Chapter 6 Hull Importing Company
Effects of Intervention on Import expense
a) Hull expects the at Mexico’s central bank will increase interest rates and that
Mexico’s inflation will not be affected. Offer any interest on how the peso’s value
may change and how Hull’s profits would be affected as a result.
Higher interest rates without an increase in inflation would adversely affect Hull,
because its expenses would increase, but it would not be able to pass on the higher
cost to its customers.
When Mexico’s central bank will increase the interest rates, the investors of neighbor
country want to invest in Mexico. The value of Peso’s will increase due to increase
demand of investors. This higher value also increases the expense of Hull Company,
and Hull profits would be affected due to its higher cost of importing. As a result
consumers would then switch to different gift Item Company.
b) Hull used to closely monitor government intervention by the Bank of England
(the British central bank) on the value of the pound. Assume that the bank of
England intervenes to strengthen the pound’s value with respect to the dollar by
5 percent. Would this have a favorable or unfavorable effect on Hull’s business?
If the British pound’s value is increased, Hull’s expenses are increased, causing an
adverse effect.
This intervention create both positive and negative situation, 5% are not small
amount. If the value of pound will increase 5%, expense will also increase which
would be unfavorable effect for Hull business. Because of importing company, Hull
has been unable to pass on higher cost to its customer. But it would be favorable for
Hull business, if expense is decrease due to decrease the value of pound by the
Brithish Central bank.
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Chapter 7 Zuber, Inc.
(Using covered interest Arbitrage)
A) Would you be willing to invest the funds in Poland without covering your
position? Explain.
The expected value of the yield on investing funds in this country would be 14
percent, versus only 9 percent in the U.S. However, there is much uncertainty about
the foreign yield. If the currency depreciates by a large amount, it will wipe out some
of the principal invested. Given that Zuber did not want to target these funds for a
speculative purpose, it would not be wise to invest these funds in the country without
covering.
B) Suggest how you could attempt covered interest arbitrage. What is the expected
return from using covered interest arbitrage?
Covered interest arbitrage would involve exchanging dollars for the currency today,
investing the currency in the country’s Treasury securities, and negotiating a forward
contract to sell the currency in one year in exchange for dollars. Given that $10
million is available, this amount would be converted into 25 million units of the
foreign currency, which would accumulate to 28.5 million units (at 14 percent) by the
end of the year, and be converted into $11,115,000 at the time (based on a forward
rate of $.39). This reflects a return of 11.15 percent.
C) What risks are involved in using covered interest arbitrage here?
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The risks of covered interest arbitrage are as follows:
•
The Treasury of the country could default on its securities issued.
•
The bank may not fulfill its obligation on the forward contract (the bank was just
recently privatized and does not have a track record as a privatized institution).
•
The government could restrict funds from being converted into dollars. (Since the
country has only allowed foreign investments recently, it does not have a track record.
There is some uncertainty about its future laws on international finance.)
D) If you had to choose between investing your funds in U.S. Treasury bills at 9
percent or using covered interest arbitrage, what would be your choice? Defend
your answer.
While covered interest arbitrage would be expected to achieve a yield of 11.15
percent (versus only 9 percent in the U.S.), the risks are significant, and especially
considering that the country is still experimenting with cross-border transactions.
Since some students will probably suggest going for the higher returns, this question
may allow for an interesting class discussion
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Chapter 8 Flame Fixtures, Inc.
(Business application of purchasing power parity)
a) Describe a scenario that could cause flame to save even more than 20 percent on
production costs.
If the peso depreciates by more than the inflation differential, then the dollar cost to
Flame will be even lower than expected.
b) Describe a scenario that could cause flame to actually incur higher production
costs than if it simply had the parts produced in the United States.
If the peso depreciates by less than the inflation differential, then the dollar cost to Flame
will be even higher than expected. Consider a scenario in which the Mexican inflation
rate is 80 percent or so, causing the bill in pesos to be 80 percent higher. Yet, if the peso
depreciated by a relatively small amount over this period (say 20 percent or so), the
dollar cost to Flame will increase substantially. Since there are other factors in addition
to inflation that also affect the peso’s exchange rate, the peso will not necessarily
depreciate by an amount that fully offsets the high inflation.
c) Do you think that Flame will experience stable dollar outflow payments to Coron
over time? Explain,(Assume that the number of parts ordered is constant over time)
Stable dollar payments would only occur if the peso depreciated by an amount that offset its
high inflation rate. It is unlikely that there will be a perfect offset in any given period.
Therefore, Flame’s dollar payments would be unstable, and so would its profits.
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d) Do you think that Flame’s risk changes at all as a result of its new relationship with
Coron Company? Explain.
The risk would increase, because its payments for parts would now be more volatile, and so
would its profits. Given that it does not have much liquidity, it will suffer a cash squeeze if
the peso does not depreciate much while Mexican inflation is high. Over the long run, there
may be periods in which this happens. Flame would be locked into this arrangement with
Coron for ten years, and therefore cannot back out, even if the peso’s depreciation does not
offset the inflation differential.
Chapter 19 Ryco Chemical Company
(Using countertrade )
a) Describe a counter trade strategy that could reduce Ryco’s exposure to Brazilian
inflation.
Ryco could attempt to work out a countertrade agreement. Ryco could provide chemicals
that Concellos needs in exchange for the chemicals that Ryco normally purchases from
Concellos. Ryco could benefit because its cost of importing some chemicals would no longer
be tied to Brazilian inflation. Instead its cost would be tied to its own cost of producing the
chemicals it must exchange for the imports. If Concellos would agree to the countertrade
agreement, Ryco may be able to stabilize its cost of imports, which could reduce the
uncertainty surrounding cash flows and profitability.
b) Would Concellos be willing to consider this strategy? Is there any favorable effect on
Concellos that may motivate it to accept the strategy?
Concellos is exposed to the weak currency (called the real). If it purchases the chemicals used
in production from Ryco, its cost will not be affected by the real’s exchange rate (as it could
purchase the U.S. goods through a countertrade agreement). Thus, it may be able to stabilize
its cost of imports in this matter.
c) Assume that both parties agree on counter trade. Why would the cost of obtaining
imports still rise over time for concellos? Would concellos earn lower profits as a result?
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Concellos’ cost of obtaining imports is the cost of producing the chemicals it uses for
exchange (based on the countertrade agreement). Given high inflation in Brazil, these
production costs will rise. However, it may be able to raise its prices on its final products by
the inflation rate to cover its higher costs of production. Overall, it will be able to offset these
higher costs easier than offsetting the higher costs that would result from exchange rate
effects. Since its competitors base their prices on local cost of production (as they are not
exposed to a weak exchange rate risk), Concellos would now incur costs that are more similar
to those of its competitors.
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