] (2.1) Merchandise (2.2) Services(3.3) Factor income (1.1) Merchandise (1.2) Services (1.3) Factor incomeCredits646.03 374.04 62.41 209.585.53 120.693.27 73.70 16.11 57.59 39.514.36 6.17Debits-516.50 -251.66 -111.83 -153.01-14.37 -24.62 -113.73 -14.00 -99.73 -109.35-131.22-6.17(6) Other investment(7) Statistical discrepancies Official Reserve AccountSource: 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.IM-5。

CHAPTER 5 THE MARKET FOR FOREIGN EXCHANGESUGGESTED ANSWERS AND SOLUTIONS TO END—OF—CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. 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。

CHAPTER 7 FUTURES AND OPTIONS ON FOREIGN EXCHANGESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. 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 thatbuyers 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 cont racts 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 S t > E (E > S t) is referred to as trading in-the-money. If S t E the option is trading at-the-money. If S t< E (E < S t) the call (put) option is trading out-of-the-money.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: S t, E, r i, r$, T andσ. When all else remains the same, the price of a European FX call (put) option will increase:1. the larger (smaller) is S,2. the smaller (larger) is E,3. the smaller (larger) is r i,4. the larger (smaller) is r$,5. the larger (smaller) r$ is relative to r i, and6. the greater is σ.When r$ and r i 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 r i, 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 r i 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.PROBLEMS1. 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 day s’ 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. What is the size of your profit (loss) if the futures price is indeed an unbiased predictor of the future spot price and this price materializes?Solution: If you expect the Mexican peso to rise from $0.08845 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 of7.3 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 TermsSeptember 20, 1999 December 20, 1999 March 20, 2000 • Borrow $100 million at • Pay interest for first three • Pay back principal September 20 LIBOR + 200 months plus interestbasis points (bps) • Roll loan over at• September 20 LIBOR = 7% December 20 LIBOR +200 bpsLoan First loan payment (9%) Second paymentinitiated and futures contract expires and principal↓↓↓•••9/20/99 12/20/99 3/20/00a. 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 First Second Third Fourth payment initiated payment (9%) payment payment and principal ↓↓↓↓↓•••••9/20/99 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 Answera. 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 FUT = Change in Value = (face value) x (days to maturity / 360) x (change in yield)= ($1 million) x (90 / 360) x (.0001)= $25The number of contract, N, can be found by:N = (BPV spot) / (BPV futures)= ($2,500) / ($25)= 100ORN = (value of spot position) / (face value of each futures contract)= ($100 million) / ($1 million)= 100ORN = (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)]102 contractsTherefore 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. For a 50 basis point increase in LIBOR, the cash flow on the short futures 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 = 0.093This 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.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 thefutures 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 OfferedRate).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. He is considering the alternative hedging strategies outlined in the following table.Initial Position (6/30/98) in90-Day LIBOR Eurodollar ContractsStrategy A Strategy BContract Month (contracts) (contracts)September 1998 300 100December 1998 0 100March 1999 0 100a. Explain why strategy B is a more effective hedge than strategy A when the yield curveundergoes an instantaneous nonparallel shift.b. Discuss an interest rate scenario in which strategy A would be superior to strategy B.CFA Guideline Answera. Strategy B’s SuperiorityStrategy 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 SuperiorStrategy 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 Value97 Sep Call 2.08 - Max[95.80 – 97.00 = - 1.20, 0] = 2.08 cents per 100 yen97 Sep Put 2.47 - Max[97.00 – 95.80 = 1.20, 0] = 1.27 cents per 100 yen9. Assume spot Swiss franc is $0.7000 and the six-month forward rate is $0.6950. What is the minimum price that a six-month American call option with a striking price of $0.6800 should sell for in a rational market? Assume the annualized six-month Eurodollar rate is 3 ½ percent.Solution:Note to Instructor: A complete solution to this problem relies on the boundary expressions presented in footnote 3 of the text of Chapter 7.C a≥Max[(70 - 68), (69.50 - 68)/(1.0175), 0]≥Max[ 2, 1.47, 0] = 2 cents10. Do problem 9 again assuming an American put option instead of a call option.Solution: P a≥Max[(68 - 70), (68 - 69.50)/(1.0175), 0]≥Max[ -2, -1.47, 0] = 0 cents11. 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 = .2675d2 = d1 - .142√.50 = .2765 - .1004 = .1671N(d1) = .6055N(d2) = .5664N(-d1) = .3945N(-d2) = .4336C e = [69.50(.6055) - 68(.5664)]e-(.035)(.50) = 3.51 centsP e = [68(.4336) - 69.50(.3945)]e-(.035)(.50) = 2.03 cents12. 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 C uT= 9.39¢ = 77.39¢ - 68. If the Swiss franc depreciates it would not be rational to exercise the option; its value would be C dT = 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 SPECULATORA 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 worthless. He will only lose the option premium.4. S T = E + C = 96 + 1.35 = 97.35 cents per 100 yen.。

CHAPTER 7 FUTURES AND OPTIONS ON FOREIGN EXCHANGESUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. 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 thatbuyers 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 cont racts 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 S t > E (E > S t) is referred to as trading in-the-money. If S t E the option is trading at-the-money. If S t< E (E < S t) the call (put) option is trading out-of-the-money.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: S t, E, r i, r$, T andσ. When all else remains the same, the price of a European FX call (put) option will increase:1. the larger (smaller) is S,2. the smaller (larger) is E,3. the smaller (larger) is r i,4. the larger (smaller) is r$,5. the larger (smaller) r$ is relative to r i, and6. the greater is σ.When r$ and r i 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 r i, 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 r i 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.PROBLEMS1. 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 day s’ 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. What is the size of your profit (loss) if the futures price is indeed an unbiased predictor of the future spot price and this price materializes?Solution: If you expect the Mexican peso to rise from $0.08845 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 of7.3 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 TermsSeptember 20, 1999 December 20, 1999 March 20, 2000 • Borrow $100 million at • Pay interest for first three • Pay back principal September 20 LIBOR + 200 months plus interestbasis points (bps) • Roll loan over at• September 20 LIBOR = 7% December 20 LIBOR +200 bpsLoan First loan payment (9%) Second paymentinitiated and futures contract expires and principal↓↓↓•••9/20/99 12/20/99 3/20/00a. 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 First Second Third Fourth payment initiated payment (9%) payment payment and principal ↓↓↓↓↓•••••9/20/99 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 Answera. 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 FUT = Change in Value = (face value) x (days to maturity / 360) x (change in yield)= ($1 million) x (90 / 360) x (.0001)= $25The number of contract, N, can be found by:N = (BPV spot) / (BPV futures)= ($2,500) / ($25)= 100ORN = (value of spot position) / (face value of each futures contract)= ($100 million) / ($1 million)= 100ORN = (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)]102 contractsTherefore 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. For a 50 basis point increase in LIBOR, the cash flow on the short futures 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 = 0.093This 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.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 thefutures 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 OfferedRate).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. He is considering the alternative hedging strategies outlined in the following table.Initial Position (6/30/98) in90-Day LIBOR Eurodollar ContractsStrategy A Strategy BContract Month (contracts) (contracts)September 1998 300 100December 1998 0 100March 1999 0 100a. Explain why strategy B is a more effective hedge than strategy A when the yield curveundergoes an instantaneous nonparallel shift.b. Discuss an interest rate scenario in which strategy A would be superior to strategy B.CFA Guideline Answera. Strategy B’s SuperiorityStrategy 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 SuperiorStrategy 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 Value97 Sep Call 2.08 - Max[95.80 – 97.00 = - 1.20, 0] = 2.08 cents per 100 yen97 Sep Put 2.47 - Max[97.00 – 95.80 = 1.20, 0] = 1.27 cents per 100 yen9. Assume spot Swiss franc is $0.7000 and the six-month forward rate is $0.6950. What is the minimum price that a six-month American call option with a striking price of $0.6800 should sell for in a rational market? Assume the annualized six-month Eurodollar rate is 3 ½ percent.Solution:Note to Instructor: A complete solution to this problem relies on the boundary expressions presented in footnote 3 of the text of Chapter 7.C a≥Max[(70 - 68), (69.50 - 68)/(1.0175), 0]≥Max[ 2, 1.47, 0] = 2 cents10. Do problem 9 again assuming an American put option instead of a call option.Solution: P a≥Max[(68 - 70), (68 - 69.50)/(1.0175), 0]≥Max[ -2, -1.47, 0] = 0 cents11. 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 = .2675d2 = d1 - .142√.50 = .2765 - .1004 = .1671N(d1) = .6055N(d2) = .5664N(-d1) = .3945N(-d2) = .4336C e = [69.50(.6055) - 68(.5664)]e-(.035)(.50) = 3.51 centsP e = [68(.4336) - 69.50(.3945)]e-(.035)(.50) = 2.03 cents12. 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 C uT= 9.39¢ = 77.39¢ - 68. If the Swiss franc depreciates it would not be rational to exercise the option; its value would be C dT = 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 SPECULATORA 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 worthless. He will only lose the option premium.4. S T = E + C = 96 + 1.35 = 97.35 cents per 100 yen.。

CHAPTER 6 INTERNATIONAL PARITY RELATIONSHIPSSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS1. 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$)]E[S t+1 I t].The exchange rate is thus determined by the relative interest rates, and the expected future spot rate, conditional on all the available information, I t, as of the present time. One thus can say that expectation is self-fulfilling. Since the information set will be continuously updated as news hit the market, the exchange rate will exhibit a highly dynamic, random behavior.3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the future spot exchange rate.Answer: The forward exchange rate will be an unbiased predictor of the future spot rate if (I) the risk premium is insignificant and (ii) foreign exchange markets are informationally efficient.4. Explain the purchasing power parity, both the absolute and relative versions. What causes the deviations from the purchasing power parity?Answer: The absolute version of purchasing power parity (PPP):S = P$/P£.The relative version is:e = π$ - π£.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.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, and3. 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 standardconsumption basket. LOP requires that the consumption basket should be selling for the same price ina given currency across countries.A. b. Absolute PPP holds that the price level in a country is equal to the price level in another countrytimes 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 aboutequalto 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 becauseinternational commodity arbitrage is a time-consuming process.B. b. PPP is useful for predicting exchange rates on the long-term basis.PROBLEMS1. 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 monthsi NY = 0.35%/month, compounding monthlyi LD = 2.0% for three monthsS = $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 diff erence between $49,755 and $48489.3. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£. The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume that you can borrow as much as $1,500,000 or £1,000,000.a. Determine whether the interest rate parity is currently holding.b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps and determine the arbitrage profit.c. Explain how the IRP will be restored as a result of covered arbitrage activities.Solution: Let’s summarize the given data first:S = $1.5/£; F = $1.52/£; I$ = 2.0%; I£ = 1.45%Credit = $1,500,000 or £1,000,000.a. (1+I$) = 1.02(1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280Thus, 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 $1,542,040Arbitrage profit will be $12,040c. Following the arbitrage transactions described above,The dollar interest rate will rise;The pound interest rate will fall;The spot exchange rate will rise;The forward exchange rate will fall.These adjustments will continue until IRP holds.4. Suppose that the current spot exchange rate is €0.80/$ and the three-month forward exchange rate is €0.7813/$. The three-month interest rate is5.6 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 tomake 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 atmaturity.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 bedifferent.5.Buy $1,014,000 forward for €1,034,280.Arbitrage profit = €1,074,310 - €1,034,280 = €40,0305. In the issue of October 23, 1999, the Economist reports that the interest rate per annum is 5.93% in the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based on the reported interest rates, how would you predict the change of the exchange rate between the U.S. dollarand the Turkish lira?Solution: A high Turkish interest rate must reflect a high expected inflation in Turkey. According to international Fisher effect (IFE), we haveE(e) = i$ - i Lira= 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(π$) - E(πR$)= 2.6% - 20.0%= -17.4%E(S T) = S o(1 + E(e))= (R$1.95/$) (1 + 0.174)= R$2.29/$7. (CFA question) Omni Advisors, an international pension fund manager, uses the concepts of purchasing power parity (PPP) and the International Fisher Effect (IFE) to forecast spot exchange rates. Omni gathers the financial information as follows:Base price level 100Current U.S. price level 105Current South African price level 111Base rand spot exchange rate $0.175Current rand spot exchange rate $0.158Expected annual U.S. inflation 7%Expected annual South African inflation 5%Expected U.S. one-year interest rate 10%Expected South African one-year interest rate 8%Calculate the following exchange rates (ZAR and USD refer to the South African and U.S. dollar, respectively).a. The current ZAR spot rate in USD that would have been forecast by PPP.b. Using the IFE, the expected ZAR spot rate in USD one year from now.c. Using PPP, the expected ZAR spot rate in USD four years from now.Solution:a. ZAR spot rate under PPP = [1.05/1.11](0.175) = $0.1655/rand.b. Expected ZAR spot rate = [1.10/1.08] (0.158) = $0.1609/rand.c. Expected ZAR under PPP = [(1.07)4/(1.05)4] (0.158) = $0.1704/rand.8. Suppose that the current spot exchange rate is €1.50/₤ and the one-year forward exchange rate is €1.60/₤. The one-year interest rate is 5.4% in euros and 5.2% in pounds. You can borrow at most €1,000,000 or the equivalent pound amount, i.e., ₤666,667, at the current spot exchange rate.a.Show how you can realize a guaranteed profit from covered interest arbitrage. Assume that you are aeuro-based investor. Also determine the size of the arbitrage profit.b.Discuss how the interest rate parity may be restored as a result of the abovetransactions.c.Suppose you are a pound-based investor. Show the covered arbitrage process anddetermine the pound profit amount.Solution:a. First, note that (1+i €) = 1.054 is less than (F/S)(1+i €) = (1.60/1.50)(1.052) = 1.1221.You should thus borrow in euros and lend in pounds.1)Borrow €1,000,000 and promise to repay €1,054,000 in one year.2)Buy ₤666,667 spot for €1,000,000.3)Invest ₤666,667 at the pound interest rate of 5.2%; the maturity value will be ₤701,334.4)To hedge exchange risk, sell the maturity value ₤701,334 forward in exchange for €1,122,134.The arbitrage profit will be the difference between €1,122,134 and €1,054,000, i.e., €68,134.b. As a result of the above arbitrage transactions, the euro interest rate will rise, the poundinterest rate will fall. In addition, the spot exchange rate (euros per pound) will rise and the forward rate will fall. These adjustments will continue until the interest rate parity is restored.c. The pound-based investor will carry out the same transactions 1), 2), and 3) in a. But to hedge, he/she will bu y €1,054,000 forward in exchange for ₤658,750. The arbitrage profit will then be ₤42,584 = ₤701,334 - ₤658,750.9. Due to the integrated nature of their capital markets, investors in both the U.S. and U.K. require the same real interest rate, 2.5%, on their lending. There is a consensus in capital markets that the annual inflation rate is likely to be 3.5% in the U.S. and 1.5% in the U.K. for the next three years. The spot exchange rate is currently $1.50/£.pute the nominal interest rate per annum in both the U.S. and U.K., assuming that the Fishereffect holds.b.What is your expected future spot dollar-pound exchange rate in three years from now?c.Can you infer the forward dollar-pound exchange rate for one-year maturity?Solution.a. Nominal ra te in US = (1+ρ) (1+E(π$)) – 1 = (1.025)(1.035) – 1 = 0.0609 or 6.09%.Nominal rate in UK= (1+ρ) (1+E(π₤)) – 1 = (1.025)(1.015) – 1 = 0.0404 or 4.04%.b. E(S T) = [(1.0609)3/(1.0404)3] (1.50) = $1.5904/₤.c. F = [1.0609/1.0404](1.50) = $1.5296/₤.Mini Case: Turkish Lira and the Purchasing Power ParityVeritas Emerging Market Fund specializes in investing in emerging stock markets of the world. Mr. Henry Mobaus, an experienced hand in international investment and your boss, is currently interested in Turkish stock markets. He thinks that Turkey will eventually be invited to negotiate its membership in the European Union. If this happens, it will boost the stock prices in Turkey. But, at the same time, he is quite concerned with the volatile exchange rates of the Turkish currency. He would like to understand what drives the Turkish exchange rates. Since the inflation rate is much higher in Turkey than in the U.S., he thinks that the purchasing power parity may be holding at least to some extent. As a research assistant for him, you were assigned to check this out. In other words, you have to study and prepare a report on the following question: Does the purchasing power parity hold for the Turkish lira-U.S. dollar exchange rate? Among other things, Mr. Mobaus would like you to do the following:Plot the past exchange rate changes against the differential inflation rates betweenTurkey and the U.S. for the last four years.Regress the rate of exchange rate changes on the inflation rate differential to estimatethe intercept and the slope coefficient, and interpret the regression results.Data source: You may download the consumer price index data for the U.S. and Turkey from the following website: /home/0,2987,en_2649_201185_1_1_1_1_1,00.html, “hot file” (Excel format) . You may download the exchange rate data from the website: merce.ubc.ca/xr/data.html.Solution:a. In the current solution, we use the monthly data from January 1999 – December 2002.b. We regress exchange rate changes (e) on the inflation rate differential and estimate theintercept (α ) and slope coefficient (β):3.095) (t 1.472βˆ0.649)- (t 0.011αˆε Inf_US) -Inf_Turkey (βˆαˆ e tt ===-=++=The estimated intercept is insignificantly different from zero, whereas the slope coefficient is positive and significantly different from zero. In fact, the slope coefficient is insignificantly different from unity. [Note that t-statistics for β = 1 is 0.992 = (1.472 – 1)/0.476 where s.e. is 0.476] In other words, we cannot reject the hypothesis that the intercept is zero and the slope coefficient is one. The results are thus supportive of purchasing power parity.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 th e 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 thatE(π$) = I$ - ρ$,E(π£) = I£ - ρ£.Assuming that the real interest rate is the same between the two countries, i.e., ρ$ = ρ£, and substituting the above results into the PPP, i.e., E(e) = E(π$)- E(π£), we obtain the international Fisher effect: E(e) = I$ - 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.。

CHAPTER 4 CORPORATE GOVERNANCE AROUND THE WORLDSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQuestions1.The majority of major corporations are franchised as public corporations. Discuss the key strengthand weakness of the ‘public corporation’. When do you think the public corporation as an organizational form is unsuitable?Answer: The key strength of the public corporation lies in that it allows for efficient risk sharing among investors. As a result, the public corporation may raise a large sum of capital at a relatively low cost. The main weakness of the public corporation stems from the conflicts of interest between managers and shareholders.2.The public corporation is owned by multitude of shareholders but managed by professional managers.Managers can take self-interested actions at the expense of shareholders. Discuss the conditions under which the so-called agency problem arises.Answer: The agency problem arises when managers have control rights but insignificant cash flow rights. This wedge between control and cash flow rights motivates managers to engage in self-dealings at the expense of shareholders.3.Following corporate scandals and failures in the U.S. and abroad, there is a growingdemand for corporate governance reform. What should be the key objectives ofcorporate governance reform? What kind of obstacles can there be thwarting reformefforts?Answer: The key objectives of corporate governance reform should be to strengthen shareholder rights and protect shareholders from expropriation by corporate insiders, whether managers or large shareholders. Controlling shareholders or managers do not wish to lose their control rights and thus resist reform efforts.4.Studies show that the legal protection of shareholder rights varies a great deal acrosscountries. Discuss the possible reasons why the English common law traditionprovides the strongest and the French civil law tradition the weakest protection ofinvestors.Answer: In civil law countries, the state historically has played an active role in regulating economic activities and has been less protective of property rights. In England, control of the court passed from the crown to the parliament and property owners in seventeenth century. English common law thus became more protective of property owners, and this protection was extended to investors over time.5.Explain ‘the wedge’ between the control and cash flow rights and discuss its implications forcorporate governance.Answer: When there is a separation of ownership and control, managers have control rights with insignificant cash flow rights, whereas shareholders have cash flow rights but no control rights. This wedge gives rise to the conflicts of interest between managers and shareholders. The wedge is the source of the agency problem.6.Discuss different ways that dominant investors use to establish and maintain the control of thecompany with relatively small investments.Answer: Dominant investors may use: (i) shares with superior voting rights, (ii) pyramidal ownership structure, and (iii) inter-firm cross-holdings.7.The Cadbury Code of the Best Practice adopted in the United Kingdom led to a successful reform ofcorporate governance in the country. Explain the key requirements of the Code and discuss how it may have contributed to the success of reform.Answer: The Code requires that chairman of the board and CEO be held by two different individuals, and that there should be at least three outside board members. The recommended board structure helped to strengthen the monitoring function of the board and reduce the agency problem.8.Many companies grant stocks or stock options to the managers. Discuss the benefitsand possible costs of using this kind of incentive compensation scheme.Answer: Stock options can be useful for aligning the interest of managers with that of shareholders and reduce the wedge between managerial control rights and cash flow rights. But at the same time, stock options may induce managers to distort investment decisions and manipulate financial statements so that they can maximize their benefits in the short run.9.It has been shown that foreign companies listed in the U.S. stock exchanges are valued more thanthose from the same countries that are not listed in the U.S. Explain the reasons why U.S.-listed foreign firms are valued more than those which are not. Also explain why not every foreign firm wants to list stocks in the United States.Answer: Foreign companies domiciled in countries with weak investor protection can bond themselves credibly to better investor protection by listing their stocks in U.S. exchanges that are known to provide a strong investor protection. Managers of some companies may not wish to list shares in U.S. exchanges, subjecting themselves to stringent disclosure and monitoring, for fear of losing their control rights and private benefits.。