Reference no: EM133054055

Problem 1

A. Assume the following quotes for pounds, U.S. dollars and euros exist today.

   Citibank quote ($/€):                            1.300

   National Westminster Bank quote ($/£):  1.600

   Deutschebank quote (€/£):                   1.150

Assume no transaction costs. Based on these quotes, is there an arbitrage opportunity, and if so, how would a currency trader with access to £1 million exploit this?

Clearly explain how the market would react to eliminate any further arbitrage opportunities above.

B. Michael who lives in Ireland is considering two alternative investments of EUR10,000,000 (i) six-month euro deposit or (ii) six-month UK pound (GBP) deposit. He does not want to bear any foreign exchange risk if he were to invest in UK pound deposit. The following information is available today:

6-month UK pound interest rate = 4% p.a.

6-month euro interest rate = 5% p.a.

Spot rate = EUR1.1960/£,

6-month forward rate = EUR1.2080/£

(i) Which of these two deposits will provide higher returns in Euros?

(ii) What should be the six-month forward rate above to ensure there is no covered interest arbitrage?

Problem 2

A. Assume a two-country world consisting of the US and the UK. Both countries produce only one good, corn. Suppose the price of corn in the US is $3.40 and in the UK it is £2.00. What is the implied exchange rate of US$/£ that satisfies the absolute purchasing power parity?

Further, suppose annual inflation is 8% and 5% in the US and the UK respectively. What would the price of corn over the next year be in the US and the UK? Hence, what would the expected exchange rate in one year be? Calculate the percentage depreciation or appreciation of the UK pound if the purchasing power parity holds. Assume no storage cost.

B. Assume the following information:

      Value of Canadian dollar in U.S. dollars                         $0.90

      Value of New Zealand dollar in U.S. dollars                           $0.30

      Value of Canadian dollar in New Zealand dollars         NZ$3.02

Given this information, is triangular arbitrage possible? If so, explain the steps to develop a triangular arbitrage and compute the profit from this strategy if you had $1,000,000. How will the values of US$, Canadian$ and New Zealand$ be affected because of the arbitrage transactions?

Problem 3

Cranfield Ltd is a UK based company that specializes in the design and manufacture of specialist aircraft components. It sells its products mainly to a French aircraft manufacturer priced in euros. Cranfield is expected to receive 20 million euros in 90 days from its client in France. John, Finance Director at Cranfield Ltd, is concerned about the recent volatility in the currency market. He is therefore considering alternative ways to hedge this exposure.

He has obtained the following market information:

Spot exchange rate:    £0.8005/€

90-day forward rate:   £0.8064/€

UK Interest rates:         3% - 6% per annum

Euro Interest rates:       2% - 4% per annum

Over the Counter (OTC) call and put options on euros with an exercise price of £0.8100 are available with a premium of £0.0106 and £0.0070 per euro, respectively. Cranfield will pay the required option premium from an overdrawn account on which it pays 6% interest per annum.

Given the information above:

A. Determine the total amount receivable, in UK pounds, for each of the possible three actions - forward hedge, money market hedge, or a currency options hedge. Which hedging strategy offers the best outcome? Assume 360 days in a year.

B. Determine the exchange rate in 90 days at which Cranfield Ltd will be indifferent between the using option hedge or the forward hedge.

Problem 4

Dana is a US based automotive parts supplier with annual sales of over US$26 bn. Dana has expanded its markets far beyond traditional automobile manufacturers to diversify its sales base. As part of the general diversification efforts, Dana wishes to diversify its debt portfolio as well. Dana enters into a US$50 million swap where it agrees to pay Euro cash flows and receive US Dollar cash flows using the following quotes and information:

(i) Show via a diagram, how this swap will work. Calculate all cash flows in both currencies over entire 5 years.

(ii) Assume that after two years, Dana decides to unwind the swap. If 3-year fixed rate in Euro has now risen to 5.05% and 3-year US$ fixed rate has fallen to 4.40%, and current spot rate is $1.02/€, should Dana unwind the swap? How much would Dana would pay or receive?

Problem 5

A. Distinguish between sterilized and non-sterilized Central Bank Intervention. Illustrate how the central bank of a country can use sterilized intervention to boost exports.

B. Compare and contrast translation, transaction, and economic exposures. Explain how each of these exposures pose financial risk to a Multinational Corporation (MNC). Why economic exposure is considered strategic?

Problem 6

A. Discuss the key differences between forward contracts and futures contracts. Explain how multinational firms could use futures to hedge their foreign exchange exposure. What could be the problems in using futures contracts for hedging?

B. Why should capital budgeting for subsidiary projects be assessed from the parent's perspective? What additional factors that normally are not relevant for a purely domestic project deserve consideration in multinational capital budgeting?

Problem 7

A. Compare and contrast interest rate parity, purchasing power parity (PPP), and the international Fisher effect (IFE).
B. From the point of view of a borrowing corporation, what are credit and repricing risks? Explain steps a company might take to minimize both.

Problem 8

a) Briefly discuss the potential benefits and risks of a pegged currency system? Using the exchange rate regimes of the UK (floating) and China (pegged), discuss the pros and cons of the floating vs pegged currency regimes.

b) The purchasing power parity (PPP), interest rate parity (IRP) and international Fisher effect (IFE) are three parity conditions often encountered in the literature. Briefly discuss the implications of these parity conditions and show the interrelationship between them.

Problem 9

a) Evaluate the arguments for and against a firm pursuing an active currency risk management program.
b) Distinguish between losses from transaction exposure, operating exposure, and translation exposure? Use examples to illustrate your answer

Problem 10

a) Discuss the important factors one should consider in the international capital budgeting process to be undertaken by a multinational firm.
b) In what ways real option analysis is superior to the traditional capital budgeting in making investment decisions?

Problem 11

a) Capital budgeting for a foreign project is considerably more complex than the domestic case. What are the factors that contribute to this complexity? Discuss.
b) Compare and contrast the fixed, freely floating, and managed float exchange rate systems. What are some advantages and disadvantages of a freely floating exchange rate systems versing a fixed exchange rate system?

Problem 12

a) Why is translation exposure is called accounting exposure? What does the word translation mean? What are the major differences in translating assets under the current rate method and the temporal method? What are the key implications?

b) What ways diversifying operations and financing help a multinational firm to strategically avoid loss from its operating exposure? Explain the following techniques used in proactively hedging the operating exposure; matching cash flows, risk sharing agreement and back-to-back loans.

Problem 13

a) Proponent of the efficient market hypothesis argue that a MNE should not hedge because investors can hedge themselves if they do not like the foreign exchange risks carried by the firm. Assess this argument.

b) Explain both absolute and relative purchasing power parity ideas and the international fisher effect. What is the general conclusion from empirical studies whether the PPP holds? What are the possible reasons for exchange rates to deviate from PPP derived exchange rate?