Reference no: EM133061535

Question 1

A. BD Bank expects that the Mexican peso will depreciate against the dollar from its spot rate of $0.15 to $0.14 in next 10 days. The following interbank lending and borrowing rates exist:

	Deposit Rate	Borrowing Rate
U.S. dollar	8.0%	8.3%
Mexican peso	8.5%	8.7%

Assume that BD Bank has a borrowing capacity of either $10 million or 70 million pesos in the interbank market, depending on which currency it wants to borrow.

How could BD Bank attempt to capitalize on its expectations? Estimate the profits that could be generated from this strategy. Assume 360 days in a year.

B. Cranfield Ltd (a UK-based company) is to pay 50 million euros in 90-days to its suppliers in Germany. The expected percentage changes of the £/euro rates over a 90-day period is -1% with a standard deviation of 5%.

Assume the exchange rate today is £0.80/€

i. Provide a qualitative description of Cranfield's exchange rate exposure to the euro.

ii. If the spot exchange rate change in 90-days turns out to be as expected, what will be the pound cost of this payment?

iii. Calculate the maximum percentage loss (increase in cost) with 99% confidence level that Cranfield could suffer over the 90-day period if Cranfield does not hedge this exposure.
(Hint: z90 =1.282; z95 =1.645; z99 =2.326)

iv. Calculate the pound value of the maximum increase in cost, with 99% confidence level, that Cranfield could suffer over the 90-day period if Cranfield does not hedge this exposure.

Question 2

A(i) You have the following direct quotes:

	Bid	Ask
Euro in $	1.11	1.25
Pesos in $	0.10	0.11
Euro in pesos	13	14

Assume that you have $1,000,000. Can you use triangular arbitrage to generate a profit? If so, explain the order of the transactions that you would execute, and the profit that you would earn. Assume that there are no transaction costs.

A (ii) You believe that the future value of the Australian dollar will be determined by purchasing power parity (PPP). You expect that inflation in Australia will be 6% next year, while inflation in the U.S. will be 2% next year. Today the spot rate of the Australian dollar is $.81, and the one-year forward rate is $.77. What is the expected spot rate of the Australian dollar in one year?

A (iii) The one-year Treasury (risk-free) interest rate in the U.S. is presently 6%, while the one-year Treasury interest rate in Switzerland is 13%. The spot rate of the Swiss franc is $.80. Assume that you believe in the international Fisher effect. You will receive 1 million Swiss francs in one year. What is the estimated amount of dollars you will receive when converting the Swiss francs to U.S. dollars in one year at the spot rate at that time?

B. The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14.

a. What is the forward rate premium?

b. What is the one-year forward rate of the peso?

c. Based on the international Fisher effect, what is the expected change in the spot rate over the next year?

d. If the spot rate changes according to the IFE, what will be the spot rate in one year?

e. Compare your answers to (b) and (d) and explain the relationship.

Question 3

A. Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $0.60. The one-year forward rate of the Singapore dollar is $0.62. Carbondale created a probability distribution for the future spot rate in one year as follows:

Future Spot Rate	Probability
$0.61	20%
0.63	50
0.67	30

Assume that one-year put options on Singapore dollars are available, with an exercise price of $0.63 and a premium of $0.04 per unit. One-year call options on Singapore dollars are available with an exercise price of $0.60 and a premium of $0.03 per unit. Assume the following money market rates:

	U.S.	Singapore
Deposit rate	8%	5%
Borrowing rate	9	6

a) Given this information, determine whether a forward hedge, money market hedge, or a currency options hedge would be most appropriate.
b) Compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables.

B. It is January and Douglas Inc. a US company, expects payment worth €5,000,000 in three months. It is considering using futures contracts for hedging the risk of Euro depreciating against US$. The Spot exchange rate is $1.2464/€. The Futures price for March delivery is $1.2240/€.

How would Douglas Inc. use the currency futures contracts to hedge their exposure to the euro if both the $/€ spot and futures rate in March turns out to be 1.2150? The futures contracts size is €125,000. Assume that there no transaction costs and ignore margin money requirements.

Question 4

(i) ABC Corporation's loan of US$10 million is serviced with annual payments and the principal paid at the end of the third year. The loan is priced at US dollar LIBOR + 1.50% and LIBOR is reset every year. ABC is concerned about the floating rate loan and anticipates that interest rates will rise over the life of the loan. ABC therefore wants protection from an increased interest payment and believes that an interest rate swap to pay fixed/receive floating would be the best alternative. ABC has received a quote of 5.75% against LIBOR from the swap dealer. This would mean that ABC will receive LIBOR and pay out 5.75% for the next three years. Set-up an interest Swap and explain how it would work through a diagram. What will be the net interest cost over next three years to ABC if it enters into a swap with the swap dealer? Show your calculations.

(ii) Explain the risks involved in using interest rate and currency swaps?

Question 5
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 system versus a fixed exchange rate system?

Question 6

A. Why is translation exposure 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.

Question 7
A. Proponents 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 the PPP derived exchange rates?