FIN 542 - Answer Scheme APR2010

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 1 a) i)

UK  FC ; US  HC (1 + rhc) (1 + rfc)

=

et e0

(1 + 0.035) x 1.6923 = (1 + 0.04) USD1.6842

b)

et

ii)

An increase in UK rate would cause an increase in the expected inflation rate. As a result of that, the demand for UK goods and its pounds would decrease and thus weaken the UK currency.

iii)

No. The pound sterling would depreciate over time. Spot RM5.6625/£; UK (FC) inflation = 4%; M’sia (HC) inflation = 3% PPP:

c)

=

et

(1 + ihc) (1 + ifc)

=

et e0

(1 + 0.03) x 5.6625 (1 + 0.04)

=

RM5.6081

et

=

Spot  US1.6340/£ 180 days fwd  US1.6165/£ Spot

= = =

Bid FC / Ask HC 1.6340 / 0.6283 €2.6007 /£

Annualized premium / disct

= = =

et

Spot  US0.6283/€ 180 days fwd  US0.6245/€ 180 days fwd = Bid FC / Ask HC = 1.6165 / 0.6245 = €2.5885 /£ Forward – Spot x 360___ x 100 Spot Fwd days 2.5885 – 2.6007 x 360 x 100 2.6007 180 - 0.94% (discount)

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 2 a) A balance of payments deficit indicates that there is more money flowing out of the economy. That is, the supply of money to the foreign exchange market is high, while the demand is low. This will result in depreciation of currency. The depreciation of currency means that imports will be more expensive. This will also increases the demand for exports which will automatically increases the price of exports. The increase in price of these classes of goods will push up the prices of other classes of goods, as long as they are considered as substitutes. So, inflation occurs. Another reason is that by requiring a balance of payments in trade, the supply of items imported into the home country would have to be decreased dramatically as there is no way for other countries to increase their purchases of our products at the same rate we purchase theirs. Therefore, the only option is for imports from other countries to be statutorily reduced. Once the supply of imports is reduced, the problem simply devolves to one of supply and demand economics. If supply decrease, price will increase and will result to inflationary pressure. b) i)

Amount of interest = 500,000 x 0.06 = 30,000 Compensating Balance (CB) = 500,000 x 0.15 = 75,000 Effective Cost = Annual interest paid / Usable funds = 30,000 / (500,000 – 0) = 0.06 (6%) **No deduction on CB since current balance (RM150,000) is more than the CB requirement. ii) Compensating Balance (CB) = Effective Cost = = = iii) Total Loan Usable Loan 500,000 500,000 + 25,000 525,000 / 0.84 RM625,000

= = = = = =

500,000 x 0.10 = 50,000 Annual interest paid / Usable funds 30,000 / (500,000 – 30,000) 0.0638 (6.38%)

L L – 0.06L – 0.1L – 25,000 0.84L – 25,000 0.84L L L

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 3 a) i)

USD0.90/CAD FC (strong) USD0.30/NZD HC (weak) Do cross rate in order to get NZD/CAD, common currency on many unit side Bid FC / Ask HC

= =

Compare with

0.90 / 0.30 NZD3.0000/CAD NZD3.0200/CAD 3.02 ≠ 3.00 , Therefore opportunity arbitrage exist.

ii) Triangular arbitrage USD0.90/CAD compare convert

NZD3.02/CAD

convert

US0.30/NZD

Strategy is to convert US to CAD, then to NZD and convert back to USD to compare how much profit has been made. 1) Convert USD1million to CAD

= =

USD1,000,000 / 0.90 CAD1,111,111.11

2) From CAD, convert to NZD

= =

CAD1,111,111.11 x 3.02 NZD3,355,555.56

3) From NZD, convert to USD

= =

NZD3,355,555.56 x 0.30 USD1,006,666.67

Therefore, USD1,006,666.67 – USD1,000,000 = USD6,666.67 (profit) iii) As more USD seek to be switched to CAD, the CAD exchange rate will rise. In addition, as more CAD is sold to exchange for NZD, the rate will fall and as more NZD is sold for USD, the rate will also decrease, eventually eliminating the arbitrage profit. b)

Higher inflation in Eastern European countries will cause a balance of trade adjustment whereby the US will reduce its purchases of goods from these countries (when the countries’ goods become more expensive due to higher price increase) while the demand for US goods by these countries should increase (when the rate of price increase is lower in the US) according to PPP. Consequently, there will be downward pressure on the value of these Eastern European currencies relative to the US dollar.

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 4 a)

When the goods are shipped by exporter to the importer by ship, at the same time exporter will send shipping documents to his bank, which after that will send the shipping documents to importer’s bank. Upon receiving the documents and taking the title of goods via bill of lading, the importer’s bank will accept the time draft. At this point, it is called banker’s acceptance (B/A).

b)

Two ways for the exporter to receive payment in banker’s acceptance 1) hold the B/A until maturity and importer’s bank will pay at face value minus acceptance fee. Alternatively 2) sell the B/A at once or discount where importer’s bank will pay at face value minus acceptance fee, discount fee and commission fee (sells at money market) prior to maturity.

c) i)

C

= = =

e1 – e0 / e0 (3.4780 - 3.5010) / 3.5010 - 0.66%

After tax ringgit cost of borrowing ringgit (HC) Chc

= = =

rhc (1 – t) + c 0.10 (1 – 0.32) + (- 0.0066 x 0.32) 0.0659 (6.59%)

After tax ringgit cost of borrowing dollar (FC) Chfc

= = =

rfc (1 + c)(1 – t) + c 0.08 (1 + (-0.0066))(1 – 0.32) + (-0.0066) 0.0474 (4.74%)

Cost of borrowing dollar is better option because the cost is lower compared to ringgit loan. ii) Indifference / Breakeven (1 + rhc) (1 + rfc)

=

e1 e0

3.5010 x (1 + 0.1) (1 + 0.08)

=

e1

RM3.5658/USD

=

e1

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 5 a) i)

Spot USD0.54/NZD ; US  HC; NZ  FC Money Market Hedge: Acct Receivables; Borrow FC ; Invest HC Borrow FC

PV

= = =

FV / (1 + r) 4,000,000 (1 + 0.08) NZD3,703,703.704

Convert NZD to USD: NZD3,703,703.704 x 0.54 = USD 2,000,000 T=0

NZD

USD

Borrow @ 8% Convert to USD @ USD0.54 Invest @ 9%

3,703,703.704 (3,703,703.704)

2,000,000 (2,000,000)

0 0 T=1 Return from investment @ 9% (2,000,000 x 1.09) Receive payment from buyer Pay borrowings @ 8% Total amount received

2,180,000 4,000,000 (4,000,000) 0

________ 2,180,000

ii) Option: Since it is a receivable, the corporation needs to sell NZD in the future, they should enter into PUT Option on NZD now. Exercise price : 0.52 x 4,000,000 = USD2,080,000 Less Premium : 0.03 x 4,000,000 = USD 120,000 Net receipt : USD1,960,000 iii) Select money market hedge because it would provide higher receivables in terms of US dollar. b)

Options hedge are useful for hedging contingent exposure, in which an MNC’s exposure is contingent on a specific event happening. It does not want to be obligated to obtain or dispose of foreign currency unless the event is certain to occur. The options hedge does not have to be exercised if the MNC would be better off un-hedged. Currency options hedge is generally more costly than forward hedge. A premium has to be paid to purchase the currency options and so there is a cost for the flexibility they provide compared to forward hedge. Moreover, the size of options contract is standardized and one may be over or under-hedged with fixed date of expiry which might not exactly coincide with the delivery dates.

ANSWER SCHEME / FIN 542 /APRIL

2010

*** Please refer to Shapiro textbook on Options Question 6 a) i)

Customer needs RM, have SGD, so sell SGD to get RM, Bank buy SGD @ 2.5682 RM3,000 ÷ 2.5682 = SGD1,168.13

ii) Customer receives SGD, wants RM. So sell SGD to get RM, Bank buy SGD @ 2.5717 (2.5682 + 0.0035) 3months fwd SGD5,000 x 2.5717 = RM12,858.50 iii) Customer wants to buy YEN, Bank will sell Yen @ 3.6202 (3.6132 + 0.0070) 2 mths fwd ¥200,000 / 100 x 3.6202 = RM7,240.40 iv) Bank pays RM to get AUD, so Bank wants to buy AUD @ 3.1350 (3.1426 – 0.0064) 2 mths fwd RM60,000 ÷ 3.1350 = AUD19,138.76 v)

Percentage spread on spot RM/AUD = =

Ask – Bid / Ask x 100 (3.1442 – 3.1426) x 100 3.1442 0.05%

vi) Annualized premium on 2 mths offer fwd RM/Yen =

Fwd – Spot x 360 ____ Spot no. of days contract

=

3.6202 – 3.6132 3.6132

= b)

x

360 60

x 100

x 100

1.16%

Fixed exchange rate is a system that is set by the government, while floating exchange rate is a system that the rate being set by the interactions between the demand and supply of the currencies against each other. In the fixed exchange rate system, the rates are less volatile and therefore less risky, unlike in the floating exchange rate system whereby the rates are very volatile and very risky. However, the rates in the fixed system sometimes do not reflect the true value of the currencies.

ANSWER SCHEME / FIN 542 /APRIL

2010

Question 7 a)

Interest rates differential and the availability of the forward market  IRP Step 1: Determine the existence of arbitrage IRP: f1 – e0 x 360 x 100 = .e0 n

rhc – rfc

3.6399 – 3.6338 x 360 x 100 = 9%/4 – 8%/4 3.6338 90 0.67% ≠ 0.25% Therefore, opportunity arbitrage exist Step 2: Determine where to invest and borrow (1 + rhc)

=

(1 + 0.09/4) = 1.0225

>

(1 + rfc) x f1 .e0 (1 + 0.08/4) x 3.6399 3.6338 1.0217

Therefore, Borrow FC, Invest HC T=0

USD

Borrow USD250,000 @ 2%(8%/4) Convert to RM @ 3.6338 Invest in RM @ 2.25% (9%/4)

250,000 (250,000) 0

RM 908,450 (908,450) 0

T = 3 months Receive from investments (RM908,450 x 1.0225) Convert to USD @ 3.6399 (928,890.13 ÷ 3.6399) Pay borrowings (250,000 x 1.02) Profit

928,890.13 255,196.61

(928,890.13)

255,000.00 196.61

Convert USD to RM USD196.61 x 3.6399 = RM715.64 b)

The likely reason for a rise in real interest rates is pickup in economic activity. Historically, an increase in real interest rates has usually signaled good economic times, while a real interest rate decrease has typically signaled economic decline. Specifically, real interest rates tend to be at their low point during a recession because of the low demand for capital. As the world economy comes out of recession, real rates typically rise. Hence, a high interest rate likely signifies that economic growth is picking

ANSWER SCHEME / FIN 542 /APRIL

2010

up. Demand for capital is the one that determines the factor for real interest rates not the supply.