FINANCIAL ISSUES IS GLOBAL BUSINESS – FIN 4218

Session: April 2017

TUTORIALS

Question 1

Assume that the British pound is worth 1.9750 U.S. dollars. If a new Jaguar costs $100,000, what
is the cost in British pounds?

Question 2

Suppose a U.S. importer purchases an Italian product today but will not pay for it for 90 days.
The cost of the product today is 50,000 euros. The spot exchange rate today is .76123 euros per
dollar. How much is the cost today in dollars?

Question 3

Suppose a U.S. importer purchases an Italian product today but will not pay for it for 90 days.
The cost of the product today is 50,000 euros. The spot exchange rate today is .76123 euros per
dollar. The importer creates a forward-market hedge. The 90-day forward rate is .75000 euros
per dollar. The amount the U.S. importer will pay in 90 days is ________.

Question 4

What is direct foreign investment? What are the additional risks that a multinational corporation
must consider before undertaking direct investment in a foreign country?

Question 5

The current direct quote in New York is .010875 dollars per yen. Suppose the current direct
quote in Tokyo is 89 yen per dollar. What is the appropriate indirect quote in New York? What
will arbitrageurs do to eliminate the differential rates in these markets?

Question 6

The spot exchange rate in New York is 1.900 dollars per British pound. The 360-day forward
exchange rate is 1.976 dollars per pound. The one-year interest rate in Great Britain is 3% while
the one-year interest rate in the United States is 4%.

(a) If the interest rate in Great Britain remains at 3%, what should the interest rate be in the
United States according to the interest rate parity theory?

(b) An American investor with $20,000 decides to take advantage of the differences in rates.
Ignoring transaction costs, how can the American investor exploit the disequilibrium?
Compare the amount of money the investor will have at the end of the year if he or she
 invests in one-year U.S. securities versus one-year British securities.

Question 7

What is arbitrage? Assume that the dollar is quoted $1 = £0.5436 in New York and the pound
sterling is quoted as £1 = $1.87 in London. Is there an arbitrage opportunity? If so, what would
an astute trader do? What will happen to the quotes as trades are made at current prices?

Question 8

The one-year forward exchange rate is Rupees 50/$. If the one-year interest rate in the United
States is 5% and in India is 8%, what is the spot exchange rate so as to preclude arbitrage?

Question 9

A U.S.-based firm is planning to make an investment in Europe. The firm estimates that the
project will generate cash flows of 100,000 euros after one year. If the one-year forward
exchange rate is $1.50/euro and the dollar cost of capital is 8%, what is the present value (PV) of
the project cash flows?

Question 10

You are a U.S. investor who is trying to calculate the present value (PV) of £5 million cash
inflow that will occur one year in the future. The spot exchange rate is S = $1.8839/£ and the
forward rate is F1 = $1.8862/£. The appropriate dollar discount rate for this cash flow is 5.32%
and the appropriate £ discount rate is 5.24%.
(a) The present value (PV) of the £5 million cash inflow computed by first discounting the £s
and then converting into dollars is closest to
(b) The present value (PV) of the £5 million cash inflow computed by first converting into
dollars and then discounting is closest to

Question 11

Suppose the domestic cost of capital for a U.S.-based company is 8%. Also, the U.S. interest
rate is 4% and the European interest rate is 7%. What is the foreign denominated cost of capital
for the company?

Question 12

The current spot exchange rate, S, is $1.8862/£. Suppose that the yield curve in both countries is
flat. The risk-free rate on dollars, r$, is 5.35% and the risk-free interest rat on pounds, r£, is
4.80%.
(a) Using the covered interest parity condition, the calculated one-year forward rate F1 is
closest to:
 (b) Using the covered interest parity condition, the calculated three-year forward rate F3 is
closest to:

Question 13

Luther Industries, a U.S. firm, is considering an investment in Japan. The dollar cost of equity
for Luther is 12%. The risk-free interest rates on dollars and yen are r$ = 5.5% and r¥ = 1.5%,
respectively. Luther industries is willing to assume that capital markets are internationally
integrated. Luther Industries needs to know the comparable cost of equity in Japanese yen for a
project with free cash flows that are uncorrelated with spot exchange rates. The yen cost of
equity for Luther Industries is closest to:

Question 14

Assume that a Toyota sold for 1,476,000 yen in 1985. If the price for this automobile was $8,200
in 1985, and the car still sells for the same amount of yen today, but the current exchange rate is
136 yen per dollar, what is the car selling for today in U.S. dollars?

Question 15

The Japanese yen is selling for 0.0080 US$ and the Euro is selling for 0.9252 US$. The cross
rate between the yen and the Euro is:

Question 16

Assume that an investor purchased 200,000,000 Japanese yen in New York at an exchange rate
of 137 yen to the dollar and simultaneously sold the yen in Tokyo at an exchange rate of 134
Japanese yen to the dollar. Further assume that there was no cost associated with this transaction.
What profit did the investor make?

Question 17

Assume that an importer of wine were to purchase 5,000 cases of premium French Bordeaux for
6,246,765 francs. Further assume that the quoted exchange rates are as follows: spot rate =
5.9815 francs to the U.S. dollar; 30-day forward rate = 5.9707 francs to the U.S. dollar; and 90-
day forward rate = 5.9493 francs to the U.S. dollar. If the actual currency exchange rate at the
time payment is due in 90 days is equal to the forward rate of 5.9493 francs to the U.S. dollar,
how much would the wine cost the importer in U.S. dollars if payment is made in 90 days?

Question 18

A bank is quoting the following exchange rates against the dollar for the Swiss franc and the
Australian dollar:

SFr/$ = 1.5960-70
A$/$ = 1.8225-35

An Australian firm asks the bank for a SFr/A$ quote. Calculate the cross-rate the bank would
quote.

Question 19

Assume an investor from the United States of America and has $ 1 million to invest. He has
obtained the following information:

Spot rate of £1 = $1.60

180-day forward rate of £1 = $1.5840

180-day British interest rate = 8% p.a.

180-day U.S. interest rate = 6% p.a.

Based on this information, does Interest Rate Parity holds? Explain.

Question 20

A New Zealand exporter exported beef to Germany and expect to receive to GBP 1 million. The
market rates are as follows:

USD / 1 NZD 0.6195 – 6200

USD / 1 GBP 1.8345 – 8350

Calculate the proceeds of the export in NZD.

Question 21

A bank is quoting the following exchange rates against the dollar for the Swiss franc and the
Australian dollar:

SFr/$ = 1.5960-70

A$/$ = 1.8225-35

An Australian firm asks the bank for a SFr/A$ quote. Calculate the cross-rate the bank would
quote.

Question 22

The exchange rate between the USD and the euro is €0.65 = $1.00 and the exchange rate
between the USD and the CND is $1.00 = C$0.98. What is the cross rate of euro to Canadian
dollar?
Question 23

Assume that one-year interest rates are 4.40% in the United States and 3.75% in the euro zone.
The spot rate between the euro and the dollar is €0.8250/$. Assuming the international Fisher
effect holds, what should the €/$ exchange rate be one year hence?

SECTION B

Question 1

Discuss the three types of exposure to exchange rate risk, including transaction exposure,
economic exposure and translation exposure.

Question 2

Compare and contrast the use of option and futures contract as a hedging instrument against
foreign exchange risk.

Question 3

Explain the meaning of interest rate parity.

Question 4

‘Forward contract is tailor-make. Therefore forward contract is more effective in hedging foreign
exchange risk than the futures contract.’ Discuss this statement by providing any FOUR (4)
differences between forward contract and futures contract.

Question 5

The spot dollar to pound exchange rate is $/£ = 1.4570-1.4576. This six-month forward dollar to
pound exchange rate is $/£ = 1.4408-1.4434.

(a) Explain whether the dollar trading at a discount or at a premium relative to the
dollar in the forward market.
(b) Compute the annualized forward discount of premium on the pound relative to the
dollar.
SECTION C

Question 1

Netting, matching, leading and lagging, and risk shares are the four techniques that could be
applied by a multinational enterprise (MNE) to hedge its exchange rate risk. Explain each of them.

Question 2

Strategic motives drive a domestic firm to invest abroad and become a multinational enterprise
(MNE). Discuss any THREE (3) main motives that drive the decision to initiate foreign direct
investment (FDI).
INTERNATIONAL FINANCE
Session: January 2013
Tutorial: Suggested Solutions
Question 1

Cost in GBP = 50,633

Question 2

Cost in USD = $65,683

Question 3

Amount in USD to pay in 90-day = $66,667

Question 4

Direct foreign investment is the purchase of plants and equipment in other countries. In addition
to business risk and financial risk, multinational corporations face political risk and exchange
risk when investing abroad.

Question 5

Indirect Quote in New York = 1/.010875 = 91.954 yen per dollar.

Arbitrageurs will buy yen in New York where the price is .010875 dollars per yen and sell yen in
Tokyo where the price is .0112359 dollars per yen. The increase in demand in New York will
increase the price while the selling pressure in Tokyo will lower the price.

Question 6

(a) 7%. The forward rate is a premium of 4% over the spot rate. The interest rate parity theory
suggests that the difference in interest rates should be of the same magnitude as the
difference in exchange rates, but in the opposite direction.
(b) If the investor buys U.S. securities, he or she will have ($20,000 x 1.04) = $20,800 at the end
of the year.
If the investor buys pounds, invests the pounds, and then sells the pounds via the forward
contract, he or she will end up with ($20,000/$1.900) x 1.03 x 1.976 = $21,424 at the end
of the year.

Question 7

Arbitrage is the simultaneous purchase and sale of an asset in more than one market resulting in
a riskless profit. There is an arbitrage opportunity because the price of a pound in New York is
$1.84 and the price of a pound in London is $1.87. Given the current quotes, an astute investor
will buy pounds in New York while simultaneously buying dollars in London. Example: A
$10,000 investment in New York will buy £5,436 ($10,000 x 0.5436). Simultaneously buying
dollars in London yields $10,165.32 (£5,436 x $1.87), a 1.65% gain. Since the transactions are
entered simultaneously, no risk is involved. The sale of dollars in New York for pounds and the
sale of pounds in London for dollars will force the rates back to equilibrium.

Question 8

Spot Rate = Forward rate x ((1 + rate in United States)/(1 + rate in India))
Spot Rate = 50 x ((1 + 0.05) / (1 + 0.08)) = 48.61

Question 9

Present Value = Cash Flows x Forward Rate /(1 + cost of capital)

Present Value = 100,000 x 1.5/(1 + 0.08) = $138,889

Question 10

(a) PV£ = = £4,751,045.23

PV$ = PV£ × S = £4,751,045.23 × $1.8839/£ = $8,950,494.10

(b) FV$ = £5 million × $1.8862/£ = $9,431,000

PV = = $8,954,615

Question 11

Foreign cost of capital = ((1 + foreign interest rate) / (1 +domestic interest rate)) x (1 + domestic
WACC) - 1
Foreign cost of capital = ((1 + 0.07) / (1 + 0.04)) x (1+ 0.08) - 1 = 11.12%

Question 12

(a) F1 = S × = $1.8862/£ × = $1.8961/£

(b) F3 = S × = $1.8862/£ × = $1.9161/£

Question 13

= (1 + )-1= (1.12) - 1 = 0.0775 or 7.75%

Question 14

Price of Car = $ 9,367

Question 15

Cross Rate = 115.650 Y/Euro

Question 16

Investor profit = $32,683

Question 17

Payment to be make in 90-day = $1,050,000

Question 18

The resulting quotation by the bank is

SFr/A$ = 0.8752-0.8763

Question 19

Since the investor is an American, the exchange rate quotation is a direct quote

Calculate the forward points by using the direct quote:

Forward points = [(Forward – Spot) / Spot] X (360 / 180) X 100

= [(1.5840 – 1.600) / 1.60] X 2 X 100

= – 2.% p.a. (2 marks)

Different in interest rate:

if – id = 8%p.a. – 6%p.a. = 2% p.a. (1 mark)

Since the interest rate differential is the same % but the oopposite sign to the forward discount on
GBP, IRP hold. (2 marks)

OR

Initially the U.S. investor could covert $ 1 million to £ and invest this amount and earn £ interest.
OR she could just invest this amount in $ and earns $ interest.

Invest in £

Covert $ 1 million into £:

$1 million / $1.60 per £ = £625,000

Invest this amount in £ to earn 180-day £ interest: £625,000 X [0.08 X (180/360)] = £25,000

Upon maturity of £ investment, convert the total amount i.e. £ (625000 + 25,000) = £650,000)
into $ at 180-day forward rate of $1.5840/£ = $ 1,029,600.00

Invest in $ and earn $ interest

$ 1 million X [0.06 X (180/360)] = $30,000

Upon maturity in 180-day time total amount receive will be $1,030,000.00

Since the total amount receive in both investments are approximately the same, there is no
arbitrage opportunity.

Question 20

Convert GBP 5 million to USD at the bank’s bid rate

= USD [1,000,000 X 1.8345]

= USD 1, 834, 5000 (2 marks)

Then convert this amount in USD to NZD at bank’s ask rate

= NZD (1,834,500 / 0.6200)

= NZD 2,958,871 (3 marks)

Question 21

The resulting quotation by the bank is

SFr/A$ = 0.8752-0.8763

Question 22
Euro / CND = (euro / USD) X (USD / CND)
= 0.65/1 X 1/0.98 = 0.65 / 0.98 = 0.6633 euro per CND
Question 23

Assumptions Value
One year interest rate, US dollars ($) 4.400%
One year interest ratre, euros (€) 3.750%

Current spot exchange rate (€/$) 0.8250

 International Fisher forecast of future spot rate (€/$)

Future Spot = Spot x ( 1 + i € ) / ( 1 + i $ ) 0.8199

SECTION B

Question 1

Economic exposure is the loss of sales that domestic exporter might experience if the domestic
currency appreciates relative to a foreign currency. That is, if the euro/dollar exchange rate
increases, a U. S. exporter to Europe would see a fall in revenue as the European buyers purchase
fewer U. S. exports that have effectively increased in price from the dollar appreciation.

Translation exposure refers to the fact that multination corporations might see a decline in the
value of their assets that are denominated in foreign currencies when those foreign currencies
depreciate. When the consolidated balance sheet is composed, changing exchange rates will
introduce variation in account values from year to year.

Transaction exposure is the risk that exchange rate fluctuations will make contracted future cash
flows from foreign trade partners decrease in domestic currency value or make planned
purchases of foreign goods more expensive.

Question 2

Option: holders of option are given the right, but not obligation, to buy/sell the underlying asset
at a predetermine strike price at a certain future date. This means option holder has limited
downside risk but unlimited profit.

Futures contract: holders of the futures contracts are committed to exercise his right at a certain
strike price in the certain future date. This means futures contract holder has unlimited profit and
loss.

Students are also required to point out other differences which include: option holder requires
paying an upfront investment sum whereas futures contract holder requires putting a margin for
entering into futures contract; etc.

Students are also expected to illustrate the payoff and, profit and loss of option contract and
futures contract by using appropriate diagram.

Question 3
 • The difference in the national interest rates for securities of similar risk and maturity
should be equal to, but opposite in sign to, the forward rate discount or premium for the
foreign currency, except for transaction costs.

Question 4

 Forwards and futures are for the same future delivery date.
 Forward and futures investors required to post margin.
 Forwards are traded in the OTC market whereas futures are traded in the exchange
market. Therefore in the forward market there is no formal and universal arrangement for
settling up as the expected future spot rate and consequent forward contract value move
up and down.
 Daily settlement of bets on futures means that a futures contract is equivalent to entering
a forward contract each day and settling each forward contract before opening another
one.
 Daily marking to futures means that any losses or gains are realized as they occur, on a
daily cycle.
 Forward contracts are customized and flexible to meet customer preferences whereas all
Futures contracts are of standard size.
 Cash Settlement and Delivery versus the Marking-to-Market Convention: Forward
contract normally lead to delivery of underlying currency but not the case for futures
contract. Therefore buyers or sellers of forward contracts are for hedging whereas futures
contract investors are for speculation.
 Forward contract – counterparty risks; Futures contract – clearinghouse risk

Question 5

(a) The midpoint of the spot dollar to pound exchange rate is $/£ = 1.4573. The midpoint of
the six-month forward dollar to pound exchange rate is $/£ = 1.4421. Based on the
midpoints, the dollar value of a pound is 1.4573 now and only 1.4421 six-month forward.
Thus, the pound is worth less than six months forward than now. That is, the pound is
trading at a discount relative to the dollar in the forward market. Put it another way, the
dollar is trading at a premium relative to the pound in the forward market.
(b)
Annualized discount

F−S 12
⋅ ⋅100 %
= S 6

1 . 4421−1 . 4573 12
⋅ ⋅100 %
= 1.4573 6

= - 2.09%
SECTION C

Question 1

Netting applies where the head office and its foreign subsidiaries net off intra-organizational
currency flows at the end of each period, leaving only the balance exposed to risk and hence in
need of hedging. Netting is illustrated in the following simple example.

A UK-based multinational has a German operating subsidiary. In a particular month, it transfers

components worth €20 million to Germany. In the same month, the subsidiary transfers finished
goods worth €40 million to the UK. With netting, the company need only make a net currency
transfer of €20 million, rather than making two separate transactions totaling €60 million. As
well as reducing exposure, netting saves transfer and commission costs, but it requires a two-way
flow in the same currency.

Matching is similar in concept to netting, but involves third parties as well as intra-group
affiliates. A company tries to match its currency inflows by amount and timing with its expected
outflows. For example, a company exporting to the USA and thus anticipating USD receipts
could match this payable by arranging a USD outflow, perhaps by contracting to import from the
same country. Clearly, as with netting, a two-way flow of currency is desirable — ‘natural
matching’. ‘Parallel matching’ can be achieved by matching in terms of currencies that tend to
move closely together over time, e.g. matching USD outflows to Canadian dollar inflows.
Matching can also be achieved by offsetting balance sheet items against profit and loss account
items. For example, a company with a long-term cash inflow stream in USD may also borrow in
USD, to create an offsetting outflow of interest and capital payments. Earlier in the chapter we
observed Compass Group plc doing exactly this.

Leading and lagging currency payments is done to speed up or delay payments when a change
in the value of a currency is expected. This involves forecasting future exchange rate
movements, and therefore carries an element of speculation. Where payables are involved, the
transfer is speeded up if the foreign currency is expected to appreciate against the domestic
currency and slowed down if the overseas currency is expected to depreciate. A UK company
importing from the USA during 2006—7, when the USD was faliing against sterling, may well
have fried to lag payments. Leading and lagging within a group of companies is relatively easy
to arrange, but when dealing with other firms, this can be problematic. A customer buying on
credit will advance payment only if offered an inducement such as a discount for early payment.
The same applies to delaying payment to an external supplier — the danger is loss of goodwill.
Even for intra-firm transactions, there may still be local regulations and currency controls that
limit flexibility.
Currency transfers by companies into and out of less-developed countries, whose currencies tend
to be weak, are closely scrutinized by the governments of those countries because of the
destabilizing effect they may have on their currency. In some cases, they are illegal, both for
their ability to exacerbate currency weakness and also because of the effect on local minority
shareholders of an overseas subsidiary. Leading a payment from the overseas subsidiary to the
UK parent will raise the GBP profits of the parent, but lower the overseas currency profits of the
subsidiary thus damaging local shareholders’ interests, which risks alienating local opinion and
antagonizing the host government. This is one reason why repatriation of profits from overseas
subsidiaries is often closely controlled by foreign governments.

The UK exporter might also consider a pre-emptive price variation. If it expects GBP to
strengthen against the currency of an overseas customer, it may raise the contract price.
However, this may have adverse consequences for sales, especially if competitors are prepared to
shoulder currency risk by accepting payment in the oversea currency. Conversely, the
acceptability of this ploy may be greater if the exporter quotes a price based on the forward rate
rather than the spot rate when setting the value of the contract. Generally, however, such price
variations require a strong competitive position in overseas markets. For this reason, another
such device, switching the currency in which the contract is denominated to a third currency, say
USD, also has to be used with caution. However, traders in basic commodities (most notably,
oil) have no such flexibility, since most of these are priced in USD.

Risk-sharing is a contractual arrangement whereby the buyer and seller agree in advance to
share between them the impact of currency movements. This is recommended when the two
parties want to build a long-term relationship. However, if exchange rate variations exceed
tolerable limits, the arrangement may have to be renegotiated.

It might work like this. Firm X supplies Firm B in another country. They may agree that all
transactions will be made at the ruling spot rate between the two parties’ respective currencies.
If, however, the rate at settlement varies by up to, say, 5 per cent either side of the original spot
rate, X may accept the transaction exposure. If the rate varies by, say, 5—10 per cent of the
original spot, they may share the difference equally, but for variations in excess of 10 per cent,
the agreement may become void. Harley Davidson is known to operate this policy with foreign
importers.

Question 2

Students are expected to discuss three of the following five motives.

(1) Market seekers produce in foreign markets either to satisfy local demand or to export to
markets other than their home market. U.S. automobile firms manufacturing in Europe for
local consumption are an example of market-seeking motivation.
(2) Raw material seekers extract raw materials wherever they can be found, either for export or
for further processing and sale in the country in which they are found—the host country.
Firms in the oil, mining, plantation, and forest industries fall into this category.
(3) Production efficiency seekers produce in countries where one or more of the factors
of production are under-priced relative to their productivity. Labor-intensive production of
electronic components in Taiwan, Malaysia, and Mexico is an example of this motivation
(4) Knowledge seekers operate in foreign countries to gain access to technology or managerial
expertise. For example, German, Dutch, and Japanese firms have purchased U.S.-located
electronics firms for their technology.
(5) Political safety seekers acquire or establish new operations in countries that are considered
unlikely to expropriate or interfere with private enterprise. For example, Hong Kong firms
invested heavily in the United States, United Kingdom, Canada, and Australia in anticipation
of the consequences of China’s 1997 takeover of the previously British colony.