72783538 Multinational Business Finance Solution Manual 12th Edition by Etiman Stone Hill Moffitt Prepared by Wasim Orakzai IM Sciences KUST ISBN 0 321 1789

Multinational Business Finance 10th Edition

Solution Manual

IM Science, KUST, Solution Manual of MBF 10tth Edition Prepared By Wasim Uddin Orakzai

1

Multinational Business Finance 10th Edition

Chapter-1

Solution Manual

Financial Goals & Corporate Governance

Problem # 1.1: Shareholder Returns……………………………………… Problem # 1.2: Shareholder Choices…………………………………….. Problem # 1.3: Microsoft's Dividend…………………………………….... Problem # 1.4: Dual Classes of Common Stock………………………… Problem # 1.5: Corporate Governance: Minority Shareholder Control… Problem # 1.6: Price/Earnings Ratios and Acquisitions………………… Problem # 1.7: Corporate Governance: Overstating Earnings…………. Problem # 1.8: Carlton Corporation's Consolidated Results…………… Problem # 1.9: Carlton's EPS Sensitivity to Exchange Rates………..… Problem # 1.10: Carlton’s Earnings & Global Taxation…………….....… Chapter-2

Problem # 2.1: Problem # 2.2: Problem # 2.3: Problem # 2.4: Problem # 2.5: Problem # 2.6: Problem # 2.7: Problem # 2.8: Problem # 2.9: Chapter-3

8 9 9 10 10 11 12 13 14 15 17

The International Monetary System (IMS) Frankfurt & New York................................................. Peso Exchange Rate Changes……………………….. Good as Sold……………………………………………. Gold Standard…………………………………………… Spot Rate Customer……………………………………. Forward Rate……………………………………………. Forward Discount on the dollars………………………. Forward Premium on the euro………………………… Iraqi Imports……………………………………………..

Balance of Payments (BOP)

Problems # 3.1 - 3.4: Problems # 3.5 - 3.9: Problems # 3.10 - 3.13: Problems # 3.14 - 3.20:

Australia's Current Account…………………… Uruguay's Current Account…………………… Myanmar's Balance of Payments……………. Argentina's Balance of Payments………….…

19 20 20 22 22 22 23 23 24 26 28 29 30 31 32

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Solution Manual

Foreign Exchange Market (FEM)

Chapter-4

Problem # 4.1: Problem # 4.2: Problem # 4.3: Problem # 4.4: Problem # 4.5: Problem # 4.6: Problem # 4.7: Problem # 4.8: Problem # 4.9: Problem # 4.10: Problem # 4.11: Problem # 4.12: Problem # 4.13: Problem # 4.14: Problem # 4.15: Problem # 4.16:

Ringgit up or down?............................................... Forward Premium & Discounts……………………. Trading in Switzerland……………………………… Yen Forward Premium……………………………… Euro Forward Premium…………………………….. Traveling: Copenhagen to St. Petersburg……….. Riskless Profit on the Franc……………………….. Trans Atlantic Arbitrage……………………………. Wall Street Journal quotes and premiums………. Finanial Times quotes……………………………… Venezuelan Bolivar (A)…………………………….. Venezuelan Bolivar (B)…………………………….. Indirect Quotation on the Dollar…………………… Direct Quotation on the Dollar…………………….. Mexican Peso - European Euro Cross Rates…… Around the Horn…………………………………….

35 36 37 41 42 43 44 45 47 48 49 50 51 54 55 57

58

Chapter-5

Foreign Currency Derivatives (FCD)

60

Problem # 5.1: Problem # 5.2: Problem # 5.3: Problem # 5.4: Problem # 5.5: Problem # 5.6: Problem # 5.7: Problem # 5.8: Problem # 5.9: Problem # 5.10: Problem # 5.11: Problem # 5.12: Problem # 5.13: Problem # 5.14: Problem # 5.15:

Peso Futures…………………………………………. Pounds Futures………………………………………. Hans Schmidt, euro Speculator…………………….. Hans Schmidt, Swiss franc Speculator……………. Katya & the yen………………………………………. Samuel’s bet………………………………………….. How much profit – calls?……………………………. How much profit – puts?......................................... Falling Canadian dollar……………………………….. Braveheart's Put on Pounds………………………… Call Options on British pounds……………………… Put Options on euros………………………………… Solar Turbines and Venezuelan bolivares………… Vitro de Mexico……………………………………… Put Options on Chinese Renminbi………………...

61 62 63 65 68 70 71 72 73 75 78 79 80 81 82

Chapter-6

International Parity Conditions (IPC)

Problem # 6.1:

Big Mac Hamburger Standard………………………

83

84

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Multinational Business Finance 10th Edition

Problem # 6.2: Problem # 6.3: Problem # 6.4: Problem # 6.5: Problem # 6.6: Problem # 6.7: Problem # 6.8: Problem # 6.9: Problem # 6.10: Problem # 6.11: Problem # 6.12: Problem # 6.13: Problem # 6.14: Problem # 6.15: Problem # 6.16: Problem # 6.17: Problem # 6.18: Problem # 6.19: Problem # 6.20: Chapter-7

Solution Manual

Exchange Rate Pass-Through…………………….. Argentine pesos…………………………………….. International Fisher Effect…………………………. Covered Interest Arbitrage (CIA) - Denmark I…… CIA Denmark B – Part (a) & Part (b)……………… CIA– Japan………………………………………….. Uncovered Interest Arbitrage – Japan……………. International Parity Conditions in Equilibrium……. Mary Smyth – CIA…………………………………… Mary Smyth – UIA…………………………………… Mary Smyth -- one month later…………………….. Langkawi Island Resort…………………………….. Covered Interest against the Norwegian krone…... Frankfurt and New York…………………………….. Chamonix chateau rentals…………………………. East Asiatic Company – Thailand…………………. Maltese Falcon: 2003-2004………………………… London Money Fund………………………………… The African Beer standard of PPP………………….

Foreign Exchange Rate Determination

Problem # 7.1: Problem # 7.2: Problem # 7.3: Problem # 7.4: Problem # 7.5: Problem # 7.6: Problem # 7.7: Problem # 7.8: Problem # 7.9: Problem # 7.10: Chapter-8

Problem # 8.1: Problem # 8.2: Problem # 8.3: Problem # 8.4: Problem # 8.5: Problem # 8.6:

Current spot rates………………………………….… Purchasing power parity forecasts…………….…… International Fisher forecasts………………………. Implied real interest rates…………………………… Forecasting with real interest rates………….…….. Forward rates………………………………….……… Real economic activity and misery………….……… Balance of payments approach……………….……. Current accounts and spot rates…………………… Exchange Rate Trends and Bounds………………..

85 87 89 92 94 97 98 99 102 103 105 106 107 109 110 111 114 115 118

120 122 123 125 127 129 131 133 135 135 135

Transaction Exposure

136

Lipitor in Indonesia…………………………………… Embraer of Brazil…………………………………….. Mattel Toys…………………………………………… Hindustan Lever……………………………………… Tek - Italian Account Receivable…………………… Tek - Japanese Account Payable…………………..

137 138 139 140 141 143

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Problem # 8.7: Problem # 8.8: Problem # 8.9: Problem # 8.10: Problem # 8.11: Problem # 8.12: Problem # 8.13: Problem # 8.14: Problem # 8.15: Problem # 8.16: Problem # 8.17: Problem # 8.18: Problem # 8.19: Problem # 8.20: Problem # 8.21: Problem # 8.22: Problem # 8.23: Problem # 8.24: Problem # 8.25:

Solution Manual

Tek - British Telecom Bid…………………………… Tek -- Swedish Price List…………………………… Tek -- Swiss Dividend Payable…………………….. Northern Rainwear…………………………………... Vamo Road Industries………………………………. Worldwide Travel……………………………………. Seattle Scientific, Inc……………………………….. Wilmington Chemical Company…………………… Dawg-Grip, Inc……………………………………..... Aqua-Pure……………………………………………. Botox Watch Company……………………………… Redwall Pump Company…………………………… Pixel's Financial Metrics……………………………. Scout Finch and Dayton Manufacturing (A)………. Scout Finch and Dayton Manufacturing (B)………. Siam Cement………………………………………… Aswan Project: Mitsubishi's Exp. (Part a & b)…… Aswan Project: Fluor's Exposure………………….. Aswan Project: DaSilva's Contingency Lever……..

145 146 148 150 151 152 153 154 155 157 159 160 162 163 165 167 168 171 173

Operating Exposure

Chapter-9

Problem # 9.1: Carlton Germany - Case 4…………………………… Problem # 9.2: Carlton Germany - Case 5…………………………… Problem # 9.3: Denver Plumbing Company (A)……………………… Problem # 9.4: Denver Plumbing Company (B)……………………... Problem # 9.5: Hawaiian Macadamia Nuts………………………….. Problem # 9.6: Cellini Fashionwear…………………………………… Problem # 9.7: Autocars, Ltd………………………………………….. Problem # 9.8: High-Profile Printers, Inc. (A)………………………… Problem # 9.9: High-Profile Printers, Inc. (B)………………………… Problem # 9.10: Hedging Hogs: Risk-Sharing at Harley Davidson…. Chapter-10

Translation Exposure (Accounting Exposure)

Problem # 10.1: Problem # 10.2: Problem # 10.3: Problem # 10.4: Problem # 10.5: Problem # 10.6:

Carlton Germany (A)……………………………….. Carlton Germany (B)……………………………….. Carlton Germany (C)……………………………….. Carlton Germany (D)……………………………….. Montevideo Products, S.A. (A)……………………. Montevideo Products, S.A. (B)…………………….

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174 175 176 178 178 179 180 181 182 183 185

187 188 189 191 192 193 194

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Problem # 10.7: Montevideo Products, S.A. (C)……………………. Problem # 10.8: Siam Toys, Ltd. (A)…………………………………. Problem # 10.9: Siam Toys, Ltd. (B)…………………………………. Problem # 10.10: Egyptian Ingot, Ltd………………………………….. Chapter-11

Sourcing Equity Globally

Problem # 11.1: Problem # 11.2: Problem # 11.3: Problem # 11.4: Problem # 11.5: Problem # 11.6: Problem # 11.7: Problem # 11.8: Problem # 11.9: Problem # 11.10:

196 198 200 202 205

Novo’s cost of equity prior to April 1980…………. Novo’s WACC prior to April 1980……………….... Novo’s cost of equity after July 1981…………….. Novo’s WACC after July 1981…………………….. Novo’s cost of equity in 2004……………………… Novo’s WACC in 2004……………………………… HangSung before equity issue abroad……………. HangSung’s WACC before equity issue abroad… HangSung after equity issue abroad……………… HangSung’s WACC after equity issue abroad……

206 206 207 207 208 208 209 209 210 210

Annexure of Currencies Used in Solution Manual……………………… Table of Contents of All Formula list…………………….....................

212 213

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Multinational Business Finance 10th Edition

Solution Manual

“Read and Lord is the most bounteous, who teaches by the pen, teaches man that which he knew not. (Al-Quran)

IM Science, KUST, Solution Manual of MBF 10tth Edition Prepared By Wasim Uddin Orakzai

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Multinational Business Finance 10th Edition

Solution Manual

Chapter-1

Financial Goals & Corporate Governance

IM Science, KUST, Solution Manual of MBF 10tth Edition Prepared By Wasim Uddin Orakzai

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Multinational Business Finance 10th Edition

Chapter # 1

Solution Manual

“Financial Goals & Corporate Governance”

Problem # 1.1: Shareholder returns. Solution: What are the shareholder's returns? Assumptions Share price, P1 Share price, P2 Dividend paid, D2

Value Part (a) $ 16.00 $ 18.00 $ ----

Value Part (b) $ 16.00 $ 18.00 $ 1.00

a. If the company paid no dividend (plugging zero in for the dividend): Return = (P2 - P1 + D2) / (P1) Return = $18.00 - $ 16.00 / $16.00 = $2.00 / $16.00 Return = 12.50% b. Total shareholder return, including dividends, is: Return = (P2 - P1 + D2) / (P1) Return = (P2 - P1 + D2) / (P1) Return = $18.00 - $ 16.00 + $1.00 / $16.00 = $2.00 / $16.00 Return = 18.75% Problem # 1.2: Solution:

Shareholder choices.

Assumptions Share price, P1 Share price, P2 Dividend paid, D2

Value $ 62.00 $ 74.00 $ 2.25

Return = (P2 - P1 + D2) / (P1) Return = $74.00 - $ 62.00 + 2.25 / $62.00 = $14.25.00 / $62.00 Return = 22.98%

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Solution Manual

The share's expected return of 22.98% far exceeds the required return by Mr. Fong of 12%. He should therefore make the investment. Problem # 1.3: Microsoft's dividend. Solution: What would the return have been on Microsoft shares if it had paid a constant dividend in the recent past? Shareholder Shareholder Closing If Return Return Share Dividend (without (with Assumptions Price Paid Dividend ) Dividend) 1998 (January 2) $131.13 1999 (January 4) $141.00 $0.16 7.53% 7.65% 2000 (January 3) $116.56 $0.16 -17.33% -17.22% 2001 (January 2) $ 43.38 $0.16 -62.78% -62.65% 2002 (January 2) $ 67.04 $0.16 54.54% 54.91% 2003 (January 2) $ 53.72 $0.16 -19.87% -19.63% a. Average shareholder return for the period : Return = (P2 - P1 + D2) / (P1) Return = $74.00 - $ 62.00 + 0 / $62.00 = $14.25.00 / $62.00 Return = -7.58% b. Total shareholder return if Microsoft had paid a constant dividend: Return = (P2 - P1 + D2) / (P1) Return = $74.00 - $ 62.00 + 0 / $62.00 = $14.25.00 / $62.00 Return = -7.39% Problem # 1.4: Dual Classes of Common Stock. Solution: What are the implications for the distribution of voting rights and dividend distributions for Powlitz? Local Votes Currency per Total Powlitz Manufacturing (millions) share Votes Long-term debt 200 0 0 Retained earnings 300 0 0 Paid-in common stock: 1 million A-shares 100 10 *1,000 Paid-in common stock: 4 million B-shares 400 1 ** 400

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Multinational Business Finance 10th Edition

Total long-term capital Notes: *100 x 10 = 1,000 votes ** 400 x 1 = 400 votes

Solution Manual

1,000

---

1,400

a. What proportion of the total long-term capital has been raised by A-shares? A-shares / Total long-term capital = 100 / 1,000 = 10.00% b. What proportion of voting rights is represented by A-shares? A-share total votes / Total Votes = 1,000 / 1,400 = 71.43% c. What proportion of the dividends should the A-shares receive? A-shares in local currency / Total equity shares in local currency = 100 / (100 + 400) = 20.00% Problem # 1.5: Corporate Governance: Minority Shareholder Control Solution: Distribution of profits versus distribution of voting rights and power.

a) Investor Group Telecom Italia Pension Funds 32% of Techold Particpacoes shares (0.32 (11%); 0.32 (62%); and 0.32 (34%) Combined Telecom Italia & Pension Funds Opportunity 100% of Timepart Particpacoes shares 68% of Techold Particpacoes shares Combined Opportunity Total Shares

Solpart Particpacoes Voting Preferred Total Shares Shares Shares 38.00% 38.00% 38.00% 3.52%

19.84%

10.88%

41.52%

57.84%

48.88%

51.00% 7.48% 58.48%

0.00% 42.16% 42.16%

28.00% 23.12% 51.12%

100.00%

100.00% 100.00%

b) Opportunity would continue to control the voting rights of SolPart, which in turn

continues to own 58.48% of the voting shares in Brasil Telecom Participacoes,

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Solution Manual

which in turn owns 93.6% of the voting shares in Brasil Telecom. Thus Opportunity is able to use its control of holding companies to control Brasil Telecom. Problem # 1.6: Solution:

Company Pharm-Italy Pharm-USA

Price/Earnings Ratios and Acquisitions

P/E Number Ratio of shares 10,000,0 20 00 10,000,0 40 00

Market value per share

Earnings

EPS

Total Market Value

$20.00

$10,000,000

$1.00

$200,000,000

$40.00

$10,000,000

$1.00

$400,000,000

Rate of exchange: Pharm-USA shares per Pharm-Italy share = 5,500,000 a. How many shares would Pharm-USA have outstanding after the acquisition

of Pharm-Italy? $10,000,000 + 5,500,000 = 15,500,000 Because Pharm-Italy shares are worth $20 per share, they are only worth one-half the value per share of Pharm-USA's $40 per share. So, on a straight exchange, 1 Pharm-USA share is worth 2 Pharm-Italy shares. But, Pharm-USA also needs to pay a premium for gaining control of Pharm-Italy, so it pays an additional 10% over market. So, Pharm-USA pays: 10 million / 2 x (1 + 10% premium) = b. What would be the consolidated earnings of the combined Pharm-USA and Pharm-Italy? Pharm-Italy earnings + Pharm-USA earnings = $20,000,000 c. Assuming the market continues to capitalize Pharm-USA's earnings at a P/E ratio of 40, what would be;

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Multinational Business Finance 10th Edition

Solution Manual

P/E x Consolidated earnings = 40 x $20,000,000 = $800,000,000.

d. What is the new earnings per share of Pharm-USA? $20,000,000 / 15,500,000 shares = $1.29 e. What is the new market value of a share of Pharm-USA? New market value / Total shares outstanding= $800,000,000 /15,500,000 = $51.61 f. How much did Pharm-USA's stock price increase? Share price rose from $40.00 to $51.61. Percentage increase = 29.03% g. Assume that the market takes a negative view of the acquisition and lowers Pharm-USA's P/E ratio to 30. What would be the new market price per share of stock? What would be its percentage loss? New market value = Total earnings x P/E = $20,000,000 x 30 = $600,000,000 New market price per share = total market value / shares outstanding = $38.71 Percentage loss to original Pharm-USA shareholders = ($38.71 - $40.00) / ($40.00) = - 3.23% Problem # 1.7:

Corporate Governance: Overstating Earnings

Solution: Number of shares

Market value per share

Earnings

EPS

Pharm-Italy 20

10,000,000

$ 20.00

$10,000,000

$1.00

Pharm-USA 40

10,000,000

$20.00

$5,000,000

$1.00

Company

P/E ratio

Total Market Value $200,000,000 $200,000,000

If earnings were lowered to $5 million from the previously reported $10 million, could Pharm-USA still do the deal?

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Solution Manual

To do the deal, Pharm-Italy's shareholders need to be paid their market value plus a 10% premium = $220,000,000 At new market rates for Pharm-USA, this would require the offer of ($220 million/$20 per share) = 11,000,000.00 Shares These 11 million shares would exceed Pharm-USA's existing shares outstanding, effectively giving Pharm-Italy control. Therefore the acquisition would probably not take place.

Problem # 1.8: Solution:

Carlton Corporation's Consolidated Results 1

S.No.

Amount

US Parent Company (US$) Brazilian Subsidiary (reais, R$) German Subsidiary (Euros, €) Chinese Subsidiary (Renminbi, Rmb)

4,500.00 6,250.00 4,500.00 2,500.00

Business Performance (000s) Earnings before taxes, EBT ( local currency) Less: Corporate income taxes Net profits of individual subsidiary Average exchange rate for the period (foreign currency / $) Net profits of individual subsidiary (US$)

2

1x 2=3

Tax rate 35% 25% 40% 30%

Corporate Income taxes $ 1,575.00 R$ 1,562.50 € 1,800.00 Rmb 750.00

US Parent Brazilian German Company Subsidiary Subsidiary (US$) (reais, R$) (euros, €) 4,500 6,250 4,500 .00 .00 .00 (1,575 (1,562 (1,800 .00) .50) .00) 2,925 4,687 2,700 .00 .50 .00 -----$ 2,925.00

3.5 000 600 $ 1,339.29

Chinese Subsidiary (renminbi, Rmb) 2,50 0.00 (75 0.00) 1,75 0.00

0.92

8. 5000

$ 2,915.77

IM Science, KUST, Solution Manual of MBF 10tth Edition Prepared By Wasim Uddin Orakzai

$ 205.88

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Multinational Business Finance 10th Edition

Consolidated profits (total across units) Total diluted shares outstanding (000s) a. Consolidated earnings per share (EPS) b. Proportion of total profits originating by country c. Proportion of total profits originating from outside the US. Problem # 1.9: Solution:

Solution Manual

$ 7,385.93 650 .00 $

11.36 39.6%

18.1%

39.5%

2.8%

60.4%

Carlton's EPS Sensitivity to Exchange Rates 1

S.No.

Amount

US Parent Company (US$) Brazilian Subsidiary (reais, R$) German Subsidiary (Euros, €) Chinese Subsidiary (Renminbi,Rmb)

4,500.00 6,250.00 4,500.00 2,500.00

Business Performance (000s) Earnings before taxes, EBT (local currency) Less: Corporate income taxes Net profits of individual subsidiary Avg exchange rate for the

US Parent Company (US$)

2

1x 2=3

Tax rate 35% 25% 40% 30%

Corporate Income taxes $ 1,575.00 R$ 1,562.50 € 1,800.00 Rmb 750.00

Brazilian Subsidiary (reais, R$)

4,500.00 6,250.00 (1,57 (1,562 5.00) .50) 2,92 4,687 5.00 .50 ------

Chinese German Subsidiary Subsidiary (renminbi, (euros, €) Rmb) 4,500 .00 2,500.00 (1,800 (750.0 .00) 0) 2,700 1,750.0 .00 0

4.5000

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Multinational Business Finance 10th Edition

period (fc/$) Net profits of individual subsidiary (US$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Baseline EPS

$2,925.00

Solution Manual

$1,041.67

0.92600

5000

$2,915.77

$205.88

$ 7,088.32 65 0.00 $11.36

a. If Brazilian real falls to R$4.50/$: EPS = $ 10.91 EPS has fallen 4 percent from baseline = - 4.0%

Business Performance (000s) Earnings before taxes, EBT (local currency) Less: Corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/$) Net profits of individual subsidiary (US$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Baseline EPS

US Parent Company (US$)

Brazilian Subsidiary (reais, R$)

4,500.00 5,800.00 (1,57 (1,562 5.00) .50) 2,92 5.00 4,350.00

Chinese German Subsidiary Subsidiary (renminbi, (euros, €) Rmb) 4,500 .00 2,500.00 (1,800 (750 .00) .00) 2,700 1,750 .00 .00 0.92

8.5

------

4.5000

600

000

$2,925.00

$966.67

$2,915.77

$205.88

$ 7,013.32 65 0.00 $11.36

b. If Brazilian real falls to R$4.50/$: EPS = $ 10.79 EPS has fallen 4 percent from baseline = - 5.0%

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Solution Manual

Problem # 1.10: Carlton's Earnings & Global Taxation Solution: 1 2 1x 2=3 4 S.No. US Parent Company (US$) Brazilian Subsidiary (reais, R$) German Subsidiary (Euros, €) Chinese Subsidiary (Renminbi, Rmb)

Amount

Tax rate

Corporate Exchange Income taxes Rate

3 ÷ 4 =5 Corporate Income taxes in $

4,500.00

35%

$ 1,575.00

-----

$1,575.00

6,250.00

25%

R$ 1,562.50

R$3.5000 /$

$ 446.43

4,500.00

40%

€

1,800.00

€0.92600 /$

$1,943.84

2,500.00

30%

Rmb 750.00

Rmb 8.5000

$ 88.24

Business Performance (000s) Earnings before taxes, EBT (local currency) Less: Corporate income taxes Net profits of individual subsidiary Average exchange rate for the period (foreign currency / $) Net profits of individual subsidiary (US$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Baseline EPS Tax payments by country in

US Parent Company (US$)

Brazilian Subsidiary (reais, R$)

4,500.00 6,250.00 (1,57 (1,562 5.00) .50) 2,92 4,687 5.00 .50 -----$2,925.00 $ 7,385.93 65 0.00 $11.36 $1,575.00

3.5000 $1,339.29

$ 446.43

Chinese German Subsidiary Subsidiary (renminbi, (euros, €) Rmb) 4,500 .00 2,500.00 (1,800 (750 .00) .00) 2,700 1,750 .00 .00 0.92600

8.5000

$ 2,915.77

$205.88

$ 1,943.84

$ 88.24

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Solution Manual

US dollars a. Total global tax bill, US$ = $1,575.00 + $ 446.43 + $ 1,943.84 + $ 88.24

Total global tax bill, US$ = $ 4,053.51 Chinese German Subsidiary Subsidiary (renminbi, (euros, €) Rmb) $4,859.61 $ 294.12

Part b. US Parent Brazilian Business Performance Company Subsidiary (000s) (US$) (reais, R$) EBT by country, US$ $ 4,500.00 $1,785.71 Consolidated EBT $11,439.44 Total Global tax bill in $ $ 4,053.51 Carlton's Effective tax rate 35.43% Calculation Notes: Consolidated EBT = $ 4,500.00 + $1,785.71 + $4,859.61 + $ 294.12 Consolidated EBT = $11,439.44 Total global tax bill, US$ = $ 4,053.51 => $ 4,053.51 ÷ $11,939.44 = 35.43% c. What would be the impact on Carlton's EPS and global effective tax rate if Germany instituted tax cut to 28% and German subsidiary earnings rose to 5 million euros? After plugging in the new values, EPS = $ 12.86 Effective tax rate = 30.20% 1 2 1x 2=3 4 3 ÷ 4 =5 Corporate S.No. Amount Tax Corporate Exchange Income rate Income taxes Rate taxes in $ US Parent Company (US$) 4,500.00 35% $ 1,575.00 ----$1,575.00 Brazilian Subsidiary (reais, R$) 6,250.00 25% R$ 1,562.50 R$3.5000 /$ $ 446.43 German Subsidiary (Euros, €) 4,500.00 28% € 1,260.00 €0.92600 /$ $ 1,360.69 Chinese Subsidiary (Renminbi, Rmb) 2,500.00 30% Rmb 750.00 Rmb 8.5000 $ 88.24 Total global tax bill, US$ = $1,575.00 + $ 446.43 + $ 1,360.69 + $ 88.24 Total global tax bill, US$ = $ 3,470.39 Consolidated EBT = $ 4,500.00 + $1,785.71 + $ 4,911.53 + $ 294.12 Consolidated EBT = $11,491. 36

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Solution Manual

=> $ 3,470.39 ÷ $11,491..36 = 30.20% Effective tax rate

Chapter-2 The International Monetary System (IMS)

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Multinational Business Finance 10th Edition

Chapter # 2

Solution Manual

“The International Monetary System”

Problem # 2.1: Frankfurt & New York. In Frankfurt & New York one can buy a U.S. dollar for €0.9200. In New York, one can buy a euro for $1.0870. What is the foreign exchange rate between the dollar & the euro? Given Data One can buy a U.S. dollar = €0.9200 / $ One can buy a Euro = $1.0870 / € Foreign Exchange Rate between = ? Solution: €0.9200 / $ $1.0870 / €

or or

(Indirect Quotation) (Direct Quotation)

$ 1.087 / € € 0.92 / $

Problem # 2.2 : Peso Exchange Rate Changes. In December 1994 the govt. of Mexico officially changed the value of Mexican peso from 3.20 peso per dollar to 5.50 peso per dollar. Was this devaluation, revaluation, depreciation, or appreciation? What was the percentage change? Solution: Given Data Initial Exchange Rate Devalued Exchange Rate

= =

Ps 3.20 / $ Ps 5.50 / $

To find percentage change, we use indirect quotation formula, which is given as under;

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Solution Manual

Anytime a government sets or resets the value of its currency, it is a managed or fixed exchange rate. If that is the case, any change in its official value must be either a "revaluation" or "devaluation." In this case, devaluation is occurred. This is evident from the fact that it now takes more pesos per U.S. dollar, so its value is less or devalued. In terms of the percentage change calculation, this is indicated by the negative percentage change. Rechecking Method: To find percentage change, we use direct quotation formula in U.S., which is given as under; Initial Exchange Rate = Ps3.20 / $ or $ 0.1818/ Ps Devalued Exchange Rate = Ps5.50 / $ or $ 0.3125/ Ps

In this case, devaluation is occurred. Hence, verified.

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Solution Manual

Problem #2.3: Good as Sold. Under the gold standard the price of the ounce of gold of U.S. dollars was $20.67 while the price of the same ounce of British pounds was £4.2474. What would the exchange rate between the dollar and the pound be if the U.S. dollar price had been $38.00 per ounce? Solution: Given Data The U.S. dollar price = $20.67 per ounce The U.S. dollar price = $38.00 per ounce The British pounds price = £4.2474 per ounce

Problem # 2.4: Gold Standard. Before World War I, $20.67 was needed to buy one ounce of gold. If, at the same time one ounce of gold can be purchased in France for FF310.00 what was the exchange rate between French francs & U.S dollars? Solution: Given Data The U.S. dollar price The French franc price

= $20.67 per ounce = FF 310.0 0 per ounce

Problem # 2.5: Spot Rate Customer. The spot rate for Mexican pesos is Ps9.5200/$. If your company buys Ps 100,000 spot from bank on Monday, how much must your company pay & on what day? Solution: Given Data The spot rate for Mexican pesos = Ps 9.5200 / $ or $0.105042 / Ps If your company buys = Ps 100,000 spot on Monday

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Solution Manual

It depends on company that the amount pays in pesos or dollars on Monday. Problem # 2.6: Forward Rate. The 180-day forward rate for the euro is quoted at €0.9210/$. If your company buys € 100,000 forward 180-days on September 6, 2003, how much must your company pay & on what date to settle the forward agreement? Solution: Given Data 180-day forward rate for the Euro is quoted = € 0.9210/ $ or $ 1.0857 / € If your company buys = €100,000 forward 180-days on September 6, 2003

It depends on company that the amount pays in euro or dollars. The forward agreement will settle on March 8, 2004 on Monday. Problem # 2.7: Forward Discount on the dollars. What is the forward discount on the dollar if the spot rate is $ 1.0200 / € & 180-days forward rate is $ 1.0858 / €? Solution: Given Data Spot rate is =1.0200 / € 180-days forward rate is = $ 1.0858 / €

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Solution Manual

Problem #2.8: Forward Premium on the euro. What is the forward premium on the euro if the spot rate on September 3, 2003 is € 0.9804 / $ & 180-days forward rate is € 0.9210 / $? Solution: Given Data Spot rate = € 0.9804 / $ 180-days Forward rate = € 0.9210 / $

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Solution Manual

Note: Problem# 7 & 8 are opposite in rates. Both questions answer are same because Spot Rate = $ 1.0200 / € or € 0.9804 / $ 180 Days Forward Rate = $ 1.0858 / € or € 0.9210 / $

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Problem # 2.9: Iraqi Imports. A European-based manufacturer ships a machine tool to a buyer in Jordan at a sale price of €375,000. Jordan imposes a 12% import duty on all products purchased from the European Union. The Jordanian importer then reexports the product to an Iraqi importer, but only after imposing their own resale fee of 22%. Given the following spot exchange rates on January 30, 2003, what is the total cost to the importer in Iraqi dinar, and what is the U.S. dollar equivalent of that price? Spot rate, Jordanian dinar (JD) per euro (€) JD 0.7597 / € Spot rate, Jordanian dinar (JD) per dollar ($) JD 0.7051 / $ Spot rate, Iraqi dinar(ID) per Jordanian dinar (JD) ID 3,843 / JD Spot rate, Iraqi dinar (ID) per dollar ($) ID 2,710 / $ Solution: Given Data Sale price, in euros (€) = Jordanian import duty on EU products = Jordanian resale fees = Spot rate, Jordanian dinar (JD) per euro (€) = Spot rate, Jordanian dinar (JD) per dollar ($) = Spot rate, Iraqi dinar(ID) per Jordanian dinar (JD) = Spot rate, Iraqi dinar (ID) per dollar ($) =

€ 375,000 12% 22% JD 0.7597 / € JD 0.7051 / $ ID 3,843 / JD ID 2,710 / $

What is the dollar price after all exchanges and fees? Sale price, ( in JD) = Sale price ( in € ) x Spot rate JD/€ Sale price, ( in JD) = €375,000 x JD 0.7597 / € = JD 284887.50 Jordanian import duty = Sale price, ( in JD) x Import duty( in JD) Jordanian import duty = JD 284887.50 x 12% = JD 34,186.50 Total cost, (in JD) = Sale price, ( in JD) + Jordanian import duty Total cost, (in JD) = JD 284887.50 + JD 34,186.50 Total cost, (in JD) = JD 319,074 Jordanian resale fees= Total cost, (in JD) x Jordanian resale fees Jordanian resale fees = JD 319,074 x 22% = JD 70,196.28

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Solution Manual

Resale price to Iraq , in JD = Total cost, (in JD) + Jordanian resale fees Resale price to Iraq , in JD = JD 319,074 + JD 70,196.28 Resale price to Iraq, in JD = JD 389,270.28 Price paid in Iraqi diner = Resale price to Iraq ( in JD ) X Spot rate ID / JD Price paid in Iraqi diner = JD 389,270.28 X ID 3,843 / JD Price paid in Iraqi diner = ID 1,495,965,686 US dollar equivalent of final price paid: US dollar equivalent = Price paid in Iraqi diner ÷ Spot rate ID / $ US dollar equivalent = ID 1,495,965,686 ÷ ID 2,710 / $ US dollar equivalent = $552,016.8583 = $552,017 Summary of all steps of Problem#2.9: What is the dollar price after all exchanges and fees? Purchase price, converted to Jordanian diner (JD) €375,000 x JD 0.8700 / € Additional fees due on importation JD 284887.50 x 12%

Amount JD

284887.50 34,186.50

Total cost, Jordanian diner (JD) Resale fee in Jordan (JD 319,074 x 22%)

JD

Resale price to Iraq , in JD Price paid in Iraqi diner, converting JD to Iraq JD 389,270.28 X ID 3,843 / JD US dollar equivalent of final price paid. ID 1,495,965,686 ÷ ID 2,710 / $

JD

319,074.00 70,196.28 389,270.28

ID 1,495,965,686.00 $552,017

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Solution Manual

Chapter-3 Balance of Payments

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Chapter # 3

Solution Manual

“Balance of Payments”

Problems# 3.1 - 3.4: Australia's Current Account. Australia’s Current Account, Use the following data from the IMF Fund to answer questions 1 through 4. Assumptions (millions of US dollars) Goods: exports Goods: imports Balance on goods Services: credit Services: debit Balance on services Income: credit Income: debit Balance on income Current transfers: credit Current transfers: debit Balance on current transfers Solution: Assumptions (millions of US dollars) 3.1 What is Australia's balance on goods? Goods: exports Less: Goods: imports Balance on goods 3.2 What is Australia's balance on services? Services: credit Less: Services: debit Balance on services

1998 55,884 61,215 -5,331 16,181 17,272 -1,091 6,532 17,842 -11,310 2,651 2,933 -282

1999 56,096 65,826 -9,730 17,354 18,304 -950 6,909 19,211 -12,302 3,003 3,032 -29

1998

1999

2000

56,096 65,826 -9,730

64,041 68,752 -4,711

17,354 18,304 -950

18,346 18,025 321

55,884 61,215 -5,331 16,181 17,272 -1,091

2000 64,041 68,752 -4,711 18,346 18,025 321 8,590 19,516 -10,926 2,629 2,629 0

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Solution Manual

3.3 What is Australia's Balance on goods & service? Balance on goods -5,331 Add : Balance on services -1,091 Balance on goods & service -6,422 3.4 What is Australia's current account balance? Add:Balance on goods -5,331 Balance on services -1,091 Balance on income -11,310 Balance on current transfers -282 Australia's C/A balance -18,014

-9,730 -950 -10,680

-4,711 321 -4,390

-9,730 -950 -12,302 -29 -23,011

-4,711 321 -10,926 0 -15,316

Problems# 3.5 - 3.9: Uruguay's Current Account.

Assumptions (millions of US dollars) Goods: exports Less: Goods: imports Balance on goods Services: credit Less: Services: debit Balance on services Income: credit Less: Income: debit Balance on income Current transfers: credit Less: Current transfers: debit Balance on current transfers

1998 2,829 3,601 -772 1,319 884 435 608 806 -198 75 16 59

1999 2,291 3,187 -896 1 ,262 802 460 736 879 -143 78 5 73

2000 2,380 3,316 -936 1,354 900 454 761 937 -176 71 5 66

Questions 1998 1999 3.5 What is Uruguay's balance on goods? -772 -896 3.6 What is Uruguay's balance on services? 435 460 3.7 What is Uruguay's balance on goods and services? -337 -436 3.8 What is Uruguay's balance on goods, services and income?

2000 -936 454

Solution:

-482

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Solution Manual

Add: Balance on goods -772 Balance on services 435 Balance on income -198 Total -535 3.9 What is Uruguay's current account balance?

-896 460 -143 -579

-936 454 -176 -658

-772 435 -198 59 -476

-896 460 -143 73 -506

-936 454 -176 66 -592

1999 -281.9 0 248.8 -12.3 45.4

2000 -243 0 160.1 59.6 23.3

Add: Balance on goods Balance on services Balance on income Balance on current transfers Uruguay's C/A balance

Problems#3.10 - 3.13: Myanmar's Balance of Payments Assumptions (millions of US dollars) A. Current account balance B. Capital account balance C. Financial account balance D. Net errors and omissions E. Reserves and related items

1998 -494.2 0 535.1 18.8 -59.7

Solution: Questions 3.10 Is Myanmar experiencing a net capital inflow (+) or outflow (-)? 3.11 What is Myanmar's Total for Groups A and B? ( A+B) 3.12 What is Myanmar's Total for Groups A through C? ( A+B+C) 3.13 What is Myanmar's Total for Groups A through D? ( A+B+C+D)

1998 535.1 “inflow”

1999 2000 248.8 160.1 “inflow” “inflow”

-494.2

-281.9

-243

40.9

-33.1

-82.9

59.7

-45.4

-23.3

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Solution Manual

Problems# 3.14 - 3.20 Argentina's Balance of Payments Problems 3.14 - 3.20 Argentina's Balance of Payments

Assumptions (millions of US dollars) A. Current Account Goods: exports Less: Goods: imports Balance on goods Services: credit Services: debit Balance on services Income: credit Income: debit Balance on income Current transfers: credit Current transfers: debit Balance on current transfers Current Account Balance (Group A) B. Capital Account (Group B) C. Financial Account Direct investment in Argentina Less: Direct investment abroad Direct investment in Argentina, net Portfolio investment assets, net Portfolio investment liabilities, net Balance on other investment assets & liabilities, net D. Net Errors and Omissions E. Reserves and Related Items

1998

1999

2000

26,433 29,532 -3,099 4,618 9,127 -4,509 6,121 13,537 -7,416 711 313 398 -14,626 73

23,309 24,103 -794 4,446 8,601 -4,155 6,085 13,557 -7,472 688 306 382 -12,039 88

26,409 23,851 2,558 4,536 8,871 -4,335 7,397 14,879 -7,482 641 352 289 -8,970 87

7,292 2,326 4,966 -1,905 10,693

23,984 1,354 22,630 -2,129 -4,782

11,665 1,113 10,552 -1,060 -1,332

5,217 -328 -4,090

-1,026 -729 -2,013

-50 -403 1,176

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Solution: Questions

Solution Manual

1998

1999

2000

-794 -4,155 -4,949

2,558 -4,335 -1,777

-794 -4,155 -7,472 382 -12,039 Income debit -7,472

2,558 -4,335 -7,482 289 -8,970 income debit -7,482

4,966 -1,905 10,693

22,630 -2,129 -4,782

10,552 -1,060 -1,332

5,217 18,971

-1,026 14,693

-50 8,110

3.14 What is Argentina's balance on goods and services? Balance on goods Balance on services Total

-3,099 -4,509 -7,608

3.15 What is Argentina's current account balance? Balance on goods Balance on services Balance on income Balance on current transfers Total 3.16 What seems to have been the primary driver in Argentina’s current account balance?

-3,099 -4,509 -7,416 398 -14,626 income debit -7,416

3.17 What is Argentina's financial account balance? Add: Direct investment in Argentina, net Portfolio investment assets, net Portfolio investment liabilities, net Balance on other investment assets & liabilities, net Total

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3.18 What is Argentina's Total for Groups A through C? Current Account Balance (Group A) Capital Account (Group B) Financial Account ( Group C) Total

-14,626 73 18,971 4,418

-12,039 88 14,693 2,742

-8,970 87 8,110 -773

-12,039 88 14,693 -729 2,013

-8,970 87 8,110 -403 -1,176

3.19 What is Argentina's Total for Groups A through D? Current Account Balance (Group A) Capital Account (Group B) Financial Account ( Group C) Net Errors and Omissions Total

-14,626 73 18,971 -328 4,090

3.20 Unless the financial account could grow a very large. Yes, the financial account could grow a very large as the amount is consider as surplus & a crisis will ensue.

Argentina's financial account balance? Add:Direct investment in Argentina, net Portfolio investment assets, net Portfolio investment liabilities, net Balance on other investment assets & liabilities, net Total

4,966 -1,905 10,693

22,630 -2,129 -4,782

10,552 -1,060 -1,332

5,217 18,971

-1,026 14,693

-50 8,110

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Solution Manual

Chapter-4 Foreign Exchange Market (FEM)

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Chapter # 4

Solution Manual

“Foreign Exchange Markets”

Problem#4.1: Ringgit up or down? Before the Asian currency crises the Malaysian ringgit traded at RM 2 .7000 /$. It currently traded at RM 3.8000 /$. Did the ringgit appreciate or depreciate & by what percentage? Solution: Given Data Malaysian ringgit, before the crisis = RM 2 .7000 /$. Malaysian ringgit, after the crisis = RM 3.8000 /$. Calculation: We use indirect quotation formula for finding percentage change.

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Solution Manual

Rechecking Method: We use direct quotation formula for finding percentage change.

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Solution Manual

Problem#4.2: Forward Premium & Discounts. Spot & 180-day forward exchange rate for several major currencies follow. For each pair, calculate the percentage premium or discounts expressed as an annual rate. Quoted spot rate 180-days forward rate

Currencies European euro British pound Japanese yen Swiss franc Hong Kong dollar

Spot Rate

Forward Rate

$ 0.8000/ € $1.562/£ ¥ 120.00/ $ SF 1.6000/ $ HK$ 8.0000/$

$0.81600/€ $1.5300/£ ¥118.00/$ SF1.6200/$ HK$7.8000/$

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Solution Manual

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Solution Manual

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Solution Manual

Summary:

Assumptions Days forward European euro ($/euro) British pound ($/pound) Japanese yen (yen/$) Swiss franc (SF/$) Hong Kong dollar (HK$/$)

Quotation

Quoted Spot rate

180-day Forward rate

Percent premium or discount per annum

Premium or Discount

180 Direct

0.8000

0.8160

+ 4.0000%

Premium

Direct

1.5620

1.5300

- 4.0973%

Discount

Indirect

120.00

118.00

+ 3.3898%

Premium

Indirect

1.6000

1.6200

- 2.4691%

Discount

Indirect

8.0000

7.8000

+ 5.1282%

Premium

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Solution Manual

Problem#4.3: Trading in Switzerland. Solution: You receive the following quotes for Swiss francs against the dollar for spot, one-month forward, 3-months forward, and 6 months forward. Calculate the outright quotes. Assumptions Spot exchange rate: Bid rate (SF/$) Ask rate (SF/$ One-month forward 3-months forward 6-months forward

Values 1.6075 1.6085 10 to 15 14 to 22 20 to 30

Mid Rate = 1.6075 + 1.6085 / 2 = 1.608 Spread = 1.6085 – 1.6075 = 0.001

b) What do you notice about the spread as quotes moves from six months

forward? Why do you this occurs? It widens, most likely a result of thinner and thinner trading volume.

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Solution Manual

Problem# 4.4: Yen Forward Premium. Using the mid rate yen quotes in Exhibit 4.5: Solution: Calculate the forward premiums for the yen in Exhibit 4.5. Implied a) ¥/$ ¥/$ *Mid Days Calculated Bid Rate Ask Rate Rates Forward **Forward Terms (spot) (forward) (¥/$) ‘n’ Premium Spot

Cash Rates

Swap Rates

118.27

118.37

118.32

1 week

-10

-9

118.23

7

3.9149%

1 month

-51

-50

117.82

30

5.0925%

2 months

-95

-93

117.38

60

4.8049%

3 months

-143

-140

116.91

90

4.8242%

4 months

- 195

-190

116.40

120

4.9485%

5 months

- 240

-237

115.94

150

4.9267%

6 months

-288

-287

115.45

180

4.9718%

9 months

-435

-429

114.00

270

5.0526%

1 year

-584

-581

112.50

360

5.1733%

2 year

-1150

-1129

106.93

720

5.3259%

3 year

-1748

-1698

101.09

1,080

5.6814%

4 year

-2185

-2115

96.82

1,440

5.5515%

5 year

-2592

-2490

92.91

1,800

5.4698%

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Solution Manual

* Mid rate = Bid + Ask / 2 ** Forward Premium = (S – F / F) x (360 / n) x 100

(Indirect Quotation)

b) Explain how the forward perineum of discount changes as maturities gets longer? The premium is gradually getting larger as the maturity lengthens to one year. After one year it seemingly stabilizes at about 5.5% to 5.6%. The forward rates progressively require fewer and fewer Japanese yen per dollar than the current spot rate. Therefore the yen is selling forward at a premium and the dollar is selling forward at a discount. The 24 month forward rate has the smallest premium, while the 1 month forward possesses the largest premium. Problem #4.5: Euro Forward Premium. Using the mid rate euros quotes in Exhibit 4.5: Solution: Calculate the forward premiums for the euro in Exhibit 4.5. Implied a) $/€ $/€ *Mid Days Calculated Bid Rate Ask Rate Rates Forward **Forward Terms (spot) (forward) $/€ ‘n’ Premium

Cash Rates

Spot

1.0897

1.0901

1.0899

1 week

3

4

1.0903

7

1.8875%

1 month

17

19

1.0917

30

1.9818%

2 months

35

36

1.0934

60

1.9268%

3 months

53

54

1.0953

90

1.9818%

4 months

72

76

1.0973

120

2.0369%

5 months

90

95

1.0992

150

2.0479%

6 months

112

113

1.1012

180

2.0736%

9 months 1 year

175 242

177 245

1.1075

270

2.1531% 2.2387%

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Swap Rates

Solution Manual

1.1143

360

2 year

481

522

1.1401

720

2.3030%

3 year

750

810

1.1679

1,080

2.3855%

4 year

960

1,039

1.1899

1,440

2.2938%

5 year

1,129

1,276

1.2102

1,800

2.2075%

* Mid rate = Bid + Ask / 2 ** Forward Premium = (F- S / S) x (360 / n) x 100

(Direct Quotation)

b). Explain how the forward perineum of discount changes as maturities gets longer? The premium is getting larger, but then diminishes somewhat for years 4 and 5. Problem# 4.6: Traveling: Copenhagen to St. Petersburg. On your post-graduation celebratory trip you are leaving Copenhagen, Denmark for St. Petersburg, Russia. Denmark’s currency is the krone (Denmark, although an EU member, is not a participant in the euro itself, but rather maintains a managed rate against the euro.)You leave Copenhagen with 10,000 Danish kroner still in your wallet. Wanting to exchange all of these for Russian rubles, you obtain the following quotes. Solution: Assumptions Values Beginning your trip with Danish krone DKr 10,000.00 Spot rate (Dkr/$) DKr 8.5515 / $ Spot rate (Ruble/$) Ruble 30.962/ $

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Solution Manual

Problem#4.7: Riskless Profit on the Franc. The following exchange rates are available to you. (You can buy or sell at the stated rates.) Assumptions Beginning funds in Swiss francs (SF) Mt. Fuji Bank (yen/$) Mt. Rushmore Bank (SF/$) Matterhorn Bank (yen/SF)

Values 10,000,000.00 ¥120.00 /$ SF1.6000 /$ ¥ 80.00 / SF or SF 0.0125

Solution:

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Solution Manual

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Solution Manual

Problem# 4.8: Trans Atlantic Arbitrage. A corporate treasury with operations in New York simultaneously calls Citibank in mid-town New York City and Barclays in London. The two banks give the following quotes at the same time on the euro. Citibank NYC quotes = $ 0.9650 – 70 / € Barclays London quotes = $ 0.9640 – 60 / € Explain, using $1 million or its euro equivalent, how the corporate treasury could make geographic arbitrage profit with the two different exchange rates quotes. Solution: Given Data Beginning funds = S.No. Bid (Buying) Ask (selling )

$1,000,000.00 Citibank NYC quotes: $0.9650 / € $0.9670 /€

Barclays London quotes: $0.9640 / € $0.9660 / €

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Solution Manual

Problem# 4.9: Wall Street Journal quotes and premiums. Calculate the percentage premium or discount from the data in Exhibit 4.6. Solution: Exhibit 4.6. US$ US$ equivalent equivalent £ / US$ £ / US$ Assumptions Thu Wed Thu Wed Britain (Pound) 1-month forward ( n=30days) 3-months forward ( n=90days) 6-months forward ( n=180days)

1.4443

1.4475

0.6924

0.6908

1.4418

1.4452

0.6936

0.6919

1.4401 1.43 36

0.6958

0.6944

1. 4371 1.4301

0. 6993

0.6975

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a)

Solution Manual

Forward premium (discount). To calculate the forward premium or discount for $/£, we use direct quotation formula, which is given as under; % premium or discount = (F-S) / (S) x (360/ n) x 100 To calculate the forward premium or discount for £/$, we use indirect quotation formula, which is given as under; % premium or discount = (S-F) / (F) x (360 / n) x 100 Forward premium (discount) US$ US$ equivalent equivalent Pound/US$ Pound/US$ Assumptions Thu Wed Thu Wed 1-month forward -2.0771% -1.9067% -2.0761% -1.9078% 3-months forward -1.9940% -2.0449% -1.9546% -2.0737% 6-months forward -1.9664% -1.9206% -1.9734% -1.9211% b) Why are the forward discounts not identical? Yes, the forward discounts of dollar & pounds are not identical. They would be if the "£/$" quote is calculated as the reciprocal of "US$ equivalent" carrying the digits. Problem#4.10: Finanial Times quotes. Solution: Using the spot and forward quotes on the British pound in Exhibit 4.5 in the chapter, demonstrate how the Financial Times is calculating the forward premiums on the: One month forward rate Three months forward rate One year forward rate From Exhibit 4.5 Spot rate, closing mid-point One month forward rate % PA (per annum) Three months forward rate % PA (per annum) One year forward rate

Values $1.4446 / £ 1.4421 2.1% 1.4374 2.0% 1.4183

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% PA (per annum)

Solution Manual

1.8%

Direct quotation formula is used for calculating the forward premium: (F-S)/(S) x (360 / n) x 100 One month rate (n=30). Three months rate (n=90). One year rate (n=180).

2.0767% 1.9936% 1.8206%

Note. These premiums are all actually "negative" in the precise calculation formula, but are reported as positives in Financial Times quotes. Problem# 4.11: Venezuelan Bolivar (A) Solution: The Venezuelan government officially floated the Venezuelan bolivar (Bs) in February 2002. Within weeks, its value had moved from the pre-float fix of BS778/$ to Bs1025/$. Beginning rate = S1= Bs 778 / $ Ending rate = S2 = Bs 1,025 / $ a) Is this a devaluation or depreciation? This is a case in which a government has changed its currency from a governmentally determined fixed rate, to a regime in which the currency is allowed to change in value based on supply and demand forces in the market. As a result of the move, the currency's value in this case was “depreciation” against the U.S. dollar. b) By what percentage did its value change? We use indirect quotation formula for percentage change:

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Problem# 4.12: Venezuelan Bolivar (B). The Venezuelan political and economic crisis deepened in late 2002 and early 2003. On January 1st, 2003, the bolivar was trading at Bs1400/$. By February 1st, its value had fallen to Bs1950/$. Many currency analysts and forecasters were predicting that the bolivar would fall an additional 40% from its February 1st value by early summer 2003. Solution: Given Data Exchange rate, January 1, 2003 = Bs 1,400 / $ Exchange rate, February 1, 2003 = Bs 1,950 / $ Forecast fall in value from Feb 1 to early summer, 2003 = - 40.0% a) What was the percentage change in January? Calculation:

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Solution Manual

b) Forecast value for June 2003?

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Solution Manual

Problem# 4.13: Indirect Quotation on the Dollar Solution: Given Data Quoted Spot rate = € 1.0200/$ 90-day Forward rate = € 1.0300/$ Days forward = 90-day Calculation:

The euro would be selling forward at a premium against the dollar, or equivalently, the dollar selling forward against the euro at a discount. In a way, the terminology is a bit tricky. One might say that the "forward premium is a premium." Rechecking Method: One way to check percentage change calculations is to invert each of the currency quotes (1 ÷ €/$ ), and recalculate the quote using the direct quotation formula.

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Hence, rechecked Problem#4.14: Direct Quotation on the Dollar Solution: Quoted Spot rate = $ 1.5500 / £ 6-month Forward rate = $ 1.5600 / £ Days forward = 180-day Calculation:

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The forward rate requires fewer US dollars in exchange for pounds than the current spot rate. The dollar is therefore selling forward at a premium against the pound & the pound is simultaneously selling forward at a discount versus the US dollar. Checking Method: One way to check percentage change calculations is to invert each of the currency quotes (1 ÷ $/£), and recalculate the quote using the indirect quotation formula.

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Problem# 4.15: Mexican Peso - European Euro Cross Rates. Given the following two exchange rates: Mexican peso Ps: Ps10.20 / $ Euro €: & € 1.02 / $. Calculate the cross rate between the Mexican peso (Ps) and the euro (€). Solution: Calculations:

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Problem# 4.16: Around the Horn. Assuming the following quotes, calculate how a market trader at Citibank with $1,000,000 can make an inter-market arbitrage profit. Assumptions Citibank quote: ($/£) National Westminster quote: (€/£) Deutschebank quote: ($/€) Initial investment

Exchange rate $ 1.5400 / £ € 1.6000 / £ or $ 0.9700 / € $ 1,000,000.00

£ 0.6250 / €

Solution:

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Solution Manual

Chapter # 5 Foreign Currency Derivatives

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Chapter # 5

a. b. c.

Solution Manual

“Foreign Currency Derivatives”

Problem#5.1: Peso Futures. Amber McClain, the currency speculator we met earlier in the chapter, sells eight June futures contracts for 500,000 pesos at the closing price quoted in Exhibit 5.1. What is the value of her position at maturity if the ending spot rate is$0.12000/Ps? What is the value of her position at maturity if the ending spot rate is $0.09800/Ps? What is the value of her position at maturity if the ending spot rate is $0.11000/Ps? Solution: a) b) c) Assumptions Values Values Values Number of pesos per futures contract 500,000 500,000 500,000 Number of contracts 8 8 8 Buy or sell the peso futures? Sell Sell Sell Ending spot rate $0.12 / Ps $0.10 / Ps $0.11 / Ps June futures settle price from Exhibit 5.1 ($/ Ps) Note: Short Position will gain if spot price fall below future price $0.11 $0.11 $0.11

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Interpretation: Amber buys at the spot price and sells at the futures price. If the futures price is greater than the ending spot price, she makes a profit otherwise she makes loss. Problem# 5.2: Pounds Futures. Michael Palin, a currency trader for a New York investment firm, uses the following futures quotes on the British pound to speculate on the value of the British pound. a. If he buys 5 June pound futures, and the spot rate at maturity is $1.3980/pound, what is the value of his position? b. If he sells 12 March pound futures, and the spot rate at maturity is $1.4560/pound, what is the value of his position? c. If he buys 3 March pound futures, and the spot rate at maturity is $1.4560/pound, what is the value of his position? d. If he sells 12 June pound futures, and the spot rate at maturity is $1.3980/pound, what is the value of his position? British Pound Futures, US$/pound (CME) Maturity

Open

March June

High

Settle

1.4246

Low 1.42 1.4268 14

Change

1.4228

0.0032

1.416

1.4188 1.4146

1.4162

0.0030

Contract = 62,500₤ Open High Interest 2 1.470 5,605 1.455 809

Solution: Assumptions Number of pounds (₤) per futures contract Maturity month Number of contracts Given condition in question. Ending spot rate ($/₤) Pound futures contract, settle price (given in table ) Spot – Future Analysis of spot & futures rate

a) Values

b) Values

c) Values

d) Values

£62,500 June 5

£62,500 March 12

£62,500 March 3

£62,500 June 12

buys $1.39.80/₤

sells $1.4560/₤

buys $1.4560/₤

sells $1.39.80/₤

$1.4162/₤ $ (0.0182)

$1.4228/₤ $1.4228/₤ $ 0.0332 $0.0332

SF

S>F

$1.4162/₤ $ (0.0182) S Spot rate ¥125/$ > ¥ 120/$ b). Using your answer in part a, what is Katya’s break even price? Ans. Katya buys a put on yen. She pays premium today. In 90 days, to exercises the put, receiving US dollar. (Note: We take values in terms of $/¥ to find Break even point, Gross profit & Net profit) =>

Break Even Price = Strike Price on put on Yen - Premium Break Even Price = $0.00800/¥ - $0.00003/¥ Break Even Price = $0.00797/¥

c).

What is Katya’s gross profit and net profit (including premium) if the ending spot rate is ¥140 /$?

Ans.

=> Gross Profit =

Strike Price – Ending spot rate

Gross Profit = $0.00800/¥ Gross Profit = $0.00086/¥ =>

Net Profit = Net Profit =

- $0.00714/¥

Strike Price – Ending spot rate – Premium $0.00800/¥ – $0.00714/¥ – $0.00003/¥

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Net Profit Net Profit

= =

Solution Manual

$0.00800/¥ – $0.00717/¥ $ 0.00083/¥

Problem# 5.6: Samuel’s bet. Samuel Samosir of Peregrine Investments in Jakarta, Indonesia, focuses nearly all of his time and attention on the U.S. dollar/Singapore dollar ($/S$) cross-rate. The current spot rate is $0.6000/S$. After considerable study this week, he has concluded that the Singapore dollar will appreciate versus the U.S. dollar in the coming 90 days, probably to about $0.7000/S$. He has the following options on the Singapore dollar to choose form: Strike price $0.6500/S$ $0.6500/S$

Option

Put on S$ Call on S$

Premium $0.00003/S$ $0.00046/S$

a). Should Samuel buy a put on Singapore dollar or call on Singapore dollar? b). Using your answer in part a, what is Samuel’s break even price? c). Using your answer in part a, what is Samuel’s gross profit and net profit (including premium) if the ending spot rate at the end of 90 days is $0.7000/S$? d). Using your answer in part a, what is Samuel’s gross profit and net profit (including premium) if the ending spot rate at the end of 90 days is indeed $0.8000/S$? Given Data Current spot rate = $0.6000/S$ or S$1.6667/$ Expected ending spot rate in 90 days = $0.7000/S$ or S$1.4286/$ Maturity of option = 90 days Strike price on Put on Yen = $0.6500/S$ or S$1.5385/S Strike price on Call on Yen = $0.6500/S$ or S$1.5385/S Premium on Put on Yen = $0.00003/S$ Premium on call on Yen = $0.00046/S$ Solution: a). Should Samuel buy a put on Singapore dollar or call on Singapore dollar? Ans. Samuel should buy a call on Singapore dollar to appreciate versus the US dollar. Samuel should buy a put on yen because the strike rate is lower then the spot rate. In this case spot rate is greater then the Strike rate. Spot rate > Strike rate S$1.6667/$ > S$1.5385/S b). Ans. => Break Even Price = Strike Price on Call on S$ + Premium Break Even Price = $0.6500/S$ + 0.00046/S$ Break Even Price = $0.65046/S$

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c).

Solution Manual

Ans.

- Strike Price

=> Gross Profit = Ending Spot Rate

Gross Profit = $0.7000/S$ - $0.6500/S$ Gross Profit = $0.05000/S$ =>

-

Net Profit

= Ending Spot Rate

Strike Price – Premium

Net Profit Net Profit Net Profit

= $0.7000/S$ - $0.6500/S$ – 0.00046/S$ = $0.7000/S$ – $65046/S$ = $0.04954/S$

d. Ans.

- Strike Price

=> Gross Profit = Ending Spot Rate

Gross Profit = $0.8000/S$ - $0.6500/S$ Gross Profit = $0.15000/S$ =>

-

Net Profit

= Ending Spot Rate

Strike Price – Premium

Net Profit Net Profit Net Profit

= $0.8000/S$ - $0.6500/S$ – 0.00046/S$ = $0.8000/S$ – $65046/S$ = $0.14954/S$

Problem# 5.7: How much profit – calls? assume a call option on euros is written with a strike price of $0.9400/ € at a premium of 0.90000Cents per euro ($0.0090/€) and with an expiration date three months from now. The option is for € 100,000. Calculate your profit or loss if you exercise before maturity at a time when the euro is traded spot at: a) $0.9000/€ b) $1.0000/€ c) $1.0200/€ d) $0.9800/€ e) $0.9200/€ f) $0.9400/€

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g) $0.9600/€

A call option is written on euros.

Assumptions Notional principal (euros) Maturity (days) Strike price (US$/euro) Premium (US$/euro) Ending spot rate (US$/euro) Gross profit on option Less premium Net profit (US$/euro) Net profit, total

a) b) c) d) e) f) Values Values Values Values Values Values

g) Values

100000 90 $0.94 $0.01

100000 90 $0.94 $0.01

100000 90 $0.94 $0.01

100000 90 $0.94 $0.01

100000 90 $0.94 $0.01

100000 90 $0.94 $0.01

100000 90 $0.94 $0.01

$0.90

$0.92

$0.94

$0.96

$0.98

$1.00

$1.02

$-0.009 ($0.01) ($900)

$-0.009 ($0.01) ($900)

$-0.009 ($0.01) ($900.)

$0.02 -0.009 $0.01 $1,100

$0.04 -0.009 $0.03 $3,100

$0.06 -0.009 $0.05 $5,100

$0.08 -0.009 $0.07 $7,100

Problem# 5.8: How much profit – puts? Assume a put option on Japanese yen is written with a strike price of $0.008000¥ (¥125.00/$) at a premium of 0.0080cents per yen and with an expiration date six months from now. The option is for ¥12,500,000. Calculate your profit or loss if you exercise before maturity at a time when the yen is traded spot at a) ¥110/$ b) ¥115/$ c) ¥120/$ d) ¥125/$ e) ¥130/$ f) ¥135/$ g) ¥140/$

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Solution: A put option on yen is written.

Assumptions

a)

b)

c)

e)

12,500,000 180 $0.01 $0.00

f)

g)

12,500,000 180 $0.01 $0.00

Ending spot rate (¥/$) in US$/yen

110 $0.01

115 $0.01

120 $0.01

125 $0.01

130 $0.01

135 $0.01

140 $0.01

$-0.00008 ($0.00) ($1,000)

$-0.00008 ($0.00) ($1,000)

$-0.00008 ($0.00) ($1,000)

$-0.00008 ($0.00) ($1,000)

$0.00 -0.00008 $0.00 $2,846.15

$0.00 -0.00008 $0.00 $6,407.41

$0.00 -0.00008 $0.00 $9,714.29

Gross profit Less premium Net profit ($/¥) Net profit, total

12,500,000 12,500,000 180 180 $0.01 $0.01 $0.00 $0.00

d)

Notional principal (¥) Maturity (days) Strike price ($/¥) Premium ($/¥)

12,500,000 12,500,000 180 180 $0.01 $0.01 $0.00 $0.00

12,500,000 180 $0.01 $0.00

Problem# 5.9: Falling Canadian dollar.. Giri Patel works for CIBC Currency Funds in Toronto. Giri is something of a contrarians - as opposed to most of the forecasts, he believes the Canadian dollar (C$) will appreciate versus the U.S. dollar over the coming 90 days. The current spot rate is $0.6750/C$. Giri may choose between the following options on the Canadian dollar: Option Put on S$ Call on S$

Strike price $0.7000/C$ $0.7000/C$

Premium $0.00003/C$ $0.00249/C$

a). Should Giri buy a put on Canadian dollars or call on Singapore dollars? b). Using your answer in part a, what is Giri’s break even price? c). Using your answer in part a, what is Giri’s gross profit and net profit (including premium) if the ending spot rate at the end of 90 days is indeed $0.7600/C$? d). Using your answer in part a, what is Giri’s gross profit and net profit (including premium) if the spot rate at the end of 90 days is indeed $0.8250/C$?

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Solution: Given Data Current spot rate Maturity of option Strike price on Put on Yen Strike price on Call on Yen Premium on Put on Yen Premium on call on Yen

= = = = = =

$0.6750/C$ 90 days $0.7000/C$ $0.7000/C$ $0.00003/C$ $0.00249/C$

or C$1.4815/$ or C$1.4286/$ or C$1.4286/$

a). Since Giri expects the Canadian dollar to appreciate versus the US dollar, he should buy a call on Canadian dollars. Giri should buy a call on Canadian dollar because the spot rate is greater then the strike rate. Spot rate > Strike rate C$1.4815/$ > C$1.4286/$ b). Ans. => Break Even Price = Strike Price on Call on S$ + Premium Break Even Price = $0.70000/C$ + $0.0249/C$ Break Even Price = $0.7249/C$ c). Ans.

- Strike Price

=> Gross Profit = Ending Spot Rate Gross Profit = $0.7600/C$ Gross Profit = $0.0600/C$ =>

-

$0.7000/C$

-

Net Profit

= Ending Spot Rate

Strike Price – Premium

Net Profit Net Profit Net Profit

= $0.7600/C$ - $0.7000/C$ – 0.0249/C$ = $0.7600/C$ – $0.7249/C$ = $0.0351/C$

d). Ans.

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Solution Manual

- Strike Price

=> Gross Profit = Ending Spot Rate Gross Profit = $0.8250/C$ Gross Profit = $0.1250/C$ =>

Net Profit

-

= Ending Spot Rate

Net Profit Net Profit Net Profit

$0.7000/C$

-

Strike Price – Premium

= $0.8250/C$ - $0.7000/C$ – 0.0249/C$ = $0.8250/C$ – $0.7249/C$ = $0.1001C$

Problem#5.10: Braveheart's Put on Pounds. Andy Furstow is a speculator for a currency fund in London named Braveheart. Braveheart’s clients are a collection of wealthy private investors who, with a minimum stake of £250,000 each, wish to speculate on the movement of currencies. The investors expect annual returns in excess of 25%. Although officed in London, all accounts and expectations are based in U.S. dollars. Andy Furstow is convinced that the British pound will slide significantly -- possibly to $1.3200/£ -- in the coming 30 to 60 days. The current spot rate is $1.4260/£. Andy wishes to buy a put on pounds which will yield the 25% return expected by his investors. Which of the following put options would you recommend he purchase. Prove your choice is the preferable combination of strike price, maturity, and up-front premium expense. Solution: Andy Furstow of Braveheart wishes to speculate on the fall of the ponds(£);Given Data Current spot rate = $1.4260 / ₤ (£ 0.7012623 / $ ) Expected endings spot rate in 30 to 60 days = $1.3200 /£ (₤0.7575758/ $ ) Potential investment principal per person = £250,000.00 Put on Pound Strike price ($/£) Maturity (days) Premium ($/£)

Put #1 $1.36 30 $0.00081

Put #2 $1.34 30 $0.0002 1

Put #3 $1.32 30 $0.00004

Put #4 $1.36 60

Put #5 $1.34 60

Put #6 $1.32 60

$0.00333

$0.00150

$0.00060

Solution: Issues for Andy to consider:

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1. Because his expectation is for "30 to 60 days" he should confine his choices to



the 60 day options to be sure and capture the timing of the exchange rate change. (We have no explicit idea of why he believes this specific timing.) 2. The choice of which strike price is an interesting debate. The lower the strike price (1.34 or 1.32), the cheaper the option price.  The reason they are cheaper is that, statistically speaking, they are increasingly less likely to end up in the money  The choice, given that all the options are relatively "cheap," is to pick the strike price which will yield the required return.  The $1.32 strike price is too far 'down,' given that Andy only expects the pound to fall to about $1.32

S.No. Put #1 Put #2 Put #3 Put #4 Put #5 Put #6

Strike Rate $1.36/£ < $1.34/£ > $1.32/£ = $1.36/£ > $1.34/£ < $1.32/£ =

Expected Spot Rate $1.3200/£ $1.3200/£ $1.3200/£ $1.3200/£ $1.3200/£ $1.3200/£

Strike Rate $1.36/£ < $1.34/£ > $1.32/£ = $1.36/£ > $1.34/£ < $1.32/£ =

Current Spot Rate $1.4260/£ $1.4260/£ $1.4260/£ $1.4260/£ $1.4260/£ $1.4260/£

Buyer of put on pound: Profit = Strike price – (Expected spot rate + Premium ) S.No. Put #1 Put #2 Put #3 Put #4 Put #5 Put #6 S.No.

Maturity Strike (days) price 30 $1.36/£ 30 $1.34/£ 30 $1.32/£ 60 $1.36/£ 60 $1.34/£ 60 $1.32/£

Maturity Current (days) Spot Rate

Less: Expected spot rate -$1.32/£ -$1.32/£ -$1.32/£ -$1.32/£ -$1.32/£ -$1.32/£

Initial Investment

Less premium = Net Profit -$0.00333 $0.0392 -$0.0015 $0.001979 -$0.0006 ($0.00004) -$0.00333 $0.03667 -$0.0015 $0.0185 -$0.0006 ($0.0006)

Initial Investment

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Put #4 Put #5 Put #6

S.No. Put #4 Put #5 Put #6

60 60 60

$1.4260 / £ $1.4260 / £ $1.4260 / £

£ 250,000.00 £ 250,000.00 £ 250,000.00

Solution Manual

At Current Spot Rate $ 356,500 $ 356,500 $ 356,500

1

2

3

Notional Principal (£) £75,075,075.08 £166,666,666.67 £416,666,666.67

Net Profit or Profit Rate $0.03667 $0.0185 ($0.0006)

Total Expected profit $2,753,003.00 $3,083,333.33 ($250,000.00)

4 Initial Investment At Current Spot Rate $ 356,500.00 $ 356,500.00 $ 356,500.00

5

ROI 772% 865% -70%

Risk: They could lose it all (full premium) Notes: 1 # If Andy invested an individual's principal purely in this specific option, they would buy an option of the following notional principal (pounds). 2 # Net Profit = Strike price – (Expected spot rate + Premium ) 3 # Long position = Notional Principal x profit rate 4 # Initial investment at current spot rate = £ 250,000 x $1.4260 / £ = $ 356,500 5 # ROI = Total profit ÷ Initial investment at Current Spot rate.

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Problem#5.11: Call Options on British pounds. Calculating call option premiums for lengthening maturities. AMERICAN MODEL PARAMETERS Current Spot Rate (US cents/fc) Foreign Interest Rate (5% as .05) Domestic Interest Rate (10% as .1)

INPU T 170 8.00% 8.00%

Price Delta Gamma Theta

3.289 0.503 0.0481 6.6954

EUROPEAN MODEL Option (1, CALL; -1, PUT) Strike Rate (US cents/fc) Days to Maturity Annual Volatility (10% as .1)

1 170 90 10.00%

Price Delta Gamma Theta

3.302 0.4999 0.0463 6.4294

The call option premium (baseline calculation shown here), changes with maturity as follows: European Maturity Price 30 1.932 60 2.714 90 3.302 120 3.787 150 4.206

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180 210 240 270 300 330 360

4.578 4.912 5.216 5.496 5.755 5.996 6.222

Days call option on premium (US cents/ pound) is a function of maturity .

Problem#5.12: Put Options on euros. Calculating put option premiums on two different volatilities. INPU T

PARAMETERS Current Spot Rate (US cents/fc) Foreign Interest Rate (5% as .05) Domestic Interest Rate (10% as.1)

1.0840 4.00% 2.00%

AMERICAN MODEL Price Delta Gamma Theta

0.402 -0.1692 0.0591 2.582

EUROPEAN MODEL Option (1, CALL; -1, PUT) Strike Rate (US cents/fc) Days to Maturity Annual Volatility (10% as .1)

-1 104 90 8%

Price Delta Gamma Theta

0.046 -0.1722 0.059 0.4023

The input set shown here is for the 8.00% volatility valuation. Replacing 8% with 12% will yield the following. Results: The put option premium based on volatility: Volatility

Premium(cents/euro)

Premium($/€)

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8% 12%

Solution Manual

0.406 1.037

$0.00 $0.01

Problem# 5.13: Solar Turbines and Venezuelan bolivares. Calculating put option premiums on a devaluing currency. Assumptions Spot rate Strike rate Notional principal (US$) Notional principal (bolivares)

Bolivares/$ 1,600.00 1,800.00 $250,000.00 400,000,000

Cents/Boliv $/Bolivares ares $0.00 0.0625 $0.00 0.05555556

AMERICAN MODEL PARAMETERS Current Spot Rate (US cents/fc) Foreign Interest Rate (5% as .05) Domestic Interest Rate (10% as .1)

INPUT 0.0625 24.00% 2.00%

Price Delta Gamma Theta

0.001 -0.2279 48.1162 0.0069

EUROPEAN MODEL Option (1, CALL; -1, PUT) Strike Rate (US cents/fc) Days to Maturity Annual Volatility (10% as .1)

-1 0.0556 90 20.00%

Price Delta Gamma Theta

0.001 -0.2336 48.0299 0.0009

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The calculated put option premium: (cents per bolivar) Divided by 100 for cents/$ (this is $/bolivar, premium) Notional principal of bolivares Total cost of put option

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0.001 $0.00 400,000,000 $4,000

Problem# 5.14: Vitro de Mexico. Calculating a call option premium on the Mexican peso.

Assumptions Spot rate Strike rate Notional principal (US$) Notional principal (Mexican pesos)

Canadian AMERICAN MODEL $/peso C$ 0.1390 Price 0.277 C$ 0.1500 Delta 0.3217 C$ 350,000.00 Gamma 0.2628 2,517,985.6 1 Theta 0.733 EUROPEAN MODEL

PARAMETERS Current Spot Rate (US cents/fc) Foreign Interest Rate (5% as .05) Domestic Interest Rate (10% as .1) Option (1, CALL; -1, PUT) Strike Rate (US cents/fc)

INPUT 13.9 6.00% 12.00% 1 15

Days to Maturity Annual Volatility (10% as .1)

180 14.00%

Price Delta Gamma Theta

0.28 0.3258 0.259 0.7286

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Put option premium on peso (Canadian cents per peso) Put option premium on peso (Canadian dollars per peso) Notional principal in pesos Total cost of put option (C$)

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0.28 C$ 0.002800 2,517,985.6 1 C$ 7,050.36

Problem# 5.15: Put Options on Chinese Renminbi Calculating put option premiums on the Rmb. Assumptions Spot rate Strike rate

Rmb/$ 8.5 9

$/Rmb $0.12 $0.11

Cents/Rmb 11.7647 11.1111

AMERICAN MODEL PARAMETERS Current Spot Rate (US cents/fc) Foreign Interest Rate (5% as .05) Domestic Interest Rate (10% as .1)

INPUT 11.7647 14.00% 4.00%

Price Delta Gamma Theta

0.003 -0.0355 0.3344 0.0765

EUROPEAN MODEL Option (1, CALL; -1, PUT) Strike Rate (US cents/fc) Days to Maturity Annual Volatility (10% as .1) Put option premium, US$ cents/Rmb Put option premium, US$/Rmb

-1 11.1111 90 4.00% 0.005 $0.00

Price Delta Gamma Theta

0.005 -0.0482 0.4254 0.0035

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Chapter-6

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Chapter # 6 “International Parity Conditions” Problem # 6.1: Big Mac Hamburger Standard Solution: (1)

U.S. Argentina Canada Euro Area Japan

Big Mac Price in Local Currency $ 2.80 Ps 7.50 C$ 3.50 € 2.90 ¥ 300

(2)

Actual Exchange Rate ----Ps 3.60 / $ C$1.63 / $ $1.02 / € ¥ 122 / $

(1) ÷ (2)= (3)

Big Mac Prices in Dollars $2.80 $2.08 $2.15 $2.96 $2.46

(1) ÷ $2.80 = (4)

(4) ÷ (2) = (5)\

Implied PPP of the Dollars 1 Ps2.68 / $ C$ 1.25 / $ $ 0.97 / € ¥ 107.14 / $

Local currency under (-) / over (+) Valuation ------- 25.60% - 23.30% 5.64% - 12.20%

Calculation notes:  Column 3 = Column 1 ÷ Column 2; except for the euro, which is Column 1 x Column 2 ( € 2.90 x $1.02 = $2.96 )  Column 4 = Column 1 ÷ $2.80; except for the euro, which is $2.80 ÷ Column 1 ($2.80 ÷ €2.90 =$ 0.97)  Column 5 = Column 4 - Column 2 ÷ Column 2

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or

In above formula of percentage change for indirect quotation, the Implied PPP becomes beginning rate (S1) and actual exchange rate becomes ending rate (S2).

Problem # 6.2: Exchange Rate Pass-Through Solution: Assumptions Initial spot exchange rate in yen per dollar Initial price of a Nissan Expected US dollar inflation rate for the coming year Expected Japanese yen inflation rate for the coming year Desired rate of pass through by Nissan

Value ¥122/$ ¥3,000,000 2.00% 0.00% 70.00%

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Problem # 6.3: Argentine pesos Solution: Assumptions Spot exchange rate, fixed peg, early January 2002 Spot exchange rate, January 29, 2003 US inflation for year (per annum) Argentine inflation for year (per annum)

Solution Manual

Value Ps 1 / $ Ps 3.2 / $ 2.20% 20.00%

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Problem # 6.4: International Fisher Effect. Solution: Assumptions One year interest rate, US dollars One year interest rate, Euro Zone Current spot exchange rate

Solution Manual

Value 3.00% 5.00% € 1.02 / $

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For International Fisher Effect, we use below formula;

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Problem # 6.5: Covered Interest Arbitrage (CIA) - Denmark I Solution: James Chang needs to determine whether the returns from the arbitrage exceed the opportunity costs of the U.S. dollar funds. The direction of potential profitability is determined by comparing the difference in interest rates (5.00% - 3.00% = 2.00%) and the forward discount, -1.974%. Arbitrage Rule of Thumb: Here, the difference in interest rates is greater than the forward premium or discount (2% > -1.97%), so James Chang should borrow dollars (lower interest rate) and invest for CIA in Danish kroner. Difference in interest rates (i kr – i $) Less: Forward discount on the kroner CIA profit potential

2.00% - 1.97% 0.03%

This tells James Chang that he should borrow dollars and invest (CIA) in Danish kroner for profit. Therefore

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James Chang generates a covered interest arbitrage profit of $13.93 because he is able to generate an even higher interest return in Danish kroner than he "gives up" by selling the proceeds forward at the forward rate.

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Problem # 6.6: Covered Interest Arbitrage (CIA) Denmark B – Part (a). Solution: The U.S. dollar 3-month interest rate now rises from 3.000% to 4.000%. (4.00% - 3.00% = 1.00%). Note that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make CIA profit one way or another. Arbitrage Rule of Thumb: Here, the difference in interest rates is less than the forward discount (1.00% < 0.97%), so James Chang should start by borrowing Danish kroner, exchanging into US dollars, investing in dollar interest and selling the dollar proceeds forward to lock in a CIA profit. Difference in interest rates (i kr – i $) Less: Forward discount on the kroner CIA profit potential

1.00% - 1.97% - 0.97%

This tells James Chang that he should borrow Danish kroner and and invest (CIA) in U.S. dollars for profit.

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a) James Chang generates a covered interest arbitrage profit of kr94,110 because, although U.S. dollar rates are lower, the U.S. dollar is selling forward at a premium against the Danish kroner. CIA- Denmark B – Part ( b). . The U.S. dollar 3-month interest rate now rises from 3.000% to 4.000%. Note that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make CIA profit one way or another. Here, the difference in interest rates is LESS than the forward discount, so James Chang should start by borrowing Danish kroner, exchanging into US dollars, investing in dollar interest and selling the dollar proceeds forward to lock in a CIA profit. Difference in interest rates (i kr – i $)

3.00%

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Less: Forward discount on the kroner CIA profit potential

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- 1.97% 1.93%

b) This is a bit of a tricky question. Denmark is not a member of the euro zone itself, but its central bank does pay a great deal of attention to neighboring interest rates and monetary policy in the euro zone. If the Danish the central bank of Denmark uses the euro as its reference rate. If the Danish authorities did increase interest rates to that of

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the euro zones, CIA profit potential is now reversed: CIA profit would be generated by starting with US dollars and investing in kroner.

Problem # 6.7: Covered Interest Arbitrage – Japan. Solution: Here, the difference in interest rates is less than the forward premium, so Yukiko Miyaki should borrow Japanese yen, exchange to dollars, invest in dollars for 6 months, and sell the dollar proceeds forward. (-2.00% < 1.63%) Difference in interest rates (i ¥ – i $) -2.00% Less: Forward premium on the yen 1.63% CIA profit potential 0.37% This tells Yukiko Miyahki that she should borrow yen and invest (CIA) in U.S. dollars for profit.

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Yukiko generates a CIA profit by investing in the higher interest rate currency, the dollar, and at the same time selling the dollar proceeds forward at a forward premium which does not completely negate the interest. Problem # 6.8: Uncovered Interest Arbitrage -- Japan Solution: Here, the difference in interest rates is not offset at all by using forwards, because Yukiko is not covering. She expects the spot exchange rate at the end of the period to be the same as at the beginning. Difference in interest rates (i$ - i¥) = 2.00% Not Using Forward cover = 0.00% UIA profit potential = 2.00%

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Problem # 6.9: International Parity Conditions in Equilibrium Solution: Assumptions Forecast annual rate of inflation for Canada Forecast annual rate of inflation for United States One-year interest rate for Canada One-year interest rate for United States Spot exchange rate One-year forward exchange rate

Solution Manual

Value 3.62% 3.00% 5.62% 5.00% C$1.60/$ C$1.61/$

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Note that the differentials are not exactly equal, reflecting the application of the approximate form. Problem # 6.10: Mary Smyth -- CIA Solution: Here, the difference in interest rates is less than the forward premium, so Mary Smyth should borrow dollars, exchange them into Swiss francs, invest for 90 days, and sell the francs forward. Forward premium on the Swiss franc = 5.06% Difference in interest rates (I SF – I $) = -2.00% CIA profit potential = 3.06% This tells Mary Smyth she should borrow U.S. dollars and invest (CIA) in Swiss francs for profit.

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Mary Smyth makes a CIA profit of $7,848.10 on each million she invests. Problem # 6.11: Mary Smyth -- UIA Solution: Now Mary Smyth is wishing to take her chances with the future spot rate. Given the fact that Swiss franc interest rates are actually lower than dollar rates, the only real way Mary Smyth can come out ahead here is if the Swiss franc ends up appreciating significantly against the dollar over 90 days. Difference in interest rates (i SF - i$) = (6%-8%) = -2.00% Not Using Forward cover = 0.00%

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UIA profit potential with no change in spot rate =

Solution Manual

-2.00%

The ending spot rate needs to be SF 1.5922/$ or more (larger) less in order for Mary to turn an uncovered interest arbitrage profit.

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Problem # 6.12: Mary Smyth -- one month later Solution: The fact that the difference in interest rates does not exactly offset the forward premium indicates that a covered interest arbitrage potential exists. Because the forward premium is greater than the interest differential, Mary Smyth she invest in the lower interest rate currency (SF) after borrowing in the relatively high interest rate currency (US$). Forward premium on the Swiss franc = 3.79.0% Difference in interest rates (iSF – i$) = ( 4.80% - 8%) = -3.20% CIA profit potential = 0.596% This tells Mary Smyth she should borrow U.S. dollars and invest (CIA) in Swiss francs for profit.

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Mary Smyth makes a CIA profit of $1,577.29 on each $1,000,000, she invests. Problem # 6.13: Langkawi Island Resort Solution: Assumptions Value Charge for suite plus meals (in ringgit) 760 Spot exchange rate (ringgit per US$) 3.8 US$ cost today for a 30 day stay $6,000.00 Malaysian ringgit inflation rate expected to be 4.00% U.S. dollar inflation rate expected to be 1.00%

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a. How many dollars might you expect to need one year hence for your 30-day vacation? Spot exchange rate Malaysian ringgit inflation rate expected to be U.S. dollar inflation rate expected to be Expected spot rate one year from now based on PPP Hotel charges expected to be paid 1 year from now for a 30-day stay US dollars needed on the basis of these two expectations:

RM 3.8 /$ 4.00% 1.00% RM 3.9129/$ 23,712.00 $6,060.00

b. By what percent has the dollar cost gone up? Why? New dollar cost Original dollar cost Percent change in US$ cost

$6,060.00 $6,000.00 1.00%

Calculation Notes: $6,060.00 ÷ $6,000.00 = *1.01 or a 1.00% increase => 1+1.00% = 1+ 0.01= *1.01 ( 1.00% is inflation of U.S. ) The dollar cost has risen by the US dollar inflation rate. This is a result of your estimation of the future suite costs and exchange rate changing in relation to inflation. Problem# 6.14: Covered Interest against the Norwegian krone. Statoil, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it considers the U.S. dollar as its functional currency, not the Norwegian krone. Ari Karlsen is a currency trader for Statoil, and has immediate use of either $4 million or the Norwegian krone equivalent). He is faced with the following market rates, and wonders whether he can make some arbitrage profits in the coming 90 days. Solution: Assumptions

Values

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Arbitrage funds available Spot exchange rate (Nkr/$) 3-month forward rate (Nkr/$) U.S. dollar 3-month interest rate Norwegian krone 3-month interest rate

Solution Manual

$4,000,000 6.552 6.5264 5.63% 4.25%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency. Difference in interest rates ( i Nkr - i $) Less: Forward premium on the krone CIA profit potential

-1.38% 1.57% 0.19%

This tells Ari Karlsen he should borrow U.S. dollars and invest in the lower yielding currency, the Norwegian krone, selling the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.

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Ari Karlsen can make $2,106.83 for Statoil on each $4 million he invests in this covered interest arbitrage (CIA) transaction. Note that this is a very slim rate of return on an investment of such a large amount. => Annualized rate of return = 0.21% Problem # 6.15: Frankfurt and New York

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Solution: Money and foreign exchange markets in Frankfurt and New York are very efficient. Using the following market information, answer the following questions: Assumptions Spot exchange rate ($/€) One-year Treasury bill rate Expected inflation rate

Frankfurt 1.2 6.50% Unknown

New York 1.2 3.20% 2.00%

a. What do the financial markets suggest for inflation in Europe next year? According to the Fisher effect, real interest rates should be the same in both Europe and the US. Since the formula for nominal rate is given as; Nominal rate = [( 1+real ) x ( 1+expected inflation ) ] - 1 Hence, 1 + real rate = (1 + nominal) ÷ (1 + expected inflation) 1 + nominal rate

Frankfurt 106.50%

New York 103.20% 1

1 + expected inflation 1 + real Therefore the real rate in the US is: The expected rate of inflation in Berlin is then:

Unknown 101.18%

02.00% < --- 101.18% 1.18%

5.26%

b. Estimate today's one-year forward exchange rate between the dollar and the euro. Spot exchange rate ($/€) US dollar one-year Treasury bill rate European euro one-year Treasury bill rate One year forward rate ($/€)

1.2 3.20% 6.50% 1.1628

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Problem # 6.16: Chamonix chateau rentals. You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are negotiating over the rental of a chateau. The chateau's owner wishes to preserve his real income against both inflation and exchange rate changes, and so the present weekly rent of €8,000 (Christmas season) will be adjusted upwards or downwards for any change in the French cost of living between now and then. You are basing your budgeting on PPP. French inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is expected to be 2.5%. The current spot rate is $1.1840/€. What should you budget as the U.S. dollar cost of the one week rental? Assumptions Spot exchange rate ($/€) Expected US inflation for coming year Expected French inflation for coming year Current chateau nominal weekly rent (€)

Values $1.18 2.50% 3.50% 8000

Forecasting the future rent amount and exchange rate: Values PPP exchange rate forecast ($/€) 1.1726 Spot (one year) = Spot x ( 1 + US$ inflation ) / ( 1 + French inflation ) Nominal monthly rent, in euros, one year from now 8,280.00 Rent now x ( 1 + France inflation ) Cost of rent one year from now in US dollars $9,708.80 Rent one year from now / PPP forecasted spot rate Note: students may inquire as to whether the euro, a currency for a multitude of countries which may actually have substantial differences in inflation locally, really will react to inflationary pressures and differentials as PPP would predict a good question.

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Problem # 6.17: East Asiatic Company – Thailand. The East Asiatic Company (EAC), a Danish company with subsidiaries all over Asia, has been funding its Bangkok subsidiary primarily with U.S. dollar debt because of the cost and availability of dollar capital as opposed to Thai baht (฿) denominated debt. The treasure of EACThailand is considering a one-year bank loan for $350,000. The current spot rate is ฿ 42.84/$. One year loans are 14.00% in baht but only 8.885% in dollars. Assumptions Values Current spot rate, ฿41.358/$ Expected Thai Baht inflation ( part a ) 4.50% Expected dollar inflation ( part a ) 2.20% Loan principal in U.S. dollars $350,000.00 US dollar interest rate, 1-year loan 8.85% a).First, it is necessary to forecast the future spot exchange rate for the ฿/$.

Different expectations of the future spot exchange rate, either PPP for part a), or an expected devaluation for part b), allow the isolation of exactly how many Thai baht would be required to repay the dollar loan.

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a) Assuming a PPP forecast of the future spot rate, ฿43.8039/$, it will take

16,693,579.00 baht to repay the U.S. dollar loan. The implied cost of funds, in baht terms, is 11.34%. b) Assuming a future spot rate for the baht which is 5% weaker than the current spot rate ฿42.84/$ that will leads to rises the implied cost to 14.60%. Current Spot Rate Pct. Change ( the value of Baht down against the dollar) New Forecast rate: New spot (S2) = old spot rate / (1 – 5%) New spot (S2) = ฿42.84/$ / (1 – 0.05%)

฿42.84/$ -5.00% ฿45.09/$

Calculation Notes: $350,000.00 x 1.0889 = $381,098.00 $350,000.00 x ฿42.84/$ = ฿14,994,000.00 (Initial investment ) $381,098.00 x ฿45.09/$ = ฿17,183,709.00 (Repaid in baht) Implied cost = Repaid ÷ Initial investment – 1 Implied cost = ฿17,183,709.00 ÷ ฿14,994,000.00 – 1 Implied cost = 1.1460 – 1 Implied cost = 0.1460 Implied cost = 14.60% c) In part a, the cost of funds is expected to be 11.34%, cheaper than borrowing

locally at 14.00%. In part b, however, the expected cost of 14.60% would indicate it would be cheaper to borrow locally--in baht.

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Problem # 6.18: Maltese Falcon: 2003-2004. The infamous solid gold falcon, initially intended as a tribute by the Knights of Rhodes to the King of Spain in appreciation for his gift of the island of Malta to the order in 1530, has recently been recovered. The falcon is 14 inches in height and solid gold, weighing approximately 48 pounds. Gold prices in late 2002 and early 2003, primarily as a result of increasing political tensions, have risen to $440/ounce. The falcon is currently held by a private investor in Istanbul, who is actively negotiating with the Maltese government on its purchase and prospective return to its island home. The sale and payment are to take place in March 2004, and the parties are negotiating over the price and currency of payment. The investor has decided, in a show of goodwill, to base the sales price only on the falcon's specie value -- its gold value. The current spot exchange rate is 0.39 Maltese lira (ML) per U.S. dollar. Maltese inflation is expected to be about 8.5% for the coming year, while U.S. inflation, on the heels of a double-dip recession, is expected to come in at only 1.5%. If the investor bases value in the U.S. dollar, would he be better off receiving Maltese lira in one year -- assuming purchasing power parity, or receiving a guaranteed dollar payment assuming a gold price of $420 per ounce? S.NO. Weight of falcon, in pounds Total number of ounces in weight Price of gold, $/ounce Falcon value based on price of gold

Mar-03 Mar-04 48 48 768 768 $440.00 $420.00 $337,920.00 $322,560.00

The PPP forecast of the ML/$ exchange rate: Current spot rate, Maltese lira/dollar Expected Maltese inflation Expected dollar inflation PPP forecast of Maltese lira/dollar

0.39 8.50% 1.50% 0.4169

If the investor bases his gross sales proceeds in U.S. dollars, the guaranteed dollar payment at $420/ounce yields a larger amount ($322,560) than accepting Maltese lira assuming PPP ($316,116).

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Problem # 6.19: London Money Fund. Tom Hogan is the manager of an international money market fund managed out of London. Unlike many money funds that guarantee their investors a near risk-free investment with variable interest earnings, Tim Hogan's fund is a very aggressive fund that searches out relatively high interest earnings around the globe, but at some risk. The fund is pound-denominated. Tim is currently evaluating a rather interesting opportunity in Malaysia. The Malaysian government has been enforcing a number of currency and capital restrictions since the Asian Crisis of 1997 to protect and preserve the value of the Malaysian ringgit (RM). The current spot rate of RM3.75/$ has been adjusted only recently (July 2005) from its previously fixed value of RM3.80/$. Local currency time deposits of 180-day maturities are earning 9.600% per annum. The London Eurocurrency market for pounds is yielding 4.200% per annum on similar 180-day maturities. The current spot rate on the British pound is $1.7640/£, and the 180-day forward rate is $1.7420/£.

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Solution: Assumptions Principal investment, British pounds Spot exchange rate ($/£) 180-day forward rate ($/£) Malaysian ringgit 180-day yield Spot exchange rate, RM / $

Solution Manual

Values £1,000,000.00 $1.76 / £ $1.74 9.60% 3.75

The initial pound investment implicitly passes through the dollar into Malaysian ringgit. The ringgit is fixed against the dollar, hence the ending RM/$ rate is the same as the current spot rate. The pound, however, is not fixed to either the dollar or ringgit. Tim Hogan can purchase a forward against the dollar, allowing him to cover the dollar/pound exchange rate.

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If Tim Hogan invests in the Malaysian ringgit deposit, and accepts the uncovered risk associated with the RM/$ exchange rate (managed by the govt.), and sells the dollar proceeds forward, he should expect a return of 6.124% on his 180-day pound investment. This is better than the 4.200% he can earn in the euro-pound market. Interestingly, if Tim Hogan chose to not sell the dollars forward, and accepted the uncovered risk of the $/£ exchange rate as well, he may or may not do better than 6.124%. For example, if the spot rate remained unchanged at $1.7640/£, Tim's return would only be 4.800%. This demonstrates that much of the added return Tim is earning is arising from the forward rate itself, and not purely from the nominal interest differentials. Problem # 6.20: The African beer standard of PPP. In 1999 the Economist magazine reported the creation of an index or standard for the evaluation of African currency values using the local prices of beer. Beer was chosen as the product for comparison because McDonald's had not penetrated the African continent beyond South Africa, and beer met most of the same product and market characteristics required for the construction of a proper currency index. Investec, a South African investment banking firm, has replicated the process of creating a measure of PPP like that of the Big Mac Index of the Economist, for Africa. The index compares the cost of a 375 milliliter bottle of clear lager beer across sub-Sahara Africa. As a measure of PPP the beer needs to be relatively homogeneous in quality across countries, needs to possess substantial elements of local manufacturing, inputs, distribution, and service, in order to actually provide a measure of relative purchasing power. The beers are first priced in local currency (purchased in the taverns of the local man, and not in the high-priced tourist centers), then converted to South African rand. The prices of the beers in rand are then compared to form one measure of whether the local currencies are undervalued (- %) or overvalued (+ %) versus the South African rand. Use the data in the exhibit and complete the calculation of whether the individual currencies are under- or over-valued.

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Beer Prices Im Country South Africa Botswana Ghana Kenya Malawi Mauritius Namibia Zambia Zimbabwe

Beer Castle Castle Star Tusker Carlsberg Phoenix Windhoek Castle Castle

In Local currency

In Local currency

Rand Pula Cedi Shilling Kwacha Rupee N$ Kwacha Z$

2.3 2.2 1,200.00 41.25 18.5 15 2.5 1,200.00 9

plied In PPP rand rate ---2.94 3.17 4.02 2.66 3.72 2.5 3.52 1.46

---0.96 521.74 17.93 8.04 6.52 1.09 521.74 3.91

Under or Spot overvalued Rate to rand (3/15/99) (%) ---0.75 379.1 10.27 6.96 4.03 1 340.68 6.15

---27.90% 37.60% 74.60% 15.60% 61.80% 8.70% 53.10% -36.40%

Notes: 1. Beer price in South African rand = Price in local currency / spot rate on 3/15/99. 2. Implied PPP exchange rate = Price in local currency / 2.30. 3. Under or overvalued to rand = Implied PPP rate / spot rate on 3/15/99.

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Chapter-7

Foreign Exchange Rate Determination

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Chapter # 7

Solution Manual

Foreign Exchange Rate Determination

Problems # Using the following economic, financial, & business indicators from February 3,2003, issue of The Economist to answer the problem 1 through 10.

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Problem # 7.1: Current spot rates. What are the current spot exchange rates for the following cross rates? a. Japanese yen/US dollar exchange rate. (¥/$) b. Japanese yen/Australian dollar exchange rate, (¥/A$)

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Australian dollar/US dollar exchange rate, (A$/$) Solution: Currency per pound Calculation of Country Feb 5th Current spot exchange rates Australia A$ 2.78 / £ ¥ 197 / £ ÷ $ 1.65 / £ = ¥ 119.39 / $ Japan ¥ 197 / £ ¥ 197 / £ ÷ A$ 2.78 / £ = ¥ 70.86 / A$ U.S. $ 1.65 / £ A$ 2.78 / £ ÷ $ 1.65 / £ = A$ 1.68 / $ c.

Problem # 7.2: Purchasing power parity forecasts. Assuming purchasing power parity, and assuming that the forecasted change in consumer prices is a good proxy of predicted inflation, forecast the following cross rates: a. Japanese yen/US dollar in 1 year b. Japanese yen/Australian dollar in 1 year c. Australian dollar/US dollar in 1 year Solution: Inflation 2003e Country (Given in table) Australia 2.7% or 0.027 Japan -0.7% or -0.0 07 U.S. 2.1% or 0.021 Spot Rate (calculation given above in problem#7.1) ¥ 119.39 / $ ¥ 70.86 / A$ A$ 1.68 / $

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Problem # 7.3: International Fisher forecasts. Assuming International Fisher applies to the coming year; forecast the following future spot exchange rates using the government bond rates for the respective country currencies: a. Japanese yen/US dollar in 1 year b. Japanese yen/Australian dollar in 1 year c. Australian dollar/US dollar in 1 year Solution: Country Australia Japan U.S.

2-year Govt Bonds interest Rates 5.14% or 0.0514 0.80% or 0.008 3.76% or 0.0376

Spot Rate (calculation given above in problem#7.1) ¥ 119.39 / $ ¥ 70.86 / A$ A$ 1.68 / $

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Problem # 7.4: Implied real interest rates. If the nominal interest rate is the government bond rate, and the current change in consumer prices is used as expected inflation, calculate the implied "real" rates of interest by currency. a). Australian dollar "real" rate b). Japanese yen "real" rate c). US dollar "real" rate Solution:

Country Australia Japan U.S.

Nominal Rate (2-year Govt. Bonds interest Rates) 5.14% or 0.0514 0.80% or 0.008 3.76% or 0.0376

Change in consumer prices (the change in consumer prices is used as expected inflation) 2.7% or 0.027 -0.7% or -0.0 07 2.1% or 0.021

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Problem # 7.5: Forecasting with real interest rates. Using the real interest rates calculated in problem 7.4; forecast the following future spot exchange rates using real interest rate differentials: a. Japanese yen/US dollar exchange rate in 1 year b. Japanese yen/Australian dollar exchange rate in 1 year c. Australian dollar/US dollar exchange rate in 1 year Solution: Country Australia Japan U.S.

Real interest rate 2.38% or 0.0238 1.51% or 0.0151 1.63% or 0.0163

Spot Rate (calculation given above in problem#7.1) ¥ 119.39 / $ ¥ 70.86 / A$ A$ 1.68 / $

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Problem # 7.6: Forward rates. Using the spot rates and three-month interest rates above, calculate the 90-day forward rates for: a. Japanese yen/US dollar exchange rate b. Japanese yen/Australian dollar exchange rate c. Australian dollar/US dollar exchange rate

Country Australia Japan U.S.

3-month money market Year Ago 4.28% or 0.0428 0.30% or 0.003 1.79% or 0.0179

Spot Rate (calculation given above in problem#7.1) ¥ 119.39 / $ ¥ 70.86 / A$ A$ 1.68 / $

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Note: All interest rates need to be adjusted for a 90 day period of a 360 day year for the calculation. Problem # 7.7: Real economic activity and misery. Calculate the country's Misery Index (unemployment + inflation) and then use it like interest differentials to forecast the future spot exchange rate, one year into the future.

Country Australia's Misery Index Japan's Misery Index U.S. Misery Index

Unemployment Recent Quarter 6.2% 5.5% 6.0%

Inflation 2003e (Given in table) 2.7% -0.7% 2.1%

Misery Index 8.9% or 0.089 4.8% or 0.048 8.1% or 0.081

Forecast spot = Spot x ( 1 + Misery-1) / ( 1 + Misery-2)

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Summary S. No. a. ¥/$ exchange rate in 1 year b. ¥/A$ exchange rate in 1 year c. A$ /$ exchange rate in 1 year

Starting Spot Rate ¥ 119.39 / $ ¥ 70.86 / A$ A$ 1.68 / $

Solution Manual

Forecast Spot Rate ¥ 115.75 / $ ¥ 69.18 / A$ A$ 1.69/ $

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Problem # 7.8: Balance of payments approach. Using the trade and current account information, forecast the direction of the spot exchange rates for the coming year. a. Japanese yen/US dollar exchange rate in 1 year  Japan is running a trade & current account surplus.  US is running a trade & current account deficit.  Dollar should weaken against the Japanese yen. b. Japanese yen/Australian dollar exchange rate in 1 year  Japan is running a trade & current account surplus.  Australia is running a trade & current account deficit.  Australian dollar should weaken against the yen. c. Australian dollar/US dollar exchange rate in 1 year  Australia is running a trade & current account  US is running a trade & current account deficit  Indeterminate. Problem # 7.9: Current accounts and spot rates. Are the current account forecasts from the previous question consistent with the exchange rate trends shown above? Ans. Japanese yen appreciated in value against the US dollar over 2002. This is consistent with the trade and current account balances being run by the two countries. The Australian dollar consistently strengthened against the US dollar over 2002. Although Australia and the United States have similar current and forecast rates of inflation, and similar trade and current account deficits, Australia has demonstrated stronger economic growth (GDP) over the past year than the US. Problem # 7.10: Exchange rate trends and bounds. Use the graphs to determine trends, mean values, and upper and lower bounds to spot exchange rate movements. Trend up or Upper Lower Cross Rates down Mean Bound Bound Yen/US$ US$ down 115-120 132.50 106.00 A$/US$ US$ down 1.65-1.80 2.00 1.55

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Chapter-8 Transaction Exposure

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Chapter # 8 Transaction Exposure Problem # 8.1: Lipitor in Indonesia. Evaluating the costs of hedging a transaction exposure. Assumptions Receivable due in 3 months, in Indonesian rupiah (Rp) Spot rate, Rp/$

Values Rp750,000,000 8,800

Expected spot rate in 90 days, Rp/$ 3-month forward rate, Rp/$ Minimum dollar amount acceptable at settlement

9,400 9,800 $78,000.00 Risk Values Assessment

Alternatives

1. Remain Uncovered. Settle A/R in 90 days at current spot rate. If spot rate in 90 days is same as current (Rp750,000,000 /Rp8,800/$) $85,227.27 If spot rate in 90 days is Rp9,400/$ (Rp750,000,000 / Rp9,400/$) $79,787.23 If spot rate in 90 days is Rp9,800/$ (Rp750,000,000 / Rp9,800/$) $76,530.61

Risky Risky Risky

2. Sell Indonesian rupiah forward. A/R sold forward 90 days "Cost of cover" is the forward discount on Rp

$76,530.61 -40.80%

Certain

Analysis: The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period, any variety of economic or political or social events could lead to an upward bounce in the exchange rate, reducing the dollar proceeds at settlement to an unacceptable level. Unfortunately, the forward contract does not result in dollar proceeds which meet the minimum margin. The forward cover yields dollar proceeds of only $76,530.61, short of the needed $78,000. The cost of forward cover, 40.8%, is indicative of the "artificial interest rates" used by some financial institutions while pricing derivatives in emerging, illiquid, and volatile markets. In the end, Pfizer will have to decide whether making

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the sale into this specific market is worth breaking a company policy on minimum proceeds (forward cover) or taking significant currency risk by not using forward cover. Problem # 8.2: Embraer of Brazil. Advise Embraer on currency exposure. Assumptions Receivable due in one year, US dollars Payable due in one year, US dollars Spot rate, R$/$ One-year US dollar eurocurrency interest rate One-year Brazilian govt deposit note Implied one year forward rate = spot x ( 1 + iR$ ) / ( 1 + i$ ) Analysis; Net exposure at time of cash settlements: One year A/R due Less: One year A/P due Net exposure

Values $80,000,000 $20,000,000 3.4 4.00% 14.00% 3.7269

Values $80,000,000 ($20,000,000) $60,000,000

Risk Assessment

Certain

This is a net long position, meaning, Embraer will be receiving US dollars on net. Given the history of the Brazilian real, that it has traditionally suffered from rapid depreciation and occasional devaluation, a net long position in dollars by most Brazilian companies is considered a good thing. Cash settlement of the net position: Brazilian reais in one year at current spot rate Brazilian reais in one year at one year forward rate

Risk Values Assessment R$ 204,000,000.00 Risky R$ 223,615,384.62 Certain

In this case, however, because the real is selling forward at a considerable discount, the net long position -- if sold forward -- yields considerably more real than the current spot rate. It should also be noted, however, that if the real were to fall considerably over the year, to a value greater than R$3.73/$, by remaining unhedged Embraer would enjoy greater reais returns.

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Problem # 8.3: Mattel Toys. Advise Mattel on its European sales. Assumptions 90-day A/R, euros Current spot rate, $/euro Credit Suisse 90-day forward rate, $/euro Barclays 90-day forward rate, $/euro Expected spot rate in 90 days, $/euro 90-day eurodollar interest rate 90-day euro-euro interest rate Implied 90-day forward rate (calculated), $/euro 90-day eurodollar borrowing rate 90-day euro-euro borrowing rate Mattel Toys weighted average cost of capital Hedging Alternatives

Values 20000000 $1.06 $1.06 $1.06 $1.03 3.60% 4.60% $1.06 7.60% 8.40% 10.00% Values

Risk Assessment

1. Remain Uncovered, settling A/R in 90 days at market rate (20 million euros / future spot rate) If spot rate in 90 days is same as current If spot rate in 90 days is same as Credit Suisse forward rate If spot rate in 90 days is same as Barclays forward rate If spot rate in 90 days is expected spot rate

$21,200,000.00

Risky

$21,160,000.00

Risky

$21,120,000.00 $20,600,000.00

Risky Risky

$21,160,000.00 $21,120,000.00

Certain Certain

2. Sell euros forward 90 days Settlement amount at Credit Suisse forward rate Settlement amount at Barclays forward rate 3. Money Market Hedge

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Principal A/R in euros Discount factor for euro borrowing rate for 90 days Borrow euros against 90-day A/R Current spot rate, $/euro US dollar current value Mattel's WACC carry-forward factor for 90 days Future value of money market hedge

Solution Manual

20000000 1/(1 + (.084 x 0.9794 90/360)) 19588638.59 $1.06 $20,763,956.90 1 + (.1000 x 1.025 90/360) $21,283,055.83 Certain

Evaluation of Alternatives: The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate (carry-forward rate). Problem # 8.4: Hindustan Lever. Advise Hindustan Lever on its Japanese yen purchase. Assumptions 180-day account payable, Japanese yen Spot rate, yen/$ Spot rate, rupees/$ Implied (calculated) spot rate, yen/rupee 180-day forward rate, yen/rupees Expected spot rate in 180 days, yen/rupees 180-day Indian rupee investing rate 180-day Japanese yen investing rate Currency agent's exchange rate fee Hindustan Lever's cost of capital Hedging Alternatives

Values 8,500,000 120.6 47.75 2.5257 2.4 2.6 8.00% 1.50% 4.85% 12.00% Values

(120.60 / 47.75)

Spot Rate (Rp/$)

Risk Assessment

1. Remain Uncovered, settling A/P in 180 days at spot rate If spot rate in 180 days is same as current spot If spot rate in 180 days is same as forward rate If spot rate in 180 days is expected spot rate

3,365,464.34

2.5257

Risky

3,541,666.67 3,269,230.77

2.4 2.6

Risky Risky

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2. Buy Japanese yen forward 180 days Settlement amount at forward rate (Rs) 3. Money Market Hedge

3,541,666.67

Principal A/P (yen) discount factor for yen investing rate for 180 days Principal needed to meet A/P in 180 days (yen)

8,500,000.00

Current spot rate, yen/rupee Indian rupee, current amount (Rs) Hindustan Lever's WACC carry-forwad factor for 180 days Future value of money market hedge (Rs) 4. Indian Currency Agent Hedge

2.5257 3,340,411.26

Principal A/P (yen) Current spot rate, yen/rupee Current A/P (Rs) Plus agent's fee (4.850%) Hindustan's WACC carry-forwad factor for 180 days on fee Total future value of agent's fee (Rs) Total A/P, future value, A/P + fee (Rs)

8,500,000.00 2.5257 3,365,464.34 163,225.02

2.4

Certain

0.9926 8,436,724.57

1.06 3,540,835.94

Certain

1.06 173,018.52 3,538,482.87

Certain

Evaluation of Alternatives: The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives. Problem#8.5: Tek - Italian account receivable. Hedging foreign exchange risk: a receivable Assumptions Account receivable due in 3 months, in euros Spot rate ($/euro) 3-month forward rate ($/euro)

Values 4000000 0.98 0.985

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3-month euro interest rate 3-month put option on euros: Strike rate ($/euro) Premium, percent per year Tek's weighted average cost of capital

6.00% 0.98 3.00% 12.00%

What are the costs and risk of each (a) alternative? Value 1. Do nothing and exchange euros for dollars at end of 3 months Amount of euro receivable If spot rate in 3 months is the same as the forward rate US dollar proceeds of receivable would be Amount of euro receivable If spot rate in 3 months is the same as the current spot rate US dollar proceeds of receivable would be

(b) Certainty?

4000000 0.985 $3,940,000.0 0 4000000

Very uncertain;

0.98 $3,920,000.0 0

Very uncertain;

Risky

Risky

2. Sell euro receivable forward at the 3-month forward rate Amount of euro receivable forward rate US dollar proceeds of receivable would be

4000000 0.985 $3,940,000.0 0

Certain; Locked-in

3. Buy a put option on euros Amount of euro receivable Current spot rate ($/euro) Premium on put option, % Cost of put option (amount x spot rate x percent premium) If the spot rate at end of 3-months is less than strike rate the option is exercised yielding gross dollars of

4000000 0.98 3.00% $117,600.00 Minimum is $3,920,000.0 0

guaranteed;

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Less cost of option (premium) plus US$ interest on premium ($121,128.00) Net proceeds of A/R if option is exercised $3,798,872.0 (this is Minimum) 0 Summary of Alternatives Value $3,920,000.0 Do Nothing 0 $3,940,000.0 Sell A/R forward 0 $3,798,872.0 Buy Put Option 0

could be greater. Certainty? Risky Certain Minimum

c) If Tek wishes to play it safe, it should lock in the forward rate. d) If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the dollar is going to depreciate versus the euro over the 3 month period -- past $0.98/euro, then Tek might consider purchasing the put option. Problem#8.6: Tek - Japanese account payable. Hedging foreign exchange risk: a payable Assumptions Account payable to Japan Sony-Tek, in Japanese yen Spot rate (yen/$) 6-month forward rate (yen/$) 6-month yen deposit rate 6-month dollar interest rate 6-month call option on yen: Strike rate (yen/$) Premium, percent per year Tek's weighted average cost of capital What are the costs and risk of each alternative?

Values 8,000,000.00 125 122 1.50% 4.00% 125 4.00% 12.00% a) Value

b) Certainty

1. Do nothing and exchange dollars for yen at end of 6 months Amount of yen payable If spot rate in 3 months is the same as the forward rate US dollar cost of settling payable would be

8,000,000.00 122 $65,573.77

Very uncertain; Risky

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Amount of yen payable If spot rate in 3 months is the same as the current spot rate US dollar cost of settling payable would be

Solution Manual

8,000,000.00 125 $64,000.00

Very uncertain; Risky

2. Buy yen forward 6-months to lock in cost of settling payable Amount of yen payable forward rate US dollar cost of settling payable would be

8,000,000.00 122 $65,573.77

Certain; Locked-in

3. Money market hedge -- invest funds in yen deposit now Principal needed at the end of 6-months, yen

8,000,000

Discount factor, 6-months @ yen deposit rate Yen deposit needed, now Current spot rate, yen/$ US dollars needed now, for exchange into yen

0.9926 7,940,447 125 $63,523.57

Carry-forward rate, 6 months @ Tek's WACC US cost of money market hedge at end of 6months

1.06

1/(1 + (.015 x 180/360))

1 + (.12 x 180/360)

$67,334.99

4. Buy a call option on Japanese yen Amount of yen payable Current spot rate (yen/$) Premium on call option, % Cost of call option If the spot rate at end of 3-months is greater than strike rate the option is exercised yielding gross dollars of Plus cost of option (premium) plus US$ interest on premium Total cost of exercising call option on yen Summary of Alternatives: Cost of settling A/P

8,000,000.00 125 4.00% $2,560.00

$64,000.00

Maximum cost guaranteed;

$2,713.60 $66,713.60

could be less.

Value

Certainty?

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Do Nothing Buy yen forward Deposit yen now (money market hedge) Buy call option on yen

Solution Manual

$64,000.00 $65,573.77 $67,334.99 $66,713.60

Risky Certain Certain Maximum

c). If Tek wishes to take a reasonable risk (definining 'reasonable' is another issue), and has a directional view that the yen may be depreciating versus the dollar over the 6 month period -to below a value of Y125/$, then Tek might consider purchasing the call option.

Problem#8.7: Tek - British Telecom bid. Hedging foreign exchange risk of a contract bid Assumptions Account receivable of bid, supply & install (British pounds) Spot rate (dollars per pound) Tek's weighted average cost of capital Forward rate (dollars per pound) British pound investment rate British pound borrowing rate Put option on pound: Strike rate (dollars per pound) Premium, US dollars per pound

Values £1,000,000 1.57 12.00% 1-month 1.572 4.00% 9.00%

4-month 1.575 4.25% 9.20%

1.58 $0.01

1.58 $0.01

Analysis and Evaluation: If Tek wins the bid, it will be long foreign currency, having a 1 million pound position which is first backlog the an A/R. If and when Tek is awarded the bid, it would have 4 months (120 days) until cash settlement of the 1 million pound position. a) b) Value Certainty 1. Do Nothing -- Remaining Uncovered Wait 120 days and exchange pounds for dollars spot

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If the ending spot rate is the same as current spot rate If the ending spot rate is the same as the 4 month forward rate It could, however, be much lower.

Solution Manual

$1,570,000.00

Risky

$1,575,000.00

Risky

$1,575,000.00

Certain Value

2. Sell the 1 million pounds forward Selling 1 million pounds forward at the 4month forward rate The primary problem with this is that if Tek does not win the bid, it has a forward contract to sell pounds which it will not earn.

If Tek Wins Bid

3. Money market hedge -- borrow against expected receipts Expected receipts, pounds Discount factor for 4-months at pound borrowing rate Proceeds from borrowing, now, in pounds Current spot rate, US$ per pound Proceeds from borrowing, now, in US$ Carry-forward rate, 4 months @ Tek's WACC Value in 4 months of money market hedge, US$ Option, if exercised (if ending spot rate less than $1.58) Put option premium, up-front and the 4-months opportunity cost of premium Total premium expense

£1,000,000 0.9702 £970,246 1.57 $1,523,285.90 1.04

1/(1+(0.092 x 120/360))

1 + (.12 x 120/360)

$1,584,217.34 $1,580,000.00 $12,000.00 480 $12,480.00 Minimum;

Minimum dollars received if put option purchased $1,567,520.00 Could be More The money market hedge provides the largest US$ value at the end of 4 months, but it assumes certainty of bid's award. The advantage of the option is if Tek does not win the bid, the option can easily be sold. Problem# 8.8: Tek -- Swedish price list.

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Hedging foreign currency price quotes and potential sales. Assumptions Expected sale over 90-day period, Swedish krona Spot rate, SKr/$ 90-day forward rate, SKr/$ 3-month dollar interest rate 3-month krone deposit interest rate 3-month krone borrowing interest rate 3-month put option on krone: Strike rate, SKr/$ Premium Tek's weighted average cost of capital

Solution Manual

Values 5,000,000.00 9.2 9.25 4.00% 6.15% 12.50% 9.2 3.50% 12.00%

Hedging Alternatives: This is an uncertain exposure. Although sales will most likely occur, it is not known what total quantity of sales will occur, and therefore what Tek's actual long position in Swedish krone will be. S.No.

Value

Certainty?

1. Do Nothing -- Remain Uncovered. The ending spot rate at the time of settlement could be nearly anything. If the ending spot rate is the same as current spot rate (SKr/$) If the ending spot rate is the same as forward (SKr/$)

$543,478.26

Risky

$540,540.54

Risky

$540,540.54

Certain

2. Sell Swedish krone forward Sold forward 3-months at forward rate (SKr/$) However, remember that Tek does not know total sales. 3. Money market hedge Tek would borrow now against expected proceeds of (SKr) Discount rate of SKr interest rate for 90-days SKr proceeds from borrowing received up-front

5,000,000.00 0.9697 4,848,484.85

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Exchanged at current spot rate (SKr/$) US dollars received now Tek carry-forward rate for US$ for 90 days Money market hedge proceeds in 90-days 4. Buy a 3-month put option on Swedish krone Proceeds will be option less premium if exercised (minimum) Exchange rate if exercised/not exercised (SKr/$) Amount of Swedish krone If exercised, it will yield a gross dollar amount of Put option premium Opportunity cost of premium Total future value of premium Minimum net dollar proceeds at end of 90 days (exercised gross amount less future value of premium)

Solution Manual

9.2 $527,009.22 1.03 $542,819.50 If exercised 9.2 5,000,000.00 $543,478.26 $19,021.74 570.65 $19,592.39 $523,885.87

If not exercised (random choice) 8.89 5,000,000.00 $562,429.70 $19,021.74 570.65 $19,592.39 $542,837.30

Minimum

The money market hedge provides the highest certain US dollar receipts. (This is again a result of the significant increase in relative value arising from carrying-forward the dollars at Tek's WACC. If Tek sincerely believes in its directional view, and is willing to take some currency risk, the SKr would have to fall to about SKr8.89/$ in order for the put option hedge to yield more US dollars than the money market hedge. Problem# 8.9: Tek -- Swiss dividend payable. Hedging an intra-company dividend payment. Assumptions Dividend declared, Swiss francs Spot rate, SFr/$ 90-day forward rate, SFr/$ 3-month US dollar interest rate 3-month Swiss franc interest rate 3-month put option on Swiss francs: Strike rate, SFr/$ Premium, $/SFr Tek's weighted average cost of capital Tek's expected spot rate in 90 days, SFr/$ Hedging Alternatives

Values SFr. 5,000,000 1.5 1.52 4.00% 5.25% 1.54 $0.02 12.00% 1.47 Value

Certainty?

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1. Do Nothing -- Remain Uncovered. If the ending spot rate is the same as current spot rate (SFr/$) If the ending spot rate is the same as forward (SKr/$) Realistically, the ending spot rate could vary between SFr1 and SFr2 per $.

Solution Manual

$3,333,333.33

Risky

$3,289,473.68

Risky

$3,289,473.68

Certain

2. Sell Swiss francs forward Sold forward 3-months at forward rate (SFr/ $) 3. Money Market Hedge Borrow SFr now against future receipt Principal Borrow SFr at SFr interest rate for 90-days SFr proceeds received now via borrowing Exchanged into US$ at spot rate of (SFr/$) Dollars received now Carry-forward rate for US$ at Tek's WACC for 90-days Money Market Hedged proceeds in 90 days 4. Buy a 3-month put option on Swiss francs Proceeds = option - premium, if exercised (minimum) Effective exchange rate if exercised/not exercised, SFr/$ Principal of payment, SFr If exercised, it will yield a gross dollar amount of Put option premium Opportunity cost of premium Total future value of premium Minimum net dollar proceeds at end of 90 days

SFr. 5,000,000 0.987 SFr. 4,935,225 1.5 $3,290,150.11 1.03 $3,388,854.62 If exercised

1.54 SFr. 5,000,000

If not exercised

1.47 SFr. 5,000,000

$3,246,753.25 $3,401,360.54 $75,000.00 $75,000.00 2,250.00 2,250.00 $77,250.00 $77,250.00 $3,169,503.25

$3,324,110.54

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(exercised gross amount less future value of premium)

Solution Manual

Minimum

Analysis. The Money market hedge yields the highest certain US dollar proceeds. If, however, Tek wishes to accept some degree of currency risk, and believes in the direction of a stronger SFr, it may choose the 3-month put option. Note that the official expectation is SFr1.47/$. This is still not superior to the Money Market Hedge. (The ending spot rate would need to be SFr1.44/$ or stronger to end up superior to the Money Market Hedge.)

Problem# 8.10: Northern Rainwear. Hedging foreign exchange risk: A/R & forward points Assumptions Spot rate, DKr/C$ 3-month forward rate, DKr/C$ 6-month forward rate, DKr/C$ 12-month forward rate, DKr/C$ Northern's Exposures A/R due in 3 months, DKr A/R due in 6 months, DKr A/R due in 12-months, DKr Northern's Manadatory Forward Cover Paying the points forward Receiving the points forward

Forw ard Values Discount Days 4.7 4.71 -0.85% 4.72 -0.85% 4.74 -0.84% > 180 0-90 days 91-180 days days 3,000,000 2,000,000 1,000,000 > 180 0-90 days 91-180 days days 75% 60% 50% 100% 90% 50%

Analysis & Exposure Management: The Danish krone is selling forward at a discount versus the Canadian dollar: it takes more DKr/C$ forward. Northern Rainwear is receiving foreign currency, DKr, at future dates ("long DKr"). Northern Rainwear is therefore expecting to PAY THE POINTS FORWARD.

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Required Forward Cover for Northern: A/R due in 3 months, DKr A/R due in 6 months, DKr A/R due in 12-months, DKr DKr Forward Cover A/R due in 3 months, DKr A/R due in 6 months, DKr A/R due in 12-months, DKr Expected Canadian dollar value of DKr sold forward

Solution Manual

0-90 days 75%

91-180 days

> 180 days

60% 50% 2,250,000 1,200,000 500,000 477,707.01

254,237.2 9 105,485.23

Problem# 8.11: Vamo Road Industries. Hedging foreign exchange risk: a payable Assumptions Construction payment due in six-months (A/P, quetzals) Present spot rate (quetzals/$) Six-month forward rate (quetzals/$) Guatemalan six-month interest rate (per annum) U.S. dollar six-month interest rate (per annum) Vamo's weighted average cost of capital (WACC) Expected spot rate in six-months (quetzals/$): Highest expected rate Expected rate Lowest expected rate a) What realistic alternatives are available to Vamo?

Values 8,400,000 7 7.1 14.00% 6.00% 20.00% 8 7.3 6.4 Cost

Certainty

1. Wait six months and make payment at spot rate Highest expected rate Expected rate Lowest expected rate 2. Purchase quetzals forward six-months divided by the forward rate)

$1,050,000.00 $1,150,684.93 $1,312,500.00

Risky Risky Risky

$1,183,098.59

Certain

(A/P

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3. Transfer dollars to quetzals today, invest for six-months quetzals needed today (A/P discounted 180 days) Cost in dollars today (quetzals to $ at spot rate) factor to carry dollars forward 180 days (1 + (WACC/2)) Cost in dollars in six-months ($ carried forward 180 days )

7,850,467.29 $1,121,495.33 1.1 $1,233,644.86

Certain

The second choice, the forward contract, results in the lowest cost alternative among certain alternatives.

Problem# 8.12: Worldwide Travel. Hedging foreign exchange risk: a payable Assumptions Acquisition price & 3-month A/P, NewTaiwan dollars (NT$) Spot rate (NT$/$) 3-month forward rate (NT$/$) 3-month Taiwan dollar deposit rate 3-month dollar borrowing rate 3-month call option on NT$ Evaluation of Alternatives

Values 7,000,000 35 36 1.50% 8.00% not available Cost

Certainty

1. Do Nothing -- Wait 3 months and buy NT$ spot If spot rate is the same as current spot rate $200,000.00 Risky If spot rate is the same as 3-month forward rate $194,444.44 Risky Although this would do nothing to cover the currency risk, there would be no required payment or borrowing for 3 -months. 2. Buy NT$ forward 3-months Assured cost of NT$ at 3-month forward rate $194,444.44

Certain

The purchase of a forward contract would not require any cash up-front line by the

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amount of the forward. This is a non-cash expense., but the Bank of Hawaii would reduce his available credit line by the amount of the forward. This is a non-cash expense. 3. Money Market Hedge: Exchanging US$ for NT$ now, depositing for 3-months until payment Acquisition price in NT$ needed in 3-months 7,000,000 Discounted back 3-months at NT$ deposit rate 0.9963 Amount of NT$ needed now for deposit 6,973,848 Spot rate, NT$/$ 35 US$ needed now for exchange $199,252.80 US$ carry-forward rate (3-month dollar borrowing rate) 8.00% Certain Carry-forward factor of US$ for 3-month period 1.02 Total cost in US$ of settling A/P in 3-months with Money Market Hedge $203,237.86 The currency risk is eliminated, but since Matt Morita would have to exchange the money upfront, it requires Matt Morita to increase his debt outstanding for the entire 3-months. Hence, forward contract hedge is best alternative. Problem#8.13: Seattle Scientific, Inc. Costs and benefits of cash versus cover. Assumptions Seattle's 30-day account receivable, Japanese yen Spot rate, yen/$ 30-day forward rate, yen/$ 90-day forwrad rate, yen/$ 180-day forward rate, yen/$ Yokasa's WACC Seattle Scientific's WACC Desired discount on purchase price by Yokasa

Values 12,500,000 120.23 119.73 118.78 117.21 8.85% 12.50% 4.50%

Josh Miller should compare two basic alternatives, both of which eliminate the currency risk. 1. Allow the discount and receive payment in Japanese yen in cash Account recievable (yen) Discount for cash payment up-front (4.500%) Amount paid in cash net of discount Current spot rate

12,500,000 -562,500 11,937,500 120.23

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Amount received in U.S. dollars by Seattle Scientific $99,288.86 2. Not offer any discounts for early payment and cover exposure with forwards Account receivable (yen) 30-day forward rate Amount received in cash in dollars, in 30 days Discount factor for 30 days @ Seattle's WACC Present value of dollar cash received

12,500,000 119.73 $104,401.57 0.9897 $103,325.27

Josh Miller should politely decline Yokasa's offer to pay cash in exchange for cash payment.

Problem# 8.14: Wilmington Chemical Company. Hedging foreign exchange risk: a payable Assumptions Shipment of phosphates from Morocco, Moroccan dirhams Wilmington's cost of capital (WACC) Spot exchange rate, dirhams/$ Six-month forward rate, dirhams/$ Options on Moroccan dirhams: Strike price, dirhams/$ Option premium (percent)

Values 6,000,000 14.00% 10 10.4 Call Option 10 2.00% United States

Put Option 10 3.00% Morocco

Six-month interest rate for borrowing (per annum) 6.00% 8.00% Six-month interest rate for investing (per annum) 5.00% 7.00% Risk Management Alternatives Values Certainty 1. Remain uncovered, making the dirham payment in six months at the spot rate in effect at that date Account payable (dirhams) Possible spot rate in six months -- the current spot rate (dirhams/$) Cost of settlement in six months (US$)

6,000,000 10 $600,000.00

Uncertain.

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Account payable (dirhams) Possible spot rate in six months -- forward rate (dirhams/$) Cost of settlement in six months (US$)

Solution Manual

6,000,000 10.4 $576,923.08

Uncertain.

2. Forward market hedge. Buy dirhams forward six months. Account payable (dirhams) Six month forward rate, dirhams/$ Cost of settlement in six months (US$)

6,000,000 10.4 $576,923.08

Certain.

3. Money market hedge. Exchange dollars for dirhams now, invest for six months. Account payable (dirhams) 6,000,000.00 Discount factor at the dirham investing rate for 6 months 1.035 Dirhams needed now for investing (payable/discount factor) 5,797,101.45 Current spot rate (dirhams/$) 10 US dollars needed now $579,710.14 Carry forward rate for six months (WACC) 1.07 US dollar cost, in six months, of settlement $620,289.86 Certain. 4. Call option hedge. (Need to buy dirhams = call on dirhams) Option principal 6,000,000.00 Current spot rate, dirhams/$ 10 Premium cost of option 2.00% Option premium (principal/spot rate x % pm) $12,000.00 If option exercised, dollar cost at strike price of 10.00 dirhams/$ $600,000.00 Plus premium carried forward six months (pm x 1.07, WACC) 12,840.00 Total net cost of call option hedge if exercised $612,840.00 Maximum. The lowest cost certain alternative is the forward. If Wilmington were to expect the dirham to depreciate significantly over the next six months, it may choose the call option. Problem# 8.15: Dawg-Grip, Inc. Hedging foreign exchange risk: a payable

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Assumptions Purchase price of Korean manufacturer, in Korean won Less initial payment, in Korean won Net settlement needed, in Korean won, in six months Current spot rate (Won/$) Six month forward rate (Won/$) Plasti-Grip's cost of capital (WACC) Options on Korean won: Strike price, won Option premium (percent) Six-month investment interest rate (per annum) Six-month borrowing rate (investment rate + 2%) Risk Management Alternatives

Values 7,030,000,000 -1,000,000,000 6,030,000,000 1,200 1,260 25.00% Call Option 1,200.00 3.00% U.S 4.00% 6.00% Values

Put Option 1,200.00 2.40% Korea 16.00% 18.00% Certainty

1. Remain uncovered, making the won payment in 6 months at the spot rate in effect at that date Account payable (won) 6,030,000,000 Possible spot rate in six months: current spot rate 1, (won/$) 200 Cost of settlement in six months (US$) $5,025,000.00 Account payable (won) 6,030,000,000 Possible spot rate in six months: forward rate (won/ $) 1,260 Cost of settlement in six months (US$) $4,785,714.29

Uncertain.

Uncertain.

2. Forward market hedge. Buy won forward six months Account payable (won) 6,030,000,000 Forward rate (won/$) 1,260.00 Cost of settlement in six months (US$) $4,785,714.29

Certain.

3. Money market hedge. Exchange dollars for won now, invest for six months. Account payable (won) Discount factor at the won interest rate for 6 months

6,030,000,000 1.08

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Won needed now (payable/discount factor) Current spot rate (won/$) US dollars needed now Carry forward rate for six months (WACC) US dollar cost, in six months, of settlement 4. Call option hedge. (Need to buy won = call on won) Option principal Current spot rate (won/$) Premium cost of option (%) Option premium (principal/spot rate x % pm) If option exercised/not exercised, dollar cost of won Premium carried forward six months (pm x 1.125, WACC) Total net cost of call option hedge if exercised

Solution Manual

5,583,333,333. 33 1,200.00 $4,652,777.78 1.125 $5,234,375.00

Certain.

If exercised If not exercised 6,030,000,000 1,200.00 1,307.00 3.00% $150,750.00 $5,025,000.00

$4,613,618.97

169,593.75 169,593.75 $5,194,593.75 $4,783,212.72 Maximum. The forward contract provides the lowest cost hedging method for payment settlement. If, however, the firm believes the ending spot rate will be Won 1307/$ or higher, the call option hedge could prove lower cost. This would require the firm, however, to accept the foreign exchange risk and suffering the higher cost of the call option hedge in the event their spot rate expectations proved incorrect. Problem# 8.16: Aqua-Pure. Hedging foreign exchange risk: a receivable Assumptions Values Amount of receivable, Japanese yen 20,000,000 Spot exchange rate at time of sale (yen/$) 118.255 Booked value of sale (amount/spot rate) $169,126.04 Days receivable due 90 Aqua-Pure's WACC 16.00% Competitor borrowing premium, yen 2.00% Forward rates and premiums Forward Rate One-month forward rate (yen/$) 117.76 Three-month forward rate (yen/$) 116.83

Premium 5.04% 4.88%

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One-year forward rate (yen/$)

Solution Manual

112.45

5.16%

Investment rates, % per annum 1 month 3 months 12 months

United States 4.88% 4.94% 5.19%

Japan 0.09% 0.09% 0.31%

Purchased options 3-month call option on yen 3-month put option on yen

Strike (yen/$) 118 118

Premium 1.00% 3.00%

Values

Certainty

a. Alternative Hedges 1. Remain uncovered. Account receivable (yen) Possible spot rate in 90 days (yen/$) Cash settlement in 90 days (US$) 2. Forward market hedge.

20,000,000 118.255 $169,126.04

Uncertain.

Account receivable (yen) Forward rate (won/$) Cash settlement in 90 days (US$)

20,000,000 116.83 $171,188.91

Certain.

3. Money market hedge. Account receivable (yen) Discount factor for 90 days Yen proceeds up front Current spot rate (won/$) US dollars received now Carry forward at Aqua-Pure's WACC Proceeds in 90 days

20,000,000 1.00523 19,895,858 118.255 $168,245.38 1.04 $174,975.20

1 + ((.0009375 + . 02) x 90/360)

1 + (.16 x 90/360) Certain.

4. Put option hedge. (Need to sell yen = put on yen) Option principal Current spot rate (won/$)

20,000,000 118.255

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Premium cost of option (%) Option pm (principal/spot rate x % pm)

3.00% $5,073.78

If option exercised, dollar proceeds

$169,491.53

Less Pm carried forward 90 days Net proceeds in 90 days

-5,276.73 $164,214.79

1.04 carry-forward rate Minimum.

The put option does not GUARANTEE the company of settling for the booked amount. The money market and forward hedges do; the money market yielding the higher proceeds. b) Breakeven rate between the money market and the forward hedge is determined by the reinvestment rate: Money market, US$ up-front $168,245.38 Forward contract, US$, end of 90 days $171,188.91 (1 + x) x Breakeven rate, % per annum

101.75% 1.75% 7.00%

$168,245 (1+x) = $171,189 For 90 days

Problem# 8.17: Botox Watch Company. Hedging policy Assumptions Account recievable in 90 days (euros) Initial spot exchange rate ($/euro) Forward rate, 90 days ($/euro) Expected spot rate in 90 to 120 days ($/euro): Case #1 Expected spot rate in 90 to 120 days ($/euro): Case #2

If Botox Watch Company …… Proportion of exposure to be hedged Total exposure (euros) hedged proportion Minimum hedge in euros (exposure x min prop)

Values 1,560,000 $0.97 $0.95 $0.93 $1.00 Hedged the Minimum 70% 1,560,000 70% 1,092,000

Hedged the Maximum 120% 1,560,000 120% 1,872,000

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at the forward rate ($/euro) locking in ($)

Solution Manual

$0.95 $1,033,032

$0.95 $1,770,912

Proportion uncovered (short) If ending spot rate is ($/€) Value of uncovered proportion ($) Value of covered proportion (from above) Total net proceeds, covered + uncovered

468,000 $0.93 $435,240 $1,033,032 $1,468,272

-312,000 $0.93 ($290,160) $1,770,912 $1,480,752

Case #2: Ending spot rate is $1.0000/€ Proportion uncovered (short) If ending spot rate is ($/€) value of uncovered proportion ($) Value of covered position (from above) Total net proceeds, covered + uncovered Benchmark: Full (100%) forward cover

468,000 $1.00 $468,000 $1,033,032 $1,501,032 $1,475,760

-312,000 $1.00 ($312,000) $1,770,912 $1,458,912 $1,475,760

Case #1: Ending spot rate is $0.93/€

This is not a conservative hedging policy. Any time a firm may choose to leave any proportion uncovered, or purchase cover for more than the exposure (creating a short position) the firm could experience nearly unlimited losses or gains. Problem#8.18: Redwall Pump Company. Hedging foreign exchange risk: a receivable Assumptions 90-day Forward rate, $/euro 180-day Forward rate, $/euro US Treasury bill rate Redwall's borrowing rate, euros, per annum Redwall's cost of equity Options on euros June maturity options September maturity options Valuation of Alternative Hedges

Values $1.11 $1.11 3.60%

Today is March 1 Date 1-Feb

8.00% 1-Mar 12.00% Strike ($/euro) Call Option $1.10 3.00% $1.10 2.60% June

Exchange Rate ($/euro) ($/euro) $1.08 $1.10

Put Option 2.00% 1.20% Sept

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Receivable 2000000

Amount of receivable, in euros

Receivable 2000000

a. Hedge in the forward market Amount of receivable, in euros Respective forward rates ($/euro) US dollar proceeds as hedged ($) Carry forward to Sept 1st at WACC Total US$ proceeds on Sept 1st Total of both payments

2000000

2000000

$1.11

$1.11

$2,212,000

$2,226,000

1.03

-----

$2,278,360

$2,226,000 $4,504,360

b. Hedge in the money market Amount of receivable, in euros Discount factor for euro funds, period Current proceeds from discounting, euros Current spot rate ($/euro) Current US dollar proceeds Carry forward rate for the period US dollar proceeds on future date Total of both payments

2000000

2000000

1.02

1.04

1960784 $1.10 $2,156,863

1923077 $1.10 $2,115,385

1.06

1.06 $2,242,308

$2,286,275 $4,528,582

c. Hedge with options Amount of receivable, in euros Buy put options for maturities (% x spot value) Carry forward for the period

2000000

2000000

($44,000) 1.06

($26,400) 1.06

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Premium cost carried forward to Sept 1

Solution Manual

($46,640)

($27,984)

Gross put option value if exercised $2,200,000 Carried forward 3 months to Sept 1 1.03 Gross proceeds, Sept 1 $2,266,000 Total net proceeds, after premium deduction, Sept 1 $4,391,376

$2,200,000 ---$2,200,000

d. Do nothing (remain uncovered) Amount of receivable, in euros Ending spot exchange rate ($/euro)

2000000 ???

2000000 ???

The money market hedge provides the highest certain outcome. If Redwall believes the euro will strengthen versus the dollar over the coming months, and it is willing to take the currency risk, the put option hedges could be considered.

Problem#8.19: Pixel's Financial Metrics. Transaction exposure life-span and accounting treatment.

Date 1-Feb 1-Mar 1-Jun 1-Aug 1-Sep

Event Price quotation by Metrica Contract signed for sale Contract amount, pounds Product shipped to Grand Met Product received by Grand Met Grand Met makes payment

Spot Rate 1.785 1.7465 £1,000,000 1.7689 1.784 1.729

Forward Rate 1.7771 1.7381

Days Forward of Forward Rate 210 180

1.7602 1.7811 ---------

90 30 ---------

Analysis: a). The sale is booked at the exchange rate existing on June 1, when the product is shipped to Grand Met, and the shipment is categorized as an account receivable. This sale is then compared to that value in effect on the date of cash settlement, the difference being the foreign exchange gain (loss). Value as settled 1 million pounds @ $1.7290/£ $1,729,000

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Value as booked 1 million pounds @ $1.7689/£ $1,768,900 FX gain (loss) ($39,900) The value of the foreign exchange gain (loss) will depend upon when Leo actually purchases the forward contract. Because many firms do not define an "exposure" as arising until the date that the product is shipped (loss of physical control over the goods) and the sale is booked on the income statement that is a common date for the purchase of the forward contract. Forward contract purchased on June 1 Value of forward settlement 1 million pounds @ $1.7602/£ $1,760,200 Less: Value as booked 1 million pounds @ $1.7689/£ $1,768,900 FX gain (loss) ($8,700) A more aggressive alternative is for Leo to purchase the forward contract on the date that the contract was signed, March 1, locking- in Pixel's US dollar settlement amount a full 90 days earlier in the transaction exposure's life span. Forward contract purchased on March 1 Value of forward settlement 1 million pounds @ $1.7381/£ Less: Value as booked 1 million pounds @ $1.7689/£ FX gain (loss)

$1,738,100 $1,768,900 ($30,800)

Note that in this case if Leo had covered forward on March 1st rather than June 1st, the amount of the foreign exchange loss would have been even greater, although "fully hedged." The difference is of course the result of the forward rate changing with spot rates and interest differentials. Problem# 8.20: Scout Finch and Dayton Manufacturing (A). Assumptions Value 90-day A/R in pounds 3,000,000 Spot rate, US$ per pound 1.762 90-day forward rate, US$ per pound 1.755 3-month U.S. dollar investment rate 6.00% 3-month U.S. dollar borrowing rate 8.00% 3-month UK investment interest rate 8.00% 3-month UK borrowing interest rate 14.00% Put options on the British pound: Strike rates, US$/pound 1.75 Put option premium 1.50% Dayton's WACC 12.00% Scout Finch's expected spot rate in 90-days, US$ per pound 1.785

1.71 1.00%

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Alternative #1: Remain Uncovered Value of A/R will be (3 million pounds x ending spot rate ($/pound)) If spot rate is the same as current spot rate If ending spot rate is the same as current forward rate If ending spot rate is the expected spot rate Alternative #2: Forward Contract Hedge Sell the pounds forward 3-months locking in the forward rate Pound A/R at the forward rate (pounds x forward) Alternative #3: Money Market Hedge Dayton borrows against the A/R, receiving pounds up-front, exchanging into US$. Amount of A/R in 90-days, in pounds Discount factor, pound borrowing rate, for 3-months Proceeds of borrowing, up-front, in pounds Exchanged to US$ at current spot rate of US$ received against A/R, up-front US$ need to be carried forward for comparison: Carry-forward rate, WACC for 90-days Money Market Hedge, US$, at end of 90-days

Solution Manual

Rate ($/pound)

Proceeds

$1.76

$5,286,000.00

$1.76 $1.79 Rate ($/pound)

$5,265,000.00 $5,355,000.00

$1.76 Rate ($/pound)

$5,265,000.00

Proceeds

Proceeds 3,000,000.00 0.9662 2,898,550.72

$1.76 $5,107,246.38

Strike Rate ($/pnd)

1.03 $5,260,463.77 Strike Rate ($/pnd)

Option premium Notional principal of option (pounds) Spot rate ($/pound) Option premium, US$ Carry-forward factor, WACC, for 90-days Total premium cost, in 90-days

1.75 1.50% 3,000,000 1.762 $79,290.00 1.03 $81,668.70

1.71 1.00% 3,000,000 1.762 $52,860.00 1.03 $54,445.80

Proceeds from put option if exercised Less cost of premium, including time-value

$5,250,000.00 -81,668.70

$5,130,000.00 -54,445.80

Alternative #4: Put Option Hedges Strike Rate

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Net proceeds from put options, in 90-days: Minimum

$5,168,331.30

$5,075,554.20

Ending spot rate needed to be superior to forward: Proceeds from exchanging pounds for US$ spot Less cost of option (allowed to expire OTM) Net proceeds from put option, unexercised

$1.78 $5,347,500.00 -81,668.70 $5,265,831.30

$1.77 $5,319,600.00 -54,445.80 $5,265,154.20

Analysis: Scout Finch would receive the most certain US$ from the forward contract, $5,265,000; the money market hedge is less attractive as a result of the higher borrowing costs in the UK now. The two put options yield unattractive amounts-- if they have to be exercised. As shown, the $1.75 strike price put would be superior to the forward if the ending spot rate were $1.7825 or higher; the $1.71 strike price would be superior to the forward if the ending spot rate were $1.7732 or higher.

Problem # 8.21: Scout Finch and Dayton Manufacturing (B) Solution: Construction of Dayton's income statement, wit h foreign exchange losses and EPS by strategy. Exchange Rate Assumptions Spot exchange rates at booking: US dollars per euro US dollars per pound Japanese yen per dollar 90-day forward rates: US dollars per euro US dollars per pound

Assumption Assumption 1.0560 1.5900 122.43

1.0250 1.5875

1.0560 1.5900 122.43

1.0250 1.5875

Assumption

Part c) Positions

1.0560 1.5900 122.43

1.0250 1.5875

Paying points Paying

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Japanese yen per dollar Spot rate forecasts: US dollars per euro US dollars per pound Japanese yen per dollar Settlement spot rates: US dollars per euro US dollars per pound Japanese yen per dollar Export sales in currency of invoice: Sales in European euros Sales in British pounds Sales in Japanese yen

S. No. FX gains (losses) by sale: Sales in European euros Sales in British pounds Sales in Japanese yen

S. No. Income Statement (US$) Sales Domestic sales Export sales

Solution Manual

120.85

120.85

120.85

1.0660 1.5600 126.00

1.0660 1.5600 126.00

1.0660 1.5600 126.00

----------------------------

----------------------------

1.048 1.6 122.5

2340000

2340000

2340000

£1,780,000

£1,780,000

£1,780,000

125,000,000 125,000,000

125,000,000

a)

points Receiving points

50% Fwd Cover 50% Fwd Cover 100% Fwd Cover

c) Settled at Settled at Forwards on Forecast Forward Points $23,400 ($72,540) ($45,630) ($53,400) ($4,450) $6,675 ($28,928) $13,349 $13,349 ($58,928) ($63,641) ($25,606) %age

b)

100% Forward

Uncovered Settled at Forecast Cover $13,622,232 $13,622,232 7,300,000 7,300,000 6,322,232 6,322,232

Forward Cover Based on Points $13,622,232 7,300,000 6,322,232

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Less cost of goods sold Gross profit Less G&A expenses Less depreciation Foreign exchange gains (losses) EBIT Less US corporate taxes Net income Shares outstanding Earnings per share (EPS)

Solution Manual

65%

-8,854,451 $4,767,781

-8,854,451 $4,767,781

-8,854,451 $4,767,781

9%

-1,226,001 -248,750

-1,226,001 -248,750

-1,226,001 -248,750

-58,928 $3,234,102 -1,293,641 $1,940,461 1,000,000 $1.94

-63,641 $3,229,389 -1,291,755 $1,937,633 1,000,000 $1.94

-25,606 $3,267,424 -1,306,969 $1,960,454 1,000,000 $1.96

40%

Dayton's EPS is highest in part c), where it determined its forward cover by whether it would receive or pay the forward points. In part c), for both the euro and the pound, Dayton is paying the points, and would therefore decide to cover only 50% of the exposure with forwards (the yen is receiving the points, and is 100% covered with forwards). The foreign exchange loss for the pound is smaller in part c) because the pound moved in the company's favor. Although the euro moves against the firm, the loss is not as large as what the forward would have imposed.

Problem # 8.22: Siam Cement Solution: Assumptions US dollar debt taken out in June 1997 US dollar borrowing rate on debt Initial spot exchange rate, baht/dollar, June 1997 Average spot exchange rate, baht/dollar, June 1998

Value $50,000,000 8.40% 25 42

Calculation of Foreign Exchange Loss on Repayment of Loan: At the time the loan was acquired, the scheduled repayment of dollar and baht amounts would have been as follows: Amou S.No. nt Scheduled Repayment: Repayment of US dollar debt: Principal $50,000,000 Repayment of US dollar debt: Interest 4,200,000 Total repayment $54,200,000

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Exchange rate at time of repayment, baht/dollar Total repayment in Thai baht Total proceeds from loan, up-front, in Thai baht Net interest to be paid, in Thai baht

25 1,355,000,000 1,250,000,000 105,000,000

Actual Repayment: Repayment of US dollar debt: Principal Repayment of US dollar debt: Interest Total repayment Exchange rate at time of repayment, baht/dollar Total repayment in Thai baht Less what Siam had EXPECTED or SCHEDULED to be repaid Amount of foreign exchange loss on debt

$50,000,000 4,200,000 $54,200,000 42 2,276,400,000 -1,355,000,000 921,400,000

Problem # 8.23: Aswan Project: Mitsubishi's Exposure (Part a) Managing a foreign currency receivable. Assumptions 6-month receivable in Egyptian pounds (E£) Spot rate, E£/$ Spot rate, yen/$ 6-month forward rate, yen/$ 6-month dollar investing rate 6-month dollar

Options on Japanese Value yen Call option: Strike rate 168,000,000 (yen/$)

Value 119

4.62 Premium Call option: Strike rate 120.64 (yen/$)

1.50%

119.62 Premium Put option: Strike rate 3.40% (yen/$) 9.60%

0.80%

116

122 1.60%

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borrowing rate 6-month yen investing rate 6-month yen borrowing rate Mitsubishi's cost of capital 1. Do Nothing -exchanging at spot rate in 6-months Expected payment in Egyptian pounds Expected spot rate, E£/$ Expected payment in $ in 180 days Expected spot rate, yen/$ Payment in yen Analysis: Very Risky with uncertain exchange rates. 3. Money market hedge -- borrow against payment Expected payment in Egyptian pounds Expected spot rate, E£/$ Expected payment in $ in 180 days Borrowing rate against $ Borrowing (discount) factor, 180-days Dollar proceeds from borrowing, now Current spot rate, yen/ $

Solution Manual

Premium Put option: Strike rate 1.25% (yen/$) 6.50% Premium Expected spot rate in 8.00% 180-days, yen/$ 2. Forward hedge -sell dollars forward Expected payment in 168,000,000 Egyptian pounds

124 0.90% 122

168,000,000

4.62 Expected spot rate, E£/$ 4.62 Expected payment in $ $36,363,636.36 in 180 days $36,363,636.36 6-month forward rate, 122 yen/$ 119.62 4,436,363,636 Payment in yen 4,349,818,182 Analysis: Yen/$ exchange rate certain; amount of exposure in $ not. 4. Call option hedge: out of the money strike rate (buying yen) Expected payment in 168,000,000 Egyptian pounds 168,000,000 4.62 Expected spot rate, E£/$ 4.62 Expected payment in $ $36,363,636.36 in 180 days $36,363,636.36 9.60% 0.9542 $34,698,126.30

Call option strike rate, yen/$ Proceeds if call option exercised

116 4,218,181,818

120.64

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Yen proceeds, now Mitsubishi carryforward at WACC for 180days Yen proceeds, 180days from now

4,185,981,957

1.04

Solution Manual

Option premium Option premium, upfront, in yen Mitsubishi carryforward

at WACC for 180-days Option premium cost, in 180-days Analysis: Yen/$ exchange rate certain; amount of exposure in $ not.

0.80% 33,745,455

4,353,421,235

Net option proceeds, in 180-days, yen This is a MINIMUM. If Call Option Not Exercised Ending spot rate, yen/$ Option expires OTM: Convert $ to yen spot Less premium carriedforward Net option proceeds, in 180-days, yen

1.04 35,095,273

4,183,086,545

122 4,436,363,636 -35,095,273 4,401,268,364

Analysis: If yen expected to fall in next 180 days against US$; this may be an attractive alternative. Final Discussion: If Mitsubishi does not wish to accept any exchange rate risk it does not have to, it should choose the money market hedge. If Mitsubishi will accept some exchange rate risk, and it believes the yen will fall to 122 or weaker versus the dollar, the call option is preferable. Regardless, the hedging analysis does not cover the Egyptian pound to US dollar exchange rate risk, which was the problem in the end. Problem # 8.23: Aswan Project: Mitsubishi's Exposure (Part b) Post devaluation, managing the expected payment after the initial hedge is difficult (to say the least). Assumptions 6-month receivable in Egyptian

Value Assumptions 168,000,000 Spot rate, EL/$ (pre-

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pounds (EL)

Solution Manual

devaluation) Spot rate, EL/$ (post120.64 devaluation) Percent devaluation versus 119.62 the dollar

Spot rate, yen/$ 6-month forward rate, yen/$ Expected spot rate in 180 days, yen/$ 1. Do Nothing -- exchanging at spot rate in 6-months Expected payment in Egyptian pounds

5.35 -13.65%

122

168,000,000

Expected spot rate, EL/$ Expected payment in $ in 180 days

5.35 $31,401,869.16

Expected spot rate, yen/$ Payment in yen

122 3,831,028,037

Mitsubishi will now be short the difference between the forward agreement above and the actual settlement in now 5 months. Amount of short-fall in US$ Amount of short-fall in yen

2. Forward hedge -sell dollars forward Expected payment in Egyptian pounds 168,000,000 Expected spot rate, EL/$ 4.62 Expected payment in $ in 180 days $36,363,636.36 6-month forward rate, yen/$ 119.62 Payment in yen 4,349,818,182

Amount ($4,961,767.20) ($518,790,144.44)

The problems this situation poses for Mitsubishi are complex. First, Mitsubishi would first go back to its contracts with the Aswan Project and the Egyptian government and push for the government itself to make good on the full amount of the original contract -- in foreign currency terms. Secondly, if Mitsubishi had not hedged in January, but left it uncovered, the value of their expected payment, all other values held constant, have now fallen by the amount of the devaluation, 13.645%. Third, if Mitsubishi had entered into any hedge agreements in January (forward, money market, or option hedges), each of those agreements would have been premised on a principal in U.S. dollars which is now no longer going to happen. This would mean that for each of the individual hedges Mitsubishi would now be "short" 13.645% of the derivative or contract principles.

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Problem # 8.24: Aswan Project: Fluor's Exposure. Post devaluation, managing the currency exposure. Assumptions 3-months 6-months 3-month expected payment, Egyptian pounds 56,000,000 44,000,000 Spot rate, EL/$ (predevaluation) 4.62 4.62 Expected US dollar proceeds $12,121,212.12 $9,523,809.52

9-months 120,000,000 4.62 $25,974,025.97

Assumptions Fluor's WACC Forward insurance agreement range Forward insurance agreement premium Spot rate, EL/$ (post-devaluation) Percent devaluation versus the dollar Actual spot rate at 3-month settlement

Values 10.60% 8.00% 0.80% 5.35 -13.65% 5.58

a. What was the cost of the forward insurance agreement? Fluor had expected the three US dollar payments: Cumulative total Percent premium Cost up-front paid to NY bank

$12,121,212.12 $9,523,809.52 $47,619,047.62 0.80% $380,952.38

$25,974,025.9 7

b. What was the actual US$ proceeds to Fluor with forward agreement less allocated premium? Expected US dollar payment Forward agreement premium Premium paid on 3-month payment 3-month payment, Egyptian pounds Actual exchange rate at 3-month settlement (EL/$)

$12,121,212.1 2 0.80% $96,969.70 56,000,000 5.58

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Actual cash settlement, US$ Gain (loss) on expected settlement Forward agreement settles one-half difference Final settlement: Actual Premium + Forward

Solution Manual

$10,035,842.2 9 ($2,085,369.83 ) ($1,042,684.91 ) $10,981,557.5 1

Fluor was wise to take out the forward insurance agreement, even for what was considered a fixed exchange rate. The history of the Egyptian pound in the past 4 years had been a series of periodic devaluations. Although the agreement did not fully compensate Fluor, given the nominal cost up-front, the agreement saved Fluor $1,042,685 on the 3-month payment alone.

Problem # 8.25: Aswan Project: DaSilva's Contingency Lever. Price quotes and exchange rate contingencies daSilva's Expected & Budgeted 3-month expected payment, Egyptian pounds Spot rate, EL/$ (predevaluation) Expected US dollar proceeds Budgeted spot rate, Brazilian real/$

3-months

6-months

9-months

28,000,000

66,000,000

24,000,000

4.62 $6,060,606.06

4.62 $14,285,714.29

4.62 $5,194,805.19

3.5

3.5

3.5

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Budgeted Brazilian real proceeds Less contingency of Budgeted proceeds, without contingency Final Outcome 3-month payment, Egyptian pounds Spot rate, EL/$ Expected US dollar proceeds Actual spot rate, Brazilian real/$ Expected Brazilian real proceeds Actual devaluation of Egyptian pnd (effective) Actual versus budget (contingency removed)

Solution Manual

21,212,121.21 -16.00% R$ 17,818,181.82

50,000,000.00 -16.00% R$ 42,000,000.00

18,181,818.18 -16.00% R$ 15,272,727.27

3-months

6-months

9-months

28,000,000 5.58 $5,017,921.15 3.5 R$ 17,562,724.01

66,000,000 6.2 $10,645,161.29 3.6 R$ 38,322,580.65

24,000,000 6.2 $3,870,967.74 3.7 R$ 14,322,580.65

-17.20%

-25.50%

-25.50%

-3,649,397

-11,677,419

-3,859,238

Even with the devaluation contingency built into the contract, the actual Egyptian pound rates proved to be worse than the 16% contingency. Although the gradual weakening of the Brazilian real versus the dollar helped the company, it was not enough to outweigh the degree of pound devaluation.

Chapter-9

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Solution Manual

Operating Exposure

Chapter # 9 Operating Exposure Problem 9.1 Carlton Germany - Case 4 Cash Accounts receivable Inventory Net plant and equipment Total

Balance Sheet Information, End of Fiscal 2002 Assets Liabilities and net worth € 1,600,000 Accounts payable 3,200,000 Short-term bank loan 2,400,000 Long-term debt 4,800,000 Common stock Retained earnings € 12,000,000 Total

€ 800,000 1,600,000 1,600,000 1,800,000 6,200,000 € 12,000,000

Important Ratios to be Maintained and Other Data

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Solution Manual

Accounts receivable, as percent of sales Inventory, as percent of annual direct costs Cost of capital (annual discount rate) Income tax rate

25.00% 25.00% 20.00% 34.00%

Assumptions Exchange rate, $/€ Sales volume (units) Export sales volume (case 4) Sales price per unit Export sales price per unit (case 4) Direct cost per unit

Base Case 1.2 1,000,000

Case 1 1 1,000,000

Case 2 1 2,000,000

12.8

12.8

12.8

15.36

Case 4 1 500,000 500,000 12.8

9.6

9.6

9.6

9.6

15.36 9.6

Assumptions Direct cost of goods sold Cash operating expenses (fixed) Depreciation Pretax profit Income tax expense Profit after tax Add back depreciation Cash flow from operations, in euros Cash flow from operations, in dollars

Base Case 9,600,000

Cash Flows before Adjustments Case 1 Case 2 9,600,000 19,200,000

Case 3 1 1,000,000

Case 3 9,600,000

Case 4 9,600,000

890,000 600,000 € 1,710,000 581,400 € 1,128,600 600,000

890,000 600,000 € 1,710,000 581,400 € 1,128,600 600,000

890,000 600,000 € 4,910,000 1,669,400 € 3,240,600 600,000

890,000 600,000 € 4,270,000 1,451,800 € 2,818,200 600,000

890,000 600,000 € 2,990,000 1,016,600 € 1,973,400 600,000

€ 1,728,600

€ 1,728,600

€ 3,840,600

€ 3,418,200

€ 2,573,400

$2,074,320

$1,728,600

$3,840,600

$3,418,200

$2,573,400

Case 2 € 6,400,000 4,800,000 € 11,200,000

Case 3 € 3,840,000 2,400,000 € 6,240,000

Case 4 € 3,520,000 2,400,000 € 5,920,000

€ € 5,600,000 Year-End Cash Flows

€ 640,000

€ 320,000

Adjustments to Working Capital for 2003 and 2007 Caused by Changes in Conditions Assumptions Accounts receivable Inventory Sum Change from base conditions in 2003

Year 1 (2003) 2 (2004) 3 (2005) 4 (2006) 5 (2007)

Base Case € 3,200,000 2,400,000 € 5,600,000 € -

Base Case $2,074,320 $2,074,320 $2,074,320 $2,074,320 $2,074,320

Case 1 € 3,200,000 2,400,000 € 5,600,000

Case 1 $1,728,600 $1,728,600 $1,728,600 $1,728,600 $1,728,600

Case 2 ($1,759,400) $3,840,600 $3,840,600 $3,840,600 $9,440,600

Case 3 $2,778,200 $3,418,200 $3,418,200 $3,418,200 $4,058,200

Case 4 $2,253,400 $2,573,400 $2,573,400 $2,573,400 $2,893,400

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Solution Manual

Change in Year-End Cash Flows from Base Conditions Year 1 (2003) 2 (2004) 3 (2005) 4 (2006) 5 (2007)

Base Case Case 1 Case 2 Case 3 na ($345,720) ($3,833,720) $703,880 na ($345,720) $1,766,280 $1,343,880 na ($345,720) $1,766,280 $1,343,880 na ($345,720) $1,766,280 $1,343,880 na ($345,720) $7,366,280 $1,983,880 Present Value of Incremental Year-End Cash Flows na ($1,033,914) $2,866,106 $3,742,892

Case 4 $179,080 $499,080 $499,080 $499,080 $819,080 $1,354,489

Problem 9.2 Carlton Germany - Case 5 Assets Cash Accounts receivable Inventory Net plant and equipment Sum

Balance Sheet Information, End of Fiscal 2002 Liabilities and net worth € 1,600,000 Accounts payable € 800,000 3,200,000 Short-term bank loan 1,600,000 2,400,000 Long-term debt 1,600,000 4,800,000 Common stock 1,800,000 Retained earnings 6,200,000 € 12,000,000 Sum € 12,000,000

Important Ratios to be Maintained and Other Data Accounts receivable, as percent of sales Inventory, as percent of annual direct costs Cost of capital (annual discount rate) Income tax rate Assumptions Exchange rate, $/€ Sales volume (units) Export sales volume (case 4) Sales price per unit Export sales price per unit (case 4) Direct cost per unit Exchange rate, $/€ Sales volume (units) Assumptions Sales revenue

Base Case 1.2 1,000,00 0

25.00% 25.00% 20.00% 34.00%

Case 1

Case 2

1 1,000,0 00

1 2,000,00 0

Case 3

Case 4

1

1

1,000,000

500,000 500,000

12.8

12.8

12.8

15.36

15.36 15.36

9.6

9.6

1.2 1,000,000

1 1,000,000

9.6 1 2,000,000

9.6

11.52 1 1,000,000

Annual Cash Flows before Adjustments Base Case Case 1 Case 2 Case 3 € 12,800,000 € € € 12,800,000 25,600,000 15,360,00

1 500,000 Case 4 € 15,360,000

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0 Direct cost of goods sold Cash operating expenses (fixed) Depreciation Pretax profit Income tax expense Profit after tax Add back depreciation Cash flow from operations, in euros Cash flow from operations, in dollars

9,600,000

9,600,000

19,200,000

9,600,000

11,520,000

890,000 600,000

890,000 600,000 € 1,710,000 581,400

890,000 600,000 € 4,270,000 1,451,800

1,068,000 600,000

€ 1,710,000 581,400

890,000 600,000 € 4,910,000 1,669,400

€ 1,128,600 600,000

€ 1,128,600 600,000

€ 1,728,600

€ 1,728,600

€ 3,240,600 600,000 € 3,840,600

$1,728,600

$3,840,600

€ 2,818,200 600,000 € 3,418,200 $3,418,20 0

$2,074,320

€ 2,172,000 738,480 € 1,433,520 600,000 € 2,033,520 $2,033,520

Adjustments to Working Capital for 2003 and 2007 Caused by Changes in Conditions Assumptions

Base Case

Case 1

Accounts receivable Inventory

€ 3,200,000 2,400,000

€ 3,200,000 2,400,000

Sum Change from base conditions in 2003

€ 5,600,000

€ 5,600,000

€ -

€ -

Case 2

Case 3 € 3,840,000 2,400,000 € 6,240,000 € 640,000

€ 6,400,000 4,800,000 € 11,200,000 € 5,600,000

Case 4 € 3,840,000 2,880,000 € 6,720,000 € 1,120,000

Year-End Cash Flows Year 1 (2003) 2 (2004) 3 (2005) 4 (2006) 5 (2007)

Base Case $2,074,320 $2,074,320 $2,074,320 $2,074,320 $2,074,320

Case 1 $1,728,600 $1,728,600 $1,728,600 $1,728,600 $1,728,600

Case 2 ($1,759,400) $3,840,600 $3,840,600 $3,840,600 $9,440,600

Case 3 $2,778,200 $3,418,200 $3,418,200 $3,418,200 $4,058,200

Case 4 $913,520 $2,033,520 $2,033,520 $2,033,520 $3,153,520

Change in Year-End Cash Flows from Base Conditions Year 1 (2003) 2 (2004) 3 (2005) 4 (2006) 5 (2007)

Base Case Case 1 Case 2 Case 3 na ($345,720) ($3,833,720) $703,880 na ($345,720) $1,766,280 $1,343,880 na ($345,720) $1,766,280 $1,343,880 na ($345,720) $1,766,280 $1,343,880 na ($345,720) $7,366,280 $1,983,880 Present Value of Incremental Year-End Cash Flows na ($1,033,914) $2,866,106 $3,742,892

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Case 4 ($1,160,800) ($40,800) ($40,800) ($40,800) $1,079,200 ($605,247)

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Solution Manual

Problem 9.3 Denver Plumbing Company (A) Solution: Assumptions Sales volume per year US dollar price per unit Direct costs as % of US$ sales price Direct costs per unit Spot exchange rate, Rmb/$ Expected spot rate, Rmb/$ Unit volume decrease if price increased

Values 1,000,000 $24.00 75% $18.00 8.2 10 -10%

S.No.

Case 1

Sales to China US dollar price per unit Unit volume Sales revenue, Rmb Less direct costs Gross profits, Rmb

Same Rmb Price

Case 2 Same US$ Price

$19.68 1,000,000

$24.00 900,000

$19,680,000 -18,000,000 $1,680,000

$21,600,000 -16,200,000 $5,400,000 Better.

Problem 9.4 Denver Plumbing Company (B). Assumptions Sales volume per year US dollar price per unit Direct costs as % of US$ price Direct costs per unit Spot exchange rate, Rmb/$ Expected spot rate, Rmb/$

Values 1,000,000 $24.00 75% $18.00 8.2

Assumptions Volume change (if price increased) Volume growth (same Rmb price) WACC

Values 1% 12% 10%

10

Alternative 1: Keep Same Chinese Sales Price Year

Volume

Revenue

Direct Costs

Gross Margin

Present Value

Present Value of

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1 2 3 4 5 6 7 8 Cum PV of Gross Margin

1,000,000 1,120,000 1,254,400 1,404,928 1,573,519 1,762,342 1,973,823 2,210,681

$19,680,000 $22,041,600 $24,686,592 $27,648,983 $30,966,861 $34,682,884 $38,844,830 $43,506,210

$18,000,000 $20,160,000 $22,579,200 $25,288,704 $28,323,348 $31,722,150 $35,528,808 $39,792,265

Solution Manual

$1,680,000 $1,881,600 $2,107,392 $2,360,279 $2,643,513 $2,960,734 $3,316,022 $3,713,945

Factor 0.9091 0.8264 0.7513 0.683 0.6209 0.5645 0.5132 0.4665

Margin $1,527,273 $1,555,041 $1,583,315 $1,612,102 $1,641,413 $1,671,257 $1,701,644 $1,732,583 $13,024,628

Alternative 2: Raise Chinese Sales Price

Year 1 2 3 4 5 6 7 8 Cum PV of Gross Margin

Volume 900,000 909,000 918,090 927,271 936,544 945,909 955,368 964,922

Revenue $21,600,000 $21,816,000 $22,034,160 $22,254,502 $22,477,047 $22,701,817 $22,928,835 $23,158,124

Direct Costs $16,200,000 $16,362,000 $16,525,620 $16,690,876 $16,857,785 $17,026,363 $17,196,626 $17,368,593

Gross Margin $5,400,000 $5,454,000 $5,508,540 $5,563,625 $5,619,262 $5,675,454 $5,732,209 $5,789,531

Present Value Factor 0.9091 0.8264 0.7513 0.683 0.6209 0.5645 0.5132 0.4665

Present Value of Margin $4,909,091 $4,507,438 $4,138,648 $3,800,031 $3,489,119 $3,203,646 $2,941,529 $2,700,859 $29,690,361

Denver Plumbing is much better off raising the Chinese sales price to maintain the US dollar price, and suffering the lower volumes. The volume decrease does not offset the stronger US dollar price per unit receieved Problem #9.5 Hawaiian Macadamia Nuts. a. How much should Hawaiian Macadamia Nuts (HMN) borrow in yen? HMN receives cash collections of one hundred million yen per month. This is the source of repayment of any balance sheet hedge. If HMN wants to be covered for one year at a time, it would need to borrow one year's cash flow plus interest, and convert the borrowed yen to US dollar at once. A sample calculation would be:

S. No. One month's cash flow Months per year

Sample Values 100,000,000 12

Units Yen

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One year's cash flow Plus interest Principal and interest Spot exchange rate US dollars

1,200,000,000 4.00% 1,248,000,000 125 $9,984,000

Solution Manual

Yen per annum Yen Yen/US$ US$

Realistically, HMN would probably want to be covered for the long term. In that case, the 1.2 billion yen loan could be structured so that it could be renewed annually with interest reset annually. This would only cover the foreign exchange and interest rate risk for a year at a time, but would probably be acceptable to a bank lender. Also unknown are the expected sales for year 2 and beyond. b. What should be the terms of payment on the loan? The loan should be repaid out of the monthly cash flow, with payments on principal only. The interest payment one year hence has already been covered by borrowing both principal and interest up-front. Note: HMN should not borrow 250 million yen to cover only its balance sheet exposure. Such a loan would cover only the accounting exposure, and not the cash flow exposure (operating exposure). Problem 9.6 Cellini Fashionwear. The use of risk-sharing agreements. a. If the exchange rate changes immediately to Ps6.00/$, what will be the dollar cost of 6 months of imports to Cellini Fashionwear? Bottom 3.5

The allowable range of exchange rates is (Ps/$) Outside of this range the trading partners will share the extra risk equally. New exchange rate (Ps/$) 6 Allowable exchange rate (Ps/$) 4.5 Difference to be shared (Ps/$) 1.5 Cellini's share 0.75 Boselli's share 0.75 Therefore, Cellini will use the following effective exchange rate after risk-sharing:

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Top of range 4.5 Cellini's share 0.75 Effective total of risk-sharing 5.25 Assuming that 6 months of imports will still be (Ps) 8,000,000 Effective exchange rate for Cellini (Ps/$) 5.25 Cellini's cost in US dollars $1,523,809.52 However, the lower cost of importing might lead to higher Cellini sales and therefore a higher import total than Ps 8 million. b. At Ps6.00/$, what will be the peso export sales in Boselli Leather goods to Cellini Fashionwear? The export sales of Boselli would remain at Ps 8 million, unless the lower dollar cost encourages Cellini to import more from Boselli. Problem 9.7 Autocars, Ltd. Assumptions Invoice price of car Spot exchange rate, NZ$/£ Risk-sharing band, percentage

Sales to New Zealand Distributors a. What are the outside ranges? (initial spot rate + or - 5%)

Values £12,000 1.64 5.00% Lower Band

Upper Band

1.722

1.558

b. Cost to the Kiwi distributor for 10 cars New current spot rate (N$/£) Is this within the band? Cost of 10 cars at this exchange rate (NZ$) Receipts to Autocar in British pounds (Within the band Autocar receives £12,000/car, as expected)

1.7 Yes 204,000 £120,000

c. Cost to the Kiwi distributor for 10 cars

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New current spot rate (N$/£) =1.65 Is this within the band? = Yes Cost of 10 cars at this exchange rate (NZ$) = 198,000 Receipts to Autocars in British pounds = £120,000 (Within the band Autocars receives £12,000/car) d. How does this shift the currency risk? The Autocars bears no risk within the 5% range. The distributor carries all of the risk within 5%.If the exchange rate falls outside the 5% range, Autocars shares the risk with distributor. e. Who benefits from this risk-sharing agreement? Both parties are in practice of risk-sharing agreement. The manufacturer has predictable revenues within the range, while the distributor bears a moderate level of currency risk within the 5% range. The distributor will hopefully be able to provide a more stable pricing to pass on to the customer, which will also benefit the manufacturer through a more stable and sustainable distributor sales outlet. Problem 9.8 High-Profile Printers, Inc. (A) Pricing decisions in foreign markets experiencing devaluations. Exchange US dollar rate Assumptions prices x (R$/$) = Existing sales price per unit $200.00 → 3.4 → If the real falls in value, the new implied US$ price: New dollar price if no real price change $170.00 If the US$ price is changed to keep US$ price : New real price is current US$ price at new exchange rate: Direct cost per unit in the US, percent of price Direct cost per unit in the US Unit volume

$200.00 60% $120.00 50,000

Prices in Brazilian reais 680

←

4 ←

680

→

4 →

800

3.4

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Decrease in unit volume from price increase New lower unit volume

Solution Manual

-20.00% 40,000

Alternative #1: Maintain same price in reais: Sales revenue (R$680 x 50,000 ) / (R$4.000/$) Less: Direct costs (US$120 x 50,000) Contribution margin in US dollars

$8,500,000 6,000,000 $2,500,000

Alternative #2: Raise price in reais (and accept lower volume): Sales revenue (R$800 x 40,000 ) / (R$4.000/$) Less: Direct costs (US$120 x 40,000) Contribution margin in US dollars

$8,000,000 4,800,000 $3,200,000

Discussion: Alternative #2 is preferable. In the short run (one year), HPP would be better off to increase its sales price in reais in Brazil and accept the lower sales volume. The contribution margin if real prices are raised is $3,200,000, whereas if the price in reais is left unchanged HPP's contribution margin is only $2,500,000. This is a shortrun solution, and does not consider possible longer-run effects that might come from raising the local price and/or accepting a smaller market share. Problem# 9.9: High-Profile Printers, Inc. (B) Pricing decisions on export sales when foreign currency denominated sales may decline from real price changes. Assumptions Value Initial sales volume 50,000 Sales volume growth 10% Sales price, US$ $170.00 Direct cost per unit $120.00 Alternative #1: Maintain current Brazilian sales price and volume grows 10% per annum

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End of year 1 2 3 4 5 6

Sales volume 50,000 55,000 60,500 66,550 73,205 80,526

US$ Direct Revenue Costs 8,500,000 6,000,000 9,350,000 6,600,000 10,285,000 7,260,000 11,313,500 7,986,000 12,444,850 8,784,600 13,689,335 9,663,060

Solution Manual

Contribution 12% PV Margin Factor 2,500,000 0.8929 2,750,000 0.7972 3,025,000 0.7118 3,327,500 0.6355 3,660,250 0.5674 4,026,275 0.5066

PV 2,232,143 2,192,283 2,153,135 2,114,686 2,076,924 2,039,836

Present value of contribution margins = $12,809,008 Assumptions Initial sales volume Sales volume growth Sales price, US$ Direct cost per unit

Value 40,000 4% $200.00 $120.00

Alternative #2: Raise Brazilian sales price to R$400 and volume grows only 4% per annum from a lower volume base. End of Sales Year volume 1 40,000 2 41,600 3 43,264 4 44,995 5 46,794 6 48,666

US$ Revenue 8,000,000 8,320,000 8,652,800 8,998,912 9,358,868 9,733,223

Direct Contribution Costs Margin 4,800,000 3,200,000 4,992,000 3,328,000 5,191,680 3,461,120 5,399,347 3,599,565 5,615,321 3,743,547 5,839,934 3,893,289

12% PV Factor 0.8929 0.7972 0.7118 0.6355 0.5674 0.5066

PV 2,857,143 2,653,061 2,463,557 2,287,589 2,124,189 1,972,462

Present value of contribution margins = $14,358,000 Alternative #2, is preferable, yielding a higher present value of total contribution margin over the expected remaining life of the export sales. Problem# 9.10: Hedging Hogs: Risk-Sharing at Harley Davidson

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Solution: Calculating boundaries for risk-sharing agreements is given as under; Assumption Set Spot rate, central rate, A$/US$ Fixed rate zone, percent from central rate Sharing zone boundaries, percent from central rate

Value 1.28 2.50% 5.00%

a. Fixed Rate & Risk Sharing Zones Sharing Zone: upper boundary

1.219

5.00%

Fixed rate: upper boundary

1.2488

2.50%

CENTRAL RATE

1.28

Fixed rate: lower boundary

1.3128

-2.50%

Sharing Zone: lower boundary

1.3474

-5.00%

If the spot rate falls between the fixed rate boundaries, between A$1.2488/$ and A$1.3128/US$, the company guarantees its distributors prices in their local currency calculated using the central rate. If the spot rate falls between the fixed rate upper boundary and the sharing zone upper boundary, the company will "share" the exchange rate risk with the distributor. It calculates the effective rate as the fixed rate upper boundary + (0.5 x (spot - 1.2190)). If the spot rate falls between the fixed rate lower boundary and the sharing zone lower boundary, If the spot rate falls between the fixed rate lower boundary and the sharing zone lower boundary, the company will "share" the exchange rate risk with the distributor. It calculates the effective rate the company will "share" the exchange rate risk with the distributor. It calculates the effective rate the company will "share" the exchange rate risk with the distributor. It calculates the effective rate as: [fixed rate lower boundary + (0.5 x (spot - 1.2190)]. b. If Harley ships a hog costing US$8,500, and the spot exchange rate on the

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order date is A$1.3442/US$, what is the price to the Australian dealership? The spot rate falls between the fixed rate lower boundary and the sharing zone lower boundary.This means that the effective rate is a "shared rate": Spot rate, A$/US$ 1.3442 Fixed rate: lower boundary A$/US$ 1.3128 Difference, A$/US$ 0.0314 Effective rate = lower boundary + (.5 x (difference)) 1.3285 Hog price in US$ $8,500.00 Effective exchange rate, A$/US$ 1.3285 Hog price to distributor, A$ 11,292.34 c. If Harley ships a hog costing US$8,500, and the spot exchange rate on the order date is A$1.2442/US$, what is the price to the Australian dealership? The spot rate falls between the central rate and fixed rate upper boundary, in the zone of fixed rate pricing. This means that the effective rate is the central rate. Hog price in US$ Effective exchange rate, A$/US$ Hog price to distributor, A$

$8,500.00 1.28 10,880.00

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Chapter-10 Translation Exposure or Accounting Exposure

Chapter # 10

“Translation Exposure or Accounting Exposure”

Problem # 10.1: Carlton Germany (A).

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Using facts in the chapter for Carlton Germany, assume the exchange rate on January 2, 2006, in Exhibit 10.4 dropped in value from $1.2000/€ to $0.9000/€ rather than to $1.0000/€. Recalculate Carlton Germany’s translated balance sheet for January 2, 2006 with the new exchange rate using the current rate method. a). What is the amount of translation gain or loss? b). Where should it appear in the financial statements? Translation Using the Current Rate Method: euro depreciates from $1.2000/euro to $0.9000/€.

Assets Cash A/R Inventory Net plant & equipment Total Liabilities & Net Worth A/P Short-term bank debt Long-term debt Common stock Retained earnings CTA account (loss) Total

Euros Statement 1,600,000 3,200,000 2,400,000

Just before Just after devaluation devaluation Exchange Translated Exchange Translated Rate Accounts Rate Accounts ($/€) US dollars ($/€)) US dollars 1.2 $1,920,000 0.9 $1,440,000 1.2 3,840,000 0.9 2,880,000 1.2 2,880,000 0.9 2,160,000

4,800,000 12,000,000

1.2

5,760,000 $14,400,000

0.9

4,320,000 $10,800,000

800,000

1.2

$960,000

0.9

$720,000

1,600,000 1,600,000 1,800,000

1.2 1.2 1.276

1,920,000 1,920,000 2,296,800

0.9 0.9 1.276

1,440,000 1,440,000 2,296,800

6,200,000

1.2

7,440,000

1.2

7,440,000

12,000,000

($136,800) $14,400,000

($2,536,800) $10,800,000

a). The translation gain (loss) = ($2,536,800) – $136,800 = ($240,000)

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b). The translation gain (loss) for the year is added to the balance in the Cumulative Translation adjustment account, which is carried as a separate balance sheet account within the equity section of the consolidated balance sheet. The lsos does not pass through the income statement under the Current Rate Method, in which the currency of the foreign subsidiary is local currency functional. Problem#10.2: Carlton Germany (B). Using facts in the chapter for Carlton Germany, assume as in question Carlton Germany (A) that the exchange rate on January 2, 2006, in Exhibit 10.4 dropped in value from $1.2000/€ to $0.9000/€ rather than to $1.0000/€. Recalculate Carlton Germany’s translated balance sheet for January 2, 2006 with the new exchange rate using the temporal rate method.

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a. The translation gain (loss) = ($240,000) – 0 = ($240,000) b. Under the Temporal Method, the translation loss of $240,000 would be closed into retained earnings through the income statement, rather than as a separate line item. It is shown as a separate line item above for pedagogical purposes only. Actual year-end retained earnings would be $7,711,200 - $240,000 = $7,471,200. c. The translation gain (loss) differs from the Current Rate Method because "exposed assets" under the Current Rate Method are larger than under the temporal method by the amount of inventory and net plant & equipment.

Problem#10.3: Carlton Germany (C). Using facts in the chapter for Carlton Germany, assume the exchange rate on January 2, 2006, in Exhibit 10.4 appreciated from $1.2000/€ to $1.500/€. Calculate Carlton

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Germany’s translated balance sheet for January 2, 2006 with the new exchange rate using the current rate method. .

Translation Using the Current Rate Method: euro appreciates from $1.2000/euro to $1.5000/euro.

Assets Cash A/R Inventory Net plant & equipment Total Liabilities & Net Worth A/P Short-term bank debt Long-term debt Common stock Retained earnings CTA account (loss) Total

Euros Statement 1,600,000 3,200,000 2,400,000

Just before revaluation Just after revaluation Exchange Translated Exchange Translated Rate Accounts Rate Accounts ($/€) US dollars ($/€) US dollars 1.2 $1,920,000 1.5 $2,400,000 1.2 3,840,000 1.5 4,800,000 1.2 2,880,000 1.5 3,600,000

4,800,000 12,000,00 0

1.2

800,000

1.2

$960,000

1.5

$1,200,000

1,600,000 1,600,000 1,800,000

1.2 1.2 1.276

1,920,000 1,920,000 2,296,800

1.5 1.5 1.276

2,400,000 2,400,000 2,296,800

6,200,000

1.2

7,440,000

1.2

7,440,000

12,000,00 0

5,760,000 $14,400,00 0

1.5

7,200,000 $18,000,000

($136,800) $14,400,00 0

$2,263,200 $18,000,000

a. The translation gain (loss) = $2,263,200 + $136800 = $2,400,000 b. The translation gain for the year is added to the balance in the Cumulative Translation adjustment account, which is carried as a separate balance sheet account within the equity section of the consolidated balance sheet. The gain does not pass

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through the income statement under the current rate method in which the currency of the foreign subsidiary is a local currency functional. Problem# 10.4: Carlton Germany (D). Using facts in the chapter for Carlton Germany, assume as in Carlton Germany (C) that the exchange rate on January 2, 2006, in Exhibit 10.4 appreciated from $1.2000/€ to $1.5000/€. Calculate Carlton Germany’s translated balance sheet for January 2, 2006 with the new exchange rate using the temporal method. Translation Using the Temporal Method: euro appreciates from $1.2000/euro to $1.5000/euro. Just before revaluation Euros

Exchange Rate

Just after revaluation Translated Accounts

Exchange Rate

Translated Accounts

Assets Cash A/R Inventory Net plant & equipment

Statement 1,600,000 3,200,000 2,400,000

($/€) (US dollars) 1.2 $1,920,000 1.2 3,840,000 1.218 2,923,200

($/€) 1.5 1.5 1.218

(US dollars) $2,400,000 4,800,000 2,923,200

4,800,000

1.276

1.276

6,124,800

Total

12,000,000

Liabilities & Net Worth Accounts payable Short-term bank debt Long-term debt Common stock Retained earnings CTA account (loss) Total

6,124,800 $14,808,000

$16,248,000

1.5 $1,200,000

800,000

1.2

$960,000

1,600,000 1,600,000 1,800,000 6,200,000 -

1.2 1.2 1.276 1.2437

1,920,000 1,920,000 2,296,800 7,711,200 $0

12,000,000

$14,808,000

1.5 1.5 1.276 1.2437

2,400,000 2,400,000 2,296,800 7,711,200 $240,000 $16,248,000

a). The Translation gain (loss) = $240,000 - $0 = $240,000

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b). Under the Temporal Method, the translation loss of $240,000 would be closed into retained earnings through the income statement, rather than as a separate line item. It is shown as a separate line item above for pedagogical purposes only. Actual year-end retained earnings would be $7,711,200 - $240,000 = $7,471,200. c). The translation gain (loss) differs from the Current Rate Method because "exposed assets" under the Current Rate Method are larger than under the temporal method by the amount of inventory and net plant & equipment. Problem#10.5: Montevideo Products, S.A. (A). Montevideo Products, S.A., is the Uruguayan subsidiary of a U.S. manufacturing company. Its balance sheet for January 1 follows. The January 1st exchange rate between the U.S. dollar and the peso Uruguayo ($U) is $U20/$. Determine Montevideo’s contribution to the translation exposure of its parent on January 1, using the current rate method

Balance Sheet (thousands of pesos Uruguayo, $U) Assets Assets Cash Accounts receivable Inventory Net plant & equipment Liabilities & Net Worth Current liabilities Long-term debt Capital stock Retained earnings

Calculation of Accounting Exposures:

Exchange Rate ($U/US$)

Exchange Rate ($U/US$)

60,000 120,000 120,000 240,000 540,000

20 20 20 20

30,000 90,000 300,000 120,000 540,000

20 20 15 15

$U

January 1st $U/US$

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(000s) Exposed assets (all assets) 540,000 Less: exposed liabilities (current Liabilities + debt) -120,000 Net exposure 420,000

20.00 $27,000 -6,000 $21,000

Problem#10.6: Montevideo Products, S.A. (B). Calculate Montevideo’s contribution to its parent’s translation loss if the exchange rate on December 31st is $U22/$. Assume all peso accounts remain as they were at the beginning of the year. Balance Sheet (thousands of pesos Uruguayo, $U)

Assets Cash A/R Inventory Net plant & equipment

January 1st ($U/US$)

Before Devaluation Exchan ge Rate Translated ($U/US Accounts US $) dollars

60,000 120,000 120,000 240,000

20 $ 3,000 20 6,000 20 6,000 20 12,000

After Devaluation Translate Exchange d Rate Accounts ($U/US$) US dollars

$27, Total Liabilities & Net Worth A/P Long-term debt Capital Stock Retained earnings CTA account (loss) Total

540,000

000

30,000 90,000 300,000 120,000

20 $ 1,500 20 4,500 20 15,000 20 6,000 --$27,000

--540,000

22 $ 2,727 22 5,455 22 5,455 22 10,909 $24,54 6 22 $1,364 22 4,091 15 5,455 15 10,909 (2727) $24,546

The translation gain (loss) = (2727) – $0 = (2727) But the translation gain (loss) of exposed asset & exposed liabilities are given as under; Calculation of Accounting

$U

January 1st

January 1st $U/US$

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Exposures: Exposed assets (current assets + fixed assets) Less: exposed liabilities (current Liabilities + Long term debt) Net exposure

Solution Manual

(000s)

$U/US$ 20.00 Before Devaluation

22.00 After Devaluation

540,000

$27,000*

$24,546*

-120,000 420,000

(6,000)** $21,000

(5455)** $19,091

Alternatively, the translation loss arising from the fall in the value of the peso Uruaguayo can be found as follows: Translation gain or (loss) = After Devaluation net exposure – Translation gain or (loss) = $19,091 - $21,000 Translation gain or (loss) = $ (1,909)

Before Devaluation net exposure

Notes: Before Devaluation: *Total Exposed Assets = Cash + A/R + Inventory + Net plant & equipment Total Exposed Assets = $ 3,000 + $6,000 + $6,000 + $ 12,000 Total Exposed Assets = $27,000 **Total Exposed Liabilities = Current Liabilities + Long term debt Total Exposed Liabilities= $1,500 + 4500 Total Exposed Liabilities = 6000 After Devaluation: *Total Exposed Assets = Cash + A/R + Inventory + Net plant & equipment Total Exposed Assets = $2,727 + 5,455 + 5,455 + 10,909 Total Exposed Assets = $24,546 **Total Exposed Liabilities = Current Liabilities + Long term debt Total Exposed Liabilities = $1,364 + $4,091 Total Exposed Liabilities = $5455

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Problem#10.7: Montevideo Products, S.A. (C ). Calculate Montevideo’s contribution to its parent’s translation gain or loss using the current rate method if the exchange rate on December 31 is $U12/$. Assume all peso accounts remain as they were at the beginning of the year. Balance Sheet (thousands of pesos Uruguayo, $U)

st

January 1 ($U/US$)

Before Devaluation Exchan ge Rate Translated ($U/US Accounts US $) dollars

After Devaluation Exchange Rate ($U/US$)

Translated Accounts US dollars

Assets Cash

60,000

20

$3,000

12

$5,000

6, A/R

120,000

20

000

12

10,000

Inventory

120,000

20

6,000

12 10,000

Net plant & equipment

240,000

20

12,000

12

20,000

$2 Total Liabilities & Net Worth A/P Long-term debt

540,000

7,000

$45,000

30,000

20

$ 1,500

12

2500

90,000

20

4,500

12

7500

2 Capital Stock Retained earnings CTA account (gain or loss) Total

300,000 120,000

15 15

--540,000

0,000 8,000

2 15 15

0,000 8,000

7000 $27,000

7000 $45,000

The translation gain (loss) = $7000– $7000 = $0 But he translation gain or loss of exposed asset & exposed liabilities are given as under;

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Calculation of Accounting Exposures: Exposed assets (current assets + fixed assets) Less: exposed liabilities (current Liabilities + Long term debt) Net exposure

Solution Manual

$U (000s)

January 1st $U/US$ 20.00 Before Devaluation

January 1st $U/US$ 22.00 After Devaluation

540,000

$27,000*

$45,000*

-120,000 420,000

(6,000)** $21,000

(10,000) ** $35,000

Alternatively, the translation loss arising from the fall in the value of the peso Uruaguayo can be found as follows: Translation gain or (loss) = After Devaluation net exposure – Translation gain or (loss) = $35,000 - $21,000 Translation gain or (loss) = $ 14,000

Before Devaluation net exposure

Notes: Before Devaluation: *Total Exposed Assets = Cash + A/R + Inventory + Net plant & equipment Total Exposed Assets = $ 3,000 + $6,000 + $6,000 + $ 12,000 Total Exposed Assets = $27,000 **Total Exposed Liabilities = Current Liabilities + Long term debt Total Exposed Liabilities= $1,500 + 4500 Total Exposed Liabilities = 6000 After Devaluation: *Total Exposed Assets = Cash + A/R + Inventory + Net plant & equipment Total Exposed Assets = $5,000 + $10,000 + $10,000 + 20,000 Total Exposed Assets = $45,000 **Total Exposed Liabilities = Current Liabilities + Long term debt Total Exposed Liabilities= $2500 + $7500

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Total Exposed Liabilities = $10,000 Problem#10.8: Siam Toys, Ltd. (A). Siam Toys, Ltd., is the Thai affiliate of a U.S. toy manufacturer. Siam Toys manufacture plastic injection molding equipment for making toy cars. Sales are primarily in the United States and Europe. Siam Toys’ balance sheet in thousands of Thai bahts (฿) as of March 31st is as follows. Using the data presented on Siam Toys, assume that the Thai baht dropped in value from ฿ 30/$ to ฿40/$ between March 31 and April 1. Assuming no change in balance sheet accounts between these two days, calculate the gain or loss from translation by both the current rate method and the temporal method. Explain the translation gain or loss in terms of changes in the value of exposed accounts. TRANSLATION BY THE CURRENT RATE METHOD Before Devaluation

After Devaluation

Balance Sheet (thousands) Thai baht

Assets Cash Accounts receivable Inventory Net plant & equipment Total Liabilities & Net Worth Accounts payable Bank loans Common stock Retained earnings CTA account (loss) Total

Exchange Translated Exchange Rate Accounts Rate

Statement ฿24,000 36,000 48,000 60,000 ฿168,000

(/฿/$) 30 30 30 30

฿18,000 60,000 18,000 72,000 0 ฿168,000

30 30 20 34

US dollars $800 1,200 1,600 2,000 $5,600 $600 2,000 900 2,100 $5,600

Translated Accounts

(/฿/$) 40 40 40 40

40 40 20 34

US dollars $600 900 1,200 1,500 $4,200 $450 1,500 900 2,100 ($750) $4,200

Note: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of

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those years. This cumulative translation account (CTA) loss of$750,000 would be entered into the company's consolidated balance sheet under equity. TRANSLATION BY THE TEMPORAL METHOD Before Devaluation

After Devaluation

Balance Sheet (thousands) Exchange Thai baht Rate

Assets Cash Accounts receivable Inventory Net plant & equipment Total Liabilities & Net Worth Accounts payable Bank loans Common stock Retained earnings CTA account (loss) Total

Statement ฿24,000 36,000 48,000 60,000 ฿168,000 ฿18,000 60,000 18,000 72,000 0 ฿168,000

(/฿$) 30 30 30 20

30 30 20 23

Translated Accounts

Exchange Translated Rate Accounts

US dollars $800 1,200 1,600 3,000 $6,600

US dollars $600 900 1,600 3,000 $6,100

$600 2,000 900 3,100 $6,600

( ฿/$) 40 40 30 20

40 40 20 23

$450 1,500 900 3,100 $150 $6,100

Note a: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of those years. Note b: Retained earnings after devaluation are translated at the same effective rate (see Note a) as before devaluation. The translation gain of $150,000 would be passed-through to the consolidated income statement. EXPLANATION OF DIFFERENT OUTCOME BY TRANSLATION METHODOLOGY: The Temporal Method results in a translation gain, as opposed to

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the CTA loss found under the Current Rate Method, because of the different exchange rates used against Net plant & equipment and the inventory line items. This gain would be impossible under the Current Rate Method because ALL assets are exposed under that method, whereas the Temporal Method carries Net plant & equipment and inventory at relevant historical exchange rates. Problem#10.9: Siam Toys, Ltd. (B). Using the original data provided for Siam Toys, assume that the Thai baht appreciated in value from B30/$ to B25/$ between March 31 and April 1. Assuming no change in balance sheet accounts between those two days, calculate the gain or loss from translation by both the current rate method and the temporal method. Explain the translation gain or loss in terms of changes in the value of exposed accounts. TRANSLATION BY THE CURRENT RATE METHOD Balance Sheet (thousands) Before Devaluation After Devaluation Exchange Translated Exchange Translated Thai baht Rate Accounts Rate Accounts Assets Statement (Baht/US$) US dollars (Baht/US$) US dollars Cash ฿24,000 30 $800 25 $960 A/R 36,000 30 1,200 25 1,440 Inventory 48,000 30 1,600 25 1,920 Net plant & equipment 60,000 30 2,000 25 2,400 Total ฿168,000 $5,600 $6,720 Liabilities & Net Worth Accounts payable ฿18,000 30 $600 25 $720 Bank loans 60,000 30 2,000 25 2,400 Common stock 18,000 20 900 20 900 Retained earnings 72,000 34 2,100 34 2,100 CTA account (loss) 0 $600 Total ฿168,000 $5,600 $6,720 Note: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of

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those years. This cumulative translation account (CTA) gain of $600,000 would be entered into the company's consolidated balance sheet under equity. TRANSLATION BY THE TEMPORAL METHOD Balance Sheet (thousands) Assets Cash Accounts receivable Inventory Net plant & equipment Total Liabilities & Net Worth Accounts payable Bank loans Common stock Retained earnings CTA account (loss) Total

After Before Devaluation Devaluation Exchange Translated Exchange Thai baht Rate Accounts Rate Statement (Baht/US$) US dollars (Baht/US$) ฿24,000 30 $800 25

Translated Accounts US dollars $960

36,000 48,000

30 30

1,200 1,600

25 30

1,440 1,600

60,000 ฿168,000

20

3,000 $6,600

20

3,000 $7,000

฿18,000 60,000 18,000 72,000

30 30 20 23

$600 2,000 900 3,100

25 25 20 23

$720 2,400 900 3,100

0 ฿168,000

$6,600

($120) $7,000

Note a: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of those years. Note b: Retained earnings after devaluation are translated at the same effective rate (see Note a) as before devaluation.The translation loss of $120,000 would be passed-through to the consolidated income statement.

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EXPLANATION OF DIFFERENT OUTCOME BY TRANSLATION METHODOLOGY: The Temporal Method results in a translation gain, as opposed to the CTA loss found under the Current Rate Method, because of the different exchange rates used against Net plant & equipment and the inventory line items. This gain would be impossible under the Current Rate Method because ALL assets are exposed under that method, whereas the Temporal Method carries Net plant & equipment and inventor at relevant historical exchange rates. Problem#10.10: Egyptian Ingot, Ltd. Egyptian Ingot, Ltd., is the Egyptian subsidiary of Tran Mediterranean Aluminum, a British multinational that fashions automobile engine blocks from aluminum. TransMediterranean’s home reporting currency is the British pound. Egyptian Ingot’s December 31st balance sheet is shown below. At the date of this balance sheet the exchange rate between Egyptian pounds and British pounds sterling was ŁE5.50/UKŁ. a). What is Egyptian Ingot’s contribution to the translation exposure of TransMediterranean on December 31st, using the current rate method? b). Calculate the translation exposure loss to Trans-Mediterranean if the exchange rate at the end of the following quarter is ŁE6.00/Ł. Assume all balance sheet accounts are the same at the end of the quarter as they were at the beginning.

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Balance Sheet of Egyptian Ingot, Ltd.

Egyptian pounds Assets Cash A/R Inventory Net plant & equipment

Statement 16,500,000 33,000,000 49,500,000

Before Exchange Rate After Exchange Rate Change Change Exchange Translated Exchange Translated Rate Accounts Rate Accounts (Egyptian (Egyptian L/UKL) US dollars L/UKL) US dollars 5.5 $3,000,000 6 $2,750,000 5.5 6,000,000 6 5,500,000 5.5 9,000,000 6 8,250,000

66,000,000

Total Liabilities & Net Worth A/P Long-term debt Invested capital CTA account (loss)

165,000,000

Total

165,000,000

5.5

12,000,000 $30,000,00 0

6

11,000,000 $27,500,000

24,750,000

5.5

$4,500,000

6

$4,125,000

49,500,000

5.5

9,000,000

6

8,250,000

90,750,000

5.5

16,500,000

5.5

16,500,000

-

$30,000,00 0

($1,375,000) $27,500,000

a. Calculation of Actg Exposures: Serial Number Exposed assets (all assets) Less: Exposed Liabilities & Current Liabilities + debt)

Egyptian pounds 165,000,000

Dec. 31st 5.5 $30,000,000

-74,250,000

-13,500,000

End of Quarter 6 $27,500,000 -12,375,000

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Net exposure

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90,750,000

$16,500,000

$15,125,000

b). Change in translation exposure: Translation Gain (Loss) = ($1,375,000) – 0 = ($1,375,000) Alternatively, the translation loss arising from the fall in the value of the peso Uruaguayo can be found as follows: Net exposed assets (US$) Percentage change in the value of the dollar Translation gain (loss)

$16,500,000 -8.30% ($1,375,000)

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Chapter-11 Sourcing Global Equity

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Chapter # 11 Sourcing Equity Globally Problem# 11.1: Novo’s cost of equity prior to April 1980. Solution: Assumptions Danish risk free rate of interest, krf Danish stock market return, km Novo’s beta before internationalization

Values 10.00% 18.00% 1.00

Calculation: What was Novo’s cost of equity? ke = krf + (km – krf) β

=

18.00%

Problem# 11.2: Novo’s WACC prior to April 1980. Solution: Assumptions Novo’s cost of debt, kd Novo’s cost of equity, ke Novo’s debt to capital ratio, D/V Novo’s equity to capital ratio, E/V Novo’s effective tax rate, t

Values 12.0% 18.0% 70.0% 30.0% 40.0%

Calculation: What was Novo’s weighted average cost of capital? WACC = (D/V × kd (1 – t)) + (E/V × ke) = 10.44%

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b). How did this affect its capital budget? The relatively high debt ratio and the tax shelter of interest led to a modest WACC despite the relatively high cost of equity. Thus the WACC was probably a reasonable hurdle rate for capital investments. However, the bigger problem was that the marginal cost of capital would increase significantly if Novo did not gain access to the liquidity provided by international portfolio investors

Problem# 11.3: Novo’s cost of equity after July 1981. Assuming the following data now apply, calculate Novo’s cost of equity. International portfolio investors dominated the trading activity in Novo’s stock. Most of the volume was executed on the New York Stock Exchange. Therefore we use international norms rather than Danish norms. Assumptions International risk free rate of interest, krf International stock market return, km Novo’s beta after internationalization

Values 8.00% 12.00% 0.80

What was Novo’s cost of equity now? ke = krf + (km – krf)β =

11.20%

This was a very significant drop from the 18% cost of equity observed before April 1980. Problem# 11.4: Novo’s WACC after July 1981. Assumptions Novo’s new cost of debt, kd Novo’s cost of equity, ke Novo’s debt to capital ratio, D/V Novo’s equity to capital ratio, E/V Novo’s effective tax rate, t

Values 10.0% 11.2% 50.0% 50.0% 40.0%

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a). What was Novo’s weighted average cost of capital? WACC = (D/V × kd (1 – t)) + (E/V × ke) = 8.60% b) How did this affect its capital budget? The lower cost of equity more than offset the lower debt ratio. The WACC was reduced to 8.60% from 10.44%. This created a better hurdle rate for capital investments. Furthermore, access to international portfolio investors improved Novo’s marginal cost of capital. Both results increased the number of capital projects that could be undertaken by Novo.

Problem# 11.5: Novo’s cost of equity in 2004. Assumptions International risk free rate of interest, krf International stock market return, km Novo’s beta after internationalization

Values 4.00% 8.00% 0.80

What was Novo’s cost of equity now? ke = krf + (km – krf)β = 7.20% This is a further drop in the cost of equity due to reduction in market expectations & much of the world and lower the interest rates.

Problem# 11.6: Novo’s WACC in 2004. Assumptions Novo’s new cost of debt, kd Novo’s cost of equity, ke Novo’s debt to capital ratio, D/V Novo’s equity to capital ratio, E/V Novo’s effective tax rate, t

Values 6.0% 7.2% 50.0% 50.0% 40.0%

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a) What was Novo’s weighted average cost of capital? WACC = (D/V × kd (1 – t)) + (E/V × ke) = 5.40% b) How did this affect its capital budget? Novo’s lower WACC in early 2004, compared to post-July 1981, was mainly due to lower overall interest rates and required rates of return. Theoretically, Novo’s lower WACC should lead to even more acceptable capital projects. However, the dismal economic outlook worldwide in early 2004 discouraged firms from investing in capital projects even though they pass the new lower hurdle rate. Problem# 11.7: HangSung before equity issue abroad. Assumptions Korean risk free rate of interest, krf Korean stock market return, km HangSung’s beta What was Novo’s cost of equity now? ke = krf + (km – krf)β

Values 10.00% 14.00% 1.00 = 14.00%

Problem# 11.8: HangSung’s WACC before equity issue abroad. Assumptions HangSung’s cost of debt, kd HangSung’s cost of equity, ke HangSung’s debt to capital ratio, D/V HangSung’s equity to capital ratio, E/V HangSung’s effective tax rate, t

Values 12.0% 14.0% 80.0% 20.0% 30.0%

What was HangSung’s WACC? WACC = (D/V × kd (1 – t)) + (E/V × ke) = 9.52% Problem# 11.9: HangSung after equity issue abroad. Assumptions International risk free rate of interest, krf International stock market return, km HangSung’s beta

Values 4.00% 8.00% 0.70

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What was Novo’s cost of equity now? ke = krf + (km – krf)β = 6.80% The cost of equity dropped significantly from 14% to 6.8% after the equity issue abroad. This demonstrates one of the advantages for a firm to internationalize its cost and availability of capital. Problem# 11.10: HangSung’s WACC after equity issue abroad. Assumptions HangSung’s cost of debt, kd HangSung’s cost of equity, ke HangSung’s debt to capital ratio, D/V HangSung’s equity to capital ratio, E/V HangSung’s effective tax rate, t

Values 6.0% 6.8% 60.0% 40.0% 30.0%

a). What was HangSung’s WACC? WACC = (D/V × kd (1 – t)) + (E/V × ke) = 5.24% b) How did this affect its capital budget? HangSung’s WACC was lowered from 9.52% before its equity issue abroad to 5.24% aftewards. This should lead to more acceptable capital projects. The equity issue abroad should also increase HangSung’s liquidity, thereby leading to a less-steeply increasing marginal cost of capital and still more acceptable capital projects.

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Annexure of Currencies Used in Solution Manual S. No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 30

Country USA Australia Hong Kong Canada Brazil Uruguay Afghanistan Pakistan India Indonesia Malyshia Switzerland Europeon Union Iran Thailand China Russia Germany Jurden Iraq Kuwit Dubai Saudi Arabia Mexican Japan UK Egypt Italy Turkey

Currency Dollar Australian Dollar Hong Kong Dollar Canadian Dollar Reais Peso Uruguayo Rupees / Dollar Rupees Rupees Rupaya Malaysian Ringget Swiss franc Euro Riyal / Toman Bhat Yoan / Renminbi Ruble Deutsche Mark Jordanian Diner Iraqi Diner Kuwaiti Diner Dirham Riyal Mexican peso Yen Pound Sterling Egyptian Pound Lira Lira

Symbol $ A$ HK$ C$ R$ $U $ Rs. Or PKR Rs. Rs. RM SF € R ฿ Y R DM JD ID KD D SRI Ps ¥ £ £E Lit TL

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Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula

Solution Manual

1# Direct Quotation Formula for Percentage Change……… 2# Indirect Quotation Formula for Percentage Change……. 3# Direct Quotation for Premium/Discount (annum)………. 4# Indirect Quotation for Premium/Discount (annum)…….. 5# Profit Formula……………………………………………… 6# Derived Formula for Direct Quotation for S1…………… 7# Derived Formula for Direct Quotation for S2 …………… 8# Derived Formula for Indirect Quotation for S1…………. 9# Derived Formula for Indirect Quotation for S2 …………. 10# Sale Price in Jordanian Dinner (JD) Formula…………… 11# Jordanian Import Duty Formula………………………….. 12# Total Cost, in Jordanian Diner (JD) Formula……........... 13# Jordanian Resale Fees Formula ………………………… 14# Resale Price to Iraq in JD Formula……………………… 15# Price Paid in Iraqi Diner Formula………………………… 16# Price Paid in US Dollar……………………………………. 17# Current Account Balances Formula……………………… 18# Financial Account Balances Formula………………….… 19# Basic Balances Formula………………………………….. 20# Overall Balances Formula…..…………………………….. 21# Mid Rates Formula…………………………………………. 22# Spread & Percent Spread or Margin Formula………….. 23# Outright Forward Bid Rate Formula……………………… 24# Outright Forward Ask Rate Formula……………………… 25# Cross Rate Formula……………………………………….. 26# Arbitrage Profit Formula………………………………….. 27# Arbitrage Loss Formula ………………………………….

4 4 4 4 4 4 4 4 4 5 5 5 5 5 5 5 6 6 6 6 7 7 7 7 7 7 7

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Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula Formula

28# 29# 30# 31# 32# 33# 34# 35# 36# 37# 38# 39# 40# 41# 42# 43# 44# 45# 46# 47# 48# 49# 50# 51# 52# 53# 54# 55# 56# 57# 58# 59# 60# 61# 62# 63# 64# 65# 66# 67# 68#

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Value of Maturity Formula for Long Position…………… 8 Value of Maturity Formula for Short Position………….. 8 Total Value of Call Premium Formula …………………. 8 Spot Rate Sensitivity (delta) Formula…………………… 8 Forward Rate Sensitivity (delta) Formula………………. Time to Maturity (theta) Formula………………………... 3-month Option Price Formula for theta……..…………….. Sensitivity to Volatility (lambda) Formula………………….. Daily Volatility Formula………………………………………. Sensitivity to Changing $ Interest Rate Formula………….. Sensitivity to Changing Foreign Interest Rate Formula…… Buyer of Call Option: P/L, BEP & Gross Profit Formula….. Buyer of Put Option: P/L, BEP & Gross Profit Formula…… Writer of Call Option: P/L, BEP & Gross Profit Formula…... Writer of Put Option: P/L, BEP & Gross Profit Formula…… Law of One Price Formula for Swiss France……………….. Law of One Price Formula for U.S. Dollars ………………… Law of One Price & PPP Formula of SF/$ and $/SF………. Law of One Price & Exchange rate pass-through SF/$....... Law of One Price & Exchange rate pass-through $/SF....... Assuming 70% Exchange rate pass-through………………. Assuming 100% Exchange rate pass-through……………… Price Elasticity of Demand Formula…………………………. Local Currency Under/Over Valuation formula for $/SF…… Local Currency Under/Over Valuation formula for SF/$....... Real/Nominal Effective Exchange Rate Index’s for $............ Fisher Effect Formula in terms of US $ and SF……………… International Fisher Effect Formula#1 ……………………….. International Fisher Effect Formula#2…………………………. Forward Rate Formula#1(n=90) ………………………………. Forward Rate Formula#2(n=360) …………………………….. Interest Rate Parity (IRP) Formula#1…………………………. Interest Rate Parity (IRP) Formula#2 ………………………. Purchasing Power Parity (PPP) Formula (Equilibrium)……… Effective or Implied Cost Formula……………………………… Covered/Uncovered Interest Arbitrage Profit Formula………. Covered/Uncovered Interest Arbitrage Loss Formula………. Misery Index Formula…………………………………………... Forward Rate Formula for Misery Indexes……………………. Forecasting of Forward Rate Formula for Real Interest Rates.. Implied Interest Rates Formula..………………………………..

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Solution Manual

69# Mean Formula……………………………………………..…….. 70# Lower Class Boundaries Formula………………………………. 71# Upper Class Boundaries Formula………………………………. 72# Net Exposure Formula ………………………………………….. 73# Net Exposure Alternate Formula ………………………………. 74# Life Span of Transaction Exposure Formula………………….. 75# Bank Loan ( Principal) Formula……………………………….. 76# Liabilities and Net Worth Formula…………………………….. 77# Forward Proceeds Formula………………………………….... 78# 3-months 90 days Investment Rate (r) Formula……………… 79# Annual Investment Rate (r) Formula………………………….. 80# Breakeven Investment Rate (r) Formula……………………… 81# SF Needed Today Formula……………………………………. 82# Total Cost of Money Market Hedge Formula………………… 83# Total Cost of Call Option Hedge Formula……………………. 84# FX Gain/Loss Formula……………………………………….… 85# Total Sales Formula……………………………………………. 86# Total Repayment in US $ Formula……………………………. 87# Ford’s Payments in US $ (Risk-sharing Agreement)……….. 88# Ford’s Cost in US $ Formula………………………………….. 89# Ford’s Savings in US $ Formula……………………………… 90# Cost of Equity Formula (CAPM)……………………………… 91# Weighted Average Cost of Capital (WACC) Formula……… 92# Total Percentage Cost of Capital Formula…………………... 93# After-tax Cost of Debt in SF Formula………………………..

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