INTERNATIONAL FINANCIAL MANAGEMENT
CHEOL S. EUN. BRUCE G. RESNICK
SUGGESTED ANSWERS AND SOLUTIONS TO
END-OF-CHAPTER QUESTIONS AND PROBLEMS
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TABLE OF CONTENTS
Chapter
1. Globalization and the Multinational Firm Suggested Answers to End-of-Chapter Questions 3
2. International Monetary System Suggested Answers and Solutions to End-of-Chapter Questions
and Problems 12
3. Balance of Payments Suggested Answers and Solutions to End-of-Chapter Questions and
Problems 17
4. The Market for Foreign Exchange Suggested Answers and Solutions to End-of-Chapter Questions
and Problems 23
5. International Parity Relationships Suggested Answers and Solutions to End-of-Chapter Questions
and Problems 33
6. International Banking Suggested Answers and Solutions to End-of-Chapter Questions and
Problems 40
7. International Bond Markets Suggested Answers and Solutions to End-of-Chapter Questions and
Problems 50
8. International Equity Markets Suggested Answers and Solutions to End-of-Chapter Questions and
Problems 56
9. Futures and Options on Foreign Exchange Suggested Answers and Solutions to End-of-Chapter
Questions and Problems 62
10. Currency and Interest Rate Swaps Suggested Answers and Solutions to End-of-Chapter Questions
and Problems 70
11. International Portfolio Investments Suggested Answers and Solutions to End-of-Chapter
Questions and Problems 78
12. Management of Economic Exposure Suggested Answers and Solutions to End-of-Chapter
Questions and Problems 87
13. Management of Transaction Exposure Suggested Answers and Solutions to End-of-Chapter
Questions and Problems 94
14. Management of Translation Exposure Suggested Answers and Solutions to End-of-Chapter
Questions and Problems 111
15. Foreign Direct Investment Suggested Answers and Solutions to End-of-Chapter Questions and
Problems 125
16. International Capital Structure and the Cost of Capital Suggested Answers and Solutions to Endof-Chapter Questions and Problems 131
17. International Capital Budgeting Suggested Answers and Solutions to End-of-Chapter Questions
and Problems 135
18. Multinational Cash Management Suggested Answers and Solutions to End-of-Chapter Questions
and Problems 150
19. Trade Financing Suggested Answers and Solutions to End-of-Chapter Questions and Problems
161
20. International Tax Environment Suggested Answers and Solutions to End-of-Chapter Questions
and Problems 166
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CHAPTER 1 GLOBALIZATION AND THE MULTINATIONAL FIRM
SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS
QUESTIONS
1. Why is it important to study international financial management?
Answer: We are now living in a world where all the major economic functions, i.e., consumption,
production, and investment, are highly globalized. It is thus essential for financial managers to fully
understand vital international dimensions of financial management. This global shift is in marked
contrast to a situation that existed when the authors of this book were learning finance some twenty
years ago. At that time, most professors customarily (and safely, to some extent) ignored international
aspects of finance. This mode of operation has become untenable since then.
2. How is international financial management different from domestic financial management?
Answer: There are three major dimensions that set apart international finance from domestic finance.
They are:
1. Foreign exchange and political risks,
2. Market imperfections, and
3. Expanded opportunity set.
3. Discuss the three major trends that have prevailed in international business during the last two
decades.
Answer: The 1980s brought a rapid integration of international capital and financial markets. Impetus
for globalized financial markets initially came from the governments of major countries that had
begun to deregulate their foreign exchange and capital markets.
The economic integration and
globalization that began in the eighties is picking up speed in the 1990s via privatization. Privatization
is the process by which a country divests itself of the ownership and operation of a business venture by
turning it over to the free market system. Lastly, trade liberalization and economic integration
continued to proceed at both the regional and global levels.
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4. How is a country’s economic well-being enhanced through free international trade in goods and
services?
Answer: According to David Ricardo, with free international trade, it is mutually beneficial for two
countries to each specialize in the production of the goods that it can produce relatively most
efficiently and then trade those goods. By doing so, the two countries can increase their combined
production, which allows both countries to consume more of both goods. This argument remains valid
even if a country can produce both goods more efficiently than the other country. International trade
is not a ‘zero-sum’ game in which one country benefits at the expense of another country. Rather,
international trade could be an ‘increasing-sum’ game at which all players become winners.
5. What considerations might limit the extent to which the theory of comparative advantage is
realistic?
Answer: The theory of comparative advantage was originally advanced by the nineteenth century
economist David Ricardo as an explanation for why nations trade with one another. The theory claims
that economic well-being is enhanced if each country’s citizens produce what they have a comparative
advantage in producing relative to the citizens of other countries, and then trade products. Underlying
the theory are the assumptions of free trade between nations and that the factors of production (land,
buildings, labor, technology, and capital) are relatively immobile.
To the extent that these
assumptions do not hold, the theory of comparative advantage will not realistically describe
international trade.
6. What are multinational corporations (MNCs) and what economic roles do they play?
Answer: A multinational corporation (MNC) can be defined as a business firm incorporated in one
country that has production and sales operations in several other countries. Indeed, some MNCs have
operations in dozens of different countries. MNCs obtain financing from major money centers around
the world in many different currencies to finance their operations. Global operations force the
treasurer’s office to establish international banking relationships, to place short-term funds in several
currency denominations, and to effectively manage foreign exchange risk.
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7. Mr. Ross Perot, a former Presidential candidate of the Reform Party, which is a third political party
in the United States, had strongly objected to the creation of the North American Trade Agreement
(NAFTA), which nonetheless was inaugurated in 1994, for the fear of losing American jobs to Mexico
where it is much cheaper to hire workers. What are the merits and demerits of Mr. Perot’s position on
NAFTA? Considering the recent economic developments in North America, how would you assess
Mr. Perot’s position on NAFTA?
Answer: Since the inception of NAFTA, many American companies indeed have invested heavily in
Mexico, sometimes relocating production from the United States to Mexico. Although this might have
temporarily caused unemployment of some American workers, they were eventually rehired by other
industries often for higher wages. Currently, the unemployment rate in the U.S. is quite low by
historical standard. At the same time, Mexico has been experiencing a major economic boom. It seems
clear that both Mexico and the U.S. have benefited from NAFTA. Mr. Perot’s concern appears to have
been ill founded.
8. In 1995, a working group of French chief executive officers was set up by the Confederation of
French Industry (CNPF) and the French Association of Private Companies (AFEP) to study the French
corporate governance structure. The group reported the following, among other things “The board of
directors should not simply aim at maximizing share values as in the U.K. and the U.S. Rather, its goal
should be to serve the company, whose interests should be clearly distinguished from those of its
shareholders, employees, creditors, suppliers and clients but still equated with their general common
interest, which is to safeguard the prosperity and continuity of the company”. Evaluate the above
recommendation of the working group.
Answer: The recommendations of the French working group clearly show that shareholder wealth
maximization is not a universally accepted goal of corporate management, especially outside the
United States and possibly a few other Anglo-Saxon countries including the United Kingdom and
Canada. To some extent, this may reflect the fact that share ownership is not wide spread in most other
countries. In France, about 15% of households own shares.
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9. Suppose you are interested in investing in shares of Nokia Corporation of Finland, which is a world
leader in wireless communication. But before you make investment decision, you would like to learn
about the company. Visit the website of CNN Financial network (www.cnnfn.com) and collect
information about Nokia, including the recent stock price history and analysts’ views of the company.
Discuss what you learn about the company. Also discuss how the instantaneous access to information
via internet would affect the nature and workings of financial markets.
Answer: As students might have learned from visiting the website, information is readily available
even for foreign companies like Nokia. Ready access to international information helps integrate
financial markets, dismantling barriers to international investment and financing. Integration, however,
may help a financial shock in one market to be transmitted to other markets.
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MINI CASE: NIKE’S DECISION
Nike, a U.S.-based company with a globally recognized brand name, manufactures athletic
shoes in such Asian developing countries as China, Indonesia, and Vietnam using subcontractors, and
sells the products in the U.S. and foreign markets. The company has no production facilities in the
United States. In each of those Asian countries where Nike has production facilities, the rates of
unemployment and underemployment are quite high. The wage rate is very low in those countries by
the U.S. standard; hourly wage rate in the manufacturing sector is less than one dollar in each of those
countries, which is compared with about $18 in the U.S. In addition, workers in those countries often
are operating in poor and unhealthy environments and their rights are not well protected.
Understandably, Asian host countries are eager to attract foreign investments like Nike’s to develop
their economies and raise the living standards of their citizens. Recently, however, Nike came under a
world-wide criticism for its practice of hiring workers for such a low pay, “next to nothing” in the
words of critics, and condoning poor working conditions in host countries.
Evaluate and discuss various ‘ethical’ as well as economic ramifications of Nike’s decision to
invest in those Asian countries.
Suggested Solution to Nike’s Decision
Obviously, Nike’s investments in such Asian countries as China, Indonesia, and Vietnam were
motivated to take advantage of low labor costs in those countries. While Nike was criticized for the
poor working conditions for its workers, the company has recognized the problem and has
substantially improved the working environments recently. Although Nike’s workers get paid very
low wages by the Western standard, they probably are making substantially more than their local
compatriots who are either under- or unemployed. While Nike’s detractors may have valid points, one
should not ignore the fact that the company is making contributions to the economic welfare of those
Asian countries by creating job opportunities.
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CHAPTER 1A THEORY OF COMPARATIVE ADVANTAGE
SUGGESTED SOLUTIONS TO APPENDIX PROBLEMS
PROBLEMS
1. Country C can produce seven pounds of food or four yards of textiles per unit of input. Compute
the opportunity cost of producing food instead of textiles. Similarly, compute the opportunity cost of
producing textiles instead of food.
Solution: The opportunity cost of producing food instead of textiles is one yard of textiles per 7/4 =
1.75 pounds of food. A pound of food has an opportunity cost of 4/7 = .57 yards of textiles.
2. Consider the no-trade input/output situation presented in the following table for Countries X and Y.
Assuming that free trade is allowed, develop a scenario that will benefit the citizens of both countries.
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INPUT/OUTPUT WITHOUT TRADE
_______________________________________________________________________
Country
X
Y
Total
________________________________________________________________________
I. Units of Input
(000,000)
_______________________
______________________________
Food
70
60
Textiles
40
30
________________________________________________________________________
II. Output per Unit of Input
(lbs or yards)
______________________
______________________________
Food
17
5
Textiles
5
2
________________________________________________________________________
III. Total Output
(lbs or yards)
(000,000)
______________________
______________________________
Food
1,190
300
1,490
Textiles
200
60
260
________________________________________________________________________
IV. Consumption
(lbs or yards)
(000,000)
_____________________
______________________________
Food
1,190
300
1,490
Textiles
200
60
260
________________________________________________________________________
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Solution:
Examination of the no-trade input/output table indicates that Country X has an absolute
advantage in the production of food and textiles. Country X can “trade off” one unit of production
needed to produce 17 pounds of food for five yards of textiles. Thus, a yard of textiles has an
opportunity cost of 17/5 = 3.40 pounds of food, or a pound of food has an opportunity cost of 5/17 =
.29 yards of textiles. Analogously, Country Y has an opportunity cost of 5/2 = 2.50 pounds of food
per yard of textiles, or 2/5 = .40 yards of textiles per pound of food. In terms of opportunity cost, it is
clear that Country X is relatively more efficient in producing food and Country Y is relatively more
efficient in producing textiles. Thus, Country X (Y) has a comparative advantage in producing food
(textile) is comparison to Country Y (X).
When there are no restrictions or impediments to free trade the economic-well being of the
citizens of both countries is enhanced through trade. Suppose that Country X shifts 20,000,000 units
from the production of textiles to the production of food where it has a comparative advantage and that
Country Y shifts 60,000,000 units from the production of food to the production of textiles where it
has a comparative advantage. Total output will now be (90,000,000 x 17 =) 1,530,000,000 pounds of
food and [(20,000,000 x 5 =100,000,000) + (90,000,000 x 2 =180,000,000) =] 280,000,000 yards of
textiles. Further suppose that Country X and Country Y agree on a price of 3.00 pounds of food for
one yard of textiles, and that Country X sells Country Y 330,000,000 pounds of food for 110,000,000
yards of textiles. Under free trade, the following table shows that the citizens of Country X (Y) have
increased their consumption of food by 10,000,000 (30,000,000) pounds and textiles by 10,000,000
(10,000,000) yards.
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INPUT/OUTPUT WITH FREE TRADE
__________________________________________________________________________
Country
X
Y
Total
__________________________________________________________________________
I. Units of Input
(000,000)
_______________________
________________________________
Food
90
0
Textiles
20
90
__________________________________________________________________________
II. Output per Unit of Input
(lbs or yards)
______________________
________________________________
Food
17
5
Textiles
5
2
__________________________________________________________________________
III. Total Output
(lbs or yards)
(000,000)
_____________________
________________________________
Food
1,530
0
1,530
Textiles
100
180
280
__________________________________________________________________________
IV. Consumption
(lbs or yards)
(000,000)
_____________________
________________________________
Food
1,200
330
1,530
Textiles
210
70
280
__________________________________________________________________________
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CHAPTER 2 INTERNATIONAL MONETARY SYSTEM
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Explain Gresham’s Law.
Answer: Gresham’s law refers to the phenomenon that bad (abundant) money drives good (scarce)
money out of circulation. This kind of phenomenon was often observed under the bimetallic standard
under which both gold and silver were used as means of payments, with the exchange rate between the
two metals fixed.
2. Explain the mechanism which restores the balance of payments equilibrium when it is disturbed
under the gold standard.
Answer: The adjustment mechanism under the gold standard is referred to as the price-specie-flow
mechanism expounded by David Hume. Under the gold standard, a balance of payment disequilibrium
will be corrected by a counter-flow of gold. Suppose that the U.S. imports more from the U.K. than it
exports to the latter. Under the classical gold standard, gold, which is the only means of international
payments, will flow from the U.S. to the U.K. As a result, the U.S. (U.K.) will experience a decrease
(increase) in money supply. This means that the price level will tend to fall in the U.S. and rise in the
U.K. Consequently, the U.S. products become more competitive in the export market, while U.K.
products become less competitive. This change will improve U.S. balance of payments and at the same
time hurt the U.K. balance of payments, eventually eliminating the initial BOP disequilibrium.
3. Suppose that the pound is pegged to gold at 6 pounds per ounce, whereas the franc is pegged to
gold at 12 francs per ounce. This, of course, implies that the equilibrium exchange rate should be two
francs per pound. If the current market exchange rate is 2.2 francs per pound, how would you take
advantage of this situation? What would be the effect of shipping costs?
Answer: Suppose that you need to buy 6 pounds using French francs. If you buy 6 pounds directly in
the foreign exchange market, it will cost you 13.2 francs. Alternatively, you can first buy an ounce of
gold for 12 francs in France and then ship it to England and sell it for 6 pounds. In this case, it only
costs you 12 francs to buy 6 pounds. It is thus beneficial to ship gold due to the overpricing of the
pound. Of course, you can make an arbitrage profit by selling 6 pounds for 13.2 francs in the foreign
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exchange market. The arbitrage profit will be 1.2 francs. So far, we assumed that shipping costs do not
exist. If it costs more than 1.2 francs to ship an ounce of gold, there will be no arbitrage profit.
4. Discuss the advantages and disadvantages of the gold standard.
Answer: The advantages of the gold standard include: (I) since the supply of gold is restricted,
countries cannot have high inflation; (2) any BOP disequilibrium can be corrected automatically
through cross-border flows of gold. On the other hand, the main disadvantages of the gold standard
are: (I) the world economy can be subject to deflationary pressure due to restricted supply of gold; (ii)
the gold standard itself has no mechanism to enforce the rules of the game, and, as a result, countries
may pursue economic policies (like de-monetization of gold) that are incompatible with the gold
standard.
5. What were the main objectives of the Bretton Woods system?
Answer: The main objectives of the Bretton Woods system are to achieve exchange rate stability and
promote international trade and development.
6. One can say that the Bretton Woods system was programmed to an eventual demise. Comment on
this proposition.
Answer: The answer to this question is related to the Triffin paradox. Under the gold-exchange
system, the reserve-currency country should run BOP deficits to supply reserves to the world
economy, but if the deficits are large and persistent, they can lead to a crisis of confidence in the
reserve currency itself, eventually causing the downfall of the system.
7. Explain how the special drawing rights (SDR) is constructed. Also, discuss the circumstances under
which the SDR was created.
Answer:
SDR was created by the IMF in 1970 as a new reserve asset, partially to alleviate the
pressure on the U.S. dollar as the key reserve currency. The SDR is a basket currency comprised of
five major currencies, i.e., U.S. dollar, German mark, Japanese yen, French franc, and British pound.
Currently, the dollar receives a 40% weight, mark 21%, yen 17%, franc 11%, and pound 11%. The
weights for different currencies tend to change over time, reflecting the relative importance of each
currency in international trade and finance.
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8. Explain the arrangements and workings of the European Monetary System (EMS).
Answer: EMS was launched in 1979 in order to (I) establish a zone of monetary stability in Europe,
(ii) coordinate exchange rate policies against the non-EMS currencies, and (iii) pave the way for the
eventual European monetary union. The main instruments of EMS are the European Currency Unit
(ECU) and the Exchange Rate Mechanism (ERM). Like SDR, the ECU is a basket currency
constructed as a weighted average of currencies of EU member countries. The ECU works as the
accounting unit of EMS and plays an important role in the workings of the ERM. The ERM is the
procedure by which EMS member countries manage their exchange rates. The ERM is based on a
parity grid system, with parity grids first computed by defining the par values of EMS currencies in
terms of the ECU. If a country’s ECU market exchange rate diverges from the central rate by as much
as the maximum allowable deviation, the country has to adjust its policies to maintain its par values
relative to other currencies.
9. There are arguments for and against the alternative exchange rate regimes.
a. List the advantages of the flexible exchange rate regime.
b. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed
exchange rate regime.
c. Rebut the above criticism from the viewpoint of the proponents of the flexible exchange rate
regime.
Answer: a. The advantages of the flexible exchange rate system include: (I) automatic achievement of
balance of payments equilibrium and (ii) maintenance of national policy autonomy.
b. If exchange rates are fluctuating randomly, that may discourage international trade and encourage
market segmentation. This, in turn, may lead to suboptimal allocation of resources.
c. Economic agents can hedge exchange risk by means of forward contracts and other techniques.
They don’t have to bear it if they choose not to. In addition, under a fixed exchange rate regime,
governments often restrict international trade in order to maintain the exchange rate. This is a selfdefeating measure. What’s good about the fixed exchange rate if international trade need to be
restricted?
10. In an integrated world financial market, a financial crisis in a country can be quickly transmitted
to other countries, causing a global crisis. What kind of measures would you propose to prevent the
recurrence of a Asia-type crisis.
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Answer: First, there should be a multinational safety net to safeguard the world financial system from
the Asia-type crisis. Second, international institutions like IMF and the World Bank should monitor
problematic countries more closely and provide timely advice to those countries. Countries should be
required to fully disclose economic and financial information so that devaluation surprises can be
prevented. Third, countries should depend more on domestic savings and long-term foreign
investments, rather than short-term portfolio capital. There can be other suggestions.
11. Discuss the criteria for a ‘good’ international monetary system.
Answer: A good international monetary system should provide (I) sufficient liquidity to the world
economy, (ii) smooth adjustments to BOP disequilibrium as it arises, and (iii) safeguard against the
crisis of confidence in the system.
12. Once capital markets are integrated, it is difficult for a country to maintain a fixed exchange rate.
Explain why this may be so.
Answer: Once capital markets are integrated internationally, vast amounts of money may flow in and
out of a country in a short time period. This will make it very difficult for the country to maintain a
fixed exchange rate.
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MINI CASE: WILL THE UNITED KINGDOM JOIN THE EURO CLUB?
When the euro was introduced in January 1999, the United Kingdom was conspicuously absent
from the list of European countries adopting the common currency. Although the current Labor
government led by Prime Minister Tony Blair appears to be in favor of joining the euro club, it is not
clear at the moment if that will actually happen. The opposition Tory party is not in favor of adopting
the euro and thus giving up monetary sovereignty of the country. The public opinion is also divided on
the issue.
Whether the United Kingdom will eventually join the euro club is a matter of considerable
importance for the future of European Union as well as that of the United Kingdom. The joining of the
United Kingdom with its sophisticated finance industry will most certainly help propel the euro into a
global currency status rivaling the U.S. dollar. The United Kingdom on its part will firmly join the
process of economic and political unionization of Europe, abandoning its traditional balancing role.
Investigate the political, economic and historical situations surrounding the British participation
in the European economic and monetary integration and write your own assessment of the prospect of
British joining the euro club. In dong so, assess from the British perspective, among other things, (1)
potential benefits and costs of adopting the euro, (2) economic and political constraints facing the
country, and (3) the potential impact of British adoption of the euro on the international financial
system, including the role of the U.S. dollar.
Suggested Solution to Will the United Kingdom Join the Euro Club?
Whether the U.K. will join the euro club will be a political as much as economic decision.
Recently, the U.K. economy was converging with those of euro-zone countries. Economic conditions
in terms of government budgets, interest rates, and inflation rate are becoming similar to those in eurozone countries. On an economic ground, this convergence is creating a condition that is conducive to
U.K.’s joining the euro club. As recently pointed out by Wim Duisenberg, the President of the
European Central Bank, British opposition to joining the euro club is more “psycho-political” than
justified on economic grounds. Since many political leaders in France and Germany consider adoption
of the euro as a step toward the European political union, the U.K. is likely to join the euro-zone if it is
prepared to join the European political union as well. Once the U.K. joins the euro-zone, the euro will
no doubt become a global currency at the expense of the U.S. dollar.
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CHAPTER 3 BALANCE OF PAYMENTS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Define the balance of payments.
Answer: The balance of payments (BOP) can be defined as the statistical record of a country’s
international transactions over a certain period of time presented in the form of double-entry
bookkeeping.
2. Why would it be useful to examine a country’s balance of payments data?
Answer: It would be useful to examine a country’s BOP for at least two reasons. First, BOP provides
detailed information about the supply and demand of the country’s currency. Second, BOP data can be
used to evaluate the performance of the country in international economic competition. For example, if
a country is experiencing perennial BOP deficits, it may signal that the country’s industries lack
competitiveness.
3. The United States has experienced continuous current account deficits since the early 1980s. What
do you think are the main causes for the deficits? What would be the consequences of continuous U.S.
current account deficits?
Answer:
The current account deficits of U.S. may have reflected a few reasons such as (I) a
historically high real interest rate in the U.S., which is due to ballooning federal budget deficits, that
kept the dollar strong, and (ii) weak competitiveness of the U.S. industries.
4. In contrast to the U.S., Japan has realized continuous current account surpluses. What could be the
main causes for these surpluses? Is it desirable to have continuous current account surpluses?
Answer: Japan’s continuous current account surpluses may have reflected a weak yen and high
competitiveness of Japanese industries. Massive capital exports by Japan prevented yen from
appreciating more than it did. At the same time, foreigners’ exports to Japan were hampered by closed
nature of Japanese markets. Continuous current account surpluses disrupt free trade by promoting
protectionist sentiment in the deficit country. It is not desirable especially when it is brought about by
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the mercantilist policies.
5. Comment on the following statement: “Since the U.S. imports more than it exports, it is necessary
for the U.S. to import capital from foreign countries to finance its current account deficits.”
Answer: The statement presupposes that the U.S. current account deficit causes its capital account
surplus. In reality, the causality may be running in the opposite direction: U.S. capital account surplus
may cause the country’s current account deficit. Suppose foreigners find the U.S. a great place to
invest and send their capital to the U.S., resulting in U.S. capital account surplus. This capital inflow
will strengthen the dollar, hurting the U.S. export and encouraging imports from foreign countries,
causing current account deficits.
6. Explain how a country can run an overall balance of payments deficit or surplus.
Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve
transactions. For example, an overall BOP deficit can be supported by drawing down the central
bank’s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central
bank’s reserve holdings.
7. Explain official reserve assets and its major components.
Answer: Official reserve assets are those financial assets that can be used as international means of
payments. Currently, official reserve assets comprise: (I) gold, (ii) foreign exchanges, (iii) special
drawing rights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges are by far the most
important official reserves.
8. Explain how to compute the overall balance and discuss its significance.
Answer: The overall BOP is determined by computing the cumulative balance of payments including
the current account, capital account, and the statistical discrepancies. The overall BOP is significant
because it indicates a country’s international payment gap that must be financed by the government’s
official reserve transactions.
9. Since the early 1980s, foreign portfolio investors have purchased a significant portion of U.S.
treasury bond issues. Discuss the short-term and long-term effects of foreigners’ portfolio investment
on the U.S. balance of payments.
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Answer: As foreigners purchase U.S. Treasury bonds, U.S. BOP will improve in the short run. But in the
long run, U.S. BOP may deteriorate because the U.S. should pay interests and principals to foreigners. If
foreign funds are used productively and contributes to the competitiveness of U.S. industries, however, U.S.
BOP may improve in the long run.
10. Describe the balance of payments identity and discuss its implications under the fixed and flexible
exchange rate regimes.
Answer: The balance of payments identity holds that the combined balance on the current and capital
accounts should be equal in size, but opposite in sign, to the change in the official reserves: BCA +
BKA = -BRA. Under the pure flexible exchange rate regime, central banks do not engage in official
reserve transactions. Thus, the overall balance must balance, i.e., BCA = -BKA. Under the fixed
exchange rate regime, however, a country can have an overall BOP surplus or deficit as the central
bank will accommodate it via official reserve transactions.
11. Exhibit 3.3 indicates that in 1991, the U.S. had a current account deficit and at the same time a
capital account deficit. Explain how this can happen?
Answer: In 1991, the U.S. experienced an overall BOP deficit, which must have been accommodated
by the Federal Reserve’s official reserve action, i.e., drawing down its reserve holdings.
12. Explain how each of the following transactions will be classified and recorded in the debit and
credit of the U.S. balance of payments:
(1) A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank account
kept in New York City.
(2) A U.S. citizen consumes a meal at a restaurant in Paris and pays with her American Express card.
(3) A Indian immigrant living in Los Angeles sends a check drawn on his L.A. bank account as a gift
to his parents living in Bombay.
(4) A U.S. computer programmer is hired by a British company for consulting and gets paid from the
U.S. bank account maintained by the British company.
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Answer:
_________________________________________________________________
Transactions
Credit
Debit
_________________________________________________________________

Japanese purchase of U.S. T bonds
Japanese payment using NYC account

U.S. citizen having a meal in Paris


Paying the meal with American Express

Gift to parents in Bombay
Receipts of the check by parents (goodwill)

Export of programming service


British payment out its account in U.S.
_________________________________________________________________
13. Construct the balance of payment table for Japan for the year of 1998 which is comparable in
format to Exhibit 3.1, and interpret the numerical data. You may consult International Financial
Statistics published by IMF or research for useful websites for the data yourself.
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Answer:
A summary of the Japanese Balance of Payments for 1998 (in $ billion)
Credits
Debits
Current Account
(1) Exports
646.03
(1.1) Merchandise
374.04
(1.2) Services
62.41
(1.3) Factor income
209.58
(2) Imports
-516.50
(2.1) Merchandise
-251.66
(2.2) Services
-111.83
(3.3) Factor income
-153.01
(3) Unilateral transfer
Balance on current account
5.53
-14.37
120.69
[(1) + (2) + (3)]
Capital Account
(4) Direct investment
3.27
-24.62
(5) Portfolio investment
73.70
-113.73
(5.1) Equity securities
16.11
-14.00
(5.2) Debt securities
57.59
-99.73
39.51
-109.35
(6) Other investment
Balance on financial account
-131.22
[(4) + (5) + (6)]
(7) Statistical discrepancies
4.36
Overall balance
-6.17
Official Reserve Account
6.17
Source: IMF, International Financial Statistics Yearbook, 1999.
Note: Capital account in the above table corresponds the ‘Financial account’ in IMF’s balance of payment statistics. IMF’s
Capital account’ is included in ‘Other investment’ in the above table.
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MINI CASE: MEXICO’S BALANCE OF PAYMENTS PROBLEM
Recently, Mexico experienced large-scale trade deficits, depletion of foreign reserve holdings and
a major currency devaluation in December 1994, followed by the decision to freely float the peso.
These events also brought about a severe recession and higher unemployment in Mexico. Since the
devaluation, however, the trade balance has improved.
Investigate the Mexican experiences in detail and write a report on the subject. In the report, you
may:
(a) document the trend in Mexico’s key economic indicators, such as the balance of payments, the
exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12.;
(b) investigate the causes of Mexico’s balance of payments difficulties prior to the peso devaluation;
(c) discuss what policy actions might have prevented or mitigated the balance of payments problem
and the subsequent collapse of the peso; and
(d) derive lessons from the Mexican experience that may be useful for other developing countries.
In your report, you may identify and address any other relevant issues concerning Mexico’s balance of
payment problem.
Suggested Solution to Mexico’s Balance-of-Payments Problem
To solve this case, it is useful to review Chapter 2, especially the section on the Mexican peso
crisis. Despite the fact that Mexico had experienced continuous trade deficits until December 1994, the
country’s currency was not allowed to depreciate for political reasons. The Mexican government did
not want the peso devaluation before the Presidential election held in 1994. If the Mexican peso had
been allowed to gradually depreciate against the major currencies, the peso crisis could have been
prevented.
The key lessons that can be derived from the peso crisis are: First, Mexico depended too much on
short-term foreign portfolio capital (which is easily reversible) for its economic growth. The country
perhaps should have saved more domestically and depended more on long-term foreign capital. This
can be a valuable lesson for many developing countries. Second, the lack of reliable economic
information was another contributing factor to the peso crisis. The Salinas administration was reluctant
to fully disclose the true state of the Mexican economy. If investors had known that Mexico was
experiencing serious trade deficits and rapid depletion of foreign exchange reserves, the peso might
have been gradually depreciating, rather than suddenly collapsed as it did. The transparent disclosure
of economic data can help prevent the peso-type crisis. Third, it is important to safeguard the world
financial system from the peso-type crisis. To this end, a multinational safety net needs to be in place
to contain the peso-type crisis in the early stage.
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CHAPTER 4 THE MARKET FOR FOREIGN EXCHANGE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Give a full definition of the market for foreign exchange.
Answer: Broadly defined, the foreign exchange (FX) market encompasses the conversion of purchasing
power from one currency into another, bank deposits of foreign currency, the extension of credit
denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and
futures contracts.
2. What is the difference between the retail or client market and the wholesale or interbank market for
foreign exchange?
Answer: The market for foreign exchange can be viewed as a two-tier market. One tier is the
wholesale or interbank market and the other tier is the retail or client market. International banks
provide the core of the FX market. They stand willing to buy or sell foreign currency for their own
account. These international banks serve their retail clients, corporations or individuals, in conducting
foreign commerce or making international investment in financial assets that requires foreign
exchange. Retail transactions account for only about 16 percent of FX trades. The other 84 percent is
interbank trades between international banks, or non-bank dealers large enough to transact in the
interbank market.
3. Who are the market participants in the foreign exchange market?
Answer: The market participants that comprise the FX market can be categorized into five groups:
international banks, bank customers, non-bank dealers, FX brokers, and central banks. International
banks provide the core of the FX market. Approximately 700 banks worldwide make a market in
foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These
international banks serve their retail clients, the bank customers, in conducting foreign commerce or
making international investment in financial assets that requires foreign exchange. Non-bank dealers
are large non-bank financial institutions, such as investment banks, whose size and frequency of trades
make it cost- effective to establish their own dealing rooms to trade directly in the interbank market
for their foreign exchange needs.
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Most interbank trades are speculative or arbitrage transactions where market participants attempt
to correctly judge the future direction of price movements in one currency versus another or attempt to
profit from temporary price discrepancies in currencies between competing dealers.
FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position
themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency
quote to many other dealers.
Central banks sometimes intervene in the foreign exchange market in an attempt to influence the
price of its currency against that of a major trading partner, or a country that it “fixes” or “pegs” its
currency against. Intervention is the process of using foreign currency reserves to buy one’s own
currency in order to decrease its supply and thus increase its value in the foreign exchange market, or
alternatively, selling one’s own currency for foreign currency in order to increase its supply and lower
its price.
4. How are foreign exchange transactions between international banks settled?
Answer: The interbank market is a network of correspondent banking relationships, with large
commercial banks maintaining demand deposit accounts with one another, called correspondent bank
accounts. The correspondent bank account network allows for the efficient functioning of the foreign
exchange market. As an example of how the network of correspondent bank accounts facilities
international foreign exchange transactions, consider a
U.S. importer desiring to purchase
merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his bank and
inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the bank will
debit the U.S. importer’s account for the purchase of the Dutch guilders. The bank will instruct its
correspondent bank in the Netherlands to debit its correspondent bank account the appropriate amount
of guilders and to credit the Dutch exporter’s bank account. The importer’s bank will then debit its
books to offset the debit of U.S. importer’s account, reflecting the decrease in its correspondent bank
account balance.
5. What is meant by a currency trading at a discount or at a premium in the forward market?
Answer: The forward market involves contracting today for the future purchase or sale of foreign
exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium)
or lower (at a discount) than the spot price.
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6. Why does most interbank currency trading worldwide involve the U.S. dollar?
Answer: Trading in currencies worldwide is against a common currency that has international appeal.
That currency has been the U.S. dollar since the end of World War II. However, the deutsche mark
and Japanese yen have started to be used much more as international currencies in recent years. More
importantly, trading would be exceedingly cumbersome and difficult to manage if each trader made a
market against all other currencies.
7. Banks find it necessary to accommodate their client’s needs to buy or sell foreign exchange
forward, in many instances for hedging purposes. How can the bank eliminate the currency exposure
it has created for itself by accommodating a client’s forward transaction?
Answer: Swap transactions provide a means for the bank to mitigate the currency exposure in a
forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange
against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To
illustrate, suppose a bank customer wants to buy dollars three months forward against British pound
sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange
rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will
lend the dollars for three months until they are needed to deliver against the dollars it has sold forward.
The British pounds received will be used to liquidate the sterling loan.
8.
A CD/$ bank trader is currently quoting a small figure bid-ask of 35-40, when the rest of the
market is trading at CD1.3436-CD1.3441. What is implied about the trader’s beliefs by his prices?
Answer: The trader must think the Canadian dollar is going to depreciate against the U.S. dollar and
therefore he is trying to reduce his inventory of Canadian dollars by discouraging purchases of CD by
standing willing to buy $ at only CD1.3435/$1.00 and offering to sell from inventory at the slightly
lower than market price of CD1.3440/$1.00.
*9. What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage
opportunity?
Answer: Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency,
then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an
arbitrage profit via trading from the second to the third currency when the direct exchange between the
two is not in alignment with the cross exchange rate.
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Most, but not all, currency transactions go through the dollar. Certain banks specialize in making
a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate
spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar
market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular
arbitrage profit is possible.
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PROBLEMS
1. Using Exhibit 4.4, calculate a cross-rate matrix for the French franc, German mark, Japanese yen,
and the British pound. Use the most current European term quotes to calculate the cross-rates so that
the triangular matrix result is similar to the portion above the diagonal in Exhibit 4.6.
Solution: The cross-rate formula we want to use is:
S(k/j) = S(k/$)/S(j/$).
The triangular matrix will contain 4 x (4 + 1)/2 = 10 elements.
Dollar
Pound
France
6.4071
10.0488
.05250
Germany
1.9104
2.9964
.01565
Japan
122.05
U.K
Yen
D-Mark
3.3538
191.42
0.6376
2. Using Exhibit 4.4, calculate the 30-, 90-, and 180-day forward cross exchange rates between the
German mark and the Swiss franc using the most current quotations. State the forward cross-rates in
“German” terms.
Solution: The formulas we want to use are:
FN(DM/SF) = FN($/SF)/FN($/DM)
or
FN(DM/SF) = FN(SF/$)/FN(DM/$).
We will use the top formula that uses American term forward exchange rates.
F30(DM/SF) = .6408/.5246 = 1.2215
F90(DM/SF) = .6453/.5270 = 1.2245
F180(DM/SF) = .6518/.5307 = 1.2282
3. Restate the following one-, three-, and six-month outright forward European term bid-ask quotes in
forward points.
Spot
1.3431-1.3436
One-Month
1.3432-1.3442
Three-Month
1.3448-1.3463
Six-Month
1.3488-1.3508
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Solution:
One-Month
01-06
Three-Month
17-27
Six-Month
57-72
4. Using the spot and outright forward quotes in problem 3, determine the corresponding bid-ask
spreads in points.
Solution:
Spot
5
One-Month
10
Three-Month
15
Six-Month
20
5. Using Exhibit 4.4, calculate the 30-, 90-, and 180-day forward premium or discount for the
Canadian dollar in European terms.
Solution: The formula we want to use is:
fN,$vCD = [(FN(CD/$) - S(CD/$))/S(CD/$)] x 360/N
f30,$vCD = [(1.4709 - 1.4715)/1.4715] x 360/30 = -.0049
f90,$vCD = [(1.4694 - 1.4715)/1.4715] x 360/90 = -.0057
f180,$vCD = [(1.4676 - 1.4715)/1.4715] x 360/180 = -.0053
6. Using Exhibit 4.4, calculate the 30-, 90-, and 180-day forward premium or discount for the British
pound in American terms using the most current quotations.
Solution: The formula we want to use is:
fN,£v$ = [(FN($/£) - S($/£))/S($/£] x 360/N
f30,£v$ = [(1.5685 - 1.5683)/1.5683] x 360/30 = .0015
f90,£v$ = [(1.5694 - 1.5683)/1.5683] x 360/90 = .0028
f180,£v$ = [(1.5714 - 1.5683)/1.5683] x 360/180 = .0040
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7.
Given the following information, what are the DM/S$ currency against currency bid-ask
quotations?
Bank Quotations
American Terms
European Terms
Bid
Ask
Bid
Deutsche Marks
.6784
.6789
1.4730 1.4741
Singapore Dollar
.6999
.7002
1.4282 1.4288
Ask
Solution: Equation 4.12 from the text implies S(DM/S$b) = S($/S$b) x S(DM/$b) = .6999 x 1.4730 =
1.0310. The reciprocal, 1/S(DM/S$b) = S(S$/DMa) = .9699. Analogously, it is implied that S(DM/S$a)
= S($/S$a) x S(DM/$a) = .7002 x 1.4741 = 1.0322. The reciprocal, 1/S(DM/S$a) = S(S$/DMb) = .9688.
Thus, the DM/S$ bid-ask spread is DM1.0310-DM1.0322 and the S$/DM spread is S$0.9688S$0.9699.
8. Assume you are a trader with Deutsche Bank. From the quote screen on your computer terminal,
you notice that Dresdner Bank is quoting DM1.6230/$1.00 and Credit Suisse is offering
SF1.4260/$1.00. You learn that UBS is making a direct market between the Swiss franc and the mark,
with a current DM/SF quote of 1.1250. Show how you can make a triangular arbitrage profit by
trading at these prices. (Ignore bid-ask spreads for this problem). Assume you have $5,000,000 with
which to conduct the arbitrage. What happens if you initially sell dollars for Swiss francs? What
DM/SF price will eliminate triangular arbitrage?
Solution: To make a triangular arbitrage profit the Deutsche Bank trader would sell $5,000,000 to
Dresdner Bank at DM1.6230/$1.00. This trade would yield DM8,115,000 = $5,000,000 x 1.6230.
The Deutsche Bank trader would then sell the deutsche marks for Swiss francs to Union Bank of
Switzerland at a price of DM1.1250/SF1.00, yielding SF7,213,333 = DM8,115,000/1.1250. The
Dresdner trader will resell the Swiss francs to Credit Suisse for $5,058,438 =SF7,213,333/1.4260,
yielding a triangular arbitrage profit of $58,438.
If the Deutsche Bank trader initially sold $5,000,000 for Swiss francs, instead of deutsche marks,
the trade would yield SF7,130,000 = $5,000,000 x 1.4260. The Swiss francs would in turn be traded
for deutsche marks to UBS for DM8,021,250 = SF7,130,000 x 1.1250. The marks would be resold to
Dresdner Bank for $4,942,237 =DM8,021,250/1.6230, or a loss of $57,763. Thus, it is necessary to
conduct the triangular arbitrage in the correct order.
The S(DM/SF) cross exchange rate should be 1.6230/1.4260 = 1.1381. This is an equilibrium
rate at which a triangular arbitrage profit will not exist. (The student can determine this for himself.)
A profit results from the triangular arbitrage when dollars are first sold for marks, because Swiss
francs are purchased for marks at too low a rate in comparison to the equilibrium cross-rate, i.e., Swiss
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francs are purchased for only DM1.1250/SF1.00 instead of the no-arbitrage rate of DM1.1381/SF1.00.
Similarly, when dollars are first sold for Swiss francs, an arbitrage loss results because Swiss francs
are sold for marks at too low a rate, resulting in too few marks, i.e. each Swiss franc is sold for DM
1.1250/SF1.00 instead of the higher no-arbitrage rate of DM1.1381/SF1.00.
IM-30
MINI CASE: SHREWSBURY HERBAL PRODUCTS, LTD.
Shrewsbury Herbal Products, located in central England, close to the Welsh border, is an old-line
producer of herbal teas, seasonings, and medicines. Their products are marketed all over the United
Kingdom and in many parts of continental Europe as well.
Shrewsbury Herbal generally invoices in British pound sterling when it sells to foreign customers
in order to guard against adverse exchange rate changes. Nevertheless, it has just received an order
from a large wholesaler in central France for £320,000 of its products, conditional upon delivery being
made in three months’ time and the order invoiced in French francs.
Shrewsbury’s controller, Elton Peters, is concerned with whether the pound will appreciate
versus the franc over the next three months, thus eliminating all or most of the profit when the French
franc receivable is paid. He thinks this is an unlikely possibility, but he decides to contact the firm’s
banker for suggestions about hedging the exchange rate exposure.
Mr. Peters learns from the banker that the current spot exchange rate is FF/£ is FF7.8709, thus the
invoice amount should be FF2,518,688. Mr. Peters also learns that the 90-day forward rates for the
pound and the French franc versus the U.S. dollar are $1.5458/£1.00 and FF5.0826/$1.00,
respectively. The banker offers to set up a forward hedge for selling the franc receivable for pound
sterling based on the FF/£ cross forward exchange rate implicit in the forward rates against the dollar.
What would you do if you were Mr. Peters?
Suggested Solution to Shrewsbury Herbal Products, Ltd.
Note to Instructor: This elementary case provides an intuitive look at hedging exchange rate
exposure. Students should not have difficulty with it even though hedging will not be formally
discussed until Chapter 13. The case is consistent with the discussion that accompanies Exhibit 4.5 of
the text.
Suppose Shrewsbury sells at a twenty percent markup. Thus the cost to the firm of the £320,000 order
is £256,000. Thus, the pound could appreciate to FF2,518,688/£256,000 = FF9.8386/£1.00 before all
profit was eliminated. This seems rather unlikely. Nevertheless, a ten percent appreciation of the
pound (FF7.8709 x 1.10) to FF8.6580/£1.00 would only yield a profit of £34,909 (=
FF2,518,688/8.6580 - £256,000). Shrewsbury can hedge the exposure by selling the French francs
forward for British pounds at F1/4(FF/£) = F1/4($/£) x F1/4(FF/$) = 1.5458 x 5.0826 = 7.8567. At this
forward exchange rate, Shrewsbury can “lock-in” a price of £320,578 (= FF2,518,688/7.8567) for the
sale. The forward exchange rate indicates that the French franc is trading at a premium to the British
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pound for forward purchase, thus the forward hedge allows Shrewsbury to lock-in a greater amount
(£578) for the sale than if payment was made up front.
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CHAPTER 5 INTERNATIONAL PARITY RELATIONSHIPS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Give a full definition of arbitrage.
Answer: Arbitrage can be defined as the act of simultaneously buying and selling the same or
equivalent assets or commodities for the purpose of making certain, guaranteed profits.
2. Discuss the implications of the interest rate parity for the exchange rate determination.
Answer: Assuming that the forward exchange rate is roughly an unbiased predictor of the future spot
rate, IRP can be written as:
S = [(1 + I£)/(1 + I$)]E[St+1It].
The exchange rate is thus determined by the relative interest rates, and the expected future spot rate,
conditional on all the available information, It, as of the present time. One thus can say that
expectation is self-fulfilling. Since the information set will be continuously updated as news hit the
market, the exchange rate will exhibit a highly dynamic, random behavior.
3. Explain the conditions under which the forward exchange rate will be an unbiased predictor of the
future spot exchange rate.
Answer: The forward exchange rate will be an unbiased predictor of the future spot rate if (I) the risk
premium is insignificant and (ii) foreign exchange markets are informationally efficient.
4. Explain the purchasing power parity, both the absolute and relative versions. What causes the
deviations from the purchasing power parity?
Answer: The absolute version of purchasing power parity (PPP):
S = P$/P£.
The relative version is:
e = $ - £.
PPP can be violated if there are barriers to international trade or if people in different countries have
different consumption taste. PPP is the law of one price applied to a standard consumption basket.
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5.
Discuss the implications of the deviations from the purchasing power parity for countries’
competitive positions in the world market.
Answer:
If exchange rate changes satisfy PPP, competitive positions of countries will remain
unaffected following exchange rate changes. Otherwise, exchange rate changes will affect relative
competitiveness of countries. If a country’s currency appreciates (depreciates) by more than is
warranted by PPP, that will hurt (strengthen) the country’s competitive position in the world market.
6. Explain and derive the international Fisher effect.
Answer: The international Fisher effect can be obtained by combining the Fisher effect and the
relative version of PPP in its expectational form. Specifically, the Fisher effect holds that
E($) = I$ - $,
E(£) = I£ - £.
Assuming that the real interest rate is the same between the two countries, i.e., $ = £, and substituting
the above results into the PPP, i.e., E(e) = E($)- E(£), we obtain the international Fisher effect: E(e)
= I$ - I£.
7. Researchers found that it is very difficult to forecast the future exchange rates more accurately than
the forward exchange rate or the current spot exchange rate. How would you interpret this finding?
Answer: This implies that exchange markets are informationally efficient. Thus, unless one has
private information that is not yet reflected in the current market rates, it would be difficult to beat the
market.
8. Explain the random walk model for exchange rate forecasting. Can it be consistent with the
technical analysis?
Answer: The random walk model predicts that the current exchange rate will be the best predictor of
the future exchange rate. An implication of the model is that past history of the exchange rate is of no
value in predicting future exchange rate. The model thus is inconsistent with the technical analysis
which tries to utilize past history in predicting the future exchange rate.
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*9. Derive and explain the monetary approach to exchange rate determination.
Answer: The monetary approach is associated with the Chicago School of Economics. It is based on
two tenets: purchasing power parity and the quantity theory of money. Combing these two theories
allows for stating, say, the $/£ spot exchange rate as:
S($/£) = (M$/M£)(V$/V£)(y£/y$),
where M denotes the money supply, V the velocity of money, and y the national aggregate output. The
theory holds that what matters in exchange rate determination are:
1. The relative money supply,
2. The relative velocities of monies, and
3. The relative national outputs.
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PROBLEMS
1. Suppose that the treasurer of IBM has an extra cash reserve of $1,000,000 to invest for six months.
The six-month interest rate is 8% per annum in the U.S. and 6% per annum in Germany. Currently, the
spot exchange rate is DM1.60 per dollar and the six-month forward exchange rate is DM1.56 per
dollar. The treasurer of IBM does not wish to bear any exchange risk. Where should he/she invest to
maximize the return?
Solution: The market conditions are summarized as follows:
I$ = 4%; iDM = 3%; S = DM1.60/$; F = DM1.56/$.
If $1,000,000 is invested in the U.S., the maturity value in six months will be
$1,040,000 = $1,000,000 (1 + .04).
Alternatively, $1,000,000 can be converted into DM and invested at the German interest rate, with the
DM maturity value sold forward. In this case the dollar maturity value will be
$1,056,410 = ($1,000,000 x 1.60)(1 + .03)(1/1.56)
Clearly, it is better to invest $1,000,000 in Germany with exchange risk hedging.
2. While you were visiting London, you purchased a Jaguar for £35,000, payable in three months.
You have enough cash at your bank in New York City, which pays 0.35% interest per month,
compounding monthly, to pay for the car. Currently, the spot exchange rate is $1.45/£ and the threemonth forward exchange rate is $1.40/£. In London, the money market interest rate is 2.0% for a
three-month investment. There are two alternative ways of paying for your Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that
the maturity value becomes equal to £35,000.
Evaluate each payment method. Which method would you prefer? Why?
Solution: The problem situation is summarized as follows:
A/P = £35,000 payable in three months
iNY = 0.35%/month, compounding monthly
iLD = 2.0% for three months
S = $1.45/£;
F = $1.40/£.
Option a:
When you buy £35,000 forward, you will need $49,000 in three months to fulfill the forward
contract. The present value of $49,000 is computed as follows:
$49,000/(1.0035)3 = $48,489.
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Thus, the cost of Jaguar as of today is $48,489.
Option b:
The present value of £35,000 is £34,314 = £35,000/(1.02). To buy £34,314 today, it will cost
$49,755 = 34,314x1.45. Thus the cost of Jaguar as of today is $49,755.
You should definitely choose to use “option a”, and save $1,266, which is the difference between
$49,755 and $48489.
3. Currently, the spot exchange rate is $1.50/£ and the three-month forward exchange rate is $1.52/£.
The three-month interest rate is 8.0% per annum in the U.S. and 5.8% per annum in the U.K. Assume
that you can borrow as much as $1,500,000 or £1,000,000.
a. Determine whether the interest rate parity is currently holding.
b. If the IRP is not holding, how would you carry out covered interest arbitrage? Show all the steps
and determine the arbitrage profit.
c. Explain how the IRP will be restored as a result of covered arbitrage activities.
Solution: Let’s summarize the given data first:
S = $1.5/£; F = $1.52/£; I$ = 2.0%; I£ = 1.45%
Credit = $1,500,000 or £1,000,000.
a. (1+I$) = 1.02
(1+I£)(F/S) = (1.0145)(1.52/1.50) = 1.0280
Thus, IRP is not holding exactly.
b. (1) Borrow $1,500,000; repayment will be $1,530,000.
(2) Buy £1,000,000 spot using $1,500,000.
(3) Invest £1,000,000 at the pound interest rate of 1.45%;
maturity value will be £1,014,500.
(4) Sell £1,014,500 forward for $1,542,040
Arbitrage profit will be $12,040
c. Following the arbitrage transactions described above,
The dollar interest rate will rise;
The pound interest rate will fall;
The spot exchange rate will rise;
The forward exchange rate will fall.
These adjustments will continue until IRP holds.
4. Suppose that the current spot exchange rate is FF6.25/$ and the three-month forward exchange rate
is FF6.28/$. The three-month interest rate is 5.6% per annum in the U.S. and 8.8% per annum in
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France. Assume that you can borrow up to $1,000,000 or FF6,250,000.
a. Show how to realize a certain profit via covered interest arbitrage, assuming that you want to realize
profit in terms of U.S. dollars. Also determine the magnitude of arbitrage profit.
b. Assume that you want to realize profit in terms of French francs. Show the covered arbitrage
process and determine the arbitrage profit in French francs.
Solution: The market data is summarized as follows:
S = FF6.25/$ = $0.16/FF;
F = FF6.28/$ = $0.1592/FF;
I$ = 1.40%; iFF = 2.20%
(1+I$) = 1.014 < (1+iFF)(F/S) = (1.022)(.1592/.16) = 1.0169
a. (1) Borrow $1,000,000; repayment will be $1,014,000.
(2) Buy FF6,250,000 spot for $1,000,000.
(3) Invest in France; maturity value will be FF6,387,500.
(4) Sell FF6,387,500 forward for $1,017,118.
Arbitrage profit will be $3,118 = $1,017,118 - $1,014,000.
b. (1) Borrow $1,000,000; repayment will be $1,014,000.
(2) Buy FF6,250,000 spot for $1,000,000.
(3) Invest in France; maturity value will be FF6,387,500.
(4) Buy $1,014,000 forward for FF6,367,920.
Arbitrage profit will be FF19,580 = FF6,387,500-FF6,367,920.
Note that only step (4) is different.
5. In the issue of October 23, 1999, the Economist reports that the interest rate per annum is 5.93% in
the United States and 70.0% in Turkey. Why do you think the interest rate is so high in Turkey? Based
on the reported interest rates, how would you predict the change of the exchange rate between the U.S.
dollar and the Turkish lira?
Solution: A high Turkish interest rate must reflect a high expected inflation in Turkey. According to
international Fisher effect (IFE), we have
E(e) = i$ - iLira
= 5.93% - 70.0% = -64.07%
The Turkish lira thus is expected to depreciate against the U.S. dollar by about 64%.
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6. As of November 1, 1999, the exchange rate between the Brazilian real and U.S. dollar is R$1.95/$.
The consensus forecast for the U.S. and Brazil inflation rates for the next 1-year period is 2.6% and
20.0%, respectively. How would you forecast the exchange rate to be at around November 1, 2000?
Solution: Since the inflation rate is quite high in Brazil, we may use the purchasing power parity to
forecast the exchange rate.
E(e)
= E($) - E(R$)
= 2.6% - 20.0%
= -17.4%
E(ST) = So(1 + E(e))
= (R$1.95/$) (1 + 0.174)
= R$2.29/$
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CHAPTER 6 INTERNATIONAL BANKING
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Briefly discuss some of the services that international banks provide their customers and the market
place.
Answer:
International banks can be characterized by the types of services they provide that
distinguish them from domestic banks.
Foremost, international banks facilitate the imports and
exports of their clients by arranging trade financing.
Additionally, they serve their clients by
arranging for foreign exchange necessary to conduct cross-border transactions and make foreign
investments and by assisting in hedging exchange rate risk in foreign currency receivables and
payables through forward and options contracts. Since international banks have established trading
facilities, they generally trade foreign exchange products for their own account.
Two major distinguishing features between domestic banks and international banks are the types of
deposits they accept and the loans and investments they make. Large international banks both borrow
and lend in the Eurocurrency market. Moreover, depending upon the regulations of the country in which
it operates and its organizational type, an international bank may participate in the underwriting of
Eurobonds and foreign bonds. In the United States, only investment banks and the investment banking
operations of bank holding companies are allowed to participate in the underwriting of international
bonds.
International banks frequently provide consulting services and advice to their clients in the areas
of exchange hedging strategies, interest rate and currency swap financing, and international cash
management services. Not all international banks provide all services. Banks that do provide a
majority of these services are known as universal banks or full service banks.
2. Briefly discuss the various types of international banking offices.
Answer: The services and operations which an international bank undertakes is a function of the
regulatory environment in which the bank operates and the type of banking facility established.
A correspondent bank relationship is established when two banks maintain a correspondent bank
account with one another. The correspondent banking system provides a means for a bank’s MNC
client to conduct business worldwide through his local bank or its contacts.
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A representative office is a small service facility staffed by parent bank personnel that is designed
to assist MNC clients of the parent bank in its dealings with the bank’s correspondents. It is a way for
the parent bank to provide its MNC clients with a level of service greater than that provided through
merely a correspondent relationship.
A foreign branch bank operates like a local bank, but legally it is a part of the parent bank. As
such, a branch bank is subject to the banking regulations of its home country and the country in which
it operates. The primary reason a parent bank would establish a foreign branch is that it can provide a
much fuller range of services for its MNC customers through a branch office than it can through a
representative office.
A subsidiary bank is a locally incorporated bank that is either wholly owned or owned in major
part by a foreign subsidiary. An affiliate bank is one that is only partially owned, but not controlled by
its foreign parent. Both subsidiary and affiliate banks operate under the banking laws of the country in
which they are incorporated.
U.S. parent banks find subsidiary and affiliate banking structures
desirable because they are allowed to engage in security underwriting.
Edge Act banks are federally chartered subsidiaries of U.S. banks which are physically located in
the United States that are allowed to engage in a full range of international banking activities. A 1919
amendment to Section 25 of the Federal Reserve Act created Edge Act banks. The purpose of the
amendment was to allow U.S. banks to be competitive with the services foreign banks could supply
their customers. Federal Reserve Regulation K allows Edge Act banks to accept foreign deposits,
extend trade credit, finance foreign projects abroad, trade foreign currencies, and engage in investment
banking activities with U.S. citizens involving foreign securities. As such, Edge Act banks do not
compete directly with the services provided by U.S. commercial banks. Edge Act banks are not
prohibited from owning equity in business corporations as are domestic commercial banks. Thus, it is
through the Edge Act that U.S. parent banks own foreign banking subsidiaries and have ownership
positions in foreign banking affiliates.
An offshore banking center is a country whose banking system is organized to permit external
accounts beyond the normal economic activity of the country. Offshore banks operate as branches or
subsidiaries of the parent bank. The primary activities of offshore banks are to seek deposits and grant
loans in currencies other than the currency of the host government.
In 1981, the Federal Reserve authorized the establishment of International Banking Facilities
(IBF). An IBF is a separate set of asset and liability accounts that are segregated on the parent bank’s
books; it is not a unique physical or legal entity. IBFs operate as foreign banks in the U.S. IBFs were
established largely as a result of the success of offshore banking. The Federal Reserve desired to
return a large share of the deposit and loan business of U.S. branches and subsidiaries to the U.S.
3. How does the deposit-loan rate spread in the Eurodollar market compare with the deposit-loan rate
spread in the domestic U.S. banking system? Why?
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Answer: The deposit-loan spread in the Eurodollar market is narrower than in the domestic U.S.
banking system. That is, in the Eurodollar market the deposit rate is greater than the deposit rate of
dollars in the U.S. banking system and the lending rate is less. The Eurodollar market can operate at a
lower cost than can the U.S. banking system because it is not subject to Federal Reserve Bank reserve
requirements on deposits or FDIC deposit insurance.
4. What is the difference between the Euronote market, the Euro-medium-term-note market, and the
Eurocommercial paper market?
Answer: Euronotes are short-term notes underwritten by a group of international investment or
commercial banks called a “facility.” A client-borrower makes an agreement with a facility to issue
Euronotes in its own name for a period of time, generally three to 10 years. Euronotes are sold at a
discount from face value, and pay back the full face value at maturity. Euronotes typically have
maturities of from three to six months. Euro-medium-term notes (Euro MTNs) are typically fixed-rate
notes issued by a corporation with maturities ranging from less than a year to about 10 years. Like
fixed-rate bonds, Euro-MTNs have a fixed maturity and pay coupon interest at periodic dates. Unlike
a bond issue, in which the entire issue is brought to market at once, permission is received for a EuroMTN issue which is then partially sold on a continuous basis through an issuance facility that allows
the borrower to obtain funds only as needed on a flexible basis.
Eurocommercial paper is an
unsecured short-term promissory note issued by a corporation or a bank and placed directly with the
investment public through a dealer. Like Euronotes, Eurocommercial paper is sold at a discount from
face value. Maturities typically range from one to six months.
5.
Briefly discuss the cause and the solution(s) to the international bank crisis involving less
developed countries.
Answer: The international debt crisis began on August 20, 1982 when Mexico asked more than 100
U.S. and foreign banks to forgive its $68 billion in loans. Soon Brazil, Argentina and more than 20
other developing countries announced similar problems in making the debt service on their bank loans.
At the height of the crisis, Third World countries owed $1.2 trillion!
The international debt crisis had oil as its source. In the early 1970’s, the Organization of
Petroleum Exporting Countries (OPEC) became the dominant supplier of oil worldwide. Throughout
this time period, OPEC raised oil prices dramatically and amassed a tremendous supply of U.S.
dollars, which was the currency generally demanded as payment from the oil importing countries.
OPEC deposited billions in Eurodollar deposits; by 1976 the deposits amounted to nearly $100
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billion. Eurobanks were faced with a huge problem of lending these funds in order to generate interest
income to pay the interest on the deposits. Third World countries were only too eager to assist the
equally eager Eurobankers in accepting Eurodollar loans that could be used for economic development
and for payment of oil imports. The high oil prices were accompanied by high interest rates, high
inflation, and high unemployment during the 1979-1981 period. Soon, thereafter, oil prices collapsed
and the crisis was on.
Today, most debtor nations and creditor banks would agree that the international debt crisis is
effectively over. U.S. Treasury Secretary Nicholas F. Brady of the Bush Administration is largely
credited with designing a strategy in the spring of 1989 to resolve the problem. Three important
factors were necessary to move from the debt management stage, employed over the years 1982-1988
to keep the crisis in check, to debt resolution. First, banks had to realize that the face value of the debt
would never be repaid on schedule. Second, it was necessary to extend the debt maturities and to use
market instruments to collateralize the debt. Third, the LDCs needed to open their markets to private
investment if economic development was to occur. Debt-for-equity swaps helped pave the way for an
increase in private investment in the LDCs. However, monetary and fiscal reforms in the developing
countries and the recent privatization trend of state owned industry were also important factors.
Treasury Secretary Brady’s solution was to offer creditor banks one of three alternatives: (1)
convert their loans to marketable bonds with a face value equal to 65 percent of the original loan
amount; (2) convert the loans into collateralized bonds with a reduced interest rate of 6.5 percent; or,
(3) lend additional funds to allow the debtor nations to get on their feet. The second alternative called
for an extension the debt maturities by 25 to 30 years and the purchase by the debtor nation of zerocoupon U.S. Treasury bonds with a corresponding maturity to guarantee the bonds and make them
marketable. These bonds have come to be called Brady bonds.
6. What warning did David Hume, the 18th-century Scottish philosopher-economist, give about
lending to sovereign governments?
Answer: (From the February 21, 1989 article “LDC Lenders Should Have Listened To David Hume”
by Thomas M. Humphrey in The Wall Street Journal.)
Hume thought no good could result from borrowing:
If the abuses of treasures [held by the state] be dangerous by engaging the state in rash
enterprise in confidence of its riches; the abuses of mortgaging are more certain and inevitable:
poverty, impotence, and subjection to foreign powers.
Nations, presuming they can find the necessary lenders, are tempted to borrow without limit and
to squander the funds on unproductive projects:
It is very tempting to a minister to employ such an expedient as enables him to make a great
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figure during his administration without over burthening the people with taxes or exciting any
immediate clamorous against himself.
The practice, therefore, of contracting debt will almost
infallibly be abused in every government. It would scarcely be more imprudent to give a prodigal son
a credit in every banker’s shop in London than to empower a statesman to draw bills in this manner
upon posterity.
Eventually, however, interest must be paid and the burden of debt service charges will fall
heavily on the poor:
The taxes which are levied to pay the interest of these debts are . . . an oppression on the poorer
sort.
Those same taxes “hurt commerce and discourage industry” and thus inhibit economic
development and condemn the borrowing nation to continuing poverty. The debt burden will also
pauperize the prosperous merchant and landowning classes that constitute the main bulwark of
political freedom and stability. With the pauperization of the middle class:
No expedient at all remains for resisting tyranny:
Elections are swayed by bribery and
corruption alone: And the middle power between king and people being totally removed, a grievous
despotism must infallibly prevail. The landholders [and merchants] despised for their oppressions,
will be utterly unable to make any opposition to it.
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PROBLEMS
1. Grecian Tile Manufacturing of Athens, Georgia borrows $1,500,000 at LIBOR plus a lending
margin of 1.25 percent per annum on a six-month rollover basis from a London bank. If six-month
LIBOR is 4 ½ percent over the first six-month interval and 5 3/8 percent over the second six-month
interval, how much will Grecian Tile pay in interest over the first year of its Eurodollar loan?
Solution: $1,500,000 x (.045 + .0125)/2 + $1,500,000 x (.05375 + .0125)/2
= $43,125 + $49,687.50 = $92,812.50.
2. A bank sells a “three against nine” $3,000,000 FRA for a six-month period beginning three months
from today and ending nine months from today. The purpose of the FRA is to cover the interest rate
risk caused by the maturity mismatch from having made a three-month Eurodollar loan and having
accepted a nine-month Eurodollar deposit. The agreement rate with the buyer is 5.5 percent. There
are actually 183 days in the six-month period. Assume that three months from today the settlement
rate is 4 7/8 percent. Determine how much the FRA is worth and who pays whom--the buyer pays the
seller or the seller pays the buyer.
Solution: Since the settlement rate is less than the agreement rate, the buyer pays the seller the
absolute value of the FRA. The absolute value of the FRA is:
$3,000,000 x [(.04875-.055) x 183/360]/[1 + (.04875 x 183/360)]
= $3,000,000 x [-.003177/(1.024781)]
= $9,300.52.
3. Assume the settlement rate in problem 2 is 6 1/8 percent. What is the solution now?
Solution: Since the settlement rate is greater than the agreement rate, the seller pays the buyer the
absolute value of the FRA. The absolute value of the FRA is:
$3,000,000 x [(.06125-.055) x 183/360]/[1 + (.06125 x 183/360)]
= $3,000,000 x [.006250/(1.031135)]
= $18,183.85.
4. The Fisher effect (Chapter 5) suggests that nominal interest rates differ between countries because
of differences in the respective rates of inflation. According to the Fisher effect and your examination
of the long-term and short-term Eurocurrency interest rates presented in Exhibit 6.4, order the five
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countries from highest to lowest in terms of the size of the inflation premium imbedded in the nominal
interest rates for 1998.
Solution: According to the Fisher effect, both the short-term and the long-term interest rates suggest
that the inflation premiums for the four countries (or zone) ordered from highest to lowest are: Great
Britain, the United States, the Euro-zone, and Japan.
5. A bank has a $500 million portfolio of investments and bank credits. The daily standard deviation
of return on this portfolio is .666 percent. Capital adequacy standards require the bank to maintain
capital equal to its VAR calculated over a ten-day holding period. What is the capital charge for the
bank?
Solution: VAR = $500 million x .00666 x 2.236 x 10 = $24.49 million.
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MINI CASE: DETROIT MOTORS’ LATIN AMERICAN EXPANSION
It is September 1990 and Detroit Motors of Detroit, Michigan is considering establishing an
assembly plant in Latin America for a new utility vehicle it has just designed. The cost of the capital
expenditure has been estimated at $65,000,000.
There is not much of a sales market in Latin
America, and virtually all output would be exported to the U.S. for sale. Nevertheless, an assembly
plant in Latin America is attractive for at least two reasons. First, labor costs are expected to be half
what Detroit Motors would have to pay in the U.S. to union workers. Since the assembly plant will be
a new facility for a newly designed vehicle, Detroit Motors does not expect any hassle from its U.S.
union in establishing the plant in Latin America. Secondly, the chief financial officer (CFO) of
Detroit Motors believes that a debt-for-equity swap can be arranged with at least one of the Latin
American countries that has not been able to meet its debt service on its sovereign debt with some of
the major U.S. banks.
The September 10, 1990 issue of Barron’s indicated the following prices (cents on the dollar) on
Latin American bank debt:
Brazil
21.75
Mexico
43.12
Argentina
14.25
Venezuela
46.25
Chile
70.25
The CFO is not comfortable with the level of political risk in Brazil and Argentina, and has decided to
eliminate them from consideration. After some preliminary discussions with the central banks of
Mexico, Venezuela, and Chile, the CFO has learned that all three countries would be interested in
hearing a detailed presentation about the type of facility Detroit Motors would construct, how long it
would take, the number of locals that would be employed, and the number of units that would be
manufactured per year. Since it is time consuming to prepare and make these presentations, the CFO
would like to approach the most attractive candidate first. He has learned that the central bank of
Mexico will redeem its debt at 80 percent of face value in a debt-for-equity swap, Venezuela at 75
percent, and Chile 100 percent. As a first step, the CFO decides an analysis based purely on financial
considerations is necessary to determine which country looks like the most viable candidate. You are
asked to assist in the analysis. What do you advise?
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Suggested Solution for Detroit Motors’ Latin American Expansion
Regardless in which LDC Detroit Motors establishes the new facility, it will need $65,000,000 in
the local currency of the country to build the plant. The analysis involves a comparison of the dollar
cost of enough LDC debt from a creditor bank to provide $65,000,000 in local currency upon
redemption with the LDC central bank.
If Detroit Motors builds in Mexico, it will need to purchase $81,250,00 (= $65,000,000/.80) in
Mexican sovereign debt in order to have $65,000,000 in pesos after redemption with the Mexican
central bank. The cost in dollars will be $35,035,000 (= $81,250,000 x .4312).
If Detroit Motors builds in Venezuela, it will need to purchase $86,666,667 (= $65,000,000/.75)
in Venezuelan sovereign debt in order to have $65,000,000 in bolivars after redemption with the
Venezuelan central bank. The cost in dollars will be $40,083,333 (= $86,666,667 x .4625).
If Detroit Motors builds in Chile, it will need to purchase $65,000,000 (= $65,000,000/1.00) in
Chilean sovereign debt in order to have $65,000,000 in pesos after redemption with the Chilean
central bank. The cost in dollars will be $45,662,500 (= $65,000,000 x .7025).
Based on the above analysis, Detroit Motors should consider approaching Mexico about the
possibility of a debt-for-equity swap to build an assembly facility in Mexico. Of course, there are
many other factors, such as tax rates, shipping costs, labor costs that need also to be considered.
Assuming all else is equal, however, Mexico appears to be the most attractive candidate.
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APPENDIX 6A QUESTION
1. Verbally explain how Eurocurrency is created.
Answer: The core of the international money market is the Eurocurrency market. A Eurocurrency is a
time deposit of money in an international bank located in a country different from the country that
issues the currency. For example, Eurodollars are deposits of U.S. dollars in banks located outside of
the United States. As an illustration, assume a U.S. Importer purchases $100 of merchandise from a
German Exporter and pays for the purchase by drawing a $100 check on his U.S. checking account
(demand deposit). If the funds are not needed for the operation of the business, the German Exporter
can deposit the $100 in a time deposit in a bank outside the U.S. and receive a greater rate of interest
than if the funds were put in a U.S. time deposit. Assume the German Exporter deposits the funds in a
London Eurobank. The London Eurobank credits the German Exporter with a $100 time deposit and
deposits the $100 into its correspondent bank account (demand deposit) with the U.S. Bank (banking
system) to hold as reserves. Two points are noteworthy. First, the entire $100 remains on deposit in the
U.s. Bank. Second, the $100 time deposit of the German Exporter in the London Eurobank represents
the creation of Eurodollars. This deposit exists in addition to the dollars deposited in the U.S. Hence,
no dollars have flowed out of the U.S. banking system in the creation of Eurodollars.
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CHAPTER 7 INTERNATIONAL BOND MARKETS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Describe the differences between foreign bonds and Eurobonds. Also discuss why Eurobonds
make up the lions share of the international bond market.
Answer: The two segments of the international bond market are: foreign bonds and Eurobonds. A
foreign bond issue is one offered by a foreign borrower to investors in a national capital market and
denominated in that nation’s currency. A Eurobond issue is one denominated in a particular currency,
but sold to investors in national capital markets other than the country which issues the denominating
currency.
Eurobonds make up over 80 percent of the international bond market. The two major reasons for
this stem from the fact that the U.S. dollar is the currency most frequently sought in international bond
financing. First, Eurodollar bonds can be brought to market more quickly than Yankee bonds because
they are not offered to U.S. investors and thus do not have to meet the strict SEC registration
requirements. Second, Eurobonds are typically bearer bonds that provide anonymity to the owner and
thus allow a means for evading taxes on the interest received. Because of this feature, investors are
generally willing to accept a lower yield on Eurodollar bonds in comparison to registered Yankee bonds
of comparable terms, where ownership is recorded. For borrowers the lower yield means a lower cost of
debt service.
2. Briefly define each of the major types of international bond market instruments, noting their
distinguishing characteristics.
Answer: The major types of international bond instruments and their distinguishing characteristics are
as follows:
Straight fixed-rate bond issues have a designated maturity date at which the principal of the
bond issue is promised to be repaid. During the life of the bond, fixed coupon payments that are some
percentage rate of the face value are paid as interest to the bondholders. This is the major international
bond type. Straight fixed-rate Eurobonds are typically bearer bonds and pay coupon interest annually.
Floating-rate notes (FRNs) are typically medium-term bonds with their coupon payments
indexed to some reference rate. Common reference rates are either three-month or six-month U.S.
dollar LIBOR. Coupon payments on FRNs are usually quarterly or semi-annual, and in a accord with
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the reference rate.
A convertible bond issue allows the investor to exchange the bond for a pre-determined number
of equity shares of the issuer. The floor value of a convertible bond is its straight fixed-rate bond
value. Convertibles usually sell at a premium above the larger of their straight debt value and their
conversion value. Additionally, investors are usually willing to accept a lower coupon rate of interest
than the comparable straight fixed coupon bond rate because they find the call feature attractive.
Bonds with equity warrants can be viewed as a straight fixed-rate bond with the addition of a call
option (or warrant) feature. The warrant entitles the bondholder to purchase a certain number of
equity shares in the issuer at a pre-stated price over a pre-determined period of time.
Zero coupon bonds are sold at a discount from face value and do not pay any coupon interest
over their life. At maturity the investor receives the full face value. Another form of zero coupon
bonds are stripped bonds. A stripped bond is a zero coupon bond that results from stripping the
coupons and principal from a coupon bond. The result is a series of zero coupon bonds represented by
the individual coupon and principal payments.
A dual currency bond is a straight fixed-rate bond which is issued in one currency and pays
coupon interest in that same currency. At maturity, the principal is repaid in a second currency.
Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount
of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for
some appreciation in the exchange rate of the stronger currency. From the investor’s perspective, a
dual currency bond includes a long-term forward contract.
Composite currency bonds are denominated in a currency basket, such as SDRs or ECUs,
instead of a single currency. They are frequently called currency cocktail bonds. They are typically
straight fixed-rate bonds. The currency composite is a portfolio of currencies: when some currencies
are depreciating others may be appreciating, thus yielding lower variability overall.
3. Why do most international bonds have high Moody’s or Standard & Poor’s credit ratings?
Answer:
Moody’s Investors Service and Standard & Poor’s provide credit ratings on most
international bond issues. It has been noted that a disproportionate share of international bonds have
high credit ratings. The evidence suggests that a logical reason for this is that the Eurobond market is
only accessible to firms that have good credit ratings to begin with.
4. What factors does Standard & Poor’s analyze in determining the credit rating it assigns a sovereign
government?
Answer: In rating a sovereign government, S&P’s analysis centers around an examination of the
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degree of political risk and economic risk. In assessing political risk, S & P examines the stability of
the political system, the social environment, and international relations with other the countries.
Factors examined in assessing economic risk include the sovereign’s external financial position,
balance of payments flexibility, economic structure and growth, management of the economy, and
economic prospects. The rating assigned a sovereign is particularly important because it usually
represents the ceiling for ratings S&P will assign an obligation of an entity domiciled within that
country.
5. Discuss the process of bringing a new international bond issue to market.
Answer: A borrower desiring to raise funds by issuing Eurobonds to the investing public will contact
an investment banker and ask it to serve as lead manager of an underwriting syndicate that will bring
the bonds to market. The lead manager will usually invite other banks to form a managing group to
help negotiate terms with the borrower, ascertain market conditions, and manage the issuance. The
managing group, along with other banks, will serve as underwriters for the issue, i.e., they will commit
their own capital to buy the issue from the borrower at a discount from the issue price. Most of the
underwriters, along with other banks, will be part of a selling group that sells the bonds to the
investing public. The various members of the underwriting syndicate receive a portion of the spread
(usually in the range of 2 to 2.5 percent of the issue size), depending upon the number and type of
functions they perform. The lead manager receives the full spread, and a bank serving as only a
member of the selling group receives a smaller portion.
6. You are an investment banker advising a Eurobank about a new international bond offering it is
considering. The proceeds are to be used to fund Eurodollar loans to bank clients. What type of bond
instrument would you recommend that the bank consider issuing? Why?
Answer: Since the Eurobank desires to use the bond proceeds to finance Eurodollar loans, which are
floating-rate loans, the investment banker should recommend that the bank issue FRNs, which are a
variable rate instrument. Thus there will a correspondence between the interest rate the bank pays for
funds and the interest rate it receives from its loans. For example, if the bank frequently makes term
loans at indexed to 3-month LIBOR, it might want to issue FRNs, also, indexed to 3-month LIBOR.
7. What should a borrower consider before issuing dual currency bonds? What should an investor
consider before investing in dual currency bonds?
Answer: A dual currency bond is a straight fixed-rate bond which is issued in one currency and pays
coupon interest in that same currency. At maturity, the principal is repaid in a second currency.
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Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds. The amount
of the dollar principal repayment at maturity is set at inception; frequently, the amount allows for
some appreciation in the exchange rate of the stronger currency. From the investor’s perspective, a
dual currency bond includes a long-term forward contract. If the second currency appreciates over the
life of the bond, the principal repayment will be worth more than a return of principal in the issuing
currency. However, if the payoff currency depreciates, the investor will suffer an exchange rate loss.
Dual currency bonds are attractive to MNCs seeking financing in order to establish or expand
operations in the country issuing the payoff currency. During the early years, the coupon payments
can be made by the parent firm in the issuing currency. At maturity, the MNC anticipates the principal
to be repaid from profits earned by the subsidiary. The MNC may suffer an exchange rate loss if the
subsidiary is unable to repay the principal and the payoff currency has appreciated relative to the
issuing currency. Consequently, both the borrower and the investor are exposed to exchange rate
uncertainty from a dual currency bond.
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PROBLEMS:
1. You firm has just issued five year floating-rate notes indexed to six-month U.S. dollar LIBOR plus
1/4%. What is the amount of first coupon payment your firm will pay per U.S. $1,000 of face value, if
six-month LIBOR is currently 7.2%?
Solution: 0.5 x (.072 + .0025) x $1,000 = $37.25.
2. The discussion of zero-coupon bonds in the text gave an example of two zero-coupon bonds issued
by Commerzbank. The DM300,000,000 issue due in 1995 sold at 50 percent of face value and the
DM300,000,000 due in 2000 sold at 33 1/3 percent of face value; both were issued in 1985. Calculate
the implied yield-to-maturity of each of these two zero-coupon bond issues.
Solution: The bonds due in 1995 sold at 50% percent of face value. Since they were issued in 1985,
they had a ten year maturity.
Assuming a DM1,000 par value, their yield-to-maturity is:
(DM1,000/DM500)1/10 - 1 = .07177 or 7.177% per annum.
The bonds due in year 2000 sold at 33 1/3%. They have a 15 year maturity. Their yield-tomaturity is: (DM1,000/DM333.33)1/15 - 1 =.07599 or 7.599% per annum.
3. Consider 8.5 percent Swiss franc/U.S. dollar dual currency bonds that pay $666.67 at maturity per
SF1,000 of par value. What is the implicit SF/$ exchange rate at maturity? Will the investor be better
or worse off at maturity if the actual SF/$ exchange rate is SF1.35/$1.00?
Solution: Implicitly, the dual currency bonds call for the exchange of SF1,000 of face value for
$666.67.
Therefore, the implicit exchange rate built into the dual currency bond issue is
SF1,000/$666.67, or SF1.50/$1.00. If the exchange rate at maturity is SF1.35/$1.00, SF1,000 would
buy $740.74 = SF1,000/SF1.35. Thus, the dual currency bond investor is worse off with $666.67
because the dollar is at a depreciated level in comparison to the implicit exchange rate of
SF1.50/$1.00.
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MINI CASE: SARA LEE CORP.’S EUROBONDS
The International Finance in Practice boxed reading in the chapter discussed a three-year $100
million Eurobond issue by Sara Lee Corporation. The article also mentions other bond issues recently
placed by various foreign divisions of Sara Lee. What thoughts do you have about Sara Lee’s debt
financing strategy?
Suggested Solution to Sara Lee Corp.’s Eurobonds
Sara Lee is the ideal candidate to issue Eurobonds.
The company has worldwide name
recognition, and it has an excellent credit rating that allows it to place new bond issues easily. By
issuing dollar denominated Eurobonds to Swiss investors, Sara Lee can bring new issues to market
much more quickly than if it sold domestic dollar denominated bonds. Moreover, the Eurodollar
bonds likely sell at a lower yield than comparable domestic bonds.
Additionally, it appears as if Sara Lee is raising funds in a variety of foreign currencies. Sara Lee
most likely has large cash inflows in these same currencies that can be used to meet the debt service
obligations on these bond issues. Thus Sara Lee is finding a use for some of its foreign currency
receipts and does not have to be concerned with the exchange rate uncertainty of these part of its
foreign cash inflows.
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CHAPTER 8 INTERNATIONAL EQUITY MARKETS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Get a current copy of The Wall Street Journal and find the Dow Jones Global Indexes listing in
Section C of the newspaper. Examine the 12-month changes in U.S. dollars for the various national
and regional indices. How do the changes from your table compare with the 12-month changes from
the sample provided in the textbook as Exhibit 8.8? Are they all of similar size? Are the same
national indexes positive and negative in both listings? Discuss your findings.
Answer:
This question is designed to provide an intuitive understanding of the benefits from
international diversification of equity portfolios. It is very unlikely that the student will find many, if
any, national market indexes that have 12- month returns that are even close to the same level as in
Exhibit 8.8. Over different time periods, different market forces will affect each national market in
unique ways and the exchange rates will be different. Some markets that previously yielded a positive
return will now show a negative return, and vice versa. Similarly, some markets that had yielded a
large positive (negative) return may now show only a small positive (negative) return.
2. As an investor, what factors would you consider before investing in the emerging stock market of a
developing country?
Answer: An investor in emerging market stocks needs to be concerned with the depth of the market
and the market’s liquidity. Depth of the market refers to the opportunities to invest in the country.
One measure of the depth of the market is the concentration ratio of a country’s stock market. The
concentration ratio frequently is calculated to show the market value of the ten largest stock traded as
a fraction of the total market capitalization of all equities traded. The lower the concentration ratio,
the less deep is the market. That is, most value is concentrated in only a few companies. While this
does not necessarily imply that the largest stocks in the emerging market are not good investments, it
does, however, suggest that there are few opportunities for investment in that country and that proper
diversification within the country may be difficult. In terms of liquidity, an investor would be wise to
examine the market turnover ratio of the country’s stock market. High market turnover suggests that
the market is liquid, or that there are opportunities for purchasing or selling the stock quickly at close
to the current market price. This is important because liquidity means you can get in or out of a stock
position quickly without spending more than you intended on purchase or receiving less than you
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expected on sale.
3. Compare and contrast the various types of secondary market trading structures.
Answer: There are two basic types of secondary market trading structures: dealer and agency. In a
dealer market, the dealer serves as market maker for the security, holding an inventory of the security.
The dealer buys at his bid price and sells at his asked price from this inventory. All public trades go
through the dealer. In an agency market, public trades go through the agent who matches it with
another public trade. Both dealer and agency markets can be continuous trade markets, but noncontinuous markets tend to be only agency markets. Over-the-counter trading, specialist markets, and
automated markets are types of continuous market trading systems. Call markets and crowd trading
are each types of non-continuous trading market systems. Continuous trading systems are desirable
for actively traded issues, whereas call markets and crowd trading offer advantages for smaller
markets with many thinly traded issues because they mitigate the possibility of sparse order flow over
short time periods.
4. Discuss any benefits you can think of for a company to (a) cross-list its equity shares on more than
one national exchange, and, (b) to source new equity capital from foreign investors as well as domestic
investors.
Answer: A MNC that has a product market presence or manufacturing facilities in several countries
may cross-list its shares on the exchanges of these same countries because there is typically investor
demand for the shares of companies that are known within a country. Additionally, a company may
cross-list its shares on foreign exchanges to broaden its investor base and therefore to increase the
demand for the its stock. An increase in demand will generally increase the stock price and improve
the its market liquidity. A broader investor base may also mitigate the possibility of a hostile
takeover.
Additional, cross-listing a company’s shares establishes name recognition and thus
facilitates sourcing new equity capital in these foreign capital markets.
5. Why might it be easier for an investor desiring to diversify his portfolio internationally to buy
depository receipts rather than the actual shares of the company?
Answer: A depository receipt can be purchased on the investor’s domestic exchange. It represents a
package of the underlying foreign security that is priced in the investor’s local currency and in a
trading range that is typical for the investor’s marketplace. The investor can purchase a depository
receipt directly from his domestic broker, rather than having to deal with an overseas broker and the
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necessity of obtaining foreign funds to make the foreign stock purchase. Additionally, dividends are
received in the local currency rather than in foreign funds that would need to be converted into the
local currency.
6. Why do you think the empirical studies about factors affecting equity returns basically showed that
domestic factors were more important than international factors, and, secondly, that industrial
membership of a firm was of little importance in forecasting the international correlation structure of a
set of international stocks?
Answer: While national security markets have become more integrated in recent years, there is still a
tremendous amount of segmentation that brings about the benefit to be derived from international
diversification of financial assets. Monetary and fiscal policies differ among countries because of
different economic circumstances. The economic policies of a country directly affect the securities
traded in the country, and they will behave differently than securities traded in another country with
other economic policies being implemented. Hence, it is not surprising that domestic factors are found
to be more important than international factors in affecting security returns. Similarly, industrial
activity within a country is also affected by the economic policies of the country; thus firms in the
same industry group, but from different countries, will not necessarily behave the same in all
countries, nor should we expect the securities issued by these firms to behave alike.
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PROBLEMS
1. On the Milan bourse, Fiat stock closed at EUR31.90 per share on Friday, September 10, 1999. Fiat
trades as and ADR on the NYSE. One underlying Fiat share equals one ADR. On September 10, the
$/EUR spot exchange rate was $1.0367/EUR1.00. At this exchange rate, what is the no-arbitrage U.S.
dollar price of one ADR?
Solution: The no-arbitrage ADR U.S. dollar price is: EUR31.90 x $1.0367 = $33.07.
2. If Fiat ADRs were trading at $35 when the underlying shares were trading in Milan at EUR31.90,
what could you do to earn a trading profit? Use the information in problem 1, above, to help you and
assume that transaction costs are negligible.
Solution: As the solution to problem 1 shows, the no-arbitrage ADR U.S. dollar price is $33.07. If
Fiat ADRs were trading at $35, a wise investor would sell short the relatively overvalued ADRs and
use the proceeds to buy the relatively undervalued Fiat shares on the Milan exchange. The profit
would be $35 - $33.07 = $1.93 per ADR.
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MINI CASE: SAN PICO’S NEW STOCK EXCHANGE
San Pico is a rapidly growing Latin American developing country. The country is blessed with
miles of scenic beaches that have attracted tourists by the thousands to in recent years to new resort
hotels financed by joint ventures of San Pico businessmen and moneymen from the Middle East,
Japan, and the U.S. Additionally, San Pico has good natural harbors that are conducive for receiving
imported merchandise and exporting merchandise produced in San Pico and other surrounding
countries that lack access to the sea. Because of these advantages, many new businesses are being
started in San Pico.
Presently, stock is traded in a cramped building in La Cobijio, the nation’s capital. Admittedly,
the San Pico Stock Exchange system is rather archaic. Twice a day an official of the exchange will
call out the name of each of the 43 companies whose stock trade on the exchange. Brokers wanting to
buy or sell shares for their clients will then attempt to make a trade with one another. This crowd
trading system has worked well for over one hundred years, but the government desires to replace it
with a new modern system that will allow greater and more frequent opportunities for trading in each
company, and will allow for trading the shares of the many new start-up companies that are expected
to trade in the secondary market. Additionally, the government administration is rapidly privatizing
many state-owned businesses in an attempt to foster their efficiency, obtain foreign exchange from the
sale, and convert the country to a more capitalist economy. The government believes that it could
conduct this privatization faster and perhaps at more attractive prices if it had a modern stock
exchange facility where the shares of the newly privatized companies will eventually trade.
You are an expert in the operation of secondary stock markets and have been retained as a
consultant to the San Pico Stock Exchange to offer your expertise in modernizing the stock market.
What would you advise?
Suggested Solution to San Pico’s New Stock Exchange
Most new and renovated stock exchanges are being established these days as either a partially or
fully automated trading system. A fully automated system is especially beneficial for a small to
medium size country in which there is only moderate trading in most issues. Such a system that
deserves special note is the continuous National Integrated Market system of New Zealand. This
system is fully computerized and does not require a physical structure. Essentially, all buyers and
sellers of a stock enter through their broker into the computer system the number of shares they desire
to buy or sell and their required transaction price. The system is updated constantly as new purchase
or sale orders are entered into the system. The computer constantly searches for a match between
buyer and seller, and when one is found a transaction takes place. This type of system would likely
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serve San Pico’s needs very well. There is existing technology to implement, the bugs have been
worked out in other countries, and it would satisfy all the demands of the San Pico government and
easily accommodate growth in market activity.
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CHAPTER 9 FUTURES AND OPTIONS ON FOREIGN EXCHANGE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Explain the basic differences between the operation of a currency forward market and a futures
market.
Answer: The forward market is an OTC market where the forward contract for purchase or sale of
foreign currency is tailor-made between the client and its international bank. No money changes
hands until the maturity date of the contract when delivery and receipt are typically made. A futures
contract is an exchange-traded instrument with standardized features specifying contract size and
delivery date. Futures contracts are marked-to-market daily to reflect changes in the settlement price.
Delivery is seldom made in a futures market. Rather a reversing trade is made to close out a long or
short position.
2. In order for a derivatives market to function two types of economic agents are needed: hedgers and
speculators. Explain.
Answer: Two types of market participants are necessary for the operation of a derivatives market:
speculators and hedgers. A speculator attempts to profit from a change in the futures price. To do
this, the speculator will take a long or short position in a futures contract depending upon his
expectations of future price movement. A hedger, on-the-other-hand, desires to avoid price variation
by locking in a purchase price of the underlying asset through a long position in a futures contract or a
sales price through a short position. In effect, the hedger passes off the risk of price variation to the
speculator who is better able, or at least more willing, to bear this risk.
3. Why are most futures positions closed out through a reversing trade rather than held to delivery?
Answer: In forward markets, approximately 90 percent of all contracts that are initially established result in
the short making delivery to the long of the asset underlying the contract. This is natural because the terms
of forward contracts are tailor made between the long and short. By contrast, only about one percent of
currency futures contracts result in delivery. While futures contracts are useful for speculation and
hedging, their standardized delivery dates make them unlikely to correspond to the actual future dates when
foreign exchange transactions will occur. Thus, they are generally closed out in a reversing trade. In fact,
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the commission that buyers and sellers pay to transact in the futures market is a single amount that covers
the round-trip transactions of initiating and closing out the position.
4. How can the FX futures market be used for price discovery?
Answer: To the extent that FX forward prices are an unbiased predictor of future spot exchange rates,
the market anticipates whether one currency will appreciate or depreciate versus another. Because FX
futures contracts trade in an expiration cycle, different contracts expire at different periodic dates into
the future. The pattern of the prices of these contracts provides information as to the market’s current
belief about the relative future value of one currency versus another at the scheduled expiration dates
of the contracts. One will generally see a steadily appreciating or depreciating pattern; however, it
may be mixed at times. Thus, the futures market is useful for price discovery, i.e., obtaining the
market’s forecast of the spot exchange rate at different future dates.
5. What is the major difference in the obligation of one with a long position in a futures (or forward)
contract in comparison to an options contract?
Answer: A futures (or forward) contract is a vehicle for buying or selling a stated amount of foreign
exchange at a stated price per unit at a specified time in the future. If the long holds the contract to the
delivery date, he pays the effective contractual futures (or forward) price, regardless of whether it is an
advantageous price in comparison to the spot price at the delivery date. By contrast, an option is a
contract giving the long the right to buy or sell a given quantity of an asset at a specified price at some
time in the future, but not enforcing any obligation on him if the spot price is more favorable than the
exercise price.
Because the option owner does not have to exercise the option if it is to his
disadvantage, the option has a price, or premium, whereas no price is paid at inception to enter into a
futures (or forward) contract.
6. What is meant by the terminology that an option is in-, at-, or out-of-the-money?
Answer: A call (put) option with St > E (E > St) is referred to as trading in-the-money. If St  E the
option is trading at-the-money. If St < E (E < St) the call (put) option is trading out-of-the-money.
7. List the arguments (variables) of which a FX call or put option model price is a function. How
does the call and put premium change with respect to a change in the arguments?
Answer: Both call and put options are functions of only six variables: St, E, ri, rus, T and . When all
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else remains the same, the price of a European FX call (put) option will increase:
1. the larger (smaller) is S,
2. the smaller (larger) is E,
3. the smaller (larger) is ri,
4. the larger (smaller) is rus,
5. the larger (smaller) rus is relative to ri, and
6. the greater is .
When rus and ri are not too much different in size, a European FX call and put will increase in price
when the option term-to-maturity increases.
However, when rus is very much larger than ri, a
European FX call will increase in price, but the put premium will decrease, when the option term-tomaturity increases. The opposite is true when ri is very much greater than rus. For American FX
options the analysis is less complicated. Since a longer term American option can be exercised on any
date that a shorter term option can be exercised, or a some later date, it follows that the all else
remaining the same, the longer term American option will sell at a price at least as large as the shorter
term option.
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PROBLEMS
1. Assume today’s settlement price on a CME DM futures contract is $0.6080/DM. You have a short
position in one contract. Your margin account currently has a balance of $1,700. The next three days’
settlement prices are $0.6066, $0.6073, and $0.5989. Calculate the changes in the margin account
from daily marking-to-market and the balance of the margin account after the third day.
Solution: $1,700 + [($0.6080 - $0.6066) + ($0.6066 - $0.6073)
+ ($0.6073 - $0.5989)] x DM125,000 = $2,837.50,
where DM125,000 is the contractual size of one DM contract.
2. Do problem 1 over again assuming you have a long position in the futures contract.
Solution: $1,700 + [($0.6066 - $0.6080) + ($0.6073 - $0.6066) + ($0.5989 - $0.6073)] x DM125,000
= $562.50,
where DM125,000 is the contractual size of one DM contract.
With only $562.50 in your margin account, you would experience a margin call requesting that
additional cash be added to the margin account to bring it back up to the initial margin level.
3. Using the quotations in Exhibit 9.3, calculate the face value of the open interest in the December
1999 Swiss franc futures contract.
Solution: 172 contracts x SF125,000 = SF21,500,000.
where SF125,000 is the contractual size of one SF contract.
4. Using the quotation in Exhibit 9.3, note that the March 2000 Mexican peso futures contract has a
price of $0.11695. You believe the spot price in March will be $0.09550. What speculative position
would you enter into to attempt to profit from your beliefs? Calculate your anticipated profits
assuming you take a position in three contracts. What is the size of your profit (loss) if the futures
price is indeed an unbiased predictor of the future spot price and this price materializes?
Solution: If you expect the Mexican peso to rise from $0.09550 to $0.11000, you would take a long
position in futures since the futures price of $0.09550 is less than your expected spot price.
Your anticipated profit from a long position in three contracts is: 3 x ($0.11000 - $0.09550) x
MP500,000 = $21,750.00, where MP500,000 is the contractual size of one MP contract.
If the futures price is an unbiased predictor of the expected spot price, the expected spot price is
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the futures price of $0.09550/MP. If this spot price materializes, you will not have any profits or
losses from your short position in three futures contracts: 3 x ($0.09550 - $0. 09550) x MP500,000 =
0.
5. Do problem 4 over again assuming you believe the March 2000 spot price will be $0.08500.
Solution: If you expect the Mexican peso to depreciate from $0.09550 to $0.08500, you would take a
short position in futures since the futures price of $0. 09550 is greater than your expected spot price.
Your anticipated profit from a short position in three contracts is: 3 x ($0.09550 - $0.08500) x
MP500,000 = $15,750.00.
If the futures price is an unbiased predictor of the future spot price and this price materializes,
you will not profit or lose from your long futures position.
6.
Recall the forward rate agreement (FRA) example in Chapter 6.
Show how the bank can
alternatively use a position in Eurodollar futures contracts to hedge the interest rate risk created by the
maturity mismatch it has with the $3,000,000 six-month Eurodollar deposit and rollover Eurocredit
position indexed to three-month LIBOR. Assume the bank can take a position in Eurodollar futures
contracts maturing in three months’ time that have a futures price of 94.00.
Solution: To hedge the interest rate risk created by the maturity mismatch, the bank would need to
buy (go long) three Eurodollar futures contracts. If on the last day of trading, three-month LIBOR is 5
1/8%, the bank will earn a profit of $6,562.50 from its futures position. This is calculated as:
[94.875 - 94.00] x 100 bp x $25 x 3 contracts = $6,562.50.
Note that this sum differs slightly from the $6,550.59 profit that the bank will earn from the FRA for
two reasons. First, the Eurodollar futures contract assumes an arbitrary 90 days in a three-month
period, whereas the FRA recognizes that the actual number of days in the specific three-month period
is 91 days. Second, the Eurodollar futures contract pays off in future value terms, or as of the end of
the three-month period, whereas the FRA pays off in present value terms, or as of the beginning of the
three-month period.
7. Use the quotations in Exhibit 9.6 to calculate the intrinsic value and the time value of the 80 ½
September Japanese yen American put options.
Solution: Premium - Intrinsic Value = Time Value
80 ½ Sep Put .60 - [80.5 – 82.64 = - 2.14] = 2.74 cents per 100 yen
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8. Assume spot Swiss franc is $0.7000 and the six-month forward rate is $0.6950. What is the
minimum price that a six-month American call option with a striking price of $0.6800 should sell for
in a rational market? Assume the annualized six-month Eurodollar rate is 3 ½ percent.
Solution:
Note to Instructor: A complete solution to this problem relies on the boundary expressions presented
in endnote 2 of the text of Chapter 9.
Ca  Max[(70 - 68), (69.50 - 68)/(1.0175), 0]
 Max[ 2, 1.47, 0] = 2 cents
9. Do problem 8 over again assuming an American put option instead of a call option.
Solution: Pa  Max[(68 - 70), (68 - 69.50)/(1.0175), 0]
 Max[ -2, -1.47, 0] = 0 cents
10. Use the European option pricing models developed in the chapter to value the call of problem 8
and the put of problem 9. Assume the annualized volatility of the Swiss franc is 14.2 percent. This
problem can be solved using the FXOPM.xls spreadsheet.
Solution:
d1 = [ln(69.50/68) + .5(.142)2(.50)]/(.142).50 = .2675
d2 = d1 - .142.50 = .2765 - .1004 = .1671
N(d1) = .6055
N(d2) = .5664
N(-d1) = .3945
N(-d2) = .4336
Ce = [69.50(.6055) - 68(.5664)]e-(.035)(.50) = 3.51 cents
Pe = [68(.4336) - 69.50(.3945)]e-(.035)(.50) = 2.03 cents
11. Use the binomial option-pricing model developed in the chapter to value the call of problem 8. The volatility of
the Swiss franc is 14.2 percent.
Solution: The spot rate at T will be either 77.39¢ = 70.00¢(1.1056) or 63.32¢ = 70.00¢(.9045), where
u = e.142.50 = 1.1056 and d = 1/u = .9045. At the exercise price of E = 68, the option will only be
exercised at time T if the Swiss franc appreciates; its exercise value would be CuT = 9.39¢ = 77.39¢ 69. If the Swiss franc depreciates it would not be rational to exercise the option; its value would be
CdT = 0.
The hedge ratio is h = (9.39 – 0)/(77.39 – 63.32) = .6674.
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Thus, the call premium is:
C0 = Max{[69.50(.6674) – 68((70/68)(.6674 – 1) +1)]/(1.0175), 70 – 68}
= Max[1.64, 2] = 2 cents per SF.
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MINI CASE: THE OPTIONS SPECULATOR
A speculator is considering the purchase of five three-month Japanese yen call options with a
striking price of 96 cents per 100 yen. The premium is 1.35 cents per 100 yen. The spot price is 95.28
cents per 100 yen and the 90-Day forward rate is 95.71 cents. The speculator believes the yen will
appreciate to $1.00 per 100 yen over the next three months. As the speculator’s assistant, you have
been asked to prepare the following:
1. Diagram the call option.
2. Determine the speculator’s profit if the yen appreciates to $1.00/100 yen.
3. Determine the speculator’s profit if the yen only appreciates to the forward rate.
4. Determine the future spot price at which the speculator will only breakeven.
Suggested Solution to the Options Speculator:
1.
+
2. (5 x ¥6,250,000) x [(100 - 96) - 1.35]/10000 = $8,281.25.
3. Since the option expires out-of-the-money, the speculator will let the option expire worthless. He
will only lose the option premium.
4. ST = E + C = 96 + 1.35 = 97.35 cents per 100 yen.
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CHAPTER 10 CURRENCY AND INTEREST RATE SWAPS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Describe the difference between a swap broker and a swap dealer.
Answer: A swap broker arranges a swap between two counterparties for a fee without taking a risk
position in the swap. A swap dealer is a market maker of swaps and assumes a risk position in
matching opposite sides of a swap and in assuring that each
counterparty fulfills its contractual obligation to the other.
2. What is the necessary condition for a fixed-for-floating interest rate swap to be possible?
Answer: For a fixed-for-floating interest rate swap to be possible it is necessary for a quality spread
differential to exist. In general, the default-risk premium of the fixed-rate debt will be larger than the
default-risk premium of the floating-rate debt.
3. Describe the difference between a parallel loan and a back-to-back loan.
Answer:
A parallel loan involves four parties.
One MNC borrows and re-lends to another’s
subsidiary and vice versa. A back-to-back loan involves only two parties. One MNC borrows and relends directly to another.
4. Discuss the basic motivations for a counterparty to enter into a currency swap.
Answer:
One basic reason for a counterparty to enter into a currency swap is to exploit the
comparative advantage of the other in obtaining debt financing at a lower interest rate than could be
obtained on its own. A second basic reason is to lock in long-term exchange rates in the repayment of
debt service obligations denominated in a foreign currency.
5. How does the theory of comparative advantage relate to the currency swap market?
Answer: Name recognition is extremely important in the international bond market. Without it, even
a creditworthy corporation will find itself paying a higher interest rate for foreign denominated funds
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than a local borrower of equivalent creditworthiness.
Consequently, two firms of equivalent
creditworthiness can each exploit their, respective, name recognition by borrowing in their local
capital market at a favorable rate and then re-lending at the same rate to the other.
6. Discuss the risks confronting an interest rate and currency swap dealer.
Answer: An interest rate and currency swap dealer confronts many different types of risk. Interest
rate risk refers to interest rates changing unfavorably before the swap dealer can lay off with an
opposing counterparty the unplaced side of a swap entered into with another counterparty. Basis risk
refers to the floating rates of two counterparties being pegged to two different indices. In this
situation, since the indexes are not perfectly positively correlated, the swap bank may not always
receive enough floating rate funds from one counterparty to pass through to satisfy the other side,
while still covering its desired spread, or avoiding a loss. Exchange-rate risk refers to the risk the
swap bank faces from fluctuating exchange rates during the time it takes the bank to lay off a swap it
undertakes on an opposing counterparty before exchange rates change.
Additionally, the dealer
confronts credit risk from one counterparty defaulting and its having to fulfill the defaulting party’s
obligation to the other counterparty. Mismatch risk refers to the difficulty of the dealer finding an
exact opposite match for a swap it has agreed to take. Sovereign risk refers to a country imposing
exchange restrictions on a currency involved in a swap making it costly, or impossible, for a
counterparty to honor its swap obligations to the dealer. In this event, provisions exist for the early
termination of a swap, which means a loss of revenue to the swap bank.
7. Briefly discuss some variants of the basic interest rate and currency swaps diagramed in the
chapter.
Answer: Instead of the basic fixed-for-floating interest rate swap, there are also zero-coupon-forfloating rate swaps where the fixed rate payer makes only one zero-coupon payment at maturity on the
notional value. There are also floating-for-floating rate swaps where each side is tied to a different
floating rate index or a different frequency of the same index. Currency swaps need not be fixed-forfixed; fixed-for-floating and floating-for-floating rate currency swaps are frequently arranged.
Moreover, both currency and interest rate swaps can be amortizing as well as non-amortizing.
8. If the cost advantage of interest rate swaps would likely be arbitraged away in competitive markets,
what other explanations exist to explain the rapid development of the interest rate swap market?
Answer: All types of debt instruments are not always available to all borrowers. Interest rate swaps
IM-71
can assist in market completeness. That is, a borrower may use a swap to get out of one type of
financing and to obtain a more desirable type of credit that is more suitable for its asset maturity
structure.
9. Assume you are the swap bank in the Eli Lilly swap discussed in the chapter. Develop an example
of how you might lay off the swap to an opposing counterparty.
Answer: The swap bank may try to lay off the swap on a Japanese MNC that has issued yen
denominated debt to finance a capital expenditure of a U.S. subsidiary. The subsidiary is earning U.S.
dollar revenues which are to be used to service the yen debt. A currency swap would allow the
Japanese MNC to avoid the foreign exchange risk of an appreciating yen; the swap could serve as a
ready means for disposing of dollars and receiving yen to service the debt.
10. Discuss the motivational difference in the currency swap presented as Example 10.5 and the Eli
Lilly and Company swap discussed in the chapter.
Answer: The currency swap presented as Example 10.5 can be classified as a liability swap. The
motivation of a counterparty to enter into a liability swap is to obtain the cost-saving advantage of the
other counterparty. Each has a comparative advantage in raising funds in a particular currency. When
the proceeds are swapped and each counterparty pays the other’s debt service, a cost-savings is
obtained. The Eli Lilly currency swap was motivated by Lilly’s desire to find a use for its yen cash
inflows. What it desired to do was to convert yen cash flow into U.S. dollar cash flow at a stable
exchange rate. The swap allowed Lilly to do this. Currency swaps that transform cash flows are
referred to as asset swaps.
*11. Assume a currency swap in which two counterparties of comparable credit risk each borrow at
the best rate available, yet the nominal rate of one counterparty is higher than the other. After the
initial principal exchange, is the counterparty that is required to make interest payments at the higher
nominal rate at a financial disadvantage to the other in the swap agreement? Explain your thinking.
Answer: Superficially, it may appear that the counterparty paying the higher nominal rate is at a
disadvantage since it has borrowed at a lower rate. However, if the forward rate is an unbiased
predictor of the expected spot rate and if IRP holds, then the currency with the higher nominal rate is
expected to depreciate versus the other. In this case, the counterparty making the interest payments at
the higher nominal rate is in effect making interest payments at the lower interest rate because the
payment currency is depreciating in value versus the borrowing currency.
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PROBLEMS
1. Develop a different arrangement of interest payments among the counterparties and the swap bank
in Example 10.1 that still leaves each counterparty with an all-in cost 1/2 percent below each’s best
rate and the swap bank with a 1/4 percent inflow.
Solution: Company B could pay a fixed-rate of 10.75 percent to the swap bank, which would pass
through 10.50 percent to Bank A. Bank A could pay LIBOR, which the swap bank would pass in its
entirety through to Company B. In fact, generic plain vanilla interest rate swaps, such as this one, are
quoted by swap banks against LIBOR flat. The swap bank would pay U.S. dollar LIBOR flat in return
for receiving dollar payments at 10.75 percent or the bank would make dollar payments at 10.50
percent in return for receiving U.S. dollar LIBOR flat. Hence, the bank is charging a fixed-rate spread
of .50 percent for the swap.
2. Alpha and Beta Companies can borrow at the following rates.
Alpha
Beta
Moody’s credit rating
Aa
Baa
Fixed-rate borrowing cost
10.5%
12.0%
Floating-rate borrowing cost
LIBOR
LIBOR + 1%
a. Calculate the Quality Spread Differential (QSD).
b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their
borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt.
Solution:
a. The QSD = (12.0% - 10.5%) minus (LIBOR + 1% - LIBOR) = .5%.
b. Alpha needs to issue fixed-rate debt at 10.5% and Beta needs to issue floating rate-debt at LIBOR +
1%. Alpha needs to pay LIBOR to Beta. Beta needs to pay 10.75% to Alpha. If this is done, Alpha’s
floating-rate all-in-cost is: 10.5% + LIBOR - 10.75% = LIBOR - .25%, a .25% savings over issuing
floating-rate debt on its own. Beta’s fixed-rate all-in-cost is: LIBOR+ 1% + 10.75% - LIBOR =
11.75%, a .25% savings over issuing fixed-rate debt.
3. Company A is a AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue FRNs
at six-month LIBOR + 1/8 percent or at the six-month Treasury-bill rate + ½ percent. Given its asset
structure, LIBOR is the preferred index. Company B is an A-rated firm that also desires to issue fiveyear FRNs. It finds that it can issue at six-month LIBOR + 5/8 percent or at the six-month TreasuryIM-73
bill rate + 1 5/8 percent. Given its asset structure, the six-month Treasury-bill rate is the preferred
index. Assume a notional principal of $15,000,000. Determine the QSD and set up a floating-forfloating rate swap where the swap bank receives 1/8 percent and the two counterparties share the
remaining savings equally.
Solution: The quality spread differential is [(T-bill + 1 3/8 percent) minus (T-bill + 4/8 percent) =] 9/8
percent minus [(LIBOR + 5/8 percent) minus (LIBOR + 1/8 percent) =] 4/8 percent, which equals 5/8
percent. If the swap bank receives 1/8 percent, each counterparty is to save 2/8 percent. Company B
would issue LIBOR indexed FRNs. Company A would issue Treasury-bill indexed notes. Semiannual payments will be made by both counterparties to the swap bank. On an annualized basis,
Company B will remit to the swap bank the T-bill rate + 11/8 percent and pay LIBOR + 5/8 percent on
its FRNs. It will receive LIBOR + 5/8 percent from the swap bank. This arrangement results in an allin cost of the T-bill rate + 11/8 percent, which is a rate 1/4 percent below the T-bill indexed FRNs
Company B could issue on its own. Company A will remit LIBOR + 5/8 percent to the swap bank and
pay the T-bill rate + 4/8 percent on its FRNs. It will receive the T-bill rate +10/8 percent from the
swap bank. This arrangement results in an all-in cost of LIBOR - 1/8 percent for Company A, which
is 1/4 percent less than the LIBOR indexed FRNs it could issue on its own. The arrangements with the
two counterparties net the swap bank 1/8 percent per annum, received semi-annually.
4. Suppose Morgan Guaranty, Ltd. is quoting swap rates as follows: 7.75 - 8.10 percent annually
against six-month dollar LIBOR for dollars and 11.25 - 11.65 percent annually against six-month
dollar LIBOR for British pound sterling. At what rates will Morgan Guaranty enter into a $/£
currency swap?
Solution:
Morgan Guaranty will pay annual fixed-rate dollar payments of 7.75 percent against
receiving six-month dollar LIBOR flat, or it will receive fixed-rate annual dollar payments at 8.10
percent against paying six-month dollar LIBOR flat. Morgan Guaranty will make annual fixed-rate £
payments at 11.25 percent against receiving six-month dollar LIBOR flat, or it will receive annual
fixed-rate £ payments at 11.65 percent against paying six-month dollar LIBOR flat. Thus, Morgan
Guaranty will enter into a currency swap in which it would pay annual fixed-rate dollar payments of
7.75 percent in return for receiving semi-annual fixed-rate £ payments at 11.65 percent, or it will
receive annual fixed-rate dollar payments at 8.10 percent against paying annual fixed-rate £ payments
at 11.25 percent.
*5. A corporation enters into a five-year interest rate swap with a swap bank in which it agrees to pay
the swap bank a fixed-rate of 9.75 percent annually on a notional amount of DM15,000,000 and
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receive LIBOR – ½ percent. As of the second reset date, determine the price of the swap from the
corporation’s viewpoint, assuming that the fixed-rate at which it can borrow has increased to 10.25
percent.
Solution: On the reset date, the present value of the future floating-rate payments the corporation will
receive from the swap bank based on the notional value will be DM15,000,000. The present value of
a hypothetical bond issue of DM15,000,000 with three remaining 9.75 percent coupon payments at the
new fixed-rate of 10.25 percent is DM14,814,304. This sum represents the present value of the
remaining payments the swap bank will receive from the corporation. Thus, the swap bank should be
willing to buy and the corporation should be willing to sell the swap for DM15,000,000 DM14,814,304 = DM185,696.
IM-75
MINI CASE: THE CENTRALIA CORPORATION’S CURRENCY SWAP
The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has
decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture
microwave ovens for sale to the European Union market.
The plant is expected to cost
Ptas620,000,000, and to take about one year to complete. The plant is to be financed over its
economic life of eight years.
The borrowing capacity created by this capital expenditure is
$1,700,000; the remainder of the plant will be equity financed. Centralia is not well known in the
Spanish or international bond market; consequently, it would have to pay 14 percent per annum to
borrow pesetas, whereas the normal borrowing rate in the Spanish capital market for well-known firms
of equivalent risk is 12.5 percent. Centralia could borrow in the U.S. at a rate of 8 percent.
Study Questions
1.
Suppose a Spanish MNC has a mirror image situation and needs $1,700,000 to finance a capital
expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed-rate in the U.S.
for dollars, whereas it can borrow pesetas at 12.5 percent. The exchange rate has been forecast to be
Ptas145.44/$1.00 in one year. Set up a currency swap that will be beneficial for each counterparty.
*2. Suppose that one year after the inception of the currency swap between Centralia and the Spanish
MNC, the U.S. dollar fixed-rate has fallen from 8 to 6 percent and the Spanish capital market fixedrate for pesetas has fallen from 12.5 to 11 percent. In both dollars and pesetas, determine the market
value of the swap if the exchange rate is Ptas152.30/$1.00.
Suggested Solution to The Centralia Corporation’s Currency Swap
1.
The Spanish MNC should issue Ptas247,250,000 of 12.5 percent fixed rate debt and Centralia
should issue $1,700,000 of fixed-rate 8
percent debt, since each counterparty has a relative
comparative advantage in their home market. They will exchange principal sums in one year. The
contractual exchange rate for the initial exchange is Ptas247,250,000/$1,700,000, or Ptas145.44/$1.00.
Annually the counterparties will swap debt service: the Spanish MNC will pay Centralia $136,000
(=$1,700,000 x .08) and Centralia will pay the Spanish MNC Ptas30,906,250 (=Ptas247,250,000 x
.125).
The contractual exchange rate of the first seven annual debt service exchanges is
Ptas30,906,250/$136,000, or Ptas227.25/$1.00. At retirement, Centralia and the Spanish MNC will
re-exchange the principal sums and the final debt service payments. The contractual exchange rate of
the
final
currency
exchange
is
Ptas278,156,250/$1,836,000
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=
(Ptas247,250,000
+
Ptas30,906,250)/($1,700,000 + $136,000), or Ptas151.50/$1.00.
*2. The market value of the dollar debt is the present value of a seven-year annuity of $136,000 and a
lump sum of $1,700,000 discounted at 6 percent. This present value is $1,889,801.
Similarly, the market value of the peseta debt is the present value of a seven-year annuity of
Ptas30,906,250 and a lump sum of Ptas247,250,000 discounted at 11 percent. This present value is
Ptas264,726,358.
The dollar value of the swap is $1,889,801 - Ptas264,726,358/152.30 = $151,611.
The peseta value of the swap is Ptas264,726,358 - (152.30)$1,889,801 =-Ptas23,090,334.
IM-77
CHAPTER 11 INTERNATIONAL PORTFOLIO INVESTMENTS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. What factors are responsible for the recent surge in international portfolio investment (IPI)?
Answer: The recent surge in international portfolio investments reflects the globalization of financial
markets. Specifically, many countries have liberalized and deregulated their capital and foreign
exchange markets in recent years. In addition, commercial and investment banks have facilitated
international investments by introducing such products as American Depository Receipts (ADRs) and
country funds. Also, recent advancements in computer and telecommunication technologies led to a
major reduction in transaction and information costs associated with international investments. In
addition, investors might have become more aware of the potential gains from international
investments.
2. Security returns are found to be less correlated across countries than within a country. Why can this
be?
Answer: Security returns are less correlated probably because countries are different from each other
in terms of industry structure, resource endowments, macroeconomic policies, and have nonsynchronous business cycles. Securities from a same country are subject to the same business cycle
and macroeconomic policies, thus causing high correlations among their returns.
3. Explain the concept of the world beta of a security.
Answer: The world beta measures the sensitivity of returns to a security to returns to the world market
portfolio. It is a measure of the systematic risk of the security in a global setting. Statistically, the
world beta can be defined as:
Cov(Ri, RM)/Var(RM),
where Ri and RM are returns to the I-th security and the world market portfolio, respectively.
4. Explain the concept of the Sharpe performance measure.
Answer: The Sharpe performance measure (SHP) is a risk-adjusted performance measure. It is
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defined as the mean excess return to a portfolio above the risk-free rate divided by the portfolio’s
standard deviation.
5. Explain how exchange rate fluctuations affect the return from a foreign market measured in dollar
terms. Discuss the empirical evidence on the effect of exchange rate uncertainty on the risk of foreign
investment.
Answer: It is useful to refer to Equations 11.4 and 11.5 of the text. Exchange rate fluctuations mostly
contribute to the risk of foreign investment through its own volatility as well as its covariance with the
local market returns. The covariance tends to be positive in most of the cases, implying that exchange
rate changes tend to add to exchange risk, rather than offset it. Exchange risk is found to be much
more significant in bond investments than in stock investments.
6. Would exchange rate changes always increase the risk of foreign investment? Discuss the condition
under which exchange rate changes may actually reduce the risk of foreign investment.
Answer: Exchange rate changes need not always increase the risk of foreign investment. When the
covariance between exchange rate changes and the local market returns is sufficiently negative to
offset the positive variance of exchange rate changes, exchange rate volatility can actually reduce the
risk of foreign investment.
7. Evaluate a home country’s multinational corporations as a tool for international diversification.
Answer: Despite the fact that MNCs have operations worldwide, their stock prices behave very much
like purely domestic firms. This is puzzling yet undeniable. As a result, MNCs are a poor substitute for
direct foreign portfolio investments.
8. Discuss the advantages and disadvantages of closed-end country funds (CECFs) relative to the
American Depository Receipts (ADRs) as a means of international diversification.
Answer: CECFs can be used to diversify into exotic markets that are otherwise difficult to access such
as India and Turkey. Being a portfolio, CECFs also provide instant diversification. ADRs do not
provide instant diversification; investors should form portfolios themselves. In addition, there are
relatively few ADRs from emerging markets. The main disadvantage of CECFs is that their share
prices behave somewhat like the host country’s share prices, reducing the potential diversification
benefits.
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9. Why do you think closed-end country funds often trade at a premium or discount?
Answer: CECFs trade at a premium or discount because capital markets of the home and host
countries are segmented, preventing cross-border arbitrage. If cross-border arbitrage is possible,
CECFs should be trading near their net asset values.
10. Why do investors invest the lion’s share of their funds in domestic securities?
Answer: Investors invest heavily in their domestic securities because there are significant barriers to
investing overseas. The barriers may include excessive transaction costs, information costs for foreign
securities, legal and institutional restrictions, extra taxes, exchange risk and political risk associated
with overseas investments, etc.
11. What are the advantages of investing via international mutual funds?
Answer:
The advantages of investing via international mutual funds include: (1) save
transaction/information costs, (2) circumvent legal/institutional barriers, and (3) benefit from the
expertise of professional fund managers.
12. Discuss how the advent of the euro would affect international diversification strategies.
Answer: As the euro-zone will have the same monetary and exchange-rate policies, the correlations
among euro-zone markets are likely to go up. This will reduce diversification benefits. However, to
the extent that the adoption of euro strengthens the European economy, investors may benefit from
enhanced returns.
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PROBLEMS
1. Suppose you are a euro-based investor who just sold Microsoft shares that you had bought six
months ago. You had invested 10,000 euros to buy Microsoft shares for $120 per share; the exchange
rate was $1.15 per euro. You sold the stock for $135 per share and converted the dollar proceeds into
euro at the exchange rate of $1.06 per euro. First, determine the profit from this investment in euro
terms. Second, compute the rate of return on your investment in euro terms. How much of the return is
due to the exchange rate movement?
Solution: It is useful first to compute the rate of return in euro terms:
rC  r$  e
1 
 1



 135  120   1.06 1.15 


1

 120  


1.15


 0.125  0.085
 0.210
This indicates that this euro-based investor benefited from an appreciation of dollar against the euro,
as well as from an appreciation of the dollar value of Microsoft shares. The profit in euro terms is
about C2,100, and the rate of return is about 21% in euro terms, of which 8.5% is due to the exchange
rate movement.
2. Mr. James K. Silber, an avid international investor, just sold a share of Rhone-Poulenc, a French
firm, for FF50. The share was bought for FF42 a year ago. The exchange rate is FF5.80 per U.S. dollar
now and was FF6.65 per dollar a year ago. Mr. Silber received FF4 as a cash dividend immediately
before the share was sold. Compute the rate of return on this investment in terms of U.S. dollars.
Solution: Mr. Silber must have paid $6.32 (=42/6.65) for a share of Rhone-Poulenc a year ago. When
the share was liquidated, he must have received $9.31 (=54/5.8). Therefore, the rate of return in dollar
terms is:
R($) = [(9.31-6.32)/6.32]x100 = 47.31%.
3. In the above problem, suppose that Mr. Silber sold FF42, his principal investment amount, forward
at the forward exchange rate of FF6.15 per dollar. How would this affect the dollar rate of return on
this French stock investment? In hindsight, should Mr. Silber have sold the French franc amount
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forward or not? Why or why not?
Solution: When FF42 is sold forward, the investor’s profit is reduced:
Profit($) = 42 (1/6.15 - 1/5.80)
= 42 ($.1626 - $.1724)
= -$.41
Thus, the total return of investment is:
R($) = [(9.31-6.32-.41)/6.32]x100 = 40.82%.
Due to hedging, the return became lower. By hindsight, Mr. Silber should not have entered into the
forward contract.
4. Japan Life Insurance Company invested $10,000,000 in pure-discount U.S. bonds in May 1995
when the exchange rate was 80 yen per dollar. The company liquidated the investment one year later
for $10,650,000. The exchange rate turned out to be 110 yen per dollar at the time of liquidation. What
rate of return did Japan Life realize on this investment in yen terms?
Solution: Japan Life Insurance Company spent ¥800,000,000 to buy $10,000,000 that was invested in
U.S. bonds. The liquidation value of this investment is ¥1,171,500,000, which is obtained from
multiplying $10,650,000 by ¥110/$. The rate of return in terms of yen is:
[(¥1,171,500,000 - ¥800,000,000)/ ¥800,000,000]x100 = 46.44%.
5. At the start of 1996, the annual interest rate was 6 percent in the United States and 2.8 percent in
Japan. The exchange rate was 95 yen per dollar at the time. Mr. Jorus, who is the manager of a
Bermuda-based hedge fund, thought that the substantial interest advantage associated with investing in
the United States relative to investing in Japan was not likely to be offset by the decline of the dollar
against the yen. He thus concluded that it might be a good idea to borrow in Japan and invest in the
United States. At the start of 1996, in fact, he borrowed ¥1,000 million for one year and invested in the
United States. At the end of 1996, the exchange rate became 105 yen per dollar. How much profit did
Mr. Jorus make in dollar terms?
Solution: Let us first compute the maturity value of U.S. investment:
(¥1,000,000,000/95)(1.06) = $11,157,895.
The dollar amount necessary to pay off yen loan is:
(¥1,000,000,000)(1.028)/105 = $9,790,476.
The dollar profit = $11,157,895 - $9,790,476 = $1,367,419.
Mr. Jorus was able to realize a large dollar profit because the interest rate was higher in the U.S. than
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in Japan and the dollar actually appreciated against yen. This is an example of uncovered interest
arbitrage.
6. From Exhibit 11.3 we obtain the following data in dollar terms:
Stock market
Return (mean)
Risk (SD)
United States
1.33% per month
4.56%
United Kingdom
1.52% per month
6.47%
The correlation coefficient between the two markets is 0.57. Suppose that you invest equally, i.e., 50%
each, in the two markets. Determine the expected return and standard deviation risk of the resulting
international portfolio.
Solution: The expected return of the equally weighted portfolio is:
E(Rp) = (.5)(1.33%) + (.5)(1.52%) = 1.43%
The variance of the portfolio is:
Var(Rp) = (.5)2(4.56)2 + (.5)2(6.47)2 +2(.5)2(4.56)(6.47)(.57)
= 5.20 +10.47 + 8.41 = 24.08
The standard deviation of the portfolio is thus 4.91%.
7. Suppose you are interested in investing in the stock markets of 7 countries--i.e., Canada, France,
Germany, Japan, Switzerland, the United Kingdom, and the United States--the same 7 countries that
appear in Exhibit 11.9. Specifically, you would like to solve for the optimal (tangency) portfolio
comprising the above 7 stock markets. In solving the optimal portfolio, use the input data (i.e.
correlation coefficients, means, and standard deviations) provided in Exhibit 11.4. The risk-free
interest rate is assumed to be 0.5% per month and you can take a short position in any stock market.
What are the optimal weights for each of the 7 stock markets? This problem can be solved using
MPTSolver.xls spreadsheet.
Solution: Using the data in Exhibit 11.4, the covariance matrix is computed and is given below.
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CN
FR
GM
JP
SW
UK
US
CN
33.99
15.53
12.97
11.08
14.01
21.88
18.61
FR
15.53
49.14
31.18
21.52
25.88
24.49
14.38
GM
12.97
31.18
45.43
17.74
28.44
21.37
11.37
JP
11.08
21.52
17.74
53.44
16.28
19.86
8.00
SW
14.01
25.88
28.44
16.28
34.34
19.72
12.83
UK
21.88
24.49
21.37
19.86
19.72
41.86
16.82
US
18.61
14.38
11.37
8.00
12.83
16.82
20.79
The optimal weights computed are -0.7457 for Canada, 0.0453 for France, 0.0237 for Germany,
0.2435 for Japan, -0.0474 for Switzerland, 0.3168 for U.K., and 1.1638 for U.S., respectively.
IM-84
MINI CASE: SOLVING FOR THE OPTIMAL INTERNATIONAL PORTFOLIO
Suppose you are a financial advisor and your client, who is currently investing only in the
U.S. stock market, is considering diversifying into the U.K. stock market. At the moment, there are
neither particular barriers nor restrictions on investing in the U.K. stock market. Your client would like
to know what kind of benefits can be expected from doing so. Using the data provided in the above
problem (i.e., problem 12), solve the following problems:
(a) Graphically illustrate various combinations of portfolio risk and return that can be generated by
investing in the U.S. and U.K. stock markets with different proportions. Two extreme proportions are
(I) investing 100% in the U.S. with no position in the U.K. market, and (ii) investing 100% in the
U.K. market with no position in the U.S. market.
(b) Solve for the ‘optimal’ international portfolio comprised of the U.S. and U.K. markets. Assume
that the monthly risk-free interest rate is 0.5% and that investors can take a short (negative) position in
either market.
(c) What is the extra return that U.S. investors can expect to capture at the ‘U.S.-equivalent’ risk
level? Also trace out the efficient set. [The Appendix 11.B provides an example.]
Suggested Solution to the Optimal International Portfolio:
Let U.S. be market 1 and U.K. be market 2. The parameter values are: ¯,R1 = 1.33%, ¯,R2 = 1.52%,
1 = 4.56%, 2 = 6.47%, Rf = 0.5%.
Accordingly, 12 = 12 (correlation coefficient) = (4.56)(6.47)(0.57) = 16.82, 12 = 20.79, 22
=41.86.
(a) E(Rp) = 1.33w1 + 1.52w2
The variance of the portfolio is:
Var(Rp) = 20.79w12 + 41.86w22 + 33.63w1w2
Some possible portfolios are:
w1
w2
E(Rp)
Var(Rp)
1.00
0.00
1.33
20.79
0.75
0.25
1.38
20.62
0.50
0.50
1.43
24.07
0.25
0.75
1.47
31.15
0.00
1.00
1.52
41.86
(b) The optimal weights are w1 = 0.71 and w2 = 0.29.
(c) ¯,RI = Rf + US
Here,  = Slope of efficient set = (¯,ROIP - Rf )/ OIP
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¯,ROIP = (0.71)(1.33) + (0.29)(1.52) = 1.39%
OIP2 = (0.71)2(20.79) + (0.29)2(16.82) + (0.71)(0.29)(33.63) = 18.79
OIP = 4.33%
Therefore, ¯,RI = 0.5 + ((1.39-0.5)/4.33)(4.56) = 1.97%
Extra return = 1.97-1.33 = 0.64%
IM-86
CHAPTER 12 MANAGEMENT OF ECONOMIC EXPOSURE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. How would you define economic exposure to exchange risk?
Answer: Economic exposure can be defined as the possibility that the firm’s cash flows and thus its
market value may be affected by the unexpected exchange rate changes.
2. Explain the following statement: “Exposure is the regression coefficient”.
Answer: Exposure to currency risk can be appropriately measured by the sensitivity of the firm’s
future cash flows and the market value to random changes in exchange rates. Statistically, this
sensitivity can be estimated by the regression coefficient. Thus, exposure can be said to be the
regression coefficient.
3. Suppose that your company has an equity position in a French firm. Discuss the condition under
which the dollar/franc exchange rate uncertainty does not constitute exchange exposure for your
company.
Answer: Mere changes in exchange rates do not necessarily constitute currency exposure. If the
French franc value of the equity moves in the opposite direction as much as the dollar value of the
franc changes, then the dollar value of the equity position will be insensitive to exchange rate
movements. As a result, your company will not be exposed to currency risk.
4. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating
cash flow.
Answer: The competitive effect: exchange rate changes may affect operating cash flows by altering
the firm’s competitive position.
The conversion effect: A given operating cash flows in terms of a foreign currency will be converted
into higher or lower dollar (home currency)amounts as the exchange rate changes.
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5. Discuss the determinants of operating exposure.
Answer: The main determinants of a firm’s operating exposure are (1) the structure of the markets in
which the firm sources its inputs, such as labor and materials, and sells its products, and (2) the firm’s
ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and
sourcing.
6. Discuss the implications of purchasing power parity for operating exposure.
Answer: If the exchange rate changes are matched by the inflation rate differential between countries,
firms’ competitive positions will not be altered by exchange rate changes. Firms are not subject to
operating exposure.
7. General Motors exports cars to Spain but the strong dollar against the peseta hurts sales of GM cars
in Spain. In the Spanish market, GM faces competition from the Italian and French car makers, such as
Fiat and Renault, whose currencies remain stable relative to the peseta. What kind of measures would
you recommend so that GM can maintain its market share in Spain.
Answer: Possible measures that GM can take include: (1) diversify the market; try to market the cars
not just in Spain and other European countries but also in, say, Asia; (2) locate production facilities in
Spain and source inputs locally; (3) locate production facilities, say, in Mexico where production costs
are low and export to Spain from Mexico.
8. What are the advantages and disadvantages of financial hedging of the firm’s operating exposure
vis-a-vis operational hedges (such as relocating manufacturing site)?
Answer: Financial hedging can be implemented quickly with relatively low costs, but it is difficult to
hedge against long-term, real exposure with financial contracts. On the other hand, operational hedges
are costly, time-consuming, and not easily reversible.
9. Discuss the advantages and disadvantages of maintaining multiple manufacturing sites as a hedge
against exchange rate exposure.
Answer: To establish multiple manufacturing sites can be effective in managing exchange risk
exposure, but it can be costly because the firm may not be able to take advantage of the economy of
scale.
IM-88
10. Evaluate the following statement: “A firm can reduce its currency exposure by diversifying
across different business lines”.
Answer: Conglomerate expansion may be too costly as a means of hedging exchange risk exposure.
Investment in a different line of business must be made based on its own merit.
11. The exchange rate uncertainty may not necessarily mean that firms face exchange risk exposure.
Explain why this may be the case.
Answer: A firm can have a natural hedging position due to, for example, diversified markets, flexible
sourcing capabilities, etc. In addition, to the extent that the PPP holds, nominal exchange rate changes
do not influence firms’ competitive positions. Under these circumstances, firms do not need to worry
about exchange risk exposure.
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PROBLEMS
1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year.
As a U.S. resident, we are concerned with the dollar value of the land. Assume that, if the British
economy booms in the future, the land will be worth £2,000 and one British pound will be worth
$1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500,
but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom
with a 60% probability and a slow-down with a 40% probability.
(a) Estimate your exposure b to the exchange risk.
(b) Compute the variance of the dollar value of your property that is attributable to the exchange rate
uncertainty.
(c) Discuss how you can hedge your exchange risk exposure and also examine the consequences of
hedging.
Solution: (a) Let us compute the necessary parameter values:
E(P) = (.6)(2800)+(.4)(2250) = 1680+900 = $2,580
E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44
Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2
= .00096+.00144 = .0024.
Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)
= -5.28-7.92 = -13.20
b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.
You have a negative exposure! As the pound gets stronger(weaker) against the dollar, the dollar
value of your British holding goes down(up).
(b) b2Var(S) = (-5500)2(.0024) =72,600($)2
(c) Buy £5,500 forward. By doing so, you can eliminate the volatility of the dollar value of your
British asset that is due to the exchange rate volatility.
IM-90
2. A U.S. firm holds an asset in France and faces the following scenario:
State 1
State 2
State 3
State 4
Probability
25%
25%
25%
25%
Spot rate
$.30/FF
$.25/FF
$.20/FF
$.18/FF
P*
FF1500
FF1400
FF1300
FF1200
P
$450
$350
$260
$216
In the above table, P* is the French franc price of the asset held by the U.S. firm and P is the dollar
price of the asset.
(a) Compute the exchange exposure faced by the U.S. firm.
(b) What is the variance of the dollar price of this asset if the U.S. firm remains unhedged against this
exposure.
(c) In case the U.S. firm hedges against this exposure using the forward contract, what is the variance
of the dollar value of the hedged position?
Solution: (a)
E(P) = .25(.30+.25+.20+.18) = $.2325
E(P) = .25(450+350+260+216) = $319
Var(S) = .25[(.30-.2325)2+(.25-.2325)2+(.2-.2325)2+(.18-.2325)2]
= .0022
Cov(P,S) = .25[(450-319)(.30-.2325)+(350-319)(.25-.2325)
(260-319)(.20-.2325)+(216-319)(.18-.2325)]
= 4.18
b = Cov(P,S)/Var(S) = 4.18/.0022 = FF1,900.
(b) Var(P) = .25[(450-319)2+(350-319)2+(260-319)2+(216-319)2]
= 8,053($)2.
(c) Var(P) - b2Var(S) = 8053-(1900)2(.0022) = 111($)2.
This means that most of the volatility of the dollar value of the French asset can be removed by
hedging exchange risk.
IM-91
MINI CASE: ECONOMIC EXPOSURE OF ALBION COMPUTERS PLC
Consider Case 3 of Albion Computers PLC discussed in the chapter. Now, assume that the
pound is expected to depreciate to $1.50 from the current level of $1.60 per pound. This implies that
the pound cost of the imported part, i.e., Intel’s microprocessors, is £341 (=$512/$1.50). Other
variables, such as the unit sales volume and the U.K. inflation rate, remain the same as in Case 3.
(a) Compute the projected annual cash flow in dollars.
(b) Compute the projected operating gains/losses over the four-year horizon as the discounted present
value of change in cash flows, which is due to the pound depreciation, from the benchmark case
presented in Exhibit 12.4.
(c) What actions, if any, can Albion take to mitigate the projected operating losses due to the pound
depreciation?
Suggested Solution to Economic Exposure of Albion Computers PLC
a) The projected annual cash flow can be computed as follows:
______________________________________________________
Sales (40,000 units at £1,080/unit)
£43,200,000
Variable costs (40,000 units at £697/unit)
£27,880,000
Fixed overhead costs
4,000,000
Depreciation allowances
1,000,000
Net profit before tax
£15,315,000
Income tax (50%)
7,657,500
Profit after tax
7,657,500
Add back depreciation
1,000,000
Operating cash flow in pounds
£8,657,500
Operating cash flow in dollars
$12,986,250
______________________________________________________
IM-92
b) ______________________________________________________
Variables
Benchmark
Current
Case
Case
______________________________________________________
Exchange rate ($/£)
1.60
1.50
Unit variable cost (£)
650
697
Unit sales price (£)
1,000
1,080
Sales volume (units)
50,000
40,000
Annual cash flow (£)
7,250,000
8,657,500
Annual cash flow ($)
11,600,000
12,986,250
Four-year present value ($)
33,118,000
37,076,946
Operating gains/losses ($)
3,958,946
______________________________________________________
c) In this case, Albion actually can expect to realize exchange gains, rather than losses. This is mainly
due to the fact that while the selling price appreciates by 8% in the U.K. market, the variable cost of
imported input increased by about 6.25%. Albion may choose not to do anything.
IM-93
CHAPTER 13 MANAGEMENT OF TRANSACTION EXPOSURE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND
PROBLEMS
QUESTIONS
1. How would you define transaction exposure? How is it different from economic exposure?
Answer: Transaction exposure is the sensitivity of realized domestic currency values of the firm’s
contractual cash flows denominated in foreign currencies to unexpected changes in exchange rates.
Unlike economic exposure, transaction exposure is well-defined and short-term.
2. Discuss and compare hedging transaction exposure using the forward contract vs. money market
instruments. When do the alternative hedging approaches produce the same result?
Answer: Hedging transaction exposure by a forward contract is achieved by selling or buying foreign
currency receivables or payables forward. On the other hand, money market hedge is achieved by
borrowing or lending the present value of foreign currency receivables or payables, thereby creating
offsetting foreign currency positions. If the interest rate parity is holding, the two hedging methods are
equivalent.
3. Discuss and compare the costs of hedging via the forward contract and the options contract.
Answer: There is no up-front cost of hedging by forward contracts. In the case of options hedging,
however, hedgers should pay the premiums for the contracts up-front. The cost of forward hedging,
however, may be realized ex post when the hedger regrets his/her hedging decision.
4. What are the advantages of a currency options contract as a hedging tool compared with the forward
contract?
Answer: The main advantage of using options contracts for hedging is that the hedger can decide
whether to exercise options upon observing the realized future exchange rate. Options thus provide a
hedge against ex post regret that forward hedger might have to suffer. Hedgers can only eliminate the
downside risk while retaining the upside potential.
5. Suppose your company has purchased a put option on the German mark to manage exchange
exposure associated with an account receivable denominated in that currency. In this case, your
IM-94
company can be said to have an ‘insurance’ policy on its receivable. Explain in what sense this is so.
Answer: Your company in this case knows in advance that it will receive a certain minimum dollar
amount no matter what might happen to the $/DM exchange rate. Furthermore, if the German mark
appreciates, your company will benefit from the rising mark.
6. Recent surveys of corporate exchange risk management practices indicate that many U.S. firms
simply do not hedge. How would you explain this result?
Answer: There can be many possible reasons for this. First, many firms may feel that they are not
really exposed to exchange risk due to product diversification, diversified markets for their products,
etc. Second, firms may be using self-insurance against exchange risk. Third, firms may feel that
shareholders can diversify exchange risk themselves, rendering corporate risk management
unnecessary.
7. Should a firm hedge? Why or why not?
Answer: In a perfect capital market, firms may not need to hedge exchange risk. But firms can add to
their value by hedging if markets are imperfect. First, if management knows about the firm’s exposure
better than shareholders, the firm, not its shareholders, should hedge. Second, firms may be able to
hedge at a lower cost. Third, if default costs are significant, corporate hedging can be justifiable
because it reduces the probability of default. Fourth, if the firm faces progressive taxes, it can reduce
tax obligations by hedging which stabilizes corporate earnings.
8. Using an example, discuss the possible effect of hedging on a firm’s tax obligations.
Answer: One can use an example similar to the one presented in the chapter.
9. Explain contingent exposure and discuss the advantages of using currency options to manage this
type of currency exposure.
Answer: Companies may encounter a situation where they may or may not face currency exposure. In
this situation, companies need options, not obligations, to buy or sell a given amount of foreign
exchange they may or may not receive or have to pay. If companies either hedge using forward
contracts or do not hedge at all, they may face definite currency exposure.
IM-95
10. Explain cross-hedging and discuss the factors determining its effectiveness.
Answer: Cross-hedging involves hedging a position in one asset by taking a position in another asset.
The effectiveness of cross-hedging would depend on the strength and stability of the relationship
between the two assets.
IM-96
PROBLEMS
1. Cray Research sold a super computer to the Max Planck Institute in Germany on credit and invoiced
DM 10 million payable in six months. Currently, the six-month forward exchange rate is $1.50/DM and
the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.43 in six
months.
(a) What is the expected gain/loss from the forward hedging?
(b) If you were the financial manager of Cray Research, would you recommend hedging this DM
receivable? Why or why not?
(c) Suppose the foreign exchange advisor predicts that the future spot rate will be the same as the
forward exchange rate quoted today. Would you recommend hedging in this case? Why or why not?
Solution: (a) Expected gain($) = 10,000,000(1/1.50-1/1.43)
= 10,000,000(.6667-.6993)
= -$326,000.
(b) There is no easy answer here. Hedging is expected to reduce the dollar receipt by $326,000. If I
were willing to sacrifice $326,000 or more to eliminate exchange risk, I would hedge. Otherwise, I
would not. It depends on the degree of my risk aversion.
(c) Since I eliminate risk without sacrificing dollar receipt, I would be more likely to hedge.
2. IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed ¥250 million
payable in three months. Currently, the spot exchange rate is ¥105/$ and the three-month forward rate is
¥100/$. The three-month money market interest rate is 8 percent per annum in the U.S. and 7 percent per
annum in Japan. The management of IBM decided to use the money market hedge to deal with this yen
account payable.
(a) Explain the process of a money market hedge and compute the dollar cost of meeting the yen
obligation.
(b) Conduct the cash flow analysis of the money market hedge.
Solution: (a). Let’s first compute the PV of ¥250 million, i.e.,
250m/1.0175 = ¥245,700,245.7
So if the above yen amount is invested today at the Japanese interest rate for three months, the
maturity value will be exactly equal to ¥25 million which is the amount of payable.
To buy the above yen amount today, it will cost:
$2,340,002.34 = ¥250,000,000/105.
The dollar cost of meeting this yen obligation is $2,340,002.34 as of today.
IM-97
(b)
___________________________________________________________________
Transaction
CF0
CF1
____________________________________________________________________
1. Buy yens spot
-$2,340,002.34
with dollars
¥245,700,245.70
2. Invest in Japan
- ¥245,700,245.70
- ¥250,000,000
3. Pay yens
Net cash flow
¥250,000,000
- $2,340,002.34
____________________________________________________________________
3.
You plan to visit Geneva, Switzerland in three months to attend an international business
conference. You expect to incur the total cost of SF 5,000 for lodging, meals and transportation during
your stay. As of today, the spot exchange rate is $0.60/SF and the three-month forward rate is
$0.63/SF. You can buy the three-month call option on SF with the exercise rate of $0.64/SF for the
premium of $0.05 per SF. Assume that your expected future spot exchange rate is the same as the
forward rate. The three-month interest rate is 6 percent per annum in the United States and 4 percent
per annum in Switzerland.
(a) Calculate your expected dollar cost of buying SF5,000 if you choose to hedge via call option on
SF.
(b) Calculate the future dollar cost of meeting this SF obligation if you decide to hedge using a
forward contract.
(c) At what future spot exchange rate will you be indifferent between the forward and option market
hedges?
(d) Illustrate the future dollar costs of meeting the SF payable against the future spot exchange rate
under both the options and forward market hedges.
Solution: (a) Total option premium = (.05)(5000) = $250. In three months, $250 is worth $253.75 =
$250(1.015). At the expected future spot rate of $0.63/SF, which is less than the exercise price, you
don’t expect to exercise options. Rather, you expect to buy Swiss franc at $0.63/SF. Since you are
going to buy SF5,000, you expect to spend $3,150 (=.63x5,000). Thus, the total expected cost of
buying SF5,000 will be the sum of $3,150 and $253.75, i.e., $3,403.75.
(b) $3,150 = (.63)(5,000).
(c) $3,150 = 5,000x + 253.75, where x represents the break-even future spot rate. Solving for x, we
obtain x = $0.57925/SF. Note that at the break-even future spot rate, options will not be exercised.
(d) If the Swiss franc appreciates beyond $0.64/SF, which is the exercise price of call option, you will
IM-98
exercise the option and buy SF5,000 for $3,200. The total cost of buying SF5,000 will be $3,453.75 =
$3,200 + $253.75.
This is the maximum you will pay.
$ Cost
$3,453.75
Options hedge
$3,150
Forward hedge
$253.75
0
$/SF
0.579
0.64
(strike price)
4. McDonnell Douglas just signed a contract to sell a DC 10 aircraft to Air France. Air France will be
billed FF50 million which is payable in one year. The current spot exchange rate is $0.20/FF and the
one-year forward rate is $0.19/FF. The annual interest rate is 6.0% in the U.S. and 9.5% in France.
McDonnell Douglas is concerned with the volatile exchange rate between the dollar and the franc and
would like to hedge exchange exposure.
(a) It is considering two hedging alternatives: sell the franc proceeds from the sale forward or borrow
francs from the Credit Lyonnaise against the franc receivable. Which alternative would you
recommend? Why?
(b) Other things being equal, at what forward exchange rate would McDonnell Douglas be indifferent
between the two hedging methods?
Solution: (a) In the case of forward hedge, the future dollar proceeds will be (50,000,000)(0.19) =
$9,500,000.
In the case of money market hedge (MMH), the firm has to first borrow the PV of its franc receivable,
i.e.,
50,000,000/1.095 =FF45,662,100. Then the firm should exchange this franc amount into dollars at the
current spot rate to receive: (FF45,662,100)(0.20) = $9,132,420, which can be invested at the dollar
interest rate for one year to yield:
$9,132,420(1.06) = $9,680,365.
Clearly, the firm can receive $180,365 more by using MMH.
(b) According to IRP, F = S(1+i$)/(1+iF). Thus the “indifferent” forward rate will be:
F = 0.20(1.06)/1.095 = $0.1936/FF.
IM-99
5. Suppose that Baltimore Machinery sold a drilling machine to a Swiss firm and gave the Swiss
client a choice of paying either $10,000 or SF 15,000 in three months.
(a) In the above example, Baltimore Machinery effectively gave the Swiss client a free option to buy
up to $10,000 dollars using Swiss franc. What is the ‘implied’ exercise exchange rate?
(b) If the spot exchange rate turns out to be $0.62/SF, which currency do you think the Swiss client
will choose to use for payment? What is the value of this free option for the Swiss client?
(c) What is the best way for Baltimore Machinery to deal with the exchange exposure?
Solution: (a) The implied exercise (price) rate is: 10,000/15,000 = $0.6667/SF.
(b) If the Swiss client chooses to pay $10,000, it will cost SF16,129 (=10,000/.62). Since the Swiss
client has an option to pay SF15,000, it will choose to do so. The value of this option is obviously
SF1,129 (=SF16,129-SF15,000).
(c) Baltimore Machinery faces a contingent exposure in the sense that it may or may not receive
SF15,000 in the future. The firm thus can hedge this exposure by buying a put option on SF15,000.
6. Princess Cruise Company (PCC) purchased a ship from Mitsubishi Heavy Industry. PCC owes
Mitsubishi Heavy Industry 500 million yen in one year. The current spot rate is 124 yen per dollar and
the one-year forward rate is 110 yen per dollar. The annual interest rate is 5% in Japan and 8% in the
U.S. PCC can also buy a one-year call option on yen at the strike price of $.0081 per yen for a
premium of .014 cents per yen.
(a) Compute the future dollar costs of meeting this obligation using the money market hedge and the
forward hedges.
(b) Assuming that the forward exchange rate is the best predictor of the future spot rate, compute the
expected future dollar cost of meeting this obligation when the option hedge is used.
(c) At what future spot rate do you think PCC may be indifferent between the option and forward
hedge?
Solution: (a) In the case of forward hedge, the dollar cost will be 500,000,000/110 = $4,545,455. In
the case of money market hedge, the future dollar cost will be: 500,000,000(1.08)/(1.05)(124)
= $4,147,465.
(b) The option premium is: (.014/100)(500,000,000) = $70,000. Its future value will be $70,000(1.08)
= $75,600.
At the expected future spot rate of $.0091(=1/110), which is higher than the exercise of $.0081, PCC
will exercise its call option and buy ¥500,000,000 for $4,050,000 (=500,000,000x.0081).
The total expected cost will thus be $4,125,600, which is the sum of $75,600 and $4,050,000.
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(c) When the option hedge is used, PCC will spend “at most” $4,125,000. On the other hand, when the
forward hedging is used, PCC will have to spend $4,545,455 regardless of the future spot rate. This means
that the options hedge dominates the forward hedge. At no future spot rate, PCC will be indifferent
between forward and options hedges.
IM-101
Suggested solution for Mini Case: Chase Options, Inc.
[See Chapter 13 for the case text]
Chase Options, Inc.
Hedging Foreign Currency Exposure Through Currency Options
Harvey A. Poniachek
I. Case Summary
This case reviews the foreign exchange options market and hedging. It presents various international
transactions that require currency options hedging strategies by the corporations involved. Seven
transactions under a variety of circumstances are introduced that require hedging by currency options.
The transactions involve hedging of dividend remittances, portfolio investment exposure, and strategic
economic competitiveness. Market quotations are provided for options (and options hedging ratios),
forwards, and interest rates for various maturities.
II. Case Objective.
The case introduces the student to the principles of currency options market and hedging strategies.
The transactions are of various types that often confront companies that are involved in extensive
international business or multinational corporations. The case induces students to acquire hands-on
experience in addressing specific exposure and hedging concerns, including how to apply various
market quotations, which hedging strategy is most suitable, and how to address exposure in foreign
currency through cross hedging policies.
III. Proposed Assignment Solution
1. The company expects DM100 million in repatriated profits, and does not want the DM/$ exchange
rate at which they convert those profits to rise above 1.70. They can hedge this exposure using DM put
options with a strike price of 1.70. If the spot rate rises above 1.70, they can exercise the option, while
if that rate falls they can enjoy additional profits from favorable exchange rate movements.
To purchase the options would require an up-front premium of:
DM 100,000,000 x 0.0164 = DM 1,640,000.
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With a strike price of 1.70 DM/$, this would assure the U.S. company of receiving at least:
DM 100,000,000 – DM 1,640,000 x (1 + 0.085106 x 272/360)
= DM 98,254,544/1.70 DM/$ = $57,796,791
by exercising the option if the DM depreciated. Note that the proceeds from the repatriated profits are
reduced by the premium paid, which is further adjusted by the interest foregone on this amount.
However, if the DM were to appreciate relative to the dollar, the company would allow the option to
expire, and enjoy greater dollar proceeds from this increase.
Should forward contracts be used to hedge this exposure, the proceeds received would be:
DM100,000,000/1.6725 DM/$ = $59,790,732,
regardless of the movement of the DM/$ exchange rate. While this amount is almost $2 million more
than that realized using option hedges above, there is no flexibility regarding the exercise date; if this
date differs from that at which the repatriate profits are available, the company may be exposed to
additional further current exposure. Further, there is no opportunity to enjoy any appreciation in the
DM.
If the company were to buy DM puts as above, and sell an equivalent amount in calls with strike price
1.647, the premium paid would be exactly offset by the premium received. This would assure that the
exchange rate realized would fall between 1.647 and 1.700. If the rate rises above 1.700, the company
will exercise its put option, and if it fell below 1.647, the other party would use its call; for any rate in
between, both options would expire worthless. The proceeds realized would then fall between:
DM 100,00,000/1.647 DM/$ = $60,716,454
and
DM 100,000,000/1.700 DM/$ = $58,823,529.
This would allow the company some upside potential, while guaranteeing proceeds at least $1 million
greater than the minimum for simply buying a put as above.
IM-103
Buy/Sell Options
“Put”
DM/$
Spot
Put Payoff
1.60
(1,742,846)
1.61
“Call”
Profits
Call Payoff
Profits
Net Profit
0
1,742,846
60,716,454
60,716,454
(1,742,846)
0
1,742,846
60,716,454
60,716,454
1.62
(1,742,846)
0
1,742,846
60,716,454
60,716,454
1.63
(1,742,846)
0
1,742,846
60,716,454
60,716,454
1.64
(1,742,846)
0
1,742,846
60,716,454
60,716,454
1.65
(1,742,846)
60,606,061
1,742,846
0
60,606,061
1.66
(1,742,846)
60,240,964
1,742,846
0
60,240,964
1.67
(1,742,846)
59,880,240
1,742,846
0
59,880,240
1.68
(1,742,846)
59,523,810
1,742,846
0
59,523,810
1.69
(1,742,846)
59,171,598
1,742,846
0
59,171,598
1.70
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.71
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.72
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.73
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.74
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.75
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.76
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.77
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.78
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.79
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.80
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.81
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.82
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.83
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.84
(1,742,846)
58,823,529
1,742,846
0
58,823,529
1.85
(1,742,846)
58,823,529
1,742,846
0
58,823,529
IM-104
Since the firm believes that there is a good chance that the pound sterling will weaken, locking them
into a forward contract would not be appropriate, because they would lose the opportunity to profit
from this weakening. Their hedge strategy should follow for an upside potential to match their
viewpoint. Therefore, they should purchase sterling call options, paying a premium of:
5,000,000 STG x 0.0176 = 88,000 STG.
If the dollar strengthens against the pound, the firm allows the option to expire, and buys sterling in
the spot market at a cheaper price than they would have paid for a forward contract; otherwise, the
sterling calls protect against unfavorable depreciation of the dollar.
Because the fund manager is uncertain when he will sell the bonds, he requires a hedge which will
allow flexibility as to the exercise date. Thus, options are the best instrument for him to use. He can
buy A$ puts to lock in a floor of 0.72 A$/$. Since he is willing to forego any further currency
appreciation, he can sell A$ calls with a strike price of 0.8025 A$/$ to defray the cost of his hedge (in
fact he earns a net premium of A$ 100,000,000 x (0.007234 – 0.007211) = A$ 2,300), while knowing
that he can’t receive less than 0.72 A$/$ when redeeming his investment, and can benefit from a small
appreciation of the A$.
Example #3:
Problem: Hedge principal denominated in A$ into US$. Forgo upside potential to buy floor protection.
I.
Hedge by writing calls and buying puts
1) Write calls for $/A$ @ 0.8025
Buy puts for $/A$ @ 0.72
# contracts needed = Principal in A$/Contract size
100,000,000A$/100,000 A$ = 100
2) Revenue from sale of calls = (# contracts)(size of contract)(premium)
$75,573 = (100)(100,000 A$)(.007234 $/A$)(1 + .0825 195/360)
3) Total cost of puts = (# contracts)(size of contract)(premium)
$75,332 = (100)(100,000 A$)(.007211 $/A$)(1 + .0825 195/360)
4) Put payoff
If spot falls below 0.72, fund manager will exercise put
If spot rises above 0.72, fund manager will let put expire
IM-105
5) Call payoff
If spot rises above .8025, call will be exercised
If spot falls below .8025, call will expire
6) Net payoff
See following Table for net payoff
Australian Dollar Bond Hedge
“Put”
Strike
Price
Put Payoff
Principal
“Call”
Call Payoff
Principal
Net Profit
0.60
(75,332)
72,000,000
75,573
0
72,000,241
0.61
(75,332)
72,000,000
75,573
0
72,000,241
0.62
(75,332)
72,000,000
75,573
0
72,000,241
0.63
(75,332)
72,000,000
75,573
0
72,000,241
0.64
(75,332)
72,000,000
75,573
0
72,000,241
0.65
(75,332)
72,000,000
75,573
0
72,000,241
0.66
(75,332)
72,000,000
75,573
0
72,000,241
0.67
(75,332)
72,000,000
75,573
0
72,000,241
0.68
(75,332)
72,000,000
75,573
0
72,000,241
0.69
(75,332)
72,000,000
75,573
0
72,000,241
0.70
(75,332)
72,000,000
75,573
0
72,000,241
0.71
(75,332)
72,000,000
75,573
0
72,000,241
0.72
(75,332)
72,000,000
75,573
0
72,000,241
0.73
(75,332)
73,000,000
75,573
0
73,000,241
0.74
(75,332)
74,000,000
75,573
0
74,000,241
0.75
(75,332)
75,000,000
75,573
0
75,000,241
0.76
(75,332)
76,000,000
75,573
0
76,000,241
0.77
(75,332)
77,000,000
75,573
0
77,000,241
0.78
(75,332)
78,000,000
75,573
0
78,000,241
0.79
(75,332)
79,000,000
75,573
0
79,000,241
0.80
(75,332)
80,000,000
75,573
0
80,000,241
0.81
(75,332)
0
75,573
80,250,000
80,250,241
0.82
(75,332)
0
75,573
80,250,000
80,250,241
0.83
(75,332)
0
75,573
80,250,000
80,250,241
0.84
(75,332)
0
75,573
80,250,000
80,250,241
0.85
(75,332)
0
75,573
80,250,000
80,250,241
4. The German company is bidding on a contract which they cannot be certain of winning. Thus, the
need to execute a currency transaction is similarly uncertain, and using a forward or futures as a hedge
is inappropriate, because it would force them to perform even if they do not win the contract.
Using a sterling put option as a hedge for this transaction makes the most sense. For a premium of:
IM-106
12 million STG x 0.0161 = 193,200 STG,
they can assure themselves that adverse movements in the pound sterling exchange rate will not
diminish the profitability of the project (and hence the feasibility of their bid), while at the same time
allowing the potential for gains from sterling appreciation.
5. Since AMC in concerned about the adverse effects that a strengthening of the dollar would have on
its business, we need to create a situation in which it will profit from such an appreciation. Purchasing
a yen put or a dollar call will achieve this objective. The data in Exhibit 1, row 7 represent a 10
percent appreciation of the dollar (128.15 strike vs. 116.5 forward rate) and can be used to hedge
against a similar appreciation of the dollar.
For every million yen of hedging, the cost would be:
Yen 100,000,000 x 0.000127 = 127 Yen.
To determine the breakeven point, we need to compute the value of this option if the dollar
appreciated 10 percent (spot rose to 128.15), and subtract from it the premium we paid. This profit
would be compared with the profit earned on five to 10 percent of AMC’s sales (which would be lost
as a result of the dollar appreciation). The number of options to be purchased which would equalize
these two quantities would represent the breakeven point.
IM-107
Example #5:
Hedge the economic cost of the depreciating Yen to AMC.
If we assume that AMC sales fall in direct proportion to depreciation in the yen (i.e., a 10 percent
decline in yen and 10 percent decline in sales), then we can hedge the full value of AMC’s sales. I
have assumed $100 million in sales.
1) Buy yen puts
# contracts needed = Expected Sales *Current Y/$ Rate / Contract size
9600 = ($100,000,000)(120¥/$) / $1,250,000¥
2) Total Cost = (# contracts)(contract size)(premium)
$1,524,000 = (9600)(1,250,000)(.0001275/¥)
3) Floor rate = Exercise – Premium
128.1499¥/$ = 128.15¥/$ - $1,524,000/12,000,000,000¥
4) The payoff changes depending on the level of the Y/$ rate. The following table summarizes the
payoffs. An equilibrium is reached when the spot rate equals the floor rate.
IM-108
AMC Profitability
Yen/$
Spot
Put Payoff
Sales
Net Profit
120
(1,524,990)
100,000,000
98,475,010
121
(1,524,990)
99,173,664
97,648,564
122
(1,524,990)
98,360,656
96,835,666
123
(1,524,990)
97,560,976
86,035,986
124
(1,524,990)
96,774,194
95,249,204
125
(1,524,990)
96,000,000
94,475,010
126
(1,524,990)
95,238,095
93,713,105
127
(847,829)
94,488,189
93,640,360
128
(109,640)
93,750,000
93,640,360
129
617,104
93,023,256
93,640,360
130
1,332,668
92,307,692
93,640,360
131
2,037,307
91,603,053
93,640,360
132
2,731,269
90,909,091
93,640,360
133
3,414,796
90,225,664
93,640,360
134
4,088,122
89,552,239
93,640,360
135
4,751,431
88,888,889
93,640,360
136
5,405,066
88,235,294
93,640,360
137
6,049,118
87,591,241
93,640,360
138
6,683,839
86,966,522
93,640,360
139
7,308,425
86,330,936
93,640,360
140
7,926,075
85,714,286
93,640,360
141
8,533,977
85,106,383
93,640,360
142
9,133,318
84,507,042
93,640,360
143
9,724,276
83,916,084
93,640,360
144
10,307,027
83,333,333
93,640,360
145
10,881,740
82,758,621
93,640,360
146
11,448,579
82,191,781
93,640,360
147
12,007,707
81,632,653
93,640,360
148
12,569,279
81,081,081
93,640,360
149
13,103,448
80,536,913
93,640,360
150
13,640,360
80,000,000
93,640,360
The parent has a DM payable, and Lira receivable. It has several ways to cover its exposure;
forwards, options, or swaps.
IM-109
The forward would be acceptable for the DM loan, because it has a known quantity and maturity, but
the Lira exposure would retain some of its uncertainty because these factors are not assured.
The parent could buy DM calls and Lira puts. This would allow them to take advantage of favorable
currency fluctuations, but would require paying for two premiums.
Finally, they could swap their Lira receivable into DM. This would leave a net DM exposure which
would probably be smaller than the amount of the loan, which they could hedge using forwards or
options, depending upon their risk outlook.
The company has Lira receivables, and is concerned about possible depreciation versus the dollar.
Because of the high costs of Lira options, they instead buy DM puts, making the assumption that
movement in the DM and Lira exchange rates versus the dollar correlate well.
A hedge of lira using DM options will depend on the relationship between lira FX rates and DM
options. This relationship could be determined using a regression of historical data.
The hedged risk as a percent of the open risk can be estimated as:
Square Root ( var(error)/(b2var(lira FX rate) ) * 100
The “cost” of the risk of the DM hedge would have to be compared with the cost of the expensive
lira options.
Whichever hedge is “cheaper” (i.e., lower cost for same risk or lower risk for same cost) should be
selected. This hedge must be closely monitored, however, to make sure that this relationship holds
true. If it does not, this “basis risk” can cause the ratio of DM versus Lira to change, so that the
appropriate amount of cross-hedge is different. If that amount is not then adjusted, a net currency
exposure could result, leaving the company open to additional currency losses.
IM-110
CHAPTER 14 MANAGEMENT OF TRANSLATION EXPOSURE
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Explain the difference in the translation process between the monetary/nonmonetary method and
the temporal method.
Answer: Under the monetary/nonmonetary method, all monetary balance sheet accounts of a foreign
subsidiary are translated at the current exchange rate. Other balance sheet accounts are translated at
the historical rate exchange rate in effect when the account was first recorded. Under the temporal
method, monetary accounts are translated at the current exchange rate. Other balance sheet accounts
are also translated at the current rate, if they are carried on the books at current value. If they are
carried at historical value, they are translated at the rate in effect on the date the item was put on the
books. Since fixed assets and inventory are usually carried at historical costs, the temporal method
and the monetary/nonmonetary method will typically provide the same translation.
2. How are translation gains and losses handled differently according to the current rate method in
comparison
to
the
other
three
methods,
that
is,
the
current/noncurrent
method,
the
monetary/nonmonetary method, and the temporal method?
Answer: Under the current rate method, translation gains and losses are handled only as an adjustment
to net worth through an equity account named the “cumulative translation adjustment” account.
Nothing passes through the income statement. The other three translation methods pass foreign
exchange gains or losses through the income statement before they enter on to the balance sheet
through the accumulated retained earnings account.
3. Identify some instances under FASB 52 that a foreign entity’s functional currency would be the
same as the parent firm’s currency.
Answer: Three examples under FASB 52, where the foreign entity’s functional currency will be the
same as the parent firm’s currency, are: i) the foreign entity’s cash flows directly affect the parent’s
cash flows and are readily available for remittance to the parent firm; ii) the sales prices for the foreign
entity’s products are responsive on a short-term basis to exchange rate changes, where sales prices are
determined through worldwide competition; and, iii) the sales market is primarily located in the
IM-111
parent’s country or sales contracts are denominated in the parent’s currency.
4.
Describe the remeasurement and translation process under FASB 52 of translating into the
reporting currency the books of a wholly owned affiliate that keeps its books in the local currency of
the country in which it operates, which is different than its functional currency.
Answer: For a foreign entity that keeps its books in its local currency, which is different from its
functional currency, the translation process according to FASB 52 is to: first, remeasure the financial
reports from the local currency into the functional currency using the temporal method of translation,
and second, translate from the functional currency into the reporting currency using the current rate
method of translation.
5. It is, generally, not possible to completely eliminate both translation exposure and transaction
exposure. In some cases, the elimination of one exposure will also eliminate the other. But in other
cases, the elimination of one exposure actually creates the other. Discuss which exposure might be
viewed as the most important to effectively manage, if a conflict between controlling both arises.
Also, discuss and critique the common methods for controlling translation exposure.
Answer: Since it is, generally, not possible to completely eliminate both transaction and translation
exposure, we recommend that transaction exposure be given first priority since it involves real cash
flows. The translation process, on-the-other hand, has no direct effect on reporting currency cash
flows, and will only have a realizable effect on net investment upon the sale or liquidation of the
assets.
There are two common methods for controlling translation exposure: a balance sheet hedge and
a derivatives hedge. The balance sheet hedge involves equating the amount of exposed assets in an
exposure currency with the exposed liabilities in that currency, so the net exposure is zero. Thus when
an exposure currency exchange rate changes versus the reporting currency, the change in assets will
offset the change in liabilities. To create a balance sheet hedge, once transaction exposure has been
controlled, often means creating new transaction exposure. This is not wise since real cash flow losses
can result. A derivatives hedge is not really a hedge, but rather a speculative position, since the size of
the “hedge” is based on the future expected spot rate of exchange for the exposure currency with the
reporting currency. If the actual spot rate differs from the expected rate, the “hedge” may result in the
loss of real cash flows.
IM-112
PROBLEMS
1. Assume that FASB 8 is still in effect instead of FASB 52. Construct a translation exposure report
for Centralia Corporation and its affiliates that is the counterpart to Exhibit 14.7 in the text. Centralia
and its affiliates carry inventory and fixed assets on the books at historical values.
Solution: The following table provides a translation exposure report for Centralia Corporation and its
affiliates under FASB 8, which is essentially the temporal method of translation. The difference
between the new report and Exhibit 14.7 is that nonmonetary accounts such as inventory and fixed
assets are translated at the historical exchange rate if they are carried at historical costs. Thus, these
accounts will not change values when exchange rates change and they do not create translation
exposure.
Examination of the table indicates that under FASB 8 there is negative net exposure for the
Mexican peso and the Spanish peseta, whereas under FASB 52 the net exposure for these currencies is
positive.
There is no change in net exposure for the Canadian dollar and the French franc.
Consequently, if the Spanish peseta depreciates against the dollar from Ptas140.00/$1.00 to
Ptas150.00/$1.00, as the text example assumed, exposed assets will now fall in value by a smaller
amount than exposed liabilities, instead of vice versa. The associated reporting currency imbalance
will be $239,333, calculated as follows:
Reporting Currency Imbalance=
- Ptas502,600,000
- Ptas502,600,000
= $239,333.
Ptas150 / $1.00
Ptas140 / $1.00
IM-113
Translation Exposure Report under FASB 8 for Centralia Corporation and its Mexican and Spanish
Affiliates,
December 31, 1997 (in 000 currency units)
Canadian
Mexican
Spanish
French
Dollar
Peso
Peseta
Franc
CD200
PS 1,800
Ptas 105,000
FF
Accounts receivable
0
2,700
133,000
0
Inventory
0
0
0
0
Net fixed assets
0
0
0
0
CD200
PS 4,500
Ptas 238,000
FF
0
CD 0
Ps 2,100
Ptas 173,600
FF
0
Notes payable
0
5,100
119,000
1,400
Long-term debt
0
8,100
448,000
0
Exposed liabilities
CD 0
Ps15,300
Ptas 740,600
FF1,400
Net exposure
CD200
(Ps10,800)
(Ptas502,600)
(FF1,400)
Assets
Cash
Exposed assets
0
Liabilities
Accounts payable
2. Assume that FASB 8 is still in effect instead of FASB 52. Construct a consolidated balance sheet
for Centralia Corporation and its affiliates after a depreciation of the Spanish peseta from
Ptas140.00/$1.00 to Ptas150.00/$1.00 that is the counterpart to Exhibit 14.8 in the text. Centralia and
its affiliates carry inventory and fixed assets on the books at historical values.
Solution: This problem is the sequel to Problem 1. The solution to Problem 1 showed that if the
Spanish peseta depreciated there would be a reporting currency imbalance of $239,333. Under FASB
8 this is carried through the income statement as a foreign exchange gain to the retained earnings on
the balance sheet.
The following table shows that consolidated retained earnings increased to
$4,190,000 from $3,950,000 in Exhibit 14.8. This is an increase of $240,000, which is the same as the
reporting currency imbalance after accounting for rounding error.
IM-114
Consolidated Balance Sheet under FASB 8 for Centralia Corporation and its Mexican and Spanish
Affiliates,
December 31, 1997 (in $000): Post-Exchange Rate Change.
Centralia Corp.
Mexican
Spanish
Consolidated
(parent)
Affiliate
Affiliate
Balance Sheet
Assets
Cash
$ 950a
$ 600
$ 700
$ 2,250
Accounts receivable
1,450b
900
887
3,237
Inventory
3,000
1,500
1,500
6,000
Investment in Mexican affiliate
-c
-
-
-
Investment in Spanish affiliate
-d
-
-
-
9,000
4,600
4,000
17,600
Net fixed assets
Total assets
$29,087
Liabilities and Net Worth
Accounts payable
$1,800
$ 700b
$1,157
$ 3,657
Notes payable
2,200
1,700
1,043e
4,943
Long-term debt
7,110
2,700
2,987
12,797
Common stock
3,500
-c
-d
3,500
Retained earnings
4,190
-c
-d
4,190
Total liabilities and net worth
$29,087
aThis includes CD200,000 the parent firm has in a Canadian bank, carried as $150,000.
CD200,000/(CD1.3333/$1.00) =
$150,000.
b$1,750,000 - $300,000 (= Ps900,000/(Ps3.00/$1.00)) intracompany loan = $1,450,000.
c,dInvestment in affiliates cancels with the net worth of the affiliates in the consolidation.
eThe Spanish affiliate owes a French bank FF1,400,000 (x Ptas26.79/FF1.00 = Ptas37,506,000). This is carried on the books,
after the exchange rate change, as part of Ptas156,506,000 = Ptas37,506,000 + Ptas119,000,000.
Ptas156,506,000/(Ptas150/$1.00) = $1,043,373.
IM-115
3. In Example 14.2, a forward contract was used to establish a derivatives “hedge” to protect Centralia
from a translation loss if the peseta depreciated from Ptas140/$1.00 to Ptas150/$1.00. Assume that an
over-the-counter call option on the dollar with a striking price of Ptas145 can be purchased for
Ptas1.50. Show how the potential translation loss can be “hedged” with an option contract.
Solution: As in example 14.2, if the potential translation loss is $110,667, the equivalent amount in
functional currency that needs to be hedged is Ptas481,400,00. If in fact the peseta does depreciate to
Ptas150/$1.00, Ptas481,400,000 can be purchased in the spot market for $3,209,333.
At a striking
price of Ptas145/$1.00, the Ptas481,400,000 can be used to purchase $3,320,000, yielding a gross
profit of $110,667. At the initial exchange rate of Ptas140/$1.00, the call option cost ($3,320,000 x
Ptas1.50)/Ptas140 = $35,571.
Thus, at an exchange rate of Ptas150/$1.00, the call option will
effectively hedge $110,667 - $35,571 = $75,096 of the potential translation loss.
At terminal
exchange rates of Ptas145/$1.00 to Ptas150/$1.00, the call option hedge will be less effective. An
option contract does not have to be exercised if doing so is disadvantageous to the option owner. The
call will not be exercised at exchange rates of less than Ptas145/$1.00, in which case the “hedge” will
lose the $35,571 cost of the option.
IM-116
MINI CASE: SUNDANCE SPORTING GOODS, INC.
Sundance Sporting Goods, Inc. is a U.S. manufacturer of high-quality sporting goods--principally golf,
tennis and other racquet equipment, and also lawn sports, such as croquet and badminton-- with
administrative offices and manufacturing facilities in Chicago, Illinois. Sundance has two wholly
owned manufacturing affiliates, one in Mexico and the other in Canada. The Mexican affiliate is
located in Mexico City and services all of Latin America. The Canadian affiliate is in Toronto and
serves only Canada. Each affiliate keeps its books in its local currency, which is also the functional
currency for the affiliate. The current exchange rates are: $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 =
W800.
The nonconsolidated balance sheets for Sundance and its two affiliates appear in the
accompanying table.
Nonconsolidated Balance Sheet for Sundance Sporting Goods, Inc. and its Mexican and Canadian
Affiliates,
December 31, 1997 (in 000 currency units)
Sundance, Inc.
(parent)
Mexican
Affiliate
Canadian
Affiliate
Cash
$ 1,500
Ps 1,420
CD 1,200
Accounts receivable
2,500a
2,800e
1,500f
Inventory
5,000
6,200
2,500
Investment in Mexican affiliate
2,400b
-
-
Investment in Canadian affiliate
3,600c
-
-
Net fixed assets
12,000
11,200
5,600
Total assets
$27,000
Ps21,620
CD10,800
Accounts payable
$ 3,000
Ps 2,500a
CD 1,700
Notes payable
4,000d
4,200
2,300
Long-term debt
9,000
7,000
2,300
Common stock
5,000
4,500b
2,900c
Retained earnings
6,000
3,420b
1,600c
$27,000
Ps21,620
CD10,800
Assets
Liabilities and Net Worth
Total liabilities and net worth
The parent firm is owed Ps1,320,000 by the Mexican affiliate. This sum is included in the parent’s accounts receivable as $400,000,
translated at Ps3.30/$1.00. The remainder of the parent’s (Mexican affiliate’s) accounts receivable (payable) are denominated in dollars
(pesos).
a
The Mexican affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $2,400,000. This represents the sum of
the common stock (Ps4,500,000) and retained earnings (Ps3,420,000) on the Mexican affiliate’s books, translated at Ps3.30/$1.00.
b
IM-117
The Canadian affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $3,600,000. This represents the sum of
the common stock (CD2,900,000) and the retained earnings (CD1,600,000) on the Canadian affiliate’s books, translated at CD1.25/$1.00.
c
The parent firm has outstanding notes payable of ¥126,000,000 due a Japanese bank. This sum is carried on the parent firm’s books as
$1,200,000, translated at ¥105/$1.00. Other notes payable are denominated in U.S. dollars.
d
e
The Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house. This sum is carried on the Mexican
affiliate’s books as Ps396,000, translated at A1.00/Ps3.30. Other accounts receivable are denominated in Mexican pesos.
f
The Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer. This sum is carried on the Canadian
affiliate’s books as CD300,000, translated at W800/CD1.25. Other accounts receivable are denominated in Canadian dollars.
You joined the International Treasury division of Sundance six months ago after spending the last
two years receiving your MBA degree. The corporate Treasurer has asked you to prepare a report
analyzing all aspects of the translation exposure faced by Sundance as a MNC. She has also asked
you to address in your analysis the relationship between the firm’s translation exposure and its
transaction exposure. After performing a forecast of future spot rates of exchange, you decide that you
must do the following before any sensible report can be written.
a. Using the current exchange rates and the nonconsolidated balance sheets for Sundance and its
affiliates, prepare a consolidated balance sheet for the MNC according to FASB 52.
b. i. Prepare a translation exposure report for Sundance Sporting Goods, Inc., and its two affiliates.
b. ii. Using the translation exposure report you have prepared, determine if any reporting currency
imbalance will result from the change in exposure currency exchange rates. Your forecast is that
exchange rates will change from $1.00 = CD1.25 = Ps3.30 = A1.00 = ¥105 = W800 to $1.00 =
CD1.30 = Ps3.30 = A1.03 = ¥105 = W800.
c. Prepare a second consolidated balance sheet for the MNC using the exchange rates you expect in
the future. Determine how any reporting currency imbalance will affect the new consolidated balance
sheet for the MNC.
d. i.
Prepare a transaction exposure report for Sundance and its affiliates.
Determine if any
transaction exposures are also translation exposures.
d. ii. Investigate what Sundance and its affiliates can do to control its transactions and translation
exposure. Determine if any of the translation exposure should be hedged.
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Suggested Solution to Sundance Sporting Goods, Inc.
Note to Instructor: It is not necessary to assign the entire case problem. Parts a. and b.i. can be used
as self-contained problems, respectively, on basic balance sheet consolidation and the preparation of a
translation exposure report.
a. Below is the consolidated balance sheet for the MNC prepared according to the current rate method
prescribed by FASB 52. Note that the balance sheet balances. That is, Total Assets and Total
Liabilities and Net Worth equal one another. Thus, the assumption is that the current exchange rates
are the same as when the affiliates were established. This assumption is relaxed in part c.
Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates,
December 31, 1997 (in $000): Pre-Exchange Rate Change
Sundance, Inc.
(parent)
Mexican
Affiliate
Canadian
Affiliate
Consolidated
Balance Sheet
Cash
$ 1,500
$ 430
$ 960
$ 2,890
Accounts receivable
2,100a
849e
1,200f
4,149
Inventory
5,000
1,879
2,000
8,879
Investment in Mexican affiliate
-b
-
-
-
Investment in Canadian affiliate
-c
-
-
-
12,000
3,394
4,480
19,874
Assets
Net fixed assets
Total assets
$35,792
Liabilities and Net Worth
Accounts payable
$ 3,000
$ 358a
$1,360
$ 4,718
Notes payable
4,000d
1,273
1,840
7,113
Long-term debt
9,000
2,121
1,840
12,961
Common stock
5,000
-b
-c
5,000
Retained earnings
6,000
-b
-c
6,000
Total liabilities and net worth
$35,792
a$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.
b,cThe investment in the affiliates cancels with the net worth of the affiliates in the consolidation.
dThe parent owes a Japanese bank ¥126,000,000.
This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)).
eThe Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house.
Mexican affiliate’s books as Ps396,000 (= A120,000 x Ps3.30/A1.00).
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This is carried on the
fThe Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer.
This is carried on the
Canadian affiliate’s books as CD300,000 (= W192,000,000/(W800/CD1.25)).
b. i. Below is presented the translation exposure report for the Sundance MNC. Note, from the report
that there is net positive exposure in the Mexican peso, Canadian dollar, Argentine austral and Korean
won. If any of these exposure currencies appreciates (depreciates) against the U.S. dollar, exposed
assets denominated in these currencies will increase (fall) in translated value by a greater amount than
the exposed liabilities denominated in these currencies. There is negative net exposure in the Japanese
yen. If the yen appreciates (depreciates) against the U.S. dollar, exposed assets denominated in the
yen will increase (fall) in translated value by smaller amount than the exposed liabilities denominated
in the yen.
Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and Canadian
Affiliates, December 31, 1997 (in 000 currency units)
Japanese
Yen
Mexican
Peso
Canadian
Dollar
Argentine
Austral
Korean
Won
¥
0
Ps 1,420
CD 1,200
A 0
W
Accounts receivable
0
2,404
1,200
120
192,000
Inventory
0
6,200
2,500
0
0
Fixed assets
0
11,200
5,600
0
0
¥
0
Ps21,224
CD10,500
A120
W192,000
Accounts payable
¥
0
Ps 1,180
CD 1,700
A 0
W
Notes payable
126,000
4,200
2,300
0
0
Long-term debt
¥
0
7,000
2,300
0
0
Exposed liabilities
¥126,000
Ps12,380
CD 6,300
A 0
W
Net exposure
(¥126,000)
Ps 8,844
CD 4,200
A120
W192,000
Assets
Cash
Exposed assets
0
Liabilities
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0
0
b. ii. The problem assumes that Canadian dollar depreciates from CD1.25/$1.00 to CD1.30/$1.00 and
that the Argentine austral depreciates from A1.00/$1.00 to A1.03/$1.00. To determine the reporting
currency imbalance in translated value caused by these exchange rate changes, we can use the
following formula:
Net Exposure Currency i
Net Exposure Currency i
S new (i / reporting)
S old (i / reporting)
= Reporting Currency Imbalance.
From the translation exposure report we can determine that the depreciation in the Canadian dollar
will cause a
CD4,200,000
CD4,200,000
= - $129,231
CD1.30 / $1.00
CD1.25 / $1.00
reporting currency imbalance.
Similarly, the depreciation in the Argentine austral will cause a
A120,000
A120,000
= - $3,495
A1.03 / $1.00
A1.00 / $1.00
reporting currency imbalance.
In total, the depreciation of the Canadian dollar and the Argentine austral will cause a reporting
currency imbalance in translated value equal to -$129,231 -$3,495= -$132,726.
c. The new consolidated balance sheet for Sundance MNC after the depreciation of the Canadian
dollar and the Argentine austral is presented below. Note that in order for the new consolidated
balance sheet to balance after the exchange rate change, it is necessary to have a cumulative
translation adjustment account balance of -$133 thousand, which is the amount of the reporting
currency imbalance determined in part b. ii (rounded to the nearest thousand).
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Consolidated Balance Sheet for Sundance Sporting Goods, Inc. its Mexican and Canadian Affiliates,
December 31, 1997 (in $000): Post-Exchange Rate Change
Sundance, Inc.
(parent)
Mexican
Affiliate
Canadian
Affiliate
Consolidated
Balance Sheet
$ 1,500
$ 430
$ 923
$ 2,853
Accounts receivable
2,100
845e
1,163f
4,108
Inventory
5,000
1,879
1,923
8,802
Investment in Mexican affiliate
-b
-
-
-
Investment in Canadian affiliate
-c
-
-
-
12,000
3,394
4,308
19,702
Assets
Cash
Net fixed assets
Total assets
$35,465
Liabilities and Net Worth
Accounts payable
$3,000
$ 358a
$1,308
$ 4,666
Notes payable
4,000b
1,273
1,769
7,042
Long-term debt
9,000
2,121
1,769
12,890
Common stock
5,000
-b
-c
5,000
Retained earnings
6,000
-b
-c
6,000
-
-
-
(133)
CTA
Total liabilities and net worth
$35,465
a$2,500,000 - $400,000 (= Ps1,320,000/(Ps3.30/$1.00)) intracompany loan = $2,100,000.
b,cThe investment in the affiliates cancels with the net worth of the affiliates in the consolidation.
dThe parent owes a Japanese bank ¥126,000,000.
This is carried on the books as $1,200,000 (=¥126,000,000/(¥105/$1.00)).
eThe Mexican affiliate has sold on account A120,000 of merchandise to an Argentine import house.
This is carried on the
Mexican affiliate’s books as Ps384,466 (= A120,000 x Ps3.30/A1.03).
fThe Canadian affiliate has sold on account W192,000,000 of merchandise to a Korean importer.
Canadian affiliate’s books as CD312,000 (=W192,000,000/(W800/CD1.30)).
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This is carried on the
d. i. The transaction exposure report for Sundance, Inc. and its two affiliates is presented below. The
report indicates that the Ps1,320,000 accounts receivable due from the Mexican affiliate is not also a
translation exposure because this is netted out in the consolidation. However, the ¥126,000,000 notes
payable of the parent is also a translation exposure. Additionally, the A120,000 accounts receivable of
the Mexican affiliate and the W192,000,000 accounts receivable of the Canadian affiliate are both
translation exposures.
Transaction Exposure Report for Sundance Sporting Goods, Inc. and
its Mexican and Canadian Affiliates, December 31, 1997
Translation
Affiliate
Amount
Account
Exposure
Parent
Ps1,320,000
Accounts
No
Receivable
Parent
¥126,000,000
Mexican
A120,000
Notes Payable
Yes
Accounts
Yes
Receivable
Canadian
W192,000,000
Accounts
Yes
Receivable
d. ii.
Since transaction exposure may potentially result real cash flow losses while translation
exposure does not have an immediate direct effect on operating cash flows, we will first address the
transaction exposure that confronts Sundance and its affiliates. The analysis assumes the depreciation
in the Canadian dollar and the Argentine austral have already taken place.
The parent firm can pay off the ¥126,000,000 loan from the Japanese bank using funds from the cash
account and money from accounts receivable that it will collect. Additionally, the parent firm can
collect the accounts receivable of Ps1,320,000 from its Mexican affiliate that is carried on the books as
$400,000. In turn, the Mexican affiliate can collect the A120,000 accounts receivable from the
Argentine importer, valued at Ps384,466 after the depreciation in the austral, to guard against further
depreciation and to use to pay off the peso liability to the parent. The Canadian affiliate can eliminate
its transaction exposure by collecting the W192,000,000 accounts receivable as soon as possible,
which is currently valued at CD300,000.
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The elimination of these transaction exposures will affect the translation exposure of Sundance
MNC. A revised translation exposure report follows.
Revised Translation Exposure Report for Sundance Sporting Goods, Inc. and its Mexican and
Canadian Affiliates,
December 31, 1997 (in 000 currency units)
Japanese
Mexican
Canadian
Argentine
Korean
Yen
Peso
Dollar
Austral
Won
¥0
Ps 484
CD 1,500
A0
W0
Accounts receivable
0
2,404
1,200
0
0
Inventory
0
6,200
2,500
0
0
Fixed assets
0
11,200
5,600
0
0
¥0
Ps20,288
CD10,800
A0
W0
¥0
Ps 1,180
CD1,700
A0
W0
Notes payable
0
4,200
2,300
0
0
Long-term debt
0
7,000
2,300
0
0
Exposed liabilities
¥0
Ps12,380
CD6,300
A0
W0
Net exposure
¥0
Ps 7,908
CD4,500
A0
W0
Assets
Cash
Exposed assets
Liabilities
Accounts payable
Note from the revised translation exposure report that the elimination of the transaction exposure
will also eliminate the translation exposure in the Japanese yen, Argentine austral and the Korean won.
Moreover, the net translation exposure in the Mexican peso has been reduced. But the net translation
exposure in the Canadian dollar has increased as a result of the Canadian affiliate’s collection of the
won receivable.
The remaining translation exposure can be hedged using a balance sheet hedge or a derivatives
hedge. Use of a balance sheet hedge is likely to create new transaction exposure, however. Use of a
derivatives hedge is actually speculative, and not a real hedge, since the size of the “hedge” is based
on one’s expectation as to the future spot exchange rate. An incorrect estimate will result in the
“hedge” losing money for the MNC.
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CHAPTER 15 FOREIGN DIRECT INVESTMENT
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Recently, many foreign firms from both developed and developing countries acquired high-tech
U.S. firms. What might have motivated these firms to acquire U.S. firms?
Answer: Many foreign firms might have been motivated to gain access to technical know-how
residing in U.S. firms and at the same time monopolize its use. Refer to the reverse-internalization
hypothesis discussed in the text.
2. Japanese MNCs, such as Toyota, Toshiba, Matsushita, etc., made extensive investments in the
Southeast Asian countries like Thailand, Malaysia and Indonesia. In your opinion, what forces are
driving Japanese investments in the region?
Answer: Most likely, these Japanese MNCs have invested heavily in Southeast Asia in order to take
advantage of under priced labor services and cheaper land and other factors of production. Refer to the
life-cycle theory of FDI.
3. Since the NAFTA was established, many Asian firms especially those from Japan and Korea made
extensive investments in Mexico. Why do you think these Asian firms decided to build production
facilities in Mexico?
Answer: Asian firms might have been motivated to gain access to NAFTA of which Mexico is a
member and circumvent the external trade barriers maintained by NAFTA.
4. How would you explain the fact that China emerged as the second most important recipient of FDI
after the United States in recent years?
Answer: China attracted a great deal of FDI recently because foreign firms want to (I) take advantage
of inexpensive labor and resources, and also (ii) gain access to the Chinese market that is often not
accessible otherwise.
5. Explain the internalization theory of FDI. What are the strength and weakness of the theory?
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Answer: According to the internalization theory, firms that have intangible assets with a public good
property tend to undertake FDI to take advantage of the assets on a large scale and, at the same time,
prevent misappropriation of returns from the assets that may occur during arm’s length transactions in
foreign countries. The theory can be effective in explaining green field investments, but not in
explaining mergers and acquisitions.
6. Explain Vernon’s product life-cycle theory of FDI. What are the strength and weakness of the
theory?
Answer: According to the product life-cycle theory, firms undertake FDI at a particular stage in the lifecycle of the products that they initially introduced. When a new product is introduced, the firm chooses to
keep production at home, close to customers. But when the product become mature and foreign demands
develop, the firm may be induced to start production in foreign countries, especially in low-cost countries,
to serve the local markets as well as to export the product back to the home country. As can be inferred
from the boxed reading on Singer in the text, the product life-cycle theory can explain historical
development of FDI quite well. In recent years, however, the international system of production has
become too complicated to be explained neatly by the life-cycle theory. For example, new products are
often introduced simultaneously in many countries and production facilities may be located in many
countries at the same time.
7. Why do you think the host country tends to resist cross-border acquisitions, rather than green field
investments?
Answer: The host country tends to view green field investments as creating new production facilities
and new job opportunities. In contrast, cross-border acquisitions can be viewed as foreign takeover of
existing domestic firms, without creating new job opportunities.
8. How would you incorporate political risk into the capital budgeting process of foreign investment
projects?
Answer: One approach is to adjust the cost of capital upward to reflect political risk and discount the
expected future cash flows at a higher rate. Alternatively, one can subtract insurance premium for
political risk from the expected future cash flows and use the usual cost of capital which is applied to
domestic capital budgeting.
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9. Explain and compare forward vs. backward internalization.
Answer: Forward internalization occurs when MNCs with intangible assets make FDI in order to
utilize the assets on a larger scale and at the same time internalize any possible externalities generated
by the assets. Backward internalization, on the other hand, occurs when MNCs acquire foreign firms
in order to gain access to the intangible assets residing in the foreign firms and at the same time
internalize any externalities generated by the assets.
10. What can be the reason for the negative synergistic gains for British acquisitions of U.S. firms?
Answer: Negative synergies for British acquisitions of U.S. firms may reflect that British managers
might have been motivated to invest in U.S. firms in order to pursue their own interests, such as
building corporate empire, rather than shareholders’ interests. Negative synergies can be viewed as
agency costs.
11. Define country risk. How is it different from political risk?
Answer: Country risk is a broader measure of risk than political risk, as the former encompasses
political risk, credit risk, and other economic performances.
12. What are the advantages and disadvantages of FDI as opposed to a licensing agreement with a
foreign partner?
Answer: The main advantage of FDI over licensing agreement with a foreign partner is that it
provides protection against possible interlopers. The main disadvantage of FDI is that it is costly and
time consuming to establish foreign presence in this manner and FDI is probably more vulnerable to
political risk.
13. What operational and financial measures can a MNC take in order to minimize the political risk
associated with a foreign investment project?
Answer: First, MNCs should explicitly incorporate political risk in the capital budgeting process and
adjust the project’s NPV accordingly. Second, MNCs can form joint-ventures with local partners or
form a consortium with other MNCs to reduce risk. Third, MNCs can purchase insurance against
political risk from OPIC, Lloyd’s, etc.
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14. Study the experience of Enron in India, and discuss what we can learn from it for the management
of political risk.
Answer:
This question can be used as a mini-case or mini-project. Students can utilize various
business/financial publications, such as Wall Street Journal, Financial Times, and Business week, to study the
issue.
15. Discuss the different ways political events in a host country may affect local operations of an
MNC.
Answer: The answer can be organized based on the three types of political risk: Namely, transfer risk,
operational risk, and control risk. Transfer risk arises from the uncertainty about cross-border flows of
capital, payments, know-how, etc. Operational risk arises from the uncertainty about the host
country’s policies affecting the local operations of MNCs. Control risk arises from the uncertainty
about the host country’s policy regarding ownership and control of local operations of MNCs.
16. What factors would you consider in evaluating the political risk associated with making FDI in a
foreign country.
Answer: Factors to be considered include: (1) the host country’s political and government system; (2)
track record of political parties and their relative strength; (3) the degree of integration into the world
system; (4) the host country’s ethnic and religious stability; (5) regional security; and (6) key economic
indicators.
17. Mini Project: Suppose you are hired as a political consultant by Coca-Cola, which is considering
investing in the bottling facilities in four countries: Mexico, Argentina, China, and Russia. Pick a
country out of the four and analyze the political risk associated with investing there. Prepare a final
report to Coca-Cola using a similar format as Exhibit 15.10.
Answer: This is an open-ended question. Students can collect basic economic data for the country of
their choice from such sources as International Financial Statistics, various publications of the World
Bank, Economist, Financial Times, etc.
Both China and Russia are shedding their socialist economic system and are in the process of
establishing market economies. Often, the “rules of the game” are not clearly stipulated for foreign
investors like Coca-Cola. Corruption is a major problem in both countries. In addition, the property
rights, tangible or intangible, and the tax codes are not well established, adding to the risk of doing
IM-128
business in these countries.
In contrast, Argentina and Mexico, which used to be inward-looking and highly protectionist
countries, have made significant progress in liberalizing their economies. In the case of Mexico,
joining NAFTA will no doubt accelerate this liberalization process. As we have seen during the 19945 peso crisis, however, gross mismanagement of the economy can negatively affect foreign investors
in Mexico. Also, there is substantial uncertainty about the long-term viability of the current political
system in Mexico. Argentina, on the other hand, appears to be the most safe among the four countries.
The country has successfully made the transition from the protectionist to the open economy and is
well positioned to become a second Chile, a well publicized success story.
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Suggest Answers for Mini Case: Enron in India
[See Chapter 15 for the case text.]
Questions for Discussion:
1) Foreign Direct Investment
a) What are the particular challenges faced by foreign companies investing in India?
Suggested Answer: among the most difficult challenges that foreign investors face in India are the
lack of infra-structure like road and port facilities, an inefficient and massive bureaucracy, and
restrictions on international trade and financing.
b) Are there financially more efficient ways to achieve the same objective without undertaking FDI?
Suggested Answer: Joint-venture with a credible local partner who is more familiar with Indian local
situations could have been an alternative mode for entry to the Indian market.
2) Political Risk
a) What were the various elements of political risk faced by Enron in India?
Suggested Answer: Like in many developing countries, there is a general lack of commitment to
legal contracts. In addition, in India, decision making authorities are diffused among different
government offices, causing confusion and uncertainty.
b) What could Enron have done differently to avoid this political risk in order to safeguard its FDI?
Suggested Answer: Enron could have done a more accurate analysis of political risk and considered
the possibility of election victory of the nationalist party. In addition, Enron could have purchased an
insurance policy against this political risk from Overseas Private Investment Corporation or other
insurers. Further, involving a local partner could have dampened the nationalistic sentiment in India.
IM-130
CHAPTER 16 INTERNATIONAL CAPITAL STRUCTURE AND THE COST OF CAPITAL
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Suppose that your firm is operating in a segmented capital market. What actions would you
recommend to mitigate the negative effects?
Answer: The best solution for this problem is to cross-list your firm’s stock in overseas markets like
London and New York that are not segmented. But you should be aware of the associated costs such
as the cost of adjusting financial statements, fees charged by the listing exchanges, etc.
2. Explain why and how a firm’s cost of capital may decrease when the firm’s stock is cross-listed on
foreign stock exchanges.
Answer: If a stock becomes internationally tradable upon overseas listing, the required return on the
stock is likely to go down because the stock will be priced according to the international systematic
risk rather than the local systematic risk. It is well known that for a typical stock, the international
systematic risk is lower than the local systematic risk.
3. Explain the pricing spill-over effect.
Answer: Suppose a firm operating in a segmented capital market (like China, for example) decides to
cross-list its stock in New York or London. Upon cross-border listing, the firm’s stock will be priced
internationally. In addition, the pricing of remaining purely domestic stocks (other Chinese stocks)
will be affected in such a way that these stocks will be priced partially internationally and partially
domestically. The degree of international pricing depends on the correlations between these purely
domestic stocks and internationally traded stocks.
4. In what sense do firms with nontradable assets get a free-ride from firms whose securities are
internationally tradable?
Answer: Due to the spillover effect, firms with nontradable securities can benefit in terms of higher
security prices and lower cost of capital, without incurring any costs associated with making the
securities internationally tradable. This is an example of free-ride.
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5. Define and discuss indirect world systematic risk.
Answer: The indirect world systematic risk can be defined as the covariance between a nontradable
asset and the world market portfolio that is induced by tradable assets. In the presence of
internationally tradable assets, nontradable assets will be priced partly by the indirect world systematic
risk and partly by the pure domestic systematic risk.
6. Discuss how the cost of capital is determined in segmented vs. integrated capital markets.
Answer: In segmented capital markets, the cost of capital will be determined essentially by the
securities’ domestic systematic risks. In integrated capital markets, on the other hand, the cost of
capital will be determined by the securities’ world systematic risk, regardless of nationality.
7. Suppose there exists a nontradable asset with a perfect positive correlation with a portfolio T of
tradable assets. How will the nontradable asset be priced?
Answer: The nontradable asset with a perfect positive correlation with portfolio T (for tradable) will
be priced as if it were tradable by itself. In a word, it will be priced solely according to its world
systematic risk.
8. Discuss what factors motivated Novo Industries to seek U.S. listing of its stock. What lessons can
be derived from Novo’s experiences?
Answer: Novo, a rapidly growing company, was domiciled in a small and segmented Danish market.
This restricted the firm’s ability to raise capital at a competitive rate. As discussed in the text, Novo
solved this problem by listing its stock in London and New York stock exchanges. This move enabled
Novo to gain access to large capital sources and lower its cost of capital.
9.
Discuss foreign equity ownership restrictions.
Why do you think countries impose these
restrictions?
Answer: Many countries restrict the maximum fractional ownership of local firms by foreigners.
Mostly, these restrictions are imposed to ensure domestic control of local firms.
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10. Explain the pricing-to-market phenomenon.
Answer: The pricing-to-market (PTM) refers to the phenomenon that the same securities are priced
differently for different investors. A well-known example of PTM is provided by Nestle. Up until
1988 November, foreigners were only allowed to hold Nestle bearer shares; only Swiss residents were
allowed to hold registered shares. As indicated in Exhibit 16.11 in the text, bearer shares were trading
for about twice the price of registered shares.
11. Explain how the premium and discount are determined when assets are priced-to-market. When
would the law of one price prevail in international capital markets even if foreign equity ownership
restrictions are imposed?
Answer: The premium and discount are determined by (I) the severity of restrictions imposed on
foreigners and (ii) foreigners’ ability to mitigate the effect of these restrictions using their own
domestic securities. In a special case where foreigners can exactly replicate the securities under
restriction, then PTM will cease to apply.
12. Under what conditions will the foreign subsidiary’s financial structure become relevant?
Answer: The subsidiary’s own financial structure will become relevant when the parent firm is not
responsible for the financial obligations of the subsidiary.
13. Under what conditions would you recommend that the foreign subsidiary conform to the local
norm of financial structure?
Answer: It may make sense for the subsidiary to confirm to the local norm if the parent is not
responsible for the subsidiary’s debt and the subsidiary has to depend on local financial markets for
raising capital.
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PROBLEMS
Answer problems 1-3 based on the stock market data given by the following table.
Correlation Coefficients
Telmex
Telmex
Mexico
World
SD(%)
R (%)
1.00
.90
0.60
18
?
1.00
0.75
15
14
1.00
10
12
Mexico
World
The above table provides the correlations among Telmex, a telephone/communication company
located in Mexico, the Mexico stock market index, and the world market index, together with the
standard deviations (SD) of returns and the expected returns ( R ). The risk-free rate is 5%.
1. Compute the domestic country beta of Telmex as well as its world beta. What do these betas
measure?
2. Suppose the Mexican stock market is segmented from the rest of the world. Using the CAPM
paradigm, estimate the equity cost of capital of Telmex.
3. Suppose now that Telmex has made its shares tradable internationally via cross-listing on NYSE.
Again using the CAPM paradigm, estimate Telmex’s equity cost of capital. Discuss the possible
effects of international pricing of Telmex shares on the share prices and the firm’s investment
decisions.
Solutions.
1. The domestic beta,  TM , and the world beta,  TW , of Telmex can be computed as follows:
 TM 
 TM  T M TM (18)(15)(0.9) 243



 1.08
225
 M2
 M2
(15) 2
 TW 
 TW  T W TW (18)(10)(0.6) 108



 1.08
2
2
100
W
W
(10) 2
Both the domestic and world beta turn out to be the same. As the market moves by 1%, Telmex stock
return will move by 1.08%
2.
RT  R f  ( RM  R f ) TM
 5  (14  5)(1.08)  14.72%
3.
RT  R f  ( RW  R f )  TW
 5  (12  5)(1.08)  12.56%
As the equity cost of capital decreases from 14.72% to 12.56%, Telmex will experience an increase in
its share price. In addition, Telmex will be able to undertake more investment projects profitably.
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CHAPTER 17 INTERNATIONAL CAPITAL BUDGETING
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Why is capital budgeting analysis so important to the firm?
Answer: The fundamental goal of the financial manager is to maximize shareholder wealth. Capital
investments with positive NPV or APV contribute to shareholder wealth.
Additionally, capital
investments generally represent large expenditures relative to the value of the entire firm. These
investments determine how efficiently and expensively the firm will produce its product.
Consequently, capital expenditures determine the long-run competitive position of the firm in the
product marketplace.
2. What is the intuition behind the NPV capital budgeting framework?
Answer: The NPV framework is a discounted cash flow technique. The methodology compares the
present value of all cash inflows associated with the proposed project versus the present value of all
project outflows. If inflows are enough to cover all operating costs and financing costs, the project
adds wealth to shareholders.
3. Discuss what is meant by the incremental cash flows of a capital project.
Answer: Incremental cash flows are denoted by the change in total firm cash inflows and cash
outflows that can be traced directly to the project under analysis.
4. Discuss the nature of the equation sequence in the chapter of going from equation 17.2a to 17.2f.
Answer: The equation sequence is a presentation of incremental annual cash flows associated with a
capital expenditure. Equation 17.2a presents the most detailed expression for calculating these cash
flows; it is composed of three terms. Equation 17.2b shows that these three terms are: i) incremental
net profit associated with the project; ii) incremental depreciation allowance; and, iii) incremental
after-tax interest expense associated with the borrowing capacity created by the project. Note, the
incremental “net profit” is not accounting profit but rather net cash actually available for shareholders.
Equation 17.2c cancels out the after-tax interest term in 17.2a, yielding a simpler formula. Equation
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17.2d shows that the first term in 17.2c is generally called after-tax net operating income. Equation
17.2e yields yet a computationally simpler formula by combining the depreciation terms of 17.2c.
Equation 17.2f shows that the first term in 17.2e is generally referred to as after-tax operating cash
flow.
5.
What makes the APV capital budgeting framework useful for analyzing foreign capital
expenditures?
Answer:
The APV framework is a value-additivity technique.
Because international projects
frequently have cash flows not encountered in domestic projects, the APV technique easily allows the
analyst to add terms to the model that represent the special cash flows.
6. Relate the concept of lost sales to the definition of incremental cash flow.
Answer: When a new capital project is under taken it may compete with an existing project(s),
causing the old project(s) to experience a loss in sales revenue. From an incremental cash flow
standpoint, the new project’s incremental revenue is the total sales revenue associated with the new
project minus the lost sales revenue from the old project(s).
7. What problems can enter into the capital budgeting analysis if project debt is evaluated instead of
the borrowing capacity created by the project?
Answer: If project debt is greater (less) than the borrowing capacity created by the capital project, and
tax shields on the actual new debt are used in the analysis, the APV will be overstated (understated)
making the project unjustly appear more (less) attractive than it actually is.
8. What is the nature of a concessionary loan and how is it handled in the APV model?
Answer: A concessionary loan is a loan offered by a governmental body at below the normal market
rate of interest as an enticement for a firm to make a capital investment that will economically benefit
the lender. The benefit to the MNC is the difference between the face value of the concessionary loan
converted into the home currency and the present value of the similarly converted concessionary loan
payments discounted at the MNC’s normal domestic borrowing rate. The loan payments will yield a
present value less than the face amount of the concessionary loan when they are discounted at the
higher normal rate. This difference represents a subsidy the host country is willing to extend to the
MNC if the investment is made. The benefit to the MNC of the concessionary loan is handled in the
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APV model via a separate term.
9. What is the intuition of discounting the various cash flows in the APV model at specific discount
rates?
Answer: The APV model is a value-additivity technique where total value is determined by the sum
of the present values of the individual cash inflows and outflows. Each cash flow will not necessarily
have the same amount of risk associated with it. To account for risk differences in the analysis, each
cash flow is discounted at a rate commensurate with the inherent riskiness of the cash flow.
10. In the Modigliani-Miller equation, why is the market value of the levered firm greater than the
market value of an equivalent unlevered firm?
Answer: The levered firm has a greater market value because less money is taken from the firm by the
government in taxes due to tax-deductible interest payments. Thus, there is more cash left for investor
groups than when the firm is financed with all-equity funds.
11. Discuss the difference between performing the capital budgeting analysis from the parent firm’s
perspective as opposed to the project perspective.
Answer: The goal of the financial manager of the parent firm is to maximize its shareholders’ wealth.
A capital project of a subsidiary of the parent may have a positive NPV (or APV) from the
subsidiary’s perspective yet have a negative NPV (or APV) from the parent’s perspective if certain
cash flows cannot be repatriated to the parent because of remittance restrictions by the host country, or
if the home currency is expected to appreciate substantially over the life of the project, yielding
unattractive cash flows when converted into the home currency of the parent. Additionally, a higher
tax rate in the home country may cause the project to be unprofitable from the parent’s perspective.
Any of these reasons could result in the project being unattractive to the parent and the parent’s
stockholders.
12. Define the concept of a real option. Discuss some of the various real options a firm can be
confronted with when investing in real projects.
Answer: A positive APV project is accepted under the assumption that all future operating decisions
will be optimal. The firm’s management does not know at the inception date of a project what future
decisions it will be confronted with because all information concerning the project has not yet been
learned. Consequently, the firm’s management has alternative paths, or options, that it can take as
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new information is discovered.
The application of options pricing theory to the evaluation of
investment options in real projects is known as real options.
The firm is confronted with many possible real options over the life of a capital asset. For
example, the firm may have a timing option as when to make the investment; it may have a growth
option to increase the scale of the investment; it may have a suspension option to temporarily cease
production; and, it may have an abandonment option to quit the investment early.
IM-138
PROBLEMS
1. The Alpha Company plans to establish a subsidiary in Greece to manufacture and sell fashion
wristwatches. Alpha has total assets of $70 million, of which $45 million is equity financed. The
remainder is financed with debt.
Alpha considered its current capital structure optimal.
The
construction cost of the Greek facility in drachmas is estimated at Dr2,400,000,000, of which
Dr1,800,000,000 is to be financed at a below-market borrowing rate arranged by the Greek
government. Alpha wonders what amount of debt it should use in calculating the tax shields on
interest payments in its capital budgeting analysis. Can you offer assistance?
Solution: The Alpha Company has an optimal debt ratio of $25 million debt/$70 million assets = .357
or 35.7%. The project debt ratio is Dr1,800/Dr2,400 = .75 or 75%. Alpha will overstate the tax shield
on interest payments if it uses the 75% figure because the proposed project will only increase
borrowing capacity by Dr856,800,000 (=Dr2,400,000,000 x .357).
2. The current spot exchange rate is Dr240/$1.00. Long-run inflation in Greece is estimated at 8
percent annually and 4.5 percent in the United States. If PPP is expected to hold between the two
countries, what spot exchange should one forecast five years into the future?
Solution: Dr240(1 + .08)5/(1 + .045)5 = Dr283/$1.00.
3. The Beta Corporation has an optimal debt ratio of 40 percent. Its cost of equity capital is 12 percent
and its before-tax borrowing rate is 8 percent. Given a marginal tax rate of 35 percent, calculate (a)
the weighted-average cost of capital and, (b) the cost of equity for an equivalent all-equity financed
firm.
Solution:
(a)
K = (1 - .40).12 + (.40).08(1 - .35)
= .0928 or 9.28%
(b)
A weighted-average cost of capital of 9.28% for a levered firm implies:
K =.0928 = Ku (1-(.35)(.40)). Solving for Ku yields .1079 or 10.79%.
4. Suppose in the illustrated mini case in the chapter that the APV for Centralia had been -$60,000.
How large would the after tax terminal value of the project need to be before the APV would be
positive and Centralia would accept the project?
IM-139
Solution: Centralia should not go ahead with its plans to build a manufacturing plant in the Spain
unless the terminal value is likely to be large enough to yield a positive APV. The terminal value of
the project must be $299,010 in order for the APV to equal zero. This is calculated as follows. Set
STTVT/(1+Kud)T = $60,000. This implies
TVT = ($60,000/ST)(1+Kud)T
= ($60,000/.005266)(1.11)8
= Ptas26,257,551.
5. With regards to the Centralia illustrated mini case in the chapter, how would the APV change if:
a. The forecast of d and/or f are incorrect?
Answer: A larger or smaller d will not have any effect because a change will affect the numerator
and denominator of each APV term in an offsetting manner. A larger (smaller) f, however, will
decrease (increase) the project APV because the foreign currency received will buy less (more) parent
country currency upon repatriation.
b. Deprecation cash flows are discounted at Kud instead of id?
Answer: The APV would be less favorable because Kud is a larger discount rate than id.
c. The host country did not provide the concessionary loan?
Answer: The APV would be less favorable because the project would have to cover a higher finance
charge, i.e., there would be no benefit received from below market financing.
IM-140
MINI CASE ONE: DORCHESTER, LTD.
Dorchester Ltd. is an old-line confectioner specializing in high-quality chocolates. Through its
facilities in the United Kingdom, Dorchester manufactures candies that it sells throughout Western
Europe and North America (United States and Canada). With its current manufacturing facilities,
Dorchester has been unable to supply the U.S. market with more than 225,000 pounds of candy per
year. This supply has allowed its sales affiliate, located in Boston, to be able to penetrate the U.S.
market no farther west than St. Louis and only as far south as Atlanta. Dorchester believes that a
separate manufacturing facility located in the United States would allow it to supply the entire U.S.
market and Canada (which presently accounts for 65,000 pounds per year). Dorchester currently
estimates initial demand in the North American market at 390,000 pounds, with growth at a 5 percent
annual rate. A separate manufacturing facility would, obviously, free up the amount currently shipped
to the United States and Canada. But Dorchester believes that this is only a short-run problem. They
believe the economic development taking place in Eastern Europe will allow it to sell there the full
amount presently shipped to North America within a period of five years.
Dorchester presently realizes £3.00 per pound on its North American exports. Once the U.S.
manufacturing facility is operating, Dorchester expects that it will be able to initially price its product
at $7.70 per pound. This price would represent an operating profit of $4.40 per pound. Both sales
price and operating costs are expected to keep track with the U.S. price level; U.S. inflation is forecast
at a rate of 3 percent for the next several years. In the U.K., long-run inflation is expected to be in the
4 to 5 percent range, depending on which economic service one follows. The current spot exchange
rate is $1.50/£1.00.
Dorchester explicitly believes in PPP as the best means to forecast future
exchange rates.
The manufacturing facility is expected to cost $7,000,000. Dorchester plans to finance this amount
by a combination of equity capital and debt. The plant will increase Dorchester’s borrowing capacity
by £2,000,000, and it plans only to borrow that amount. The local community in which Dorchester
has decided to build will provide $1,500,000 of debt financing for a period of seven years at 7.75
percent. The principal is to be repaid in equal installments over the life of the loan. At this point,
Dorchester is uncertain whether to raise the remaining debt it desires through a domestic bond issue or
a Eurodollar bond issue. It believes it can borrow pounds sterling at 10.75 percent per annum and
dollars at 9.5 percent. Dorchester estimates its all-equity cost of capital to be 15 percent.
The U.S. Internal Revenue Service will allow Dorchester to depreciate the new facility over a seven
year period.
After that time the confectionery equipment, which accounts for the bulk of the
investment, is expected to have substantial market value.
Dorchester does not expect to receive any special tax concessions. Further, because the corporate
tax rates in the two countries are the same--35 percent in the U.K. and in the U.S.--transfer pricing
IM-141
strategies are ruled out.
Should Dorchester build the new manufacturing plant in the United States?
Suggested Solution to Dorchester Ltd.
Summary of Key Information
The current exchange rate in European terms is So(£/$) = 1/1.50 = .6667.
The initial cost of the project in British pounds is SoCo = £0.6667($7,000,000) =
£4,666,900.
The U.K. inflation rate is estimated at 4.5% per annum, or the mid-point of the 4%-5% range. The
U.S. inflation rate is forecast at 3% per annum. Under the simplifying assumption that PPP holds S t
= .6667(1.045)t/(1.03)t.
The before-tax nominal contribution margin per unit at t=1 is $4.40(1.03)t-1.
It is assumed that Dorchester will be able to sell one-fifth of the 290,000 pounds of candy it presently
sells to North America in Eastern Europe the first year the new manufacturing facility is in operation;
two-fifths the second year; etc.; and all 290,000 pounds beginning the fifth year.
The contribution margin on lost sales per pound in year t equals £3.00(1.045)t.
Terminal value will initially be assumed to equal zero.
Straight line depreciation over the seven year economic life of the project is assumed:
Dt =
$1,000,000 = $7,000,000/7 years.
The marginal tax rate, , is the U.K. (or U.S.) rate of 35%.
Dorchester will borrow $1,500,000 at the concessionary loan rate of 7.75% per annum. Optimally,
Dorchester should borrow the remaining funds it needs, £1,000,000, in pounds sterling because
according to the Fisher equation, the real rate is less for borrowing pounds sterling than it is for
borrowing dollars:
5.98% or .0598 = (1.1075)/(1.045) - 1.0 versus
6.31% or .0631 = (1.095)/(1.03) - 1.0.
Kud = 15%.
IM-142
Calculation of the Present Value of the After-Tax Operating Cash Flows
St x
Year
(t)
St
Quantity
Quantity
Quantity
Quantity
x $4.40
Lost
Lost Sales
x (1.03)t-1
Sales
x £3.00
S t OCF t
S t OCF t ( 1 -  )
( 1+ K ud )t
x (1.045)t
(a)
(b)
(a + b)
£
£
£
£
1
.6764
390,000
1,160,702
(232,000)
(696,000)
464,702
262,658
2
.6863
409,500
1,273,673
(174,000)
(545,490)
728,183
357,897
3
.6963
429,975
1,397,548
(116,000)
(380,025)
1,017,523
434,875
4
.7064
451,474
1,533,373
(58,000)
(198,563)
1,334,810
496,068
5
.7167
474,048
1,682,524
0
0
1,682,524
543,733
6
.7271
497,750
1,846,053
0
0
1,846,053
518,765
7
.7377
522,638
2,025,613
0
0
2,025,613
494,977
3,108,972
IM-143
Calculation of the Present Value of the Depreciation Tax Shields
Year
(t)
St
Dt
S t  Dt
( 1+ i d )t
$
£
1
.6764
1,000,000
213,761
2
.6863
1,000,000
195,837
3
.6963
1,000,000
179,404
4
.7064
1,000,000
164,340
5
.7167
1,000,000
150,552
6
.7271
1,000,000
137,911
7
.7377
1,000,000
126,340
1,168,146
IM-144
Calculation of the Present Value of the Concessionary Loan Payments
Year
(t)
St
(a)
Principal
Payment
It
(b)
(c)
S t LPt
S t LPt
t
(1+i d )
$
$
(a) x (b + c)
£
£
1
.6764
214,286
116,250
330,536
201,873
2
.6863
214,286
99,643
313,929
175,654
3
.6963
214,286
83,036
297,321
152,402
4
.7064
214,286
66,429
280,714
131,808
5
.7167
214,286
49,821
264,107
113,605
6
.7271
214,286
33,214
247,500
97,523
7
.7377
214,286
16,607
230,893
83,346
1,500,000
956,211
Calculation of the Present Value of the Benefit from the Concessionary Loan
T
S t LPt =£0.6667 x $1,500,000 - £956,211 = £43,839
t
t =1 ( 1 + i d )
S o CLo - 
IM-145
Calculation of the Present Value of the Interest Tax Shields
from the $1,500,000 Concessionary Loan
Year
(t)
St
It
St  I t
(a)
(b)
(a x b x )
$
£
£
St  I t
t
(1+i d )
1
.6764
116,250
27,521
24,850
2
.6863
99,643
23,935
19,514
3
.6963
83,036
20,236
14,897
4
.7064
66,429
16,424
10,917
5
.7167
49,821
12,497
7,501
6
.7271
33,214
8,452
4,581
7
.7377
16,607
4,288
2,098
84,357
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Calculation of the Present Value of the Interest Tax Shields
from the £1,000,000 Bond Issue
Year
(t)
 It
Outstanding
Loan
Balance
Principal
Payment
Interest
Payment
£
£
£
£
1
1,000,000
0
107,500
33,973
2
1,000,000
0
107,500
30,675
3
1,000,000
0
107,500
27,698
4
1,000,000
0
107,500
25,009
5
1,000,000
0
107,500
22,582
6
1,000,000
0
107,500
20,390
7
1,000,000
1,000,000
107,500
18,411
( 1+ i d )t
178,738
IM-147
Without considering the terminal value of the project, the APV of the project is negative:
APV = £3,108,972 + 1,168,146 + 43,839 + 84,357 + 178,738 - 4,666,900 =
-£82,848).
Dorchester should not go ahead with its plans to build a manufacturing plant in the U.S. unless the
terminal value is likely to be large enough to yield a positive APV. The terminal value of the project
must be $298,736 in order for the APV to equal zero. This is calculated as follows. Set
STTVT/(1+Kud)T = £82,848. This implies
TVT = (£82,848/ST)(1+Kud)T
= (£82,848/.7377)(1.15)7
= $298,736.
Since the terminal value is expected to be substantial, and the initial cost of the project is $7,000,000,
it appears likely that the terminal value will be sufficient to yield a positive APV. Thus, Dorchester
should go ahead with its plans to build a manufacturing plant in the U.S.
IM-148
MINI-CASE: STRIK-IT-RICH GOLD MINING COMPANY
The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so it will
need to purchase land that its geologists believe is rich in gold. Strik-it-Rich’s management believes
that the expansion will allow it to mine and sell an additional 2000 troy ounces of gold per year. The
expansion, including the cost of the land, will cost $500,000. The current price of gold bullion is $275
per ounce and one-year gold futures are trading at $291.50 = $250(1.06). Extraction costs are $225
per ounce. The firm’s cost of capital is 10%. At the current price of gold, the expansion appears
profitable: NPV = ($275 – 225) x 2000/.10 - $500,000 = $500,000. Strik-it-Rich’s management is,
however, concerned with the possibility that large sales of gold reserves by Russia and the United
Kingdom will drive the price of gold down to $240 for the foreseeable future. On-the-other-hand,
management believes there is some possibility that the world will soon return to a gold reserve
international monetary system. In the latter event, the price of gold would increase to at least $310 per
ounce. The course of the future price of gold bullion should become clear within a year. Strik-it-Rich
can postpone the expansion for a year by buying a purchase option on the land for $25,000. What
should Strik-it-Rich’s management do?
Suggested Solution to Strik-it-Rich Gold Mining Company
There is considerable risk in expanding operations at the present time, even though the NPV based on
the current price of gold is a positive $500,000. If the price of gold falls to $240 per ounce, the NPV =
($240 – 225) x 2000/.10 - $500,000 = -$200,000. On-the-other-hand, if the price of gold increases to
$310, the NPV is a very attractive NPV= ($310 – 225) x 2000/.10 - $500,000 = $1,200,000. The
purchase option for $25,000 on the land is a relatively small amount to have the opportunity to
postpone the decision until additional information is learned. Obviously, Strik-it-Rich’s management
will only invest if the NPV is positive. The risk-neutral probability of gold increasing to $310 per
ounce is:
q = (F0 - S0·d)/S0(u – d) = (291.50 – 240)/(310 – 240) = .7357.
Thus, the value of the timing option to postpone the decision one year is:
C = .7357($1,200,000)/(1.06) = $832,868.
Since this amount is substantially in excess of the $25,000 cost of the purchase option on the land,
Strik-it-Rich’s management should definitely take advantage of the timing option it is confronted with
to wait and see what the price of gold is in one year before it makes a decision to expand operations.
IM-149
CHAPTER 18 MULTINATIONAL CASH MANAGEMENT
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Describe the key factors contributing to effective cash management within a firm. Why is the cash
management process more difficult in a MNC?
Answer: An effective cash management system should be based on a cash budget that projects
expected cash inflows and outflows over some planning horizon. It provides for the systematic receipt
and disbursement of cash. It also provides for funds mobilization, where cash shortages are covered
by borrowing at the most favorable rates and surplus funds are invested at the most advantageous
rates. Within a MNC the complexity of the cash management process is compounded because the
firm does business in a variety of currencies, and hence the cost of foreign exchange transactions is an
additional dimension to be managed.
2. Discuss the pros and cons of a MNC having a centralized cash manager handle all investment and
borrowing for all affiliates of the MNC versus each affiliate having a local manager who performs the
cash management activities of the affiliate.
Answer: Under a centralized cash management system, the cash manager will have a global view of
the cash requirements of the MNC. There will be less chance that funds will be mislocated, i.e.,
denominated in the wrong currency. Additionally, under a global view, transaction exposure for the
MNC can be more efficiently managed. Moreover, a centralized system readily allows for investing
excess cash at the most advantageous rates and borrowing to cover cash shortages at the most
favorable rates.
Under a decentralized system, the local cash manager is given more responsibility for managing the
cash needs of the affiliate than under a centralized system. Consequently, the local cash management
position serves as good training for higher level positions within the affiliate or MNC. Also, under a
decentralized system, local bank relationships are better developed since the affiliate conducts more of
its cash management functions at the local level. This may prove important if funds need to be
borrowed locally. But overall, the benefits of a centralized cash management system tend to outweigh
its disadvantages.
3. How might a MNC use transfer pricing strategies? How do import duties affect transfer pricing
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policies?
Answer: A MNC might use transfer pricing strategies for two basic purposes: income tax liability
reduction or funds repositioning. If the tax rate in the country of the selling affiliate is less than the tax
rate in buying affiliate country, a high markup policy on sales will leave little taxable income in the
buying affiliate country to be taxed at the higher rate. Even if the tax rate in the buying affiliate
country is not more than that in the selling affiliate country, a high markup policy will leave less funds
to be removed from the buying affiliate country. In general, import duties work in the opposite
direction from income taxes. For example, a high markup policy will decrease the income taxes due
in the buying affiliate country, but increase the import duty due in that country. Generally, the income
tax is more important in comparison to the import duty in its after-tax effect on consolidated net
income.
4. What are the various ways the taxing authority of a country might use to determine if a transfer
price is reasonable?
Answer: The U.S. and many other countries require the transfer price to be consistent with arm’s
length pricing, i.e., be a price that an unrelated party would pay for the same good or service. The
taxing authority can arbitrarily set the transfer price if it believes that transfer pricing schemes are
being used to evade taxes or that taxable income is not being clearly reflected. There are three general
methods to establish arm’s length pricing. One method is to use a comparable uncontrolled price at
which the good or service would be priced between unrelated parties. A second method is the resale
price approach; that is, reduce the price at which the good is resold by an amount sufficient to cover
overhead costs and a reasonable profit for the selling affiliate. The third method is the cost-plus
approach, where an appropriate profit is added to the cost of the manufacturing affiliate.
5. Discuss how a MNC might attempt to repatriate blocked funds from a host country?
Answer: There are several methods a parent firm might use to repatriate profits from an affiliate in a
host country that is blocking funds. Some of these measures should be enacted early on as a guard
against future funds blockage. One is to establish a regular dividend policy that the host country
becomes used to and expects. This assumes, however, the host country will let a reasonable amount of
funds be repatriated. If this is not the case, the parent firm might attempt to use a high markup policy
transfer pricing scheme. Since host countries are aware of transfer pricing strategies, a large change in
the transfer price is likely not to go unquestioned by the host country. Thus, the parent firm should
establish early on recognition of, and payment for, specific services that are being provided by the
IM-151
affiliate in addition to payment at an arm’s length price for the physical goods. For example, the
parent firm might charge for a share of worldwide advertising, technical training of employees of the
affiliate, appropriate overhead charges, or a royalty or licensing fee for use of well-recognized brand
names, technology, or patents. The host country might accept these charges as reasonable, whereas a
large transfer price that incorporates all charges into a single price might be questioned as
unreasonably large. Additionally, the parent firm can create exports, by having the affiliate charged in
the blocked currency for goods and services for which the parent would typically pay, or through
direct negotiation appeal to the host country for more reasonable treatment, if it is in an important
industry to the host country.
IM-152
PROBLEMS
1. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A is
25 percent and the marginal income tax rate for Affiliate B is 40 percent. The transfer price per unit is
currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive a formula to
determine how much annual after-tax profits can be increased by selecting the optimal transfer price.
Note To Instructor: The solution to this problem is consistent with the example presented in the text
as Exhibit 18.13.
Solution: Let A and B be the marginal income tax rate for Affiliate A and B. Further let Q denote
quantity, and let P be the current transfer price per unit and P* be the optimal transfer price per unit.
The increase in annual after-tax profit (or the tax savings) can be stated as Q(P - P*)(A - B). For each
unit there is a tax savings of (A - B) on (P - P*). Using the above numbers, there is a tax savings of
(.25 - .40) = .15 for each additional dollar of cost transferred from the low tax affiliate to the high tax
affiliate. Thus, at the maximum there can be a $60 = ($2,000 - 2,400)(.25 - .40) tax savings per unit
from raising the transfer price from $2,000 to $2,400. In total, the tax savings is 5,000 units x $60 =
$300,000.
2. Affiliate A sells 5,000 units to Affiliate B per year. The marginal income tax rate for Affiliate A is
25 percent and the marginal income tax rate for Affiliate B is 40 percent. Additionally, Affiliate B
pays a tax-deductible tariff of 5 percent on imported merchandise. The transfer price per unit is
currently $2,000, but it can be set at any level between $2,000 and $2,400. Derive (a) a formula to
determine the effective marginal tax rate for Affiliate B and, (b) a formula to determine how much
annual after-tax profits can be increased by selecting the optimal transfer price.
Note to Instructor: The solution to this problem is consistent with the example presented in the text as
Exhibit 18.14.
Solution: This problem extends the work in problem 1, above. When the ad-valorem import tariff is
tax deductible, the effective marginal tax rate paid by Affiliate B is:
(1 + Tariff)B - Tariff = (1 + .05)(.40) - .05 = .37. Hence, for each additional dollar of cost transferred
from the low tax affiliate to the high tax affiliate there is an after-tax savings of: (P - P*)[A + Tariff (1 + Tariff) B]. In total, the tax savings is:
Q(P - P*)[A + Tariff - (1 + Tariff) B] = 5,000 x ($2,000 - 2,400)(.25 - .37) = 5,000 x $48 = $240,000.
IM-153
MINI CASE 1: EFFICIENT FUNDS FLOW AT EASTERN TRADING COMPANY
The Eastern Trading Company of Singapore purchases spices in bulk from around the world,
packages them into consumer size quantities and sells them through sales affiliates in Hong Kong, the
United Kingdom and the United States. For a recent month, the following payments matrix of
interaffiliate cash flows, stated in Singapore dollars, was forecasted. Show how Eastern Trading can
use multilateral netting to minimize the foreign exchange transactions necessary to settle interaffiliate
payments. If foreign exchange transactions cost the company .5 percent, what savings result from
netting?
Eastern Trading Company Payments Matrix (S$000)
Disbursements
Receipts
Singapore
Hong Kong
U.K.
U.S.
Total
Receipts
Singapore
--
40
75
55
170
Hong Kong
8
--
--
22
30
U.K.
15
--
--
17
32
U.S.
11
25
9
--
45
Total disbursements
34
65
84
94
277
IM-154
Suggested Solution to Mini Case 1: Efficient Funds Flow at Eastern Trading Company
S$8
Singapore
S$40
Hong Kong
S$11
S$15
S$75
S$25
S$22
S$55
S$9
United
Kingdom
S$17
United
States
Bilateral Netting
Singapore
S$32
S$60
Hong Kong
S$3
S$44
United
Kingdom
S$8
IM-155
United
States
Multilateral Netting
Singapore
S$35
Hong Kong
S$52
S$49
United
States
United
Kingdom
Without netting, S$277,000 of interaffiliate foreign exchange transactions occur among the four
affiliates of Eastern Trading. With multilateral netting, interaffiliate foreign exchange transactions
are reduced to S$136,000, or by S$141,000. The savings are .005 x S$141,000 = S$705 for the
planning period.
IM-156
MINI CASE 2:
EASTERN TRADING COMPANY’S OPTIMAL TRANSFER PRICING
STRATEGY
The Eastern Trading Company of Singapore ships prepackaged spices to Hong Kong, the United
Kingdom, and the United States, where they are resold by sales affiliates.
Eastern Trading is
becoming concerned with what might happen in Hong Kong now that control has been turned over to
China. Eastern Trading has decided that it should reexamine its transfer pricing policy with its Hong
Kong affiliate as a means of repositioning funds from Hong Kong to Singapore. The following table
shows the present transfer pricing scheme, based on a carton of assorted, prepackaged spices, which is
the typical shipment to the Hong Kong sales affiliate. What do you recommend that Eastern Trading
should do?
Eastern Trading Company Current Transfer Pricing
Policy with Hong Kong Sales Affiliate
Singapore
Parent
Hong Kong
Affiliate
Consolidated
Company
S$300
S$500
S$500
Cost of goods sold
200
300
200
Gross profit
100
200
300
Operating expenses
50
50
100
Taxable income
50
150
200
Income taxes (31%/16.5%)
16
25
41
Net income
34
125
159
Sales revenue
IM-157
Suggested Solution to Mini Case 2: Eastern Trading Company’s Optimal Transfer Pricing Strategy
Eastern Trading is currently in a good situation. Because the income tax rate in Hong Kong is less
than in Singapore, Eastern Trading’s present low markup transfer price strategy results in larger pretax income in Hong Kong, which is taxed at only a 16.5% rate versus the 31% rate on taxable income
in Singapore. If Eastern Trading is free to repatriate profits from Hong Kong, it defers paying the
additional tax due (31% - 16.5% = 14.5%) in Singapore until the profits are actually repatriated.
Nevertheless, the marginal tax rate on Hong Kong taxable income will eventually be 31% upon
repatriation.
Since Eastern Trading is concerned about 1997, it should attempt to increase its transfer price at the
current time. If successful in being able to change the transfer price, more of the taxable income per
unit will be taxed at the current time in Singapore at 31%. This is better than postponing a change to a
high markup transfer price strategy, which may be more difficult to change later under the communist
Chinese. It is better to have the new transfer price already firmly established. Moreover, given the
current political climate, Eastern Trading might meet with little resistance from the Hong Kong
authorities in changing to a high markup policy, since capital flight in a variety of forms is taking
place. A 25% increase in the transfer price would raise it from S$300 to S$375 per unit. At S$375,
the split would be as follows:
Eastern Trading Company Current Transfer Pricing
Policy with Hong Kong Sales Affiliate
Singapore
Parent
Hong Kong
Affiliate
Consolidated
Company
S$375
S$500
S$500
Cost of goods sold
200
375
200
Gross profit
175
125
300
Operating expenses
50
50
100
Taxable income
125
75
200
Income taxes (31%/16.5%)
39
12
51
Net income
86
63
149
Sales revenue
IM-158
MINI CASE 3: EASTERN TRADING COMPANY’S NEW M.B.A.
The Eastern Trading Company of Singapore presently follows a decentralized system of cash
management where it and its affiliates each maintains its own transaction and precautionary cash
balances. Eastern Trading believes that it and its affiliates’ cash needs are normally distributed and
independent from one another. It is corporate policy to maintain two and one-half standard deviations
of cash as precautionary holdings. At this level of safety there is a 99.37 percent chance that each
affiliate will have enough cash holdings to cover transactions.
A new MBA hired by the company claims that the investment in precautionary cash balances is
needlessly large and can be reduced substantially if the firm converts to a centralized cash
management system. Use the projected information for the current month, which is presented below,
to determine the amount of cash Eastern Trading needs to hold in precautionary balances under its
current decentralized system and the level of precautionary cash it would need to hold under a
centralized system. Was the new MBA a good hire?
Affiliate
Expected
Transactions
One Standard
Deviation
Singapore
S$125,000
S$40,000
Hong Kong
60,000
25,000
United Kingdom
95,000
40,000
United States
70,000
35,000
Suggested Solution to Mini Case 3: Eastern Trading Company’s New M.B.A.
Affiliate
Expected
Transactions (a)
One Standard
Deviation
(b)
Expected Needs plus
Precautionary (a +
2.5b)
Singapore
S$125,000
S$45,000
S$237,500
Hong Kong
60,000
25,000
122,500
United Kingdom
95,000
40,000
195,000
United States
70,000
35,000
157,500
S$712,500
Total
S$350,000
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Eastern Trading is holding S$350,000 to cover expected transactions and S$362,500 as
precautionary balances among the four affiliates.
In total, it is holding S$712,500 under its
decentralized cash management system.
If Eastern Trading views its cash needs from a portfolio perspective under a centralized cash
management system, one portfolio standard deviation of cash would be:
Portfolio = (S $45,000 ) 2 + (S $25,000 ) 2 + (S $40,000 ) 2 + (S $35,000 ) 2
Std . Dev .
= S $73,993
Hence, under a centralized system, Eastern Trading would continue to need S$350,000 to cover
expected transactions, but precautionary cash balances could be reduced to $184,983 (= 2.5 x
S$73,993). Thus, the investment in precautionary cash can be reduced by S$177,517 (= S$362,500 184,983). The new MBA was a good hire.
IM-160
CHAPTER 19 TRADE FINANCING
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Discuss some of the reasons why international foreign trade is more difficult and risky from the
exporter’s perspective than is domestic trade.
Answer: International trade is more difficult and risky for a firm than is domestic trade. In foreign
trade, the exporter may not be familiar with the buyer, and thus not know if the importer is
creditworthy. If merchandise is exported abroad and the buyer does not pay, it may prove difficult, if
not impossible, for the exporter to have any legal recourse. Additionally, political instability makes it
risky to ship merchandise abroad to certain parts of the world.
2. What three basic documents are necessary to conduct a typical foreign commerce trade? Briefly
discuss the purpose of each.
Answer: The three basic documents necessary to conduct a typical foreign commerce trade are: letter
of credit, time draft, and a bill of lading. A letter of credit (L/C) is a guarantee from the importer’s
bank that it will act on behalf of the importer and pay the exporter for the merchandise if all relevant
documents specified in the L/C are presented according to the terms of L/C. A time draft is a written
order instructing the importer or his agent, the importer’s bank, to pay the amount specified on its face
on a certain date. A bill of lading (B/L) is a document issued by the common carrier specifying that it
has received the goods for shipment; it can serve as title to the goods.
3. How does a time draft become a banker’s acceptance?
Answer: When the goods are shipped by the exporter via common carrier, the exporter’s bank
presents the shipping documents and the time draft to the importer’s bank. After taking title to the
goods via the bill of lading, the importer’s bank accepts the time draft, creating at this point a
banker’s acceptance (B/A). A B/A is a money market instrument for which a secondary market exists.
4. What is a forfaiting transaction?
Answer: Forfaiting is a form of medium-term trade financing used to finance the sale of capital
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goods. A forfaiting transaction involves the sale by the exporter of promissory notes signed by the
exporter in favor of the importer. The forfait, usually a bank, buys the notes at a discount from face
value. The forfait does not have recourse against the exporter in the event of default by the importer.
The promissory notes typically extend out in a series over a period of three to five years, with a note in
the series maturing every six months.
5. What is the purpose of the Export-Import Bank?
Answer: The Export-Import Bank (Eximbank) of the United States was founded as an independent
government agency to facilitate and finance U.S. export trade. Eximbank’s purpose is to provide
financing in situations where private financial institutions are unable or unwilling because: i) the loan
maturity was too long; ii) the amount of the loan was too large; iii) the loan risk was too great; and,
iv) where the importing firm had difficulty obtaining hard currency for payment.
To meet its
objectives, Eximbank provides service through three types of programs: direct loans to foreign
borrowers, loan guarantees, and credit insurance.
6.
Do you think that a country’s government should assist private business in the conduct of
international trade through direct loans, loan guarantees, and/or credit insurance?
Answer: When a country’s government offers below-market financing directly to foreign importers,
or offers loan guarantees to domestic banks financing the foreign import, or provides low cost credit
insurance to U.S. exporters to alleviate the commercial and political risk in the sale, it is using
taxpayers’ money to subsidize foreign trade. Consequently, the foreign trade is not paying for itself.
Nevertheless, if most governments of developed countries offer such assistance to their domestic
exporters, it is difficult for one to refuse if the country desires to have its export-oriented industries
remain competitive.
7. Briefly discuss the various types of countertrade.
Answer: Countertrade is an umbrella term used to describe six types of international trade: barter,
clearing arrangement, switch trading, buy-back, counterpurchase, and offset. The first three do not
involve the use of money, whereas the later three do.
Barter is the direct exchange of goods between two parties. While money does not exchange hands
in a barter transaction, it is common to value the goods each party exchanges in an agreed-upon
currency. A clearing arrangement is a form of barter in which the counterparties contract to purchase
a certain amount of goods and services from one another. Both parties set up accounts with each other
IM-162
that are debited whenever one country imports from the other. The clearing arrangement introduces
the concept of credit to barter transactions, and means bilateral trade can take place that does not have
to be immediately settled. A switch trade is the purchase by a third party of one country’s clearing
agreement imbalance for hard currency, which is in turn resold. The second buyer uses the account
balance to purchase goods and services from the original clearing agreement counterparty who had the
account imbalance.
A buy-back transaction involves a technology transfer via the sale of a manufacturing plant. As part
of the transaction, the seller agrees to purchase a certain portion of the plant output once it is
constructed. First, the plant buyer borrows hard currency in the capital market to pay the seller for the
plant. Second, the plant seller agrees to purchase enough of the plant output over a period of time to
enable the buyer to pay back the borrowed funds. A counterpurchase is similar to a buy-back
transaction, but with some notable differences. The major difference between a buy-back and a
counterpurchase transaction is that in the latter, the buyer agrees to purchase unrelated merchandise
that has not been produced on the exported equipment. The seller agrees to purchase goods from a list
drawn up by the importer at prices set by the importer. The list frequently includes items the buyer
may be experiencing difficulty in selling. An offset transaction can be viewed as a counterpurchase
trade agreement involving the aerospace/defense industry.
8. Discuss some of the pros and cons of countertrade from the country’s perspective and the firm’s
perspective.
Answer: Arguments both for and against countertrade transactions can be made. There are both
negative and positive incentives for a country to be in favor of countertrade. Negative incentives are
those that are forced upon a country or corporations whether or not they desire to engage in
countertrade. Negative reasons include: the conservation of cash and hard currency, the improvement
of trade imbalances, and the maintenance of export prices. Positive reasons from both the country and
corporate perspectives include: enhanced economic development, increased employment, technology
transfer, market expansion, increased profitability, less costly sourcing of supply, reduction of surplus
goods from inventory, and the development of marketing expertise.
Those against countertrade transactions claim that such transactions tamper with the fundamental
operation of free markets, and therefore, resources are used inefficiently. Opponents claim that
transaction costs are increased, that multilateral trade is restricted through fostering bilateral trade
agreements, and that, in general, transactions that do not make use of money represent a step
backwards in economic development.
IM-163
PROBLEMS
1. Assume the time from acceptance to maturity on a $2,000,000 bankers’ acceptance is 90 days.
Further assume the importing bank’s acceptance commission is 1.25 percent and that the market rate
for 90-day B/As is 7.00 percent. Determine the amount the exporter will receive if he holds the B/A
until maturity and also the amount the exporter will receive if he discounts the B/A with the importer’s
bank.
Solution: The exporter will receive $1,993,750 = $2,000,000 x [1 - (.0125 x 90/360)] if he holds the
B/A to maturity. The acceptance commission is $6,250. The exporter will receive $1,958,750 =
$2,000,000 x [1 - ((.0700 + .0125) x 90/360)] if he discounts the B/A with the importer’s bank.
2. The time from acceptance to maturity on a $1,000,000 banker’s acceptance is 120 days. The
importer’s bank’s acceptance commission is 1.75 percent and the market rate for 120-day B/As is 5.75
percent. What amount will the exporter receive if he holds the B/A until maturity? If he discounts the
B/A with the importer’s bank? Also determine the bond equivalent yield the importer’s bank will
earn from discounting the B/A with the exporter. If the exporter’s opportunity cost of capital is 11
percent, should he discount the B/A or hold it to maturity?
Solution:
If the exporter holds the B/A until maturity, he will receive $994,166.67 =
$1,000,000 x [1 - (.0175 x 120/360)]. Thus, the acceptance commission is $5,833.33.
If the exporter discounts the B/A he will receive $975,000 = $1,000,000
x [1 - ((.0575 + .0175) x 120/360)].
The importer’s bank receives a discount rate of interest of 7.5 percent
(= 5.75 + 1.75 percent) on its investment. At maturity it will receive $1,000,000 from the importer.
The bond equivalent yield the importer’s bank earns on its investment is 7.8 percent, or .078 =
($1,000,000/$975,000 - 1) x 365/120.
The exporter pays the acceptance commission regardless of whether he discounts the B/A or holds it
to maturity. The bond equivalent rate the exporter receives from discounting the B/A is 5.98 percent,
or .0598 = ($994,166.67/$975,000 - 1) x 365/120. Since the exporter’s opportunity cost of capital is
11 percent, which is greater than 5.98 percent compounded tri-annually (an effective annual rate of
6.10 percent), he should discount the B/A.
IM-164
MINI CASE: AMERICAN MACHINE TOOLS, INC.
American Machine Tools is a Midwestern manufacturer of tool-and-die-making equipment. The
company has had an inquiry from a representative of the Estonian government about the terms of sale
for a $5,000,000 order of machinery. The sales manager spoke with the Estonian representative, but
he is doubtful that the Estonian government will be able to obtain enough hard currency to be able to
make the purchase. While the U.S. economy has been growing, American Machine Tools has not had
a very good year. An additional $5,000,000 in sales would definitely help. If something cannot be
arranged, the firm will likely be forced to lay off some of its skilled work force.
Is there a way that you can think of that American Machine Tools might be able to make the
machinery sale to Estonia?
Suggested Solution to American Tools, Inc.
American Machine Tools needs a manager in charge of countertrade. This manage would be skilled
in negotiating trades for his firm’s machine tools. Since the U.S. economy is fairly strong, there are
two types of countertrades that might work with the Estonian government and help American Machine
Tools consummate the sale: a buy-back transaction or a countertrade.
In a buy-back transaction, the Estonian government would issue debt denominated in a hard currency
to obtain the funds to purchase the equipment from American Machine Tools. It should be able to
obtain hard currency debt financing if it is likely that it can service the debt. American Machine
Tools, in turn, would agree to buy in dollars from the Estonian tool and die manufacturer enough of
the output produced on the machinery to enable it to meet the debt service obligations. A countertrade
works similarly, except that American Machine Tools would agree to purchase enough other goods
produced in Estonia to enable the hard currency debt service obligations to be met. Either of these two
types of countertrade would work if American Machine Tools has the sales ability to market the
Estonia output in the U.S., or elsewhere.
IM-165
CHAPTER 20 INTERNATIONAL TAX ENVIRONMENT
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Discuss the twin objectives of taxation. Be sure to define the key words.
Answer: There are two basic objectives of taxation that are necessary to discuss to help frame our
thinking about the international tax environment: tax neutrality and tax equity.
Tax neutrality has its foundations in the principles of economic efficiency and equity.
neutrality is determined by three criteria.
Tax
Capital-export neutrality is the criterion that an ideal tax
should be effective in raising revenue for the government and not have any negative effects on the
economic decision making process of the taxpayer. That is, a good tax is one that is efficient in
raising tax revenue for the government and does not prevent economic resources from being allocated
to their most appropriate use no matter where in the world the highest rate of return can be earned. A
second neutrality criterion is national neutrality. That is, regardless of where in the world taxable
income is earned it is taxed in the same manner by the taxpayer’s national tax authority. In theory,
national tax neutrality is a commendable objective, as it is based on the principle of equality. The
third neutrality criterion is capital-import neutrality. This criterion implies that the tax burden placed
on the foreign subsidiary of a MNC by the host country should be the same regardless in which
country the MNC is incorporated and the same as that placed on domestic firms.
Tax equity is the principle that all similarly situated taxpayers should participate in the cost of
operating the government according to the same rules. This means that regardless in which country an
affiliate of a MNC earns taxable income, the same tax rate and tax due date apply.
2. Compare and contrast the three basic types of taxation that governments levy within their tax
jurisdiction.
Answer: There are three basic types of taxation that national governments throughout the world use in
generating tax revenue: income tax, withholding tax, and value-added tax. Many countries in the
world obtain a significant portion of their tax revenue from imposing an income tax on personal and
corporate income. An income tax is a direct tax, that is, one that is paid directly by the taxpayer on
whom it is levied. The tax is levied on active income, that is, income that results from production by
the firm or individual or from services that have been provided. A withholding tax is a tax levied on
passive income earned by an individual or corporation of one country within the tax jurisdiction of
IM-166
another country. Passive income includes dividends and interest income, and income from royalties,
patents or copyrights paid to the taxpayer. A withholding tax is an indirect tax, that is, a tax borne by
a taxpayer that did not directly generate the income that serves as the source of the passive income.
The tax is withheld from payments the corporation makes to the taxpayer and turned over to the local
tax authority. A value-added tax (VAT) is an indirect national tax charged on the sales price of a
service or consumption good as it moves through the various stages of production and/or service. As
such, a VAT is a sales tax borne by the final consumer.
3. Show how double taxation on a taxpayer may result if all countries were to tax the worldwide
income of their residents and the income earned within their territorial boundaries.
Answer: There are two fundamental types of tax jurisdiction: the worldwide and the territorial. The
worldwide method of declaring a national tax jurisdiction is to tax national residents of the country on
their worldwide income no matter in which country it is earned. The territorial method of declaring a
tax jurisdiction is to tax all income earned within the country by any taxpayer, domestic or foreign.
Hence, regardless of the nationality of a taxpayer, if the income is earned within the territorial
boundary of a country it is taxed by that country.
If a MNC was a resident of a country that taxed worldwide income, the foreign-source income of its
foreign affiliates would be taxed in the parent country. If the host country also taxes the income of the
affiliate earned within its territorial borders, the foreign affiliate would pay taxes on the same income
both in the host country and in the parent country. To avoid this “evil,” some mechanism needs to be
established to prevent double taxation.
4. What methods do taxing authorities use to eliminate or mitigate the evil of double taxation?
Answer: The typical approach to avoiding double taxation is for a nation not to tax foreign-source
income of its national residents. An alternative method, and the one the U.S. follows, is to grant to the
parent firm foreign tax credits against U.S. taxes for taxes paid to foreign tax authorities on foreignsource income.
5. There is a difference in the tax liability levied on foreign-source income depending upon whether a
foreign branch or subsidiary form of organizational structure is selected for a foreign affiliate. Please
elaborate on this statement.
Answer: A foreign branch is not an independently incorporated firm separate from the parent, it is an
extension of the parent. Consequently, active or passive foreign-source income earned a the branch is
consolidated with the domestic-source income of the parent for determining the U.S. tax liability,
IM-167
regardless of whether or not the foreign-source income has been repatriated to the parent. A foreign
subsidiary is an affiliate organization of the MNC that is independently incorporated in the foreign
country, and one in which the U.S. MNC owns at least 10 percent of the voting equity stock. A
foreign subsidiary in which the U.S. MNC owns more than 10 but less than 50 percent of the voting
equity is a minority foreign subsidiary or a uncontrolled foreign corporation. Active and passive
foreign-source income derived from a minority foreign subsidiary is taxed in the U.S. only when
remitted to the U.S. parent firm via a dividend. A foreign subsidiary in which the U.S. MNC owns
more than 50 percent of the voting equity is a controlled foreign corporation. Active foreign-source
income from a controlled foreign corporation is taxed in the U.S. only as remitted to the U.S. parent,
but passive income is taxed in the U.S. as earned, even if it has not been repatriated to the parent.
IM-168
PROBLEMS
1. There are three production stages required before a pair of skies produced by Innsbruck Fabrication
retails for S2,300. Fill in the following table to show the value added at each stage in the production
process and the incremental and total VAT. The Austrian VAT rate is 20 percent.
_______________________________________________________________________
Production
Selling
Value
Incremental
Stage
Price
Added
VAT
_______________________________________________________________________
1
S 450
2
S1,900
3
S2,300
Total VAT
_______________________________________________________________________
Solution:
Production
Selling
Value
Incremental
Stage
Price
Added
VAT
_______________________________________________________________________
1
S 450
S 450
S 90
2
S1,900
S1,450
S290
3
S2,300
S 400
S 80
Total VAT S460
_______________________________________________________________________
IM-169
MINI CASE: SIGMA CORP.’S LOCATION DECISION
Sigma Corporation of Boston is contemplating establishing an affiliate operation in the
Mediterranean. Two countries under consideration are Spain and Cyprus. Sigma intends to repatriate
all after-tax foreign-source income to the United States. At this point, Sigma is not certain whether it
would be best to establish the affiliate operation as a branch operation or a wholly owned subsidiary of
the parent firm.
In Cyprus, the marginal corporate tax rate is 25 percent. Foreign branch profits are taxed at the same
rate. In Spain, corporate income is taxed at 35 percent, the same rate as in the U.S. Additionally,
foreign branch income in Spain is also taxed at 35 percent. The U.S. withholding tax treaty rates on
dividend income are 5 percent with Cyprus and 10 percent with Spain.
The financial manager of Sigma has asked you to help him determine where to locate the new
affiliate and which organization structure to establish. The location decision will be largely based on
whether the total tax liability would be smallest for a foreign branch or a wholly owned subsidiary in
Cyprus or Spain.
Suggested Solution for Sigma Corp.’s Location Decision
Foreign-source income of a foreign branch of a U.S. MNC in Cyprus would be taxed at a rate of 25
per cent in Cyprus. The after-tax foreign-source income would be grossed-up for U.S. tax purposes,
and income taxes at the rate of 35 percent would be levied in the U.S.. If the Cyprus affiliate was
established as a wholly owned subsidiary, the total (income and withholding) tax liability in Cyprus
would be: [.20 + .05 - (.20 x .05)] = .24, or 24 percent. Additional taxes in the U.S. would be due,
bringing the total tax liability up to the U.S. income tax rate of 35 percent.
Foreign-source income of a foreign branch of a U.S. MNC in Spain would be taxed at a rate of 35
per cent in Spain. Since the Spanish income tax rate and the U.S. income tax rate are both 35 percent,
no additional income taxes would be due in the U.S. on grossed-up foreign-source taxable income. If
the Spanish affiliate was a wholly owned subsidiary, the total (income and withholding) tax liability in
Spain would be: [.35 + .10 - (.35 x .10)] = .415, or 41.5 percent. Since this is greater than the U.S.
income tax rate of 35 percent, no additional taxes would be due in the U.S. If the excess foreign tax
credits (equal to 6.5 percent of foreign-source taxable income) could all be used by carrying them back
two years or forward five years, the total tax liability would be equal to the U.S. income tax rate of 35
percent. If the excess foreign tax credits cannot all be used, as is more typical, the total tax liability
could be as high as 41.5 percent.
Consequently, all else being equal, Sigma Corporation should be indifferent between establishing
either a wholly owned subsidiary or branch in Cyprus and a branch operation in Spain.
IM-170