Reference no: EM133047868

QUESTIONS FOR SECTION A

Question 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?

Question 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?

Question 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.

Question 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?

QUESTIONS FOR SECTION B

Question 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?

Question 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?

Question 7

A. Compare and contrast interest rate parity (discussed in the previous chapter), 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.