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Madura IFM10e IM Ch03 - Solution manual International
Financial Management
International Financial Management (COMSATS University Islamabad)
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Answers to End of Chapter 3 Questions
1. Motives for Investing in Foreign Money Markets. Explain why an MNC may invest funds in a
financial market outside its own country.
ANSWER: The MNC may be able to earn a higher interest rate on funds invested in a financial
market outside of its own country. In addition, the exchange rate of the currency involved may be
expected to appreciate.
2. Motives for Providing Credit in Foreign Markets. Explain why some financial institutions prefer
to provide credit in financial markets outside their own country.
ANSWER: Financial institutions may believe that they can earn a higher return by providing credit in
foreign financial markets if interest rate levels are higher and if the economic conditions are strong so
that the risk of default on credit provided is low. The institutions may also want to diversity their
credit so that they are not too exposed to the economic conditions in any single country.
3. Exchange Rate Effects on Investing. Explain how the appreciation of the Australian dollar against
the U.S. dollar would affect the return to a U.S. firm that invested in an Australian money market
security.
ANSWER: If the Australian dollar appreciates over the investment period, this implies that the U.S.
firm purchased the Australian dollars to make its investment at a lower exchange rate than the rate at
which it will convert A$ to U.S. dollars when the investment period is over. Thus, it benefits from the
appreciation. Its return will be higher as a result of this appreciation.
4. Exchange Rate Effects on Borrowing. Explain how the appreciation of the Japanese yen against
the U.S. dollar would affect the return to a U.S. firm that borrowed Japanese yen and used the
proceeds for a U.S. project.
ANSWER: If the Japanese yen appreciates over the borrowing period, this implies that the U.S. firm
converted yen to U.S. dollars at a lower exchange rate than the rate at which it paid for yen at the
time it would repay the loan. Thus, it is adversely affected by the appreciation. Its cost of borrowing
will be higher as a result of this appreciation.
5. Bank Services. List some of the important characteristics of bank foreign exchange services that
MNCs should consider.
ANSWER: The important characteristics are (1) competitiveness of the quote, (2) the firm’s
relationship with the bank, (3) speed of execution, (4) advice about current market conditions, and (5)
forecasting advice.
6. Bid/ask Spread. Utah Bank’s bid price for Canadian dollars is $.7938 and its ask price is $.81.
What is the bid/ask percentage spread?
ANSWER: ($.81 – $.7938)/$.81 = .02 or 2%
7. Bid/ask Spread. Compute the bid/ask percentage spread for Mexican peso retail transactions in
which the ask rate is $.11 and the bid rate is $.10.
ANSWER: [($.11 – $.10)/$.11] = .091, or 9.1%.
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2International Financial Markets
8. Forward Contract. The Wolfpack Corporation is a U.S. exporter that invoices its exports to the
United Kingdom in British pounds. If it expects that the pound will appreciate against the dollar in
the future, should it hedge its exports with a forward contract? Explain.
ANSWER: The forward contract can hedge future receivables or payables in foreign currencies to
insulate the firm against exchange rate risk. Yet, in this case, the Wolfpack Corporation should not
hedge because it would benefit from appreciation of the pound when it converts the pounds to
dollars.
9. Euro. Explain the foreign exchange situation for countries that use the euro when they engage in
international trade among themselves.
ANSWER: There is no foreign exchange. Euros are used as the medium of exchange.
10. Indirect Exchange Rate. If the direct exchange rate of the euro is worth $1.25, what is the indirect
rate of the euro? That is, what is the value of a dollar in euros?
ANSWER: 1/1.25 = .8 euros.
11. Cross Exchange Rate. Assume Poland’s currency (the zloty) is worth $.17 and the Japanese yen is
worth $.008. What is the cross rate of the zloty with respect to yen? That is, how many yen equal a
zloty?
ANSWER: $.17/$.008 = 21.25
1 zloty = 21.25 yen
12. Syndicated Loans. Explain how syndicated loans are used in international markets.
ANSWER: A large MNC may want to obtain a large loan that no single bank wants to accommodate
by itself. Thus, a bank may create a syndicate whereby several other banks also participate in the
loan.
13. Loan Rates. Explain the process used by banks in the Eurocredit market to determine the rate to
charge on loans.
ANSWER: Banks set the loan rate based on the prevailing LIBOR, and allow the loan rate to float
(change every 6 months) in accordance with changes in LIBOR.
14. International Markets. What is the function of the international money market? Briefly describe the
reasons for the development and growth of the European money market. Explain how the
international money, credit, and bond markets differ from one another.
ANSWER: The function of the international money market is to efficiently facilitate the flow of
international funds from firms or governments with excess funds to those in need of funds.
Growth of the European money market was largely due to (1) regulations in the U.S. that limited
foreign lending by U.S. banks; and (2) regulated ceilings placed on interest rates of dollar deposits in
the U.S. that encouraged deposits to be placed in the Eurocurrency market where ceilings were
nonexistent.
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International Financial Markets 3
The international money market focuses on short-term deposits and loans, while the international
credit market is used to tap medium-term loans, and the international bond market is used to obtain
long-term funds (by issuing long-term bonds).
15. Evolution of Floating Rates. Briefly describe the historical developments that led to floating
exchange rates as of 1973.
ANSWER: Country governments had difficulty in maintaining fixed exchange rates. In 1971, the
bands were widened. Yet, the difficulty of controlling exchange rates even within these wider bands
continued. As of 1973, the bands were eliminated so that rates could respond to market forces
without limits (although governments still did intervene periodically).
16. International Diversification. Explain how the Asian crisis would have affected the returns to a U.S.
firm investing in the Asian stock markets as a means of international diversification. [See the chapter
appendix.]
ANSWER: The returns to the U.S. firm would have been reduced substantially as a result of the
Asian crisis because of both declines in the Asian stock markets and because of currency
depreciation. For example, the Indonesian stock market declined by about 27% from June 1997 to
June 1998. Furthermore, the Indonesian rupiah declined again the U.S. dollar by 84%.
17. Eurocredit Loans.
a. With regard to Eurocredit loans, who are the borrowers?
b. Why would a bank desire to participate in syndicated Eurocredit loans?
c. What is LIBOR and how is it used in the Eurocredit market?
ANSWER:
a. Large corporations and some government agencies commonly request Eurocredit loans.
b. With a Eurocredit loan, no single bank would be totally exposed to the risk that the borrower may
fail to repay the loan. The risk is spread among all lending banks within the syndicate.
c. LIBOR (London interbank offer rate) is the rate of interest at which banks in Europe lend to each
other. It is used as a base from which loan rates on other loans are determined in the Eurocredit
market.
18. Foreign Exchange. You just came back from Canada, where the Canadian dollar was worth $.70.
You still have C$200 from your trip and could exchange them for dollars at the airport, but the
airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico
and will need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met
a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your
C$200 for 1,300 pesos. Should you accept the offer or cash the Canadian dollars in at the airport?
Explain.
ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange desk,
the cross-rate is $.60/$10 = 6. Thus, the C$200 would be exchanged for 1,200 pesos (computed as
200 × 6). If you exchange Canadian dollars for pesos with the tourist, you will receive 1,300 pesos.
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4International Financial Markets
19. Foreign Stock Markets. Explain why firms may issue stock in foreign markets. Why might U.S.
firms issue more stock in Europe since the conversion to the euro in 1999?
ANSWER: Firms may issue stock in foreign markets when they are concerned that their home
market may be unable to absorb the entire issue. In addition, these firms may have foreign currency
inflows in the foreign country that can be used to pay dividends on foreign-issued stock. They may
also desire to enhance their global image. Since the euro can be used in several countries, firms may
need a large amount of euros if they are expanding across Europe.
20. Financing With Stock. Chapman Co. is a privately owned MNC in the U.S. that plans to engage
in an initial public offering (IPO) of stock, so that it can finance its international expansion. At the
present time, world stock market conditions are very weak but are expected to improve. The U.S.
market tends to be weak in periods when the other stock markets around the world are weak. A
financial manager of Chapman Co. recommends that it wait until the world stock markets recover
before it issues stock. Another manager believes that Chapman Co. could issue its stock now even if
the price would be low, since its stock price should rise later once world stock markets recover. Who
is correct? Explain.
ANSWER: Chapman Co. should wait until the world stock markets recover, and the U.S. stock
market conditions have improved. If it issues stock now when the price is low, it would receive a
lower dollar amount of proceeds to use for its expansion. If its stock price rises later, it would not
benefit because it already sold the shares (only its shareholders who originally purchased the
shares would benefit if the stock price increased).
Advanced Questions
21. Effects of September 11. Why do you think the terrorist attack on the U.S. was expected to cause a
decline in U.S. interest rates? Given the expectations for a potential decline in U.S. interest rates and
stock prices, how were capital flows between the U.S. and other countries likely affected?
ANSWER: The attack was expected to cause a weaker economy, which would result in lower U.S.
interest rates. Given the lower interest rates, and the weak stock prices, the amount of funds invested
by foreign investors in U.S. securities would be reduced.
22. International Financial Markets. Recently, Wal-Mart established two retail outlets in the city of
Shanzen, China, which has a population of 3.7 million. These outlets are massive and contain
products purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs
in Shanzen, it may remit those earnings back to the United States. Wal-Mart is likely to build
additional outlets in Shanzen or in other Chinese cities in the future.
a. Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange.
ANSWER: The Wal-Mart stores in China need other currencies to buy products from other
countries, and must convert the Chinese currency (yuan) into the other currencies in the spot market
to purchase these products. They also could use the spot market to convert excess earnings
denominated in yuan into dollars, which would be remitted to the U.S. parent.
b. Explain how Wal-Mart might utilize the international money market when it is establishing other
Wal-Mart stores in Asia.
ANSWER: Wal-Mart may need to maintain some deposits in the Eurocurrency market that can be
used (when needed) to support the growth of Wal-Mart stores in various foreign markets. When
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International Financial Markets 5
some Wal-Mart stores in foreign markets need funds, they borrow from banks in the Eurocurrency
market. Thus, the Eurocurrency market serves as a deposit or lending source for Wal-Mart and other
MNCs on a short-term basis.
c. Explain how Wal-Mart could use the international bond market to finance the establishment of
new outlets in foreign markets.
ANSWER: Wal-Mart could issue bonds in the Eurobond market to generate funds needed to
establish new outlets. The bonds may be denominated in the currency that is needed; then, once the
stores are established, some of the cash flows generated by those stores could be used to pay interest
on the bonds.
23. Interest Rates. Why do interest rates vary among countries? Why are interest rates normally similar
for those European countries that use the euro as their currency? Offer a reason why the government
interest rate of one country could be slightly higher than the government interest rate of another
country, even though the euro is the currency used in both countries.
ANSWER: Interest rates in each country are based on the supply of funds and demand for funds for
a given currency. However, the supply and demand conditions for the euro are dictated by all
participating countries in aggregate, and do not vary among participating countries. Yet, the
government interest rate in one country that uses the euro could be slightly higher than others that use
the euro if it is subject to default risk. The higher interest rate would reflect a risk premium.
24. Interpreting Exchange Rate Quotations. Today you notice the following exchange rate
quotations:
*$1 is equal to 3.00 Argentine pesos
*1 Argentine peso = 0.50 Canadian dollars
* You need to purchase 100,000 Canadian dollars with U.S. dollars. How many U.S. dollars will you
need for your purchase?
ANSWER: Value of AP = $.333
Value of C$ in AP = 2
Value of C$ in $ = $.666
So you need $66,666 to purchase C$100,000.
25. Pricing ADRs. Today, the stock price of Genevo Company (based in Switzerland) is priced at
SF80 per share. The spot rate of the Swiss franc (SF) is $.70. During the next year, you expect that
the stock price of Genevo Company will decline by 3%. You also expect that the Swiss franc will
depreciate against the U.S. dollar by 8% during the next year. You own American depository receipts
(ADRs) that represent Genevo stock. Each share that you own represents one share of the stock
traded on the Swiss stock exchange. What is the estimated value of the ADR per share in one year?
ANSWER: Expected value of Swiss stock in 1 year = SF80 x (1 - .03) = SF77.6.
Expected value of Swiss franc in 1 year = $.70 (1 - .08) = $.644
Expected value of ADR in 1 year = SF77.6 x ($.644 per franc) = $49.97.
26. Explaining Variation in Bid-Ask Spreads. Go to the currency converter at
http://finance.yahoo.com/currency and determine the bid-ask spread for the euro. Then determine the
bid-ask spread for a currency in a less developed country. Why do you think is the main reason for
the difference in the bid-ask spreads between these two currencies?
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6International Financial Markets
ANSWER: The percentage spread is estimated as:
(Ask quote – Bid quote)/Ask quote.
A key part of this question is to ensure that students can obtain bid and ask quotations.
Thus, foreign exchange dealers are more willing to hold an inventory in the euro, because they do
more business in euros. Also, there is less chance for a major loss from holding an inventory of euros
versus currencies of less developed countries because there the euro is less likely to experience an
abrupt decline in the value of the euro than to a decline in the value of a currency in a less developed
country.
27. Direct Versus Indirect Exchange Rates. Assume that during this semester, the euro appreciated
against the dollar. Did the direct exchange rate of the euro increase or decrease? Did the indirect
exchange rate of the euro increase or decrease?
ANSWER: The indirect exchange rate is the reciprocal of the direct exchange rate. Thus, as the euro
appreciates against the U.S. dollar over time, this means that the direct rate of the euro increases
while the indirect rate of the euro decreases.
28. Transparency and Stock Trading Activity. Explain the relationship between transparency of
firms and investor participation (or trading activity) among stock markets. Based on this relationship,
how can governments of countries increase the amount of trading activity (and therefore liquidity) of
their stock markets?
ANSWER: In general, stock market participation and trading activity is higher in countries where
managers of firms are encouraged to make decisions that serve shareholder interests, and where there
is greater transparency so that investors can more easily monitor firms. An active stock market
requires the trust of the local investors.
29. How Governance Affects Stock Market Liquidity. Identify some of the key factors that can
allow for stronger governance and therefore increase participation and trading activity in a stock
market.
ANSWER: Governance is stronger when:
*shareholders have voting power,
*shareholders are allowed to sue companies that do not serve their interests,
*security laws are strong,
*corruption is low, and
*financial disclosure requirements for companies are high.
30. International Impact of the Credit Crisis. Explain how the international integration of financial
markets caused the credit crisis to spread across many countries.
ANSWER: Since financial markets are integrated, they allow institutional investors in one country to
invest in securities in other countries. Thus, the problems in the U.S. and U.K. financial markets
spread to other markets. Some financial institutions based in Asia and Europe countries were
common purchasers of subprime mortgages that were originated in the U.S. and U.K. Furthermore,
the weakness of the U.S. and other European economies caused a reduction in their demand for
imports in other countries.
31. Issuing Stock in Foreign Markets. Bloomington Co. is a large U.S.-based MNC with large
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International Financial Markets 7
subsidiaries in Germany. It has issued stock in Germany in order to establish its business. It could
have issued stock in the U.S. and then used the proceeds in order to support the growth in Europe.
What is a possible advantage of issuing the stock in Germany to finance German operations? Also,
why might the German investors prefer to purchase the stock that was issued in Germany rather than
purchase the stock of Bloomington on a U.S. stock exchange?
ANSWER: By issuing stock in Germany, Bloomington can use the euro proceeds to support its
growth in Germany. It can establish a secondary market in Germany by listing the stock on an
exchange there, and this will make it easier for it to engage in a secondary stock offering there in the
future. If German investors can purchase the stock and sell the stock on a German stock exchange,
they will not have to worry about exchange rate risk.
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